Foreign currency hedge bifurcated into two transactions

The IRS has issued a private letter ruling (PLR 202440005) holding that an option was treated as two distinct transactions that could not be integrated and treated as a single hedging transaction for purposes of the currency gain and loss rules under Section 988.

The PLR involved a parent corporation of a subsidiary in a consolidated group for federal income tax purposes.

Both the parent and subsidiary had the U.S. dollar (USD) as their functional currency. The subsidiary was formed to acquire the shares of a target corporation. 

On a specified date, the subsidiary issued an offer to purchase all outstanding target shares in exchange for a cash payment per the target share. Some employees of the target held options that would become exercisable upon the target acquisition, which allowed these employees to pay the strike price and receive the full amount per target share or cash cancel the options for a payment net of the target share price less the option’s strike price. At the time of the offer, the subsidiary could not determine its precise exposure with respect to a foreign currency, Currency A, related to the offer due to: (i) the remote possibility that the transaction would not occur; and (ii) the uncertainty of the manner that employees would elect to settle their options.

On the same date of the offer, the subsidiary acquired an option from a bank to hedge the anticipated Currency A exposure related to the offer. The option allowed the subsidiary to receive a specified amount of Currency A from the bank in exchange for a specified amount of USD. The subsidiary paid an arm’s-length premium to bank for the option.

The transaction occurred on a subsequent date and the subsidiary paid the cash consideration for target shares (final payment). The option was terminated on the closing date of the acquisition for the same amount as the final payment.

The parent determined that an arm’s-length premium for an option to purchase Currency A in the amount of the final payment was less than the premium it paid for the option.

Section 988(a)(1)(A) provides that foreign currency gain or loss that is attributable to a “Section 988 transaction” is computed separate and treated as ordinary income or loss. The term “Section 988 transaction” includes entering into, or acquiring, any forward contract, futures contract, option, or similar financial instrument if the amount that the taxpayer is entitled to receive (or is required to pay) is denominated in a nonfunctional currency, or the value of one or more nonfunctional currencies.

Section 988(d)(1) provides that, to the extent provided in regulations, a Section 988 transaction part of a “Section 988 hedging transaction” is integrated and treated as a single transaction. The regulations under Treas. Reg. Sec. 1.988-5(b) provides requirements for such integration treatment with respect to a hedged executory contract.

The commissioner has discretion under Treas. Reg. Sec. 1.988-5(e) to issue an advance ruling addressing both a Section 988 transaction making up a hedge and the transactions being hedged. However, absent a ruling, the subsidiary was required to treat the option separate from the target acquisition.

The parent represented that if the acquisition had been an executory contract on the date of the offer and the option had an expiration date on the date of the target acquisition date, the option would have satisfied the requirements of Treas. Reg. Sec. 1.988-5(b).

Without an advance ruling, the option was not eligible for integration for two reasons: (i) there was no executory contract because the offer was not binding on the target shareholders, i.e., the target shareholders had the right to reject the offer; and (ii) the option was not a hedge because the expiration date of the option was after the accrual date of the target acquisition despite actually settling on such date.

The IRS ruled that the option was bifurcated into two separate transactions:

• An option to acquire the amount paid for the target acquisition, exercisable on the date payment was made for the acquisition (hedge), and purchased for a premium equal to the arm’s-length premium for such an option
• A separate option purchased for the excess of the premium actually paid for the option over the arm’s length premium (excess hedge), which was terminated in exchange for the cash payment received upon the actual termination of the option

The IRS further ruled the target acquisition was integrated with the hedge, and thus the amount of the premium for the hedge was added to the basis of the stock acquired by subsidiary in the target acquisition.

The excess hedge was subject to the general rules under Section 988.

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