Interest Rate Hedging and Related Issues
in a Rising Interest Rate Environment
Detroit TEI – December 9, 2014
William R. Pomierski
wpomierski@mwe.com
(312) 984-7531
www.mwe.com
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Agenda
 Common Interest Rate Hedging Transactions . . . . . . . . . . . .
 What are the Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . .
 Tax Hedging Considerations . . . . . . . . . . . . . . . . . . . . . . . . .
 Redemption Premium Opportunities. . . . . . . . . . . . . . . . . . . .
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Common Interest Rate
Hedging Transactions
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Managing Rising Interest Rates
 In a rising interest rate environment, a borrower may consider the following
hedging (or unwind) scenarios:
– A floating rate borrower can synthetically convert the loan to a fixed rate through a swap
agreement.
– A fixed rate borrower that previously converted the loan to a floating rate through a swap
may want to unwind the hedge.
– A borrower that expects to issue fixed rate debt in the future can lock in a current rate
through a forward starting swap or similar rate lock transaction.
 In a rising interest rate environment, a lender may consider the following hedging
(or unwind) scenarios:
– A lender that holds fixed rate debt can synthetically convert the loan to a floating rate
through a swap agreement.
– A lender that previously converted a floating rate loan to a fixed rate loan through a
swap may want to unwind the hedge.
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How Does an Interest Rate Swap Work
Pay fixed-receive floating
Pay floating-receive fixed
Pay Fixed: 6% x $100mm (notional)
Counterparty
SWAP
SWAP DEALER
(5-year term, annual payments)
Receive Floating: LIBOR x $100mm (notional)
Swap commences immediately.
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Floating-for-Fixed Interest Rate Swap
 Assume that at the time of the first swap payment, LIBOR is 6.5%:
Floating Leg (swap dealer)
$6,500,000
Fixed Leg (counterparty)
($6,000,000)
Net Payment (swap dealer)
$500,000
• Note: the fixed and floating swap payments are generally netted, so that a
net payment of $500,000 would be made by the floating rate party.
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Hedging Floating Rate Debt with a
Floating-for-Fixed Interest Rate Swap
$100 Million Loan @ LIBOR
5-year term, annual interest
LENDER(S)
Interest on $100mm loan @ LIBOR
Pay Fixed: 6% x $100mm (notional)
BORROWER
SWAP
SWAP DEALER
(5-year term, annual payments)
Receive Floating: LIBOR x $100mm (notional)
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Floating-for-Fixed Interest Rate Swap
 Assume that at the time the first interest payment/swap payment is
due, LIBOR is 6.5%:
Interest due to lender(s)
($6,500,000)
Swap
payment received
$6,500,000 (floating leg)
payment made
($6,000,000) (fixed leg)
Net Payment
($6,000,000)
Note: the fixed and floating swap payments are generally netted, so that the
borrower would receive a net swap payment of $500,000.
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Floating-for-Fixed Interest Rate Swap
 Assume that at the time the first interest payment/swap payment is
due, LIBOR is 5%:
Interest due to lender(s)
($5,000,000)
Swap
payment received
$5,000,000 (floating leg)
payment made
($6,000,000) (fixed leg)
Net Payment
($6,000,000)
Note: the fixed and floating swap payments are generally netted, so that the
borrower would make a net swap payment of $1,000,000.
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Hedging Fixed Rate Debt with a
Fixed-for-Floating Interest Rate Swap
$500 Million Loan @ 5% Coupon
10-year term, semi-annual interest
LENDER(S)
Interest on $500mm loan @ 5%
Pay Floating: LIBOR x $500mm (notional)
BORROWER
SWAP
SWAP DEALER
(10-year term, semi-annual payments)
Receive Fixed: 5% x $500mm (notional)
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Floating-for-Fixed Interest Rate Swap
 Assume that at the time the first interest payment/swap payment is
due, LIBOR is 4%:
Interest due to lender(s)
($25,000,000)
Swap
payment received
$25,000,000 (fixed leg)
payment made
($20,000,000) (floating leg)
Net Payment
($20,000,000)
Note: the fixed and floating swap payments are generally netted, so that the
borrower would receive a net swap payment of $5,000,000.
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How Does a Forward Starting Interest Rate
Swap Work
Pay Fixed: 6% x $100mm (notional)
BORROWER
SWAP
SWAP DEALER
(5-year term, semi-annual payments)
Receive Floating: LIBOR x $100mm (notional)
Swap commences one year from date forward contract is entered into.
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Floating-for-Fixed Interest Rate Swap
 Assume that immediately prior to the swap commencement date,
LIBOR is 6.5%:
Floating Leg (swap dealer)
$6,500,000 x 5
Fixed Leg (counterparty)
($6,000,000) x 5
Net Payment (swap dealer)
$500,000 x 5
• Note: the “value” of the forward swap immediately prior to swap
commencement is the discounted present value of the net payments to be
made during the term of the swap.
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What are the Tax Issues
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Interest Rate Hedging:
What are the main tax issues?
 General Rule: financial product gains and losses are separately
recognized even if part of an overall risk management strategy.
– Exception: tax integration is available for limited interest rate hedging
transactions under Reg. §1.1275-6.
 Separate recognition of gains and losses on derivatives can lead
to tax character and/or timing mismatches.
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Tax Character Mismatch Issues
 Certain financial products (or payments) result in capital losses
(absent an exception).
– Capital losses can only be used to offset capital gains, but not ordinary
income.
 Corporations often have limited potential to generate capital gains.
– Excess capital losses are subject to limited carrybacks and carryforwards.
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Tax Timing Issues
 Separate recognition of derivative gains and losses can lead to
potential timing mismatches.
– Absent an exception, straddle rules (Code §1092) may apply to require
deferral of realized losses, but not realized gains.
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How are Derivatives Taxed?
 There is not a uniform set of tax rules for derivatives.
– Tax character and timing depends on (1) the type of derivative and (2)
whether or not it qualifies (and is identified) as a tax hedge.
– “Camp” reform proposals.
 Types of derivative products can be classified as:
– notional principal contracts (swaps, caps or floors).
– forward contracts.
– futures contracts.
– options.
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How are Interest Rate Swaps Taxed?
 Most interest rate swaps are taxed as “notional principal
contracts,” defined in Reg. §1.446-3(c) as:
– A financial instrument providing for two or more payments by one party to the
other at specified intervals based on a notional (hypothetical) principal amount
multiplied by an index based on objective financial information.
 This definition includes interest rate caps, interest rate floors, and
similar agreements.
 Under current law, contracts calling for a single settlement
payment, such as futures, options and forwards, are not taxed as
notional principal contracts (“NPCs”).
– Combination products, such as forward starting swaps and swaptions, are not
taxed as NPCs unless the underlying swap commences.
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Notional Principal Contracts:
Three Categories of Payments
 Under the NPC regulations, tax character and timing varies for:
– periodic payments.
– nonperiodic payments.
– termination payments.
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Notional Principal Contracts:
Periodic Payments
 Periodic payments: payments required to be made at periodic
intervals of one year or less throughout the entire term of the
contract.
 General Timing Rule: amortize pro rata (daily) portion of periodic
payments (year-end accrual).
– this is not mark to market.
– accruals will approximate annual cash flows, but is not exact.
 General Character Rule: ordinary income and deductions.
 Interest rate swap payments are not treated as interest, except for:
– Potential deemed loan treatment for “significant” upfront payments
(Reg. §1.446-3(g)(4)).
– Special allocation rules apply for foreign tax credit purposes under Reg.
§1.861-9T.
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Notional Principal Contracts:
Nonperiodic Payments
 Nonperiodic payments: any NPC payment that is not a periodic
payment or termination payment.
– Includes upfront premiums for off-market swaps, premiums for caps/floors,
payments at irregular intervals, and scheduled end-of-term payments.
 General Timing Rule: amortize upfront nonperiodic payments over
life of contract.
– 2004 proposed regulations address end-of-term nonperiodic payments.
 General Character Rule: ordinary income and deductions (see
Prop. Reg. §1.1234A-1(b)).
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Notional Principal Contracts:
Termination Payments
 Termination payments: payments made to assign or early terminate a
NPC.
 General Timing Rule: termination payments are generally recognized
only upon assignment/termination (not subject to accrual principles).
 General Character Rule: Code §1234A applies and provides that the
character depends on the tax character of the underlying asset.
– What is the “asset” underlying an interest rate swap?
 Timing and character exceptions are available for certain hedging
transactions.
– Consider for swap “unwind” scenarios.
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How are Forward Starting Swaps Taxed?
 Forward contracts are bi-lateral agreements relating to the future
sale or purchase of property.
 Generally timing is on a “when realized” basis (i.e., no tax
consequences until settlement).
– NPC rules would apply only if the underlying swap commences.
 Cash settlement: Code §1234A applies and provides that the
character depends on the character of the underlying asset.
– What is the “asset” underlying a forward starting interest rate swap?
 Timing and character exceptions are available for certain hedging
transactions.
– Consider for forward starting swap/rate lock terminations.
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Tax Hedging Considerations
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Consider Availability of Tax Hedging Rules
 Interest rate hedging transactions may fall under either or both of
Code §1221(a)(7) and Reg. §1.1275-6.
 If available, the special rules for qualified hedging transactions can
eliminate tax character and/or timing mismatches.
– Qualified hedging transactions are also exempt from the straddle rules.
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Code §1221(a)(7) Hedging Transactions
Defined
 Defined in Code §1221(b)(2) as any transaction entered into by the taxpayer in
the normal course of the taxpayer’s trade or business primarily:
(i) to manage risk of price changes or currency fluctuations with respect to ordinary
property which is held or to be held by the taxpayer,
(ii) to manage risk of interest rate or price changes or currency fluctuations with respect
to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by
the taxpayer, or
(iii) to manage such other risks as the Secretary may prescribe in regulations.
 The definition of a hedge for purposes of Code §1221(a)(7) is significantly
different than the definition of a hedge for financial accounting purposes.
– SFAS 133/ASC 815/IAS 39 considerations:
• “fair value” versus “cash flow” hedge accounting for book purposes.
• effectiveness testing for book, but not for tax.
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Activities Covered
 Current borrowings:
– interest rate conversions (fixed-to-floating or floating-to-fixed)
– use of proceeds is irrelevant
 Anticipatory borrowings
 Bonds held as assets – only if ordinary assets
– insurance company “gap” hedging issues
 Transactions that counteract hedging transactions
– active management of hedging positions is allowed
– e.g., reversal of a pre-existing swap through a mirror swap
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Consolidated Group Hedging:
Single Entity Approach
 A taxpayer must generally hedge its own risk.
 Regulations default to “single entity” approach for members of US
consolidated group.
– One member can hedge another member’s risks.
– Transactions between group members are not hedges – but consider
application of intercompany obligation provisions of Reg. §1.1502-13(g).
 Risks of “related” parties outside of US consolidated group are not
eligible for indirect hedging.
– Regarded tax partnerships and foreign subsidiaries are outside of scope even
if 100% owned by consolidated group members.
 A separate entity election is available.
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Hedge Identification Requirements
 Two independent identification rules:
– same-day identification of the “hedging transaction” (the derivative transaction
intended to manage risk).
– substantially contemporaneous identification of the “hedged item” (asset,
obligation or borrowing being hedged) (but not more than 35 days later).
 Identification must be clear and unambiguous.
 Accounting and regulatory identifications are not determinative.
 Losses from properly identified hedging transactions are not
“reportable transactions” per Section 4.03(5) of Rev. Proc. 201311.
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Alternative Hedge Identification Methods
 Specific versus aggregate hedging.
– most interest rate hedging is specific.
 Designated hedge account.
– e.g., general ledger account.
 One-time statement extending to all future transactions in a
specified derivative product.
– e.g., pre-identify all interest rate derivatives.
 Designated mark on record of transaction (such as trading ticket,
purchase order, or trade confirmation).
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Hedge Identification Whipsaws
 Failure to identify “qualifying” transactions.
– General rule: character of gains and losses based on general rules for the
product.
– Inadvertent error exception: taxpayer “may” treat gains and losses as ordinary.
– IRS anti-abuse rule: IRS may treat gains as ordinary; character of losses is
based on general rules for the product.
• “no reasonable grounds” standard.
• considers treatment for financial accounting purposes.
 Regulations also penalize non-qualifying transactions that are
identified as tax hedges.
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Inadvertent Error Exception
 Inadvertent error has not been defined
– PLR 200051035 (“In the absence of a specific definition in the regulations, the
term ‘inadvertent error’ should be given its ordinary meaning. . . . The ordinary
meaning of the term “inadvertence” is “an accidental oversight; a result of
carelessness.”)
– CCA 200851082 (“Taxpayer should bear the burden of proving inadvertence,
and its satisfaction should be judged on all surrounding facts and objective
indicia of whether the claimed oversight was truly accidental. The size of the
transaction, the treatment of the transaction as a hedge for financial
accounting purposes, the sophistication of the taxpayer, its advisors, and
counterparties, among other things, are all probative.”)
– CCA 201046015 (“Absent a change in the regulation, we see no compelling
policy justification for reading the inadvertent error rule as an open-ended
invitation for taxpayers to brush aside establishing hedge identification
procedures, knowing that inattention to the rules or even unsound judgment
(as seems to be the case here) can be fixed on an as needed basis.”)
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Hedge Timing Requirements
 Reg. §1.446-4 requires “clear reflection” of income and matching
of hedge gains and losses to timing of gains and losses on items
being hedged.
 Hedge timing rules apply irrespective of identification and
character under Code §1221(a)(7) (see Rev. Rul. 2003-127).
– Separate identification of hedge accounting methods is required.
 Hedge timing for tax often differs from financial accounting.
– cash flow hedges.
– fair value hedges.
– ineffective portion.
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Hedge Timing Requirements
 Hedge timing rules specifically address NPCs by providing that
Reg. §1.446-3 generally governs the timing of income and
deductions with respect to periodic and nonperiodic payments
even though the NPC is a hedge.
– NPC termination payments, however, must be accounted for under Reg.
§1.446-4.
 Reg. §1.446-4(e)(4) sets out special rules for hedges of debt
instruments.
– Rev. Rul. 2002-71 addresses early termination payments with respect to
interest rate swaps hedging outstanding indebtedness.
– Example addresses the early termination of a 5-year swap hedging a 10-year
borrowing.
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Hedge Timing Requirements (Cont’d)
 Anticipatory debt hedges are addressed by Reg. §1.446-4(e)(4)
and -4(e)(8).
– if “consummated,” gain or loss realized on a transaction that hedges an
anticipated fixed rate borrowing for its entire term is accounted for “as if” the
hedge gain or loss decreased or increased the issue price of the debt
instrument (i.e., by amortizing such gain or loss on the constant yield method
similar to OID).
 If an anticipatory debt hedge is not consummated, gain or loss on
the hedge is taken into account when realized.
– An anticipatory debt hedge is consummated for these purposes upon the
occurrence (within a reasonable interval around the expected time of the
anticipated transaction) of either the anticipated transaction or a different but
similar transaction for which the hedge serves to reasonably reduce risk.
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Integration Under Reg. §1.1275-6
 Integrated treatment for a “qualifying debt instrument” and
related hedge.
– asset or liability hedging.
– no trade or business requirement.
– not limited to debt held as an ordinary asset.
– functional currency only.
 Eliminates any character and timing mismatch during period of
hedge transaction.
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Hedge Integration Under Reg. §1.1275-6
 The combined cash flows of the qualifying debt instrument (QDI)
and the hedge(s) must be substantially equivalent to the cash
flows on a fixed or variable rate debt instrument.
 The resulting synthetic debt instrument must have the same term
to maturity as the remaining term of the QDI.
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Hedge Integration Under Reg. §1.1275-6
 Additional requirements include:
– same day identification.
– the parties to the hedge cannot be related, or, if related, the party proposing
the hedge must use a mark-to-market method of accounting for the hedge and
all similar or related transactions.
– the same taxpayer must enter into both the hedge and the QDI.
– if the taxpayer is a foreign person engaged in a U.S. trade or business, all
items of income and expense (other than interest expense) must be effectively
connected with the U.S. trade or business for the period of the QDI had Reg.
§1.1275-6 not applied.
 If integrated treatment is considered as an alternative to Code
§1221(a)(7) hedging treatment, “legging-out” consequences need to be
compared.
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Hedge Integration Under Reg. §1.1275-6
 Additional requirements include:
– neither the hedge or the QDI nor any other debt instrument that is part of the
same issue as the QDI can be part of an integrated transaction with respect to
the taxpayer or otherwise legged out of in the 30 days preceding the issue
date of the QDI.
– the taxpayer must issue (or purchase) QDI on or before the date on which the
taxpayer makes or receives the first payment on the qualified hedge.
– neither the hedge nor the QDI may have previously been a part of a Code
§1092 straddle.
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Redemption Premium
Opportunities
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Current Interest Rate Hedging Activities
10-Q Disclosures
Note 7. Debt and Financing Arrangements (Continued)
 In October 20X1, the Company issued $x million of 4.016% Debentures due in
2043 (the New Debentures) in exchange for $x(+)y million of its previously issued
and outstanding 5.765%, 5.935%, 6.45%, 6.625%, 6.75%, 6.95%, 7% and 7.5%
debentures. The Company paid $196 million of debt premium to certain
bondholders associated with these exchanges. The discount on the New
Debentures and debt premium paid to the bondholders is being amortized over
the life of the New Debentures using the effective interest method.
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Redemption Premium Opportunities
 Under Reg. §1.163-7(c) an issuer is entitled to an interest expense
deduction for a repurchase premium where an existing debt
instrument is repurchased (1) for cash or (2) pursuant to an actual
or a deemed exchange for new debt resulting from a significant
modification.
– A “significant modification” is determined under Reg. §1.1001-3.
– See, e.g., Private Letter Ruling 200742016 (October 19, 2007), addressing
debt-for-debt exchange issues.
 The redemption premium is the excess of the redemption price
over the adjusted issue price of the old debt instrument.
 Under Reg. §1.163-7(c), the redemption premium in a cash
redemption is deductible in full in the year of repurchase.
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Redemption Premium Opportunities
 Under Reg. §1.163-7(c), the redemption premium in a debt-fordebt exchange is deductible in full in the year of repurchase
provided that either the new debt or the old debt is publicly
traded (as defined in Reg. §1.1273-2(f)).
– If neither instrument is publicly traded in a debt-for-debt exchange, the
repurchase premium must be amortized over the term of the newly issued
debt as if it were OID.
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Redemption Premiums
 Code §249 limits the deductibility of bond premium paid on the
retirement of convertible debt. An exception is provided for:
– a normal call premium.
– a premium that exceeds a normal call premium, to the extent the issuer
demonstrates to the satisfaction of the Service that the repurchase premium is
attributable to the cost of borrowing, and not to the conversion features.
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Debt Modification/Exchange Considerations:
Redemption Premiums
 Holder Issues:
– General rule: a holder has a taxable sale in an actual exchange
or a deemed exchange resulting from a significant modification.
– Possible application of Code §368(a)(1)(E) recapitalization to
avoid gain or loss recognition by holders.
• Old debt and new debt have to meet the definition of a
“security” for tax purposes.
• Key is the term of the instrument.
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Debt Modification/Exchange Considerations:
Legislative Proposals
 Financial Product Reform Proposals were released by the House
Ways and Means Committee Chairman Camp on February 26,
2014.
 The issue price determination in a debt-for-debt exchange (a
“specified modification”) would be revised.
 This change is intended to eliminate an issuer’s phantom COD
income resulting from a debt-for-debt exchange.
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Debt Modification/Exchange Considerations:
Legislative Proposals
 The issue price of the new debt in a specified modification
would equal to the lesser of (1) the adjusted issue price of the
existing (old) debt instrument or (2) the issue price of the
modified (new) debt instrument, but in that case determined
under Section 1274 as if the new debt instrument were an
instrument to which that section applied (resulting in an issue
price equal to the stated principal amount where the new
instrument provides for adequate stated interest).
 This proposal would apply to transactions occurring after
December 31, 2014.
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William R. Pomierski
William R. Pomierski
William R. Pomierski is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm’s
Chicago office. Bill focuses his practice on the taxation of financial products and capital markets transactions, as
well as on executive compensation matters.
CHICAGO
Partner
wpomierski@mwe.com
+1 312 984 7531
University of Illinois
College of Law, J.D.
(magna cum laude), 1983
Michigan State University,
B.S. (with highest
honors), 1980
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Bill advises clients on the federal income tax implications of a variety of domestic, cross-border, and global
financial products and related transactions. He has worked extensively with both public and private companies,
hedge funds, trading firms, financial institutions, high net worth individuals, trust advisors and family offices, in
connection with a range of capital market and financial product issues. His industry experience includes
advising insurance companies, financial institutions, equipment manufacturers, retailers, energy companies,
food processors and manufacturers, and chemical companies, to name a few.
His experience in financial product issues extends to derivatives involving a wide range of commodities, along
with interest rate, currency and equity derivatives. Bill’s experience covers domestic and foreign exchangetraded positions, cleared bilateral products, as well as over-the-counter transactions. Beyond the more traditional
derivatives, Bill routinely advises clients on a variety of other forms of derivative transactions, including total
return transactions, variable prepaid forwards, collars, credit default swaps and other credit derivatives, and
weather derivatives. Bill also focuses his practice on the unique federal income tax rules that potentially apply to
domestic and international derivative activities depending on the circumstances surrounding the particular
product or the type of taxpayer, including the various hedging and straddle issues, subpart F considerations,
cross-border withholding issues, U.S. trade or business issues for foreign persons (including the availability of
trading safe harbors), constructive sales and constructive ownership rules, mandatory and elective mark-tomarket issues, securities lending, short sales, repo transactions and wash sales.
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