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
Boston Brussels Chicago Dsseldorf Frankfurt Houston London Los Angeles Miami Milan Munich New York Orange County Paris Rome Seoul Silicon Valley Washington, D.C.
Strategic alliance with MWE China Law Offices (Shanghai)
2014 McDermott Will & Emery. The following legal entities are collectively referred to as "McDermott Will & Emery," "McDermott" or "the Firm": McDermott Will & Emery LLP, McDermott Will & Emery AARPI,
McDermott Will & Emery Belgium LLP, McDermott Will & Emery Rechtsanwlte Steuerberater LLP, McDermott Will & Emery Studio Legale Associato and McDermott Will & Emery UK LLP. These entities coordinate their
activities through service agreements. This communication may be considered attorney advertising. Previous results are not a guarantee of future outcome.

Agenda
Common Interest Rate Hedging Transactions . . . . . . . . . . . .
What are the Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tax Hedging Considerations . . . . . . . . . . . . . . . . . . . . . . . . .
Redemption Premium Opportunities. . . . . . . . . . . . . . . . . . . .

www.mwe.com

Common Interest Rate

Hedging Transactions

www.mwe.com

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.

www.mwe.com

How Does an Interest Rate Swap Work

Pay fixed-receive floating

Counterparty
Counterparty

Pay floating-receive fixed

Pay Fixed: 6% x $100mm (notional)

SWAP

SWAP DEALER

(5-year term, annual payments)

Receive Floating: LIBOR x $100mm (notional)

Swap commences immediately.

www.mwe.com

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.

www.mwe.com

Hedging Floating Rate Debt with a

Floating-for-Fixed Interest Rate Swap

$100 Million Loan @ LIBOR

5-year term, annual interest

LENDER(S)
LENDER(S)

Interest on $100mm loan @ LIBOR

BORROWER
BORROWER

Pay Fixed: 6% x $100mm (notional)

SWAP

SWAP DEALER

(5-year term, annual payments)

Receive Floating: LIBOR x $100mm (notional)

www.mwe.com

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.

www.mwe.com

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.

www.mwe.com

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)
LENDER(S)

Interest on $500mm loan @ 5%

BORROWER
BORROWER

Pay Floating: LIBOR x $500mm (notional)

SWAP

SWAP DEALER

(10-year term, semi-annual payments)

Receive Fixed: 5% x $500mm (notional)

www.mwe.com

10

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.

www.mwe.com

11

How Does a Forward Starting Interest Rate

Swap Work

BORROWER
BORROWER

Pay Fixed: 6% x $100mm (notional)

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.

www.mwe.com

12

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.

www.mwe.com

13

What are the Tax Issues

www.mwe.com

14

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.

www.mwe.com

15

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.

www.mwe.com

16

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.

www.mwe.com

17

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.

www.mwe.com

18

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.
www.mwe.com

19

Notional Principal Contracts:

Three Categories of Payments
Under the NPC regulations, tax character and timing varies for:
periodic payments.
nonperiodic payments.
termination payments.

www.mwe.com

20

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.
www.mwe.com

21

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)).

www.mwe.com

22

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.

www.mwe.com

23

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.
www.mwe.com

24

Tax Hedging Considerations

www.mwe.com

25

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.

www.mwe.com

26

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 taxpayers 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.
www.mwe.com

27

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

www.mwe.com

28

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 members 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.

www.mwe.com

29

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.

www.mwe.com

30

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).

www.mwe.com

31

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.

www.mwe.com

32

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.)

www.mwe.com

33

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.

www.mwe.com

34

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.
www.mwe.com

35

Hedge Timing Requirements (Contd)

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.
www.mwe.com

36

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.

www.mwe.com

37

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.

www.mwe.com

38

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.
www.mwe.com

39

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.

www.mwe.com

40

Redemption Premium
Opportunities

www.mwe.com

41

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.

www.mwe.com

42

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.

www.mwe.com

43

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.

www.mwe.com

44

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.

www.mwe.com

45

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.

www.mwe.com

46

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 issuers phantom COD
income resulting from a debt-for-debt exchange.

www.mwe.com

47

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.

www.mwe.com

48

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 Firms 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

www.mwe.com

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. Bills experience covers domestic and foreign exchange-traded 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-to-market issues, securities lending, short sales, repo transactions and wash sales.

49