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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