On September 5, the IRS issued temporary regulations on the
application of the straddle rules to debt instruments (the
"Temporary Regulations").[1] The Temporary
Regulations provide that a taxpayer's obligation under a debt
instrument can be a position in personal property that is part of a
straddle. The Temporary Regulations will affect taxpayers that
issue debt instruments that provide for one or more payments that
reference the value of personal property or a position in personal
property. The language of the Temporary Regulations is drawn
from, without change, language contained in proposed regulations
that the IRS issued in 2001 purporting to clarify the application of
the straddle rules to various financial instruments, including that
a taxpayer's obligation under a debt instrument can be a position in
personal property that is part of a straddle (the "2001 Proposed
Regulations"). Earlier this year, the IRS issued temporary and
proposed regulations under section 1092(b) dealing with identified
mixed straddles.[2] See our Tax
Law Update – IRS Issues Changes to the Mixed Straddle
Regulations.
The Temporary Regulations provide guidance on the straddle rules
under section 1092 with respect to when an issuer's obligation under
a debt instrument may be a position in personal property.
Under the straddle rules, losses in certain positions in personal
property are deferred to the extent of unrealized gain in other
positions in personal property. Section 1092(d)(1) defines
"personal property" to mean "personal property of a type that is
actively traded." The preamble to the Temporary Regulations
notes that, while a debt or obligation generally is not property of
the debtor or obligor, if a debt instrument provides for payments
that are (or are reasonably expected to be) linked to the value of
personal property as so defined, then the obligor on the instrument
has a position in the personal property referenced by the debt
instrument.
Section 1092(d)(7) provides that if a debt instrument is
denominated in a foreign currency, the obligor's position under the
debt obligation is a position in the foreign currency.
Commentators have maintained that section 1092(d)(7) evidences an
intent by Congress to limit the circumstances in which an obligor's
interest in a debt instrument may be a position in a straddle, and
that such treatment is proper only with respect to debt obligations
denominated in nonfunctional currency. However, the preamble
states that the IRS and the Treasury Department do not believe that
section 1092(d)(7) describes the only circumstance in which an
obligor's interest in a debt instrument may be treated as part of a
straddle. The preamble goes on to note that the statute and
the legislative history do not contain any indication that Congress
intended to limit section 1092 in this manner; rather, the
legislative history characterizes section 1092(d)(7) as a
clarification of prior law. Therefore, because a debt
instrument may be a position in personal property if the obligation
is linked to personal property, section 1.1092(d)-1T(d) of the
Temporary Regulations expressly provides that an obligation under a
debt instrument may be a position in personal property that is part
of a straddle. Interestingly, as noted in the preamble to the 2001
Proposed Regulations, the same position is taken in the regulations
applicable to contingent payment debt instruments under Treasury
Regulation section 1.1275-4. Under those rules, increased
interest expense on a contingent payment debt instrument issued by a
taxpayer may be a straddle loss subject to section 1092 deferral.[3]
The Temporary Regulations apply to straddles established on or
after January 17, 2001, the effective date indicated in the 2001
Proposed Regulations for debt instruments linked to the value of
personal property and the date the 2001 Proposed Regulations were
filed with the Federal Register.[4]
The 2001 Proposed Regulations are part of a larger package of
regulations addressing issues with respect to financial products and
included amendments to regulations under both section 263 and
section 1092. For example, the 2001 Proposed Regulations
contain provisions with respect to the types of payments that are
subject to, and the operation of, the capitalization rules of
section 263(g). The straddle rules by themselves apply only to
losses, so application of section 263(g) was proposed to be expanded
to cover ongoing payments on financial products such as interest
rate swaps. Much of the 2001 Proposed Regulations package was
considered controversial and the length of time between the issuance
of the 2001 Proposed Regulations and their partial reissuance as the
Temporary Regulations is telling. It suggests that the
Temporary Regulations are aimed at particular transactions that
troubled the IRS and Treasury. It is also significant that
large portions of the 2001 Proposed Regulations have not been made
temporary or final.
Operation of the 2001 Proposed Regulations is illustrated by a
number of examples. The Temporary Regulations contain no
examples and it is likely that taxpayers will still look to the 2001
Proposed Regulations for guidance on how the Temporary Regulations
should be interpreted. For instance, the 2001 Proposed
Regulations provide an example where a contingent payment debt
instrument and a forward contract to deliver fuel oil are offsetting
positions with respect to the same personal property and, therefore,
constitute a straddle.[5] In this case, the
debt pays interest quarterly at a rate determined at the beginning
of each quarter equal to the greater of zero and the London
Interbank Offered Rate (LIBOR) adjusted by an index that varies
inversely with changes in the price of fuel oil. When issued,
the example goes on to state that the debt instrument is a position
in personal property that is part of a straddle. Consequently,
the taxpayer's interest payments are interest and carrying charges
properly allocable to personal property that is part of a straddle
and must be allocated to the capital account for the forward
contract. The 2001 Proposed Regulations add to this fact
pattern in a second example, where the taxpayer also enters into an
interest rate swap. Because of the relationship between the
debt instrument issued by the taxpayer and the interest rate swap,
the interest rate swap is a financial instrument that carries
personal property that is part of a straddle. Net payments
made by the taxpayer under the interest rate swap are chargeable to
the capital account for the forward contract. Similarly, net
payments received by the taxpayer under the interest rate swap are
allowable offsets.[6] A third example
illustrates a situation where a contingent payment debt instrument
has an embedded short position in stock while the taxpayer purchases
shares of common stock that are publicly traded.[7] However, neither
example addresses the possible application of the qualified hedge
rules under Treasury Regulation section 1.1275-6 or integration by
the Commissioner.
The approach of the Temporary Regulations is not entirely
consistent with the House Committee on Ways & Means discussion
draft of legislative provisions released on January 24, 2013 (the
"Draft Legislation"), although some parallels can be seen. For
example, under the Draft Legislation, debt instruments containing
embedded derivative components would be bifurcated, with the
derivative, but not the debt instrument, being subject to
mark-to-market treatment under proposed section 485 of the Draft
Legislation.[8] The embedded
derivative proposal would not apply to foreign currency dominated
debt instruments. Bifurcation generally is not allowed under the tax
law, so the proposal represents a significant change. The
Technical Explanation to the Draft Legislation provides as an
example of a debt instrument with an embedded derivative, debt that
is convertible into the stock of the issuer. Such an
instrument would be bifurcated into two instruments, non-convertible
debt (not subject to the mark-to-market rule), and an option to
acquire stock of the issuer (subject to the mark-to-market
rule). The Temporary Regulations do not contain a similar
bifurcation regime.
[1]
T.D. 9635. The text of the Temporary Regulations also serves
as the text of proposed regulations that were issued on the same
date. REG-111753-12, 2013-40 I.R.B. 302.
[2]
All section references are to the Internal Revenue Code of 1986, as
amended (the "Code"), unless otherwise specified.
[3]
Treas. Reg. § 1.1275-4(b)(9)(vi). This provision is similarly
questionable because section 1092 operates to defer losses under
section 165, not deductible expenses or items that are not
losses.
[4]
Treas. Prop. Reg. § 1.1092(d)-1(e) (2001).
[5]
Prop. Treas. Reg. § 1.263(g)-4(c) Example 3 (2001).
[6]
Prop. Treas. Reg. § 1.263(g)-4(c) Example 4 (2001).
[7]
Prop. Treas. Reg. § 1.263(g)-4(c) Example 5 (2001).
[8]
Draft Legislation proposed section 486(d)(2)(A) (2013). The
term "embedded derivative component" means any terms of a debt
instrument that affect some or all of the cash flows or the value of
other payments required by the instrument in a manner similar to a
derivative. However, bifurcation will not be required merely
because a debt instrument is denominated in or specifies payments by
reference to a nonfunctional currency, is a contingent payment debt
instrument or variable rate debt instrument, or has an alternative
payment schedule. Draft Legislation proposed section
486(d)(2)(B) (2013).
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