Understanding Interest Rate Swap Transactions
and
Interest Rate Hedging in a Rising Market
Denver TEI – Federal Taxation Update
December 8, 2015
William R. Pomierski
wpomierski@mwe.com
(312) 984-7531
www.mwe.com
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Agenda
 Understanding interest rate swaps
 How are interest rate swaps taxed?
– Basic rules
– New embedded loan regulations
– Tax hedging considerations
 Interest rate hedging transactions in a rising market
– Common borrower transactions
– Related tax considerations
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Understanding Interest Rate Swaps
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What Is A Swap?
 An interest rate swap is an agreement between two parties
(“counterparties”) who agree to exchange payments at specified
intervals over a specified term.
 Each party agrees to make payments to the other equal to the
product of an interest rate (swap rate) times a “notional” principal
amount.
– Usually, the swap rate for one counterparty is a fixed rate, while the swap rate
for the other counterparty is a variable (floating) rate
– The principal amount is “notional,” as it is used to calculate swap payments;
the notional principal amount is not exchanged between the parties
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What Is A Swap?
 Swaps historically were entered into “over the counter,” i.e.,
bilaterally
– The Dodd-Frank Act has caused some interest rate swaps to be subjected to
“clearing” by a central clearing organization
• A clearing exception may be available to an “end-user”
– Some interest rate swaps are traded on futures exchanges
• CME’s deliverable swap futures (functions like a forward starting swap)
• Eris Exchange interest rate swap futures
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Floating-for-Fixed Interest Rate Swap
Pay fixed-receive floating
Pay floating-receive fixed
Fixed Leg: 6% x $100mm (notional)
Party A
SWAP
Party B
(5-year term, annual payments)
Floating Leg: LIBOR x $100mm (notional)
Swap commences immediately
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Floating-for-Fixed Interest Rate Swap (Cont’d)
 Assume that at the time of the first swap payment, LIBOR is:
6.5%
Fixed Leg (Party A)
($6,000,000)
6.0%
5.0%
($6,000,000)
($6,000,000)
5,000,000
Floating Leg (Party B)
6,500,000
6,000,000
Net Payment Received (Made)
$500,000
$0
($1,000,000)
• Note: if the settlement dates are the same, the fixed and floating swap
payments are generally netted, so that a single payment is made by one
party to the other.
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Interest Rate Cap
Periodic payment obligation:
excess of floating rate over 6% x
$100mm (notional)
Cap Seller
Cap Buyer
Cap premium
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Interest Rate Cap (Cont’d)
 Assume that at the time of the first cap payment, LIBOR is:
6.5%
Cap Seller
($5,000,000)
6.0%
$0
5.0%
$0
• Note: the cap premium payment paid by the cap buyer is not reflected in
these cash flows.
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How Does a Forward Starting Swap Work?
Pay fixed-receive floating
Pay floating-receive fixed
Fixed Leg: 6% x $100mm (notional)
Party A
SWAP
Party B
(5-year term, semi-annual payments)
Floating Leg: LIBOR x $100mm (notional)
Swap commences at specified future date
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Forward Starting Rate Swap (Cont’d)
 Assume that swap commences one year from date contract is
entered into and that immediately prior to the swap
commencement date, LIBOR is 6.5%. In that event, swap value
would be measured as follows:
Floating Leg (Party B)
$6,500,000 x 5
Fixed Leg (Party A)
($6,000,000) x 5
Net Payment (Party B)
$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, determined based on rates measured
as of relevant valuation date.
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How are Interest Rate Swaps
Taxed?
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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 qualifying 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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Character and Timing 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
– Excess capital losses are subject to limited carrybacks and carryforwards
 Separate recognition of derivative gains and losses can lead to
potential timing mismatches.
– If not part of an integrated transaction, derivative may produce gain or loss in
a different tax period than the underlying transaction being hedged
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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 principal amount multiplied by
an index based on objective financial information
– This definition may change if 2011 proposed regulations are adopted
 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 and until the underlying swap commences
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Potential Section 1256 Contract
Characterization
Certain exchange-traded derivatives are classified as “section
1256 contracts,” which are subject to two special rules:
– the 60/40 capital gain/loss rule
– the Mark-to-Market Rule
 Application is limited, in relevant part, to certain exchangetraded futures and options on future
– 2011 proposed regulations are aimed at sorting out classification issues for
swap futures
Notional Principal Contracts:
Three Categories of Payments
 Under the NPC regulations (Reg. §1.446-3), tax character and
timing depends on whether NPC payments are classified as:
– 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 (see Prop.
Reg. §1.162-30(a)).
– Hedging rules are not needed to characterize NPC periodic payments as
ordinary
 Interest rate swap periodic payments are not treated as interest,
except for:
– Consider special allocation rules for foreign tax credit purposes under Reg.
§1.861-9T (automatic for losses, with identification for gains)
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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 (total
return swaps)
 General Timing Rule: amortize upfront nonperiodic payments over
life of contract.
– Consider potential deemed loan treatment for nonperiodic payments
(Temp. Reg. §1.446-3T(g)(4)), as described below
 General Character Rule: ordinary income and deductions (see
Prop. Reg. §§1.162-30(a) and 1.1234A-1(b)).
– Hedging rules are not needed to characterize nonperiodic payments as
ordinary
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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 (see Prop.
Reg. §1.1234A-1(a)).
– What is the “asset” underlying an interest rate swap?
– IRS position is a hypothetical Treasury bond
– Ordinary character if Code §1234A does not apply (executory contract case
law)
 Timing and character exceptions are available for qualifying hedging
transactions.
– Consider for swap “unwind” scenarios
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How are Forward Starting Swaps Taxed?
 Forward swaps are bi-lateral agreements to enter into a swap at a
future start date, where the swap terms are fixed at the time the
forward agreement is entered into.
– Both parties are obligated to enter into the underlying swap unless the forward
contract is cash-settled before swap commencement
 Generally no tax consequences until swap commences or forward
contract is cash-settled.
– NPC rules would apply only if (and when) the underlying swap commences
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How are Forward Starting Swaps Taxed
(Cont’d)?
 Cash settlement of Forward Starting Swap: 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.
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Notional Principal Contracts:
Embedded Loan Considerations
 Prior to the amendments made in May, 2015 (the “Temporary
Regulations”), Reg. §1.446-3 provided that if a swap involved
significant nonperiodic payments, the transaction was treated for
federal income tax purposes as two separate transactions, namely
an on-market, level payment NPC and a loan in the amount of the
upfront nonperiodic payment.
– No specific guidance was provided in the prior regulations as to when an
upfront swap payment would be considered significant for these purposes
 If this recharacterization rule applies, the embedded loan is to be
accounted for by both parties to the contract independently of the
swap.
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Notional Principal Contracts:
Embedded Loan Considerations (Cont'd)
 Under the Temporary Regulations, any nonperiodic payment is treated as
resulting in an embedded loan unless an exception applies.
 Exceptions are limited to:
– Short term transactions: NPCs with a term of one year or less, subject to a
carve out for tax exempt organizations
– Full Margin transactions: NPCs where there is an upfront payment made and
the NPC is subject to specified margin or collateral requirements, including
that the margin or collateral be posted in cash and that such margin or
collateral fully collateralizes the mark-to-market exposure on the contract for
its entire term
– Section 956 exception
 The Temporary Regulations apply to NPCs entered into on or after the
later of January 1, 2017, or six months after the date final regulations are
published (T.D. 9719).
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Notional Principal Contracts:
Embedded Loan Example
 On January 1, 2016, unrelated parties M and N enter into an interest rate
swap contract. Under the terms of the contract, N agrees to make five
annual payments to M equal to LIBOR times a notional principal amount
of $100 million. In return, M agrees to pay N 6% of $100 million annually,
plus an upfront payment of $15,163,147 on January 1, 2016.
 At the time M and N enter into the contract, the rate for similar on-market
swaps is LIBOR to 10%, and N provides M with information that the
amount of the upfront payment was determined as the present value, at
10% compounded annually, of five annual payments from M to N of
$4,000,000 (4% of $100,000,000).
 Assume the contract does not qualify for any of the exceptions to
embedded loan treatment, resulting in a deemed $15,163,147 loan from
M to N that N repays in installments over the term of the contract.
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Notional Principal Contracts:
Embedded Loan Example
 Cash flows/tax treatment before loan recharacterization:
– M receives LIBOR periodic payments from N
– M pays fixed periodic payments to N (6% times notional)
– M amortizes $15,163,147 upfront payment as a nonperiodic payment (deduct
over life of swap on constant yield basis)
– M’s net NPC payment (LIBOR periodic payment received LESS 6% fixed
periodic payment made LESS nonperiodic payment amortization) results in
ordinary income/ordinary deductions under NPC rules
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Notional Principal Contracts:
Embedded Loan Example
 Cash flows/tax treatment with loan recharacterization:
– M receives LIBOR periodic payments from N
– M pays fixed periodic payments to N (deemed 10% fixed rate times notional)
– M’s net NPC payment (LIBOR periodic payment received LESS 10% fixed
periodic payment made) results in ordinary income/deduction under NPC rules
– M treats the $15,163,147 upfront payment as a loan too N that will be repaid
by N with level payments over the life of the swap
• M recognizes interest income, and N claims an interest deduction, each
taxable year equal to the interest component of the deemed installment
payments on the loan
• These interest amounts are not included in the parties’ net income or net deduction
from the swap under Reg. §1.446-3
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Notional Principal Contracts:
Embedded Loan Example
 Deemed loan cash flows:
– Assuming a constant yield to maturity and annual compounding at 10%, M
and N account for the principal and interest on the loan as follows:
Level
Payment
2016
2017
2018
2019
2020
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$4,000,000
4,000,000
4,000,000
4,000,000
4,000,000
$20,000,000
Interest
Component
$1,516,315
1,267,946
994,741
694,215
363,636
$4,836,853
Principal
Component
$2,483,685
2,732,054
3,005,259
3,305,785
3,636,364
$15,163,147
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Notional Principal Contracts:
Embedded Loan Example
 What are the consequences of deemed loan characterization to M?
– M’s net periodic payment income will decrease (or its net deduction will
increase) by the $4,000,000 deemed on-market annual periodic payment
(10% rate) by M to N ($20,000,000 in the aggregate)
– M loses its amortization deduction for the $15,163,147 upfront payment over
the life of the contract
– M recognizes interest income of $4,836,853 on the repayment of the deemed
loan
 The net impact to M is largely classification:
– Instead of claiming an ordinary deduction for an NPC nonperiodic payment of
$15,163,147, M will instead claim an aggregate $20,000,000 greater
deduction for periodic payments made and will report $4,836,853 of interest
income, for a net of $15,163,147
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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.
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Code §1221(a)(7) Hedging Transactions
Defined
 Defined in Code §1221(b)(2) as any transaction entered into by a taxpayer in the
normal course of its 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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Transactions Covered
 Debt held as an asset only if an ordinary asset (banks and dealers)
– Consider insurance company hedging
 Current borrowings:
– interest rate conversions (fixed-to-floating or floating-to-fixed)
– use of proceeds is irrelevant
 Anticipatory borrowings
 Transactions that counteract hedging transactions
– active management of hedging positions is allowed
– e.g., reversal of a pre-existing swap through a mirror swap (consider as a
potential fix for a prior missed hedge identification)
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Consolidated Group Hedging
 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)
– A separate entity election is available
 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
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Hedge Identification Requirements
 Two independent identification rules:
– Identification of the “hedging transaction” (the derivative transaction intended
to manage risk): same day requirement
– Substantially contemporaneous identification of the “hedged item” (asset,
obligation or borrowing being hedged): substantially contemporaneous, 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
 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).
 Specific versus aggregate hedging.
– most interest rate hedging is specific
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Hedge Identification Whipsaws
 Failure to identify “qualifying” transactions.
– General rule: character of gains and losses are based on general rules for the
product
• Consider application to NPC payments (periodic, nonperiodic, termination)
– 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 (Cont’d)
 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 reflects 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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Hedge Timing Requirements (Cont’d)
 Reg. §1.446-4 has its own recordkeeping/identification
requirements.
 Rev. Rul. 2003-127 confirms that hedge timing rules apply even if
hedge is not identified as such for purposes of Code
§1221(a)(7)/Reg. §1.1221-2.
– Section 1256 contract issues
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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.
– Can hedge a portion of the QDI principal and interest, but not a portion of the
term of the QDI
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Hedge Integration Under Reg. §1.1275-6
(Cont’d)
 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
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Hedge Integration Under Reg. §1.1275-6
(Cont’d)
 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
 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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Interest Rate Hedging Transactions
in a Rising Market
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Managing Rising Interest Rates
 In a rising interest rate environment, a borrower may consider the
following hedging (or unwind) scenarios:
(1) A floating rate borrower can synthetically convert the loan to a fixed
rate through a swap agreement
- could also include use of interest rate cap
- consider forward starting products (forward swaps and swaptions)
(2) A borrower that expects to issue fixed rate debt in the future can lock in
a current rate through a forward starting swap, a swaption or similar
rate lock transaction
(3) A fixed rate borrower that previously converted the loan to a floating
rate (a fair value hedge) through a swap may want to unwind the
hedge through:
(A) Early termination (cash-settlement) of the hedge
(B) Entering into an offsetting (mirror) transaction
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(1) Hedge Outstanding Floating Rate Debt with
a Floating-for-Fixed Interest Rate Swap
$100 Million Loan @ LIBOR
5-year remaining term, annual
interest
LENDER(S)
Interest on $100mm loan @ LIBOR
Fixed Leg: 6% x $100mm (notional)
BORROWER
SWAP
SWAP DEALER
(5-year term, annual payments)
Floating Leg: LIBOR x $100mm (notional)
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(1) Hedge Outstanding Floating Rate Debt with
a Floating-for-Fixed Interest Rate Swap (Cont’d)
 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)
Swap payment made
($6,000,000) (fixed leg)
Net Payment (6.0%)
($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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(1) Hedge Outstanding Floating Rate Debt with
a Floating-for-Fixed Interest Rate Swap (Cont’d)
 Assume that at the time the second interest payment/swap
payment is due, LIBOR has dropped to 5%:
Interest due to lender(s)
($5,000,000)
Swap payment received
$5,000,000 (floating leg)
Swap payment made
($6,000,000) (fixed leg)
Net Payment (6.0%)
($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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(1) Hedge Outstanding Floating Rate Debt with
a Floating-for-Fixed Interest Rate Swap (Cont’d)
 Here, the swap cash flows are closely aligned with the cash flows
on the debt, so that the borrower could either identify the swap as
a hedge under Code §1221(a)(7)/Reg. §1.1221-2, or elect to
integrate the hedge with the borrowing under Reg. §1.1275-6.
 Assuming the swap is not integrated, how will the swap be
accounted for:
– Periodic payments:
– Early termination payment (IF swap is terminated early):
• Character
• Timing
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(1) Hedge Outstanding Floating Rate Debt with
an Interest Rate Cap
LENDER
Interest on $100mm loan @ LIBOR
Cap Buyer
Cap Premium
SWAPS
DEALER
CAP AGREEMENT
Periodic payment: Excess of
LIBOR over 6% x $100mm
(notional)
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(1) Hedge Outstanding Floating Rate Debt with
an Interest Rate Cap (Cont’d)
 Assume that at the time the first interest payment/cap payment is
due, LIBOR is 6.5%:
Interest due to lender(s)
($6,500,000)
Cap payment received
$ 500,000
Net payment (6%)
($6,000,000)
Note: the cap premium payment paid by the cap buyer is not reflected in these
cash flows.
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(1) Hedge Outstanding Floating Rate Debt with
an Interest Rate Cap (Cont’d)
 Assume that at the time the second interest payment/cap payment
is due, LIBOR has dropped to 5%:
Interest due to lender(s)
($5,000,000)
Swap payment received
$
Net payment (5%)
0
($5,000,000)
Note: the cap premium payment paid by the cap buyer is not reflected in these
cash flows.
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(1) Hedge Outstanding Floating Rate Debt with
an Interest Rate Cap (Cont’d)
 Here, the cap manages the risk of rate increases on the loan, so
the borrower could identify the swap as a hedge under Code
§1221(a)(7)/Reg. §1.1221-2
– Consider integration of the cap with the borrowing under Reg. §1.1275-6
 Assuming the cap is not integrated, how will the cap be accounted
for:
– Periodic payments received:
– Cap premium made
• Character and timing
– Early termination payment (IF swap is terminated early):
• Character and timing
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(2) Hedge of Anticipated Fixed Rate Debt with
a Forward Swap
Taxpayer anticipates issuing $100mm of fixed rate debt
in one year
Pay fixed-receive floating
Pay floating-receive fixed
Fixed Leg: 6% x $100mm (notional)
BORROWER
SWAP
SWAP DEALER
(5-year term, semi-annual payments)
Floating Leg: LIBOR x $100mm (notional)
Swap commences at on first anniversary of date forward is entered into
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(2) Hedge of Anticipated Fixed Rate Debt with
a Forward Swap (Cont’d)
 Assume that forward swap is cash settled shortly before
commencement of underlying swap and taxpayer also issues
$100mm of fixed rate debt at 6.5%.
 Assume that immediately prior to the swap commencement date,
LIBOR is 6.5%, swap value would be measured as follows:
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
Termination Payment from Swap Dealer approx. $2,078,000*
* “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. Here, the discount rate is assumed to be 6.5%.
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(2) Hedge of Anticipated Fixed Rate Debt with
a Forward Swap (Cont’d)
 Here, the forward starting swap manages the borrower’s risk with
respect to the anticipated issuance of fixed rate debt, so that the
borrower could identify the swap as a hedge under Code
§1221(a)(7)/Reg. §1.1221-2
– Integrated treatment is not available under Reg. §1.1275-6 for anticipatory
hedges
 How will the approximately $2,078,000 on cash settlement of the
forward starting swap be accounted for:
– Character
– Timing
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(3) Unwind existing Hedge of Fixed Rate Debt
$500 Million Loan @ 5%, 10-year
term, semi-annual interest
LENDER(S)
Interest on $500mm loan @ 5%
Floating Leg: LIBOR x $500mm (notional)
BORROWER
SWAP
SWAP DEALER
(10-year term, semi-annual payments)
Fixed Leg: 5% x $500mm (notional)
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(3) Unwind existing Hedge of Fixed Rate Debt
(Cont’d)
 Assume that on the fourth anniversary of the swap (6 years left) at
the time the first interest payment/swap payment is due, LIBOR is
6% and the borrower considers early terminating the swap:
 The swap termination payment value would be measured as
follows:
Floating Leg (borrower)
$30,000,000 x 6
Fixed Leg (swap dealer)
($25,000,000) x 6
Net Payment (swap dealer)
$5,000,000 x 6
Termination Payment from Swap Dealer approximately *$24,600,000
* “Value” of the swap at the time of early termination is the discounted
present value of the net payments to be made over the remaining term of the
swap. Here, the discount rate is assumed to be 6%.
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Tax Hedging Considerations
 How will the approximately $24,600,000 on cash settlement of the
forward starting swap be accounted for:
– Character
– Timing
 How does the answer change if the taxpayer did not previously
identity the swap as a tax hedge?
 How would the answer change if the taxpayer instead entered into
an offsetting (mirror) swap.
– At the market
– Off-market
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Concluding Remarks/Questions
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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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