Tax

IRS Shortchanges Company on Hedge Gains

How a company lost the right to defer gains on a swap designed to manage interest-rate risk.
Robert WillensOctober 17, 2011

In a private letter ruling issued by the office of the chief counsel of the Internal Revenue Service in September, the IRS turned down a corporate taxpayer’s assertion of the right to defer hedging gains. The chief counsel’s office turned the company down even though the service allowed the cancellation of indebtedness (COD) income linked to those gains to be deferred. Arguably, the taxpayer got shortchanged.

The matter began when the taxpayer, which we’ll call TP, decided to issue a certain amount of junior subordinated debentures for a specified issue price per debenture. TP entered into a 10-year interest-rate swap with a counterparty, which we can dub CP, in order to lock in interest rates for the 10-year, fixed-rate term of the debentures. The hedge was identified as a hedge of the debentures for both book and tax purposes.

The hedge was intended to protect TP from changes in interest rates from the start of the hedge until the issuance of the debentures. The hedge was terminated on the date of issuance of the debentures, and CP paid a termination payment in an amount that resulted in a gain to TP. TP amortized the hedge gain over 10 years for both book and tax purposes.

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After issuing the debentures, TP offered to buy them at a price below the principal amount. Holders accepted the offer with respect to a certain percentage of the debentures. The holders’ purchase resulted in COD income to TP of “E” amount.

For book purposes, TP will recognize both COD income and the hedge gain allocable to the repurchased debentures during the year of repurchase. For tax purposes, TP chose to defer the recognition of the COD income.

TP argued that it could defer recognition of the hedge gain allocable to the repurchased debentures until the years in which the COD income is recognized. The IRS, however, rejected TP’s argument. In its ruling, it found the hedge gain could not be deferred in that way.

The IRS noted that TP entered into the hedge to manage interest-rate risk by locking in a borrowing rate on the debentures for the first 10 years of the life of the debentures. As a result, TP amortized the hedge gain over the period with respect to which it was locking in its fixed rate of interest. TP’s accounting for the hedge gain, the IRS noted, is “fully consistent” with existing rules.

When the debentures were repurchased, the term of the debentures ended, and interest that had been effectively reduced by the hedge of those debentures no longer existed. Thus, upon repurchase, the item being hedged ceased to exist. To clearly reflect income, the unamortized hedge gain allocable to the repurchased debentures should be recognized.

TP wanted to change how it matched the hedge gain so that the gain allocable to the repurchased debentures would be matched to COD income. The IRS thought differently.

Robert Willens, founder and principal of Robert Willens LLC, writes a tax column for CFO.com.