Yoram Keinan Taxation of Financial Instruments

Integration

Transcript

1. Integration of a Debt Instrument and a Hedge (Reg. §1.1275-6)
2. Overview • The Regulations provide for the integration of a “qualifying debt instrument” with a “§1.1275-6 hedge” if the combined cash flows of the components are substantially equivalent to the cash flows on a fixed or variable rate debt instrument. Reg. §1.1275-6(a). • The integration creates a “synthetic debt instrument” which is a hypothetical debt instrument with the same cash flows as the combined cash flows of the qualified debt instrument and the §1.1275-6 hedge. Reg. §1.1275-6(b)(4). • A similar but separate set of rules exists with respect to integration of foreign currency-denominated debt instruments and hedges. Reg. §1.988-5.
3. Definition: Qualified Debt Instrument • A qualifying debt instrument (QDI) is any debt instrument, including a synthetic debt instrument arising from another integrated transaction, other than: (i) a tax-exempt obligation, as defined in IRC §1275(a)(3), (ii) a debt instrument to which IRC §1272(a)(6) applies, or (iii) a debt instrument that is subject to Reg. §1.483-4 or §1.1275-4(c) (certain CPDIs issued for nonpublicly traded property). Reg. §1.1275-6(b)(1).
4. Definition: §1.1275-6 Hedge • A “§1.1275-6 hedge” is any financial instrument if the combined cash flows of the QDI and the hedging instrument permit the calculation of a yield to maturity under the principles of IRC §1272, or the right to the combined cash flows would qualify as a VRDI that pays interest at a qualified floating rate or rates. Reg. §1.1275-6(b)(2). • A financial instrument is not a §1.1275-6 hedge if the resulting synthetic debt instrument does not have the same term as the remaining term of the QDI. • A financial instrument that hedges currency risk is not a §1.1275-6 hedge, but may be a hedge under Reg. §1.988-5. • A debt instrument can be a §1.1275-6 hedge only if it is issued substantially contemporaneously with, and has the same maturity as, the QDI. Reg. §1.1275-6(b)(2)(ii)(B).
5. Definitions: Financial Instrument • A “financial instrument” is a spot, forward, or futures contract, an option, a notional principal contract, a debt instrument, or a similar instrument, or combination or series of financial instruments. • Stock is not a financial instrument for this purpose. Reg. §1.1275-6(b)(3).
6. Example 1 • Debt: Holder of a 5 year debt instrument with $1,000 face, receiving a coupon of 5% semiannually. • Swap: 5-year term, notional amount of $1,000, paying fixed of 5% and receiving LIBOR, every 6 months. • Resulting Synthetic Debt: The holder is deemed to have a 5-year VRDI receiving LIBOR semiannually.
7. Example 2 • Debt: 10 years, principal amount of $1,000 (issued at par), convertible into 10 shares of the issuer’s stock, with a conversion value of $800 (e.g., convertible into 10 shares, spot rate $80). Cash coupon is 2.0%. • Hedge: Purchased American Style Call Option: the issuer has the right to receive a payment in cash or stock equal to the excess of the price of the issuer’s stock over the option’s exercise price, which is equal to the debt’s’ conversion price. The option premium equals 30% of the debt’s proceeds. • Result: the resulting synthetic debt will be treated as issued with OID equal to the amount of the purchased call premium (i.e., 30%, or $300 discount). Consequently, the issuer will be able to deduct the cash coupon plus the OID throughout the term of the debt. • The YTM is 6.04%, as opposed to 2.0% YTM with no integration.
8. Requirements for Integration • Identification on or before the hedge date. Reg. §1.1275-6(e). • None of the parties to the hedge are related or, if they are, the party providing the hedge marks the hedge (and other transactions) to market. • QDI and hedge are entered into by the same individual or entity. • If the taxpayer is a foreign person engaged in a U.S. trade or business and issues or acquires the QDI or enters into the hedge through that trade or business, income and expense associated with the debt or hedge (other than interest subject to Reg. §1.882-5) would be effectively connected with the U.S. trade or business if Reg. §1.1275-6 were not applied.
9. Requirements (cont’d) • Neither the QDI, nor other debt that is part of the same issue, nor the hedge were part of an integrated transaction that was terminated by the taxpayer under the legging out rules within 30 days immediately preceding the issue date of the synthetic debt. • The QDI is issued/acquired by the taxpayer on or before the date of the first payment on the hedge, or issued/ acquired after (but substantially contemporaneously with) the date of the first payment on the hedge. • Neither the hedge nor the QDI was part of a straddle prior to the issue date of the synthetic debt instrument.
10. Integration by the Commissioner • The Commissioner may require integration if a QDI and a financial instrument have, in substance, the same combined cash flows as a fixed or variable rate debt instrument. Reg. §1.1275- 6(c)(2). • The Commissioner may not integrate a transaction unless the QDI either is a CPDI or a VRDI that pays interest at an objective rate. So IRS can’t force integration of plain vanilla debt and a swap. • The Commissioner may integrate even if the taxpayer fails one or more of the integration requirements.
11. Integration by the Commissioner • Circumstances under which the Commissioner may require integration include: – (i) the taxpayer fails to properly identify a QDI and the §1.1275-6 hedge; – (ii) the taxpayer issues or acquires a QDI and a related party enters into the §1.1275-6 hedge; – (iii) the taxpayer issues or acquires a QDI and enters into the §1.1275-6 hedge with a related party; and – (iv) the taxpayer legs out of an integrated transaction and subsequently enters into a new §1.1275-6 hedge with respect to the same QDI or other debt that is part of the same issue. • Commissioner can’t override the fact that stock is not a financial instrument.
12. Taxation of Integrated Transactions • An integrated transaction is generally treated as a single transaction by the taxpayer, i.e., as if it actually issued or owned the synthetic debt instrument. • The separate components of an integrated transaction are not subject to rules that would otherwise apply to them on a separate basis, but the synthetic debt instrument may itself be subject to those rules. Reg. §1.1275-6(f)(1). • The issue date of the synthetic debt is the first date on which the taxpayer entered into all the components of the synthetic debt instrument. Reg. §1.1275-6(f)(2).
13. Taxation of Integrated Transactions (Cont.) • The term of the synthetic debt is the period beginning on the issue date of the synthetic debt and ending on the maturity date of the QDI. Reg. §1.1275-6(f)(3). Even if the synthetic debt has a term of 1 year or less, the instrument is not treated as a short-term obligation for purposes of exempting it from the OID rules. Reg. §1.1275-6(f)(10). • The issue price of the synthetic debt is the AIP of the QDI on the issue date of the synthetic debt. Reg. §1.1275-6(f)(4). • The AIP of the synthetic debt is determined in the manner of an instrument subject to the OID rules. Reg. §1.1275-6(f)(5).
14. Taxation of Integrated Transactions (Cont.) • No amounts payable on the synthetic debt are QSI. Reg. §1275-6(f)(6). • If the instrument is a borrowing, the SRPM is the sum of all amounts paid or to be paid on the QDI and the hedge, reduced by all amounts received or to be received on the hedge. Reg. §1.1275- 6(f)(7)(i). • If the instrument is held by the taxpayer, the SRPM is the sum of all amounts received or to be received on the QDI and the hedge, reduced by any amounts paid or to be paid on the hedge. Reg. §1.1275-6(f)(7)(ii).
15. Legging In • Legging into an integrated transaction means entering into the hedge after the QDI is issued/acquired. Reg. §1.1275-6(d)(1)(i). • The QDI is subject to the OID rules up to the leg-in date, except that the day before the leg-in date is treated as the end of an accrual period for purposes of computing OID and interest accruals on the QDI.
16. Legging In • After the leg-in, the QDI and the §1.1275-6 hedge are integrated. • Built-in gain or loss on the QDI is not treated as realized on the leg-in date but rather will be recognized over the term of the synthetic debt. Reg. §1.1275-6(d)(1)(ii). • If a taxpayer legs into an integrated transaction with a principal purpose of accelerating or deferring income or deductions, the Commissioner may treat the QDI as sold for its FMV on the leg-in date or refuse to allow the taxpayer to integrate the QDI and the §1.1275-6 hedge. Reg. §1.1275- 6(d)(1)(iii).
17. Legging Out • Legging out means disposing of or terminating the hedge or QDI prior to the synthetic instrument’s maturity. • Legging out can occur if the requirements for integration cease to be met or if the hedge is no longer a §1.1275-6 hedge. • If the taxpayer terminates both the QDI and hedge on the same day, it is treated as having disposed of or terminated the synthetic debt rather than legged out. Reg. §1.1275-6(d)(2)(i)(A). • The Commissioner may disallow a legging out if the taxpayer continues to meet the requirements for Commissioner integration. • If the Commissioner integrated the transaction, the taxpayer is treated as legging out only if it ceases to meet the requirements for Commissioner integration or the taxpayer fails to meet the requirements for taxpayer integration and the Commissioner allows to leg out. Reg. §1.1275-6(d)(2)(i)(B).
18. Legging Out (Cont’d) • If a taxpayer disposes of, or ceases to be primarily liable on, the QDI and hedge, in a single nonrecognition transaction, it is not treated as legging out and the integrated transaction is treated under the rules governing nonrecognition transaction. Reg. §1.1275-6(d)(2)(i)(C). • If a taxpayer legs out by disposing of the QDI or hedge before the leg out, the transaction is treated as an integrated transaction prior to leg out, the synthetic debt is treated as sold for its FMV, and any gain or loss is recognized immediately. Reg. §1.1275-6(d)(2)(ii)(A) and (B). • If immediately after legging out the taxpayer holds or remains primarily liable on the QDI, adjustments are made to reflect any difference between the QDI’s FMV and its AIP (which is determined without regard to the fact that the instrument was part of an integrated transaction).
19. Legging Out (cont’d) • If a debt issuer legs out of a hedge, it is necessary to apply concepts normally limited to secondary market holders. If, immediately after the taxpayer legs out, the taxpayer is a party to a hedge, the hedge is treated as entered into at its FMV. Reg. §1.1275-6(d)(2)(ii)(C). • If a holder of debt legs into an integrated transaction and subsequently legs out, any gain recognized is treated as interest income to the extent determined under the principles of Reg. §1.1275-4(b)(8)(iii)(B) (rules for determining the character of gain on the sale of a debt instrument all of the payments on which have been fixed). If the synthetic debt instrument would qualify as a VRDI, the equivalent fixed rate debt instrument determined under Reg. §1.1275-5(e) is used for this purpose. Reg. §1.1275-6(d)(2)(ii)(E).
20. Example 3 • K issues a 7% fixed rate debt instrument for $1000, its face amount. • Interest rates rise, so the debt is trading for $950 one year later. • K decides it wants to synthetically convert the debt to floating rate so enters into an interest rate swap and integrates. On the swap, K pays LIBOR and receives 6%. • On the legging in, gain of $50 is not recognized.
21. Example 3 (cont’d) • Some more time passes and interest rates rise further. Debt is now trading for $910 and the swap has a value of −$40. So the synthetic debt has retained its value of $950. K decides to terminate the swap by paying $40. K has legged out. • K does not recognize a $40 loss on the swap. Instead, K recognizes $50 of debt discharge income because the synthetic debt is deemed terminated for its value of $950. • K is deemed to have reissued the bond for $910, so K has $90 of OID to deduct over the life of the bond. The excess of the OID amount over the recognized gain accounts for the $40 swap termination payment.
22. Wash Sale Rules • To prevent taxpayers from inappropriately generating tax losses by legging into and immediately legging out of an integrated transaction, a special rule disallows losses if the taxpayer legs out within 30 days of legging into an integrated transaction. Reg. §1.1275- 6(d)(2)(ii)(D). This is similar to the “wash sale” rules, discussed later in the course. • An adjustment for the disallowed loss is made to the QDI and taken into account on a YTM basis over its remaining term.
23. Separate Transaction Rules • The Commissioner may publish guidance that requires use of separate transaction rules for any aspect of an integrated transaction. • In addition, two separate transaction instances are provided in the regulations. – Withholding tax and information reporting rules – Any rules affecting dealings with other taxpayers. Reg. §1.1275-6(f)(12).