Tax Aspects of Currency Hedging Problems, Solutions and Policy Recommendations for Currency Translation, Transactions

1. Tax Aspects of Currency Hedging � Problems, Solutions and Policy Recommendations for Currency Translation, Transactions and Hedging

2. 2 Subpart J � Why You Should Care

3. 3 Increasing Importance Overseas investments have increased dramatically over the last 25 years Significant currency volatility since the Fall of 2008 Increased sensitivity by in-house Treasury personnel to minimize: (i) Income Statement Volatility; and (ii) Balance Sheet Volatility; due to: Impact of Volatility on the Share Price Impact on Bank Covenants Increased IRS awareness of the issues surrounding currency exposures and currency hedging

4. 4 Reportable Transaction Rules A $10 M or greater loss can be considered a reportable transaction. Will a series of rolling forwards or options will be aggregated to reach the $10 M threshhold under Treas. Reg. �1.6011-4(b)(1) (defining the term �transaction�)? There is an exception for hedges in �4.03(5) of Rev. Proc. 2004-66, 2004-2 C.B. 966 but it does not apply to the underlying item being hedged. Failure to report gives rise to a penalty of 75% of tax benefit up to a maximum of $50,000 for non-listed and $200,000 for a listed transaction. The penalty cannot be relieved by a court. Possible reporting to SEC for undisclosed listed transactions or undisclosed non-listed reportable transactions where the penalty on the underpayment is increased to 30% due to failure to adequately disclose. See 6707A(e).

5. 5 GAAP / Tax Tension The definition of �hedge� is not the same for GAAP and tax. GAAP: Fair Value Hedge Cash Flow Hedge Net Investment Hedge

6. 6 GAAP / Tax Tension The definition of �hedge� is not the same for GAAP and tax. Tax: Section 1221(b)(2) �Hedging Transaction� Properly Identified Not Identified but Inadvertent Error Exception Applies Not Identified and Inadvertent Error Exception Does not Apply Section 988(d) Integrated Transaction Treatment Debt Instruments Executory Contracts This is not simply an issue of identification! The substantive requirements must be satisfied: Section 1221 requires a hedge of �ordinary property� Section 988 requires that the hedges permit the calculation of a synthetic yield to maturity and must be on the books of the exact same QBU

7. 7 GAAP / Tax Tension EXAMPLE: USCO owns 100% of CFC1. USCO uses the U.S. dollar for tax and GAAP purposes. CFC1 uses the Euro for GAAP and Tax. CFC1�s balance sheet shows a net equity (Assets � Liabilities) of �10,000,000. USCO has to translate that equity from Euros to dollars each quarter for GAAP purposes. This causes USCO�s consolidated balance sheet to expand and contract due solely to currency movements, thereby creating �balance sheet volatility�. To hedge this, USCO enters into a forward to sell �10,000,000 for $12,000,000 one year in the future. QUESTION 1: Is this a GAAP hedge? QUESTION 2: Is this a tax hedge?

8. 8 GAAP / Tax Tension The identification procedures are not the same: GAAP identification only prepared if you have a GAAP hedge GAAP identification is not sufficient for tax purposes � you must specifically identify the transaction as a hedge for tax purposes regardless whether the hedge does or does not qualify as a GAAP hedge

9. 9 GAAP / Tax Tension EXAMPLE: USCO owns 100% of CFC1. USCO uses the U.S. dollar for tax and GAAP purposes. CFC1 uses the Euro for GAAP and Tax. USCO loans CFC1 $1,000,000. CFC1 enters into a forward contract to hedge the currency risk with respect to the principal on this borrowing. QUESTION 1: Is this a GAAP hedge? QUESTION 2: Will your Treasury department even notify you of this transaction or provide you with any documentation? QUESTION 3: Is this a tax hedge? QUESTION 4: Is a tax identification necessary, and when should it be done?

10. 10 GAAP/Tax Tension Tensions with GAAP (and between in-house Tax and Treasury) driven primarily by: Location of Hedge Type of Hedge Existence of Risk

11. 11 Location of Hedge: Corporate treasurers want to enter into the hedge with unrelated parties at specific locations within their group because: U.S. Parent has banking relationships; The U.S. Parent may be only entity that is �rated�; There may be a �derivative netting agreement� witht that entity; and Even if there is no derivative netting agreement, the counterparty wants the ability to offset various positions they may have with the group in the event there is a bankruptcy or other insolvency and that only works if the positions are with the same company in the organization. There are GAAP and tax constraints, however: GAAP imposes limits on location. See e.g., ASC 815-20-25-30. Tax also imposes restrictions on location outside of the consolidated group context. In the case of integrated hedges entered into by foreign resident QBUs, the risk and hedge have to be on the books of the same QBU. GAAP / Tax Tension

12. 12 Type of Hedge (e.g., Treasury prefers rolling forwards, but tax requires swaps or longer term forwards so that maturities match): Swaps and long-term forwards suffer from the same defects: They are both very difficult to price Swaps in particular, have to have terms that are calibrated with the underlying terms of the loan The market for them is not liquid, and so banks have more leverage in negotiating price They both involve an implicit �credit charge� which can be significant for companies with lower credit ratings Swaps and long-term forwards are less flexible If the taxpayer decides they do not need the hedge � through the term, the taxpayer has to negotiate to get out of the contract, and even if the position is in the money, the counterparty has significant leverage in negotiating an early contract termination GAAP / Tax Tension

13. 13 Existence of Risk: The check the box rules create a significant discontinuity between what constitutes a �risk� that needs to be hedged from a GAAP perspective and what constitutes a �risk� that needs to be hedged from a tax perspective GAAP / Tax Tension

14. 14 Example One

15. 15 USCO is a U.S. publicly traded corporation that owns all of the outstanding shares of CFC1 and CFC2. CFC1 has the GBP as its functional currency. CFC2 has the Euro as its functional currency. CFC1 advances cash to CFC2 in exchange for a �1,000 note receivable bearing interest at 6% payable annually on December 31st, maturing 5 years in the future. USCO�s tax department requests USCO�s treasury to enter into a five-year currency swap so that integration can be achieved under section 988(d).

16. 16 USCO�s treasury department does not want to enter into a cross currency swap. Lacks flexibility Less transparency in pricing The GAAP �risk� is the revaluation risk and that revaluation is happening every month, not just when interest is paid Instead, it causes CFC1 to enter into a series of monthly forward contracts to sell Euros and receive pounds. As each new settlement date approaches, a new forward is entered into. CFC1 identifies each one of these forwards as a �hedge� under section 1221(b)(2) of its underlying long position in Euro � both principal and interest.

17. 17 Assume that CFC1 recognizes foreign currency gain of �10.00 for U.S. tax purposes on the interest, due to the following exchange rates: Accrual of �1,000 x 6% x GBP/EUR AVG Exch. Rate �1.3333/�1 = �80.00. Value of �60 interest payment on December 31st at spot GBP/EUR exchange rate of �1.5000/�1 = �90. Net Gain �10.00 = �90.00 - �80.00. If one assumes that the spot GBP/EUR exchange rate was �1.3000:�1 on the date the loan was advanced, the inherent (built in) gain in the principal would be �200 as of 12/31. Importantly, under U.S. tax principles, there has not been a realization event and so there is no recognized gain or loss on the principal yet.

18. 18 Assume that CFC1 recognizes foreign currency gains and losses on the forwards with one month maturities as follows:

19. 19 If the various forwards do not qualify as a �hedge�, then the following results would occur: CFC 1 would recognize �50.85 of gain on the various forwards, all of which would be foreign personal holding company income, despite: Not being able to recognize its losses on the forwards due to the straddle rules Not having had a realization event with respect to the principal on the Euro denominated loan receivable If the losses are subsequently allowed, they may be reportable transactions, if the amounts are large enough

20. 20 To qualify as a �hedge� under section 1221, the regulations require that the underlying risk be with respect to �ordinary property� which is defined as property which �under no circumstance� could give rise capital gain or loss. The difficulty is that a nonfunctional currency loan receivable could, conceivably, generate a capital gain or loss. See generally, �988(b)(1) and (2). Can we solve this conundrum by proper identification? What if we phrased the hedge as a hedge of the currency �to be received� instead of a hedge of the interest bearing loan receivable? Analogy to anticipatory hedge of nonfunctional currency sales revenue.

21. 21 Even if the section 1221 hurdle is overcome, we still have a timing issue. The �50.85 currency gains and �185.55 of losses that are recognized are predominantly due to the principal, with respect to which CFC1 has not yet had a realization event. If these are recognized prior to the realization event with respect to the principal, then there is a timing discontinuity. This is where section 446(b) and Treas. Reg. �1.446-4 should apply to allow the taxpayer to defer the gains and losses on the forwards in order to achieve proper �matching� and clearly reflect income. But absent express examples, how comfortable should taxpayers be? Treas. Reg. �1.446-1(a)(2) (�Each taxpayer shall adopt such forms and systems as are, in his judgment, best suited to his needs. However, no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income.�). After all, one could argue that the underlying �risk� that is really being hedged is the revaluation of the underlying receivable for GAAP purposes . . . and that occurs every month.

22. 22 Even if the section 1221 and 446 hurdles are overcome, what is the result if: taxpayer inadvertently fails to identify; or taxpayer identifies, but fails to identify the �currency to be received�. The forwards remain �hedging transactions� within the meaning of Section 1221(b)(2), but they are not �identified� on or before the date the hedge is entered into as required by section 1256(e)(2). Treas. Reg. �1.1221-2(g)(2)(ii) provides for ordinary gain and loss treatment but does not cause an unidentified transaction to be considered �identified�. What happens, does section 446(b) and Treas. Reg. �1.446-4 trump sections 1256 and 1092?

23. 23 Example Two

24. 24

25. 25 If hedge treatment does not apply: CFC1�s gains on the forwards will be considered foreign personal holding company income. Losses will be trapped as they will only reduce CFC1�s E&P and cannot be used to reduce other categories of foreign personal holding company income.

26. 26 If hedge treatment did apply: CFC1 could possibly qualify the gains and losses on the hedge as gains and losses on a �bona fide hedge� that qualifies for the business needs exception.

27. 27 For hedge treatment to apply: Can CFC1 identify the hedges as hedging the risk of changes in the value of the Euro revenue stream that OPCO is entitled to (essentially ignores the separate QBU); or Can CFC1 identify the hedges as hedging the risk of distributions of Euros that CFC1 will receive from OPCO with respect to the royalty and that it will be forced to recognize under section 987; or Can CFC1 identify the hedges as hedging its investment in OPCO generally and the section 987 gains and losses that will arise? Are any of these arguments viable? Are the business needs exception rules broad enough to encompass situations where a CFC owns a number of disregarded QBUs and hedges its exposures to their risks?

28. 28 What if USCO enters into the hedges? USCO could enter into the hedge transaction. It is a hedge of a related party royalty receivable and so hedge accounting is not permitted anyway. So there should not be a GAAP restriction. If it does, however, and the U.S. tax rate exceeds the tax rate in CFC1, then the size of the hedge will have to be increased to ensure that the after-tax proceeds from the hedge are large enough to hedge the risk. QUESTION: Will the IRS seek to challenge loss deductions under a Columbian Rope or Young and Rubicam or section 482 clear reflection of income theory?

29. 29 Example Three

30. 30

31. 31 Consequences / Questions In this case, Treas. Reg. �1.954-2(g)(2)(iii) requires the F(x) loss with respect to the payment of the interest to be apportioned between subpart F and non-subpart F in the same manner as interest would be allocated and apportioned, which means: $80 reduces non-subpart F income; and $20 reduces subpart F income. Does this rule make sense from a policy perspective?

32. 32 Consequences / Questions Open Questions in Applying the Rule: Is a portion of the loss allocated to subpart F income treated as a loss outside of the FPHCI category of subpart F where the CFC has other categories of subpart F income? Is the loss apportioned by applying the priority rule provided by Section 954(b)(5) (related party interest reduces passive FPHCI first)?

33. 33 Consequences / Questions Absent some contrary argument, the entire $100 gain on the hedges would be subpart F income, yielding a whipsaw (i.e., net $80 of subpart F income where there should not be any). Is there an argument that the hedge relates to a borrowing that satisfies the requirements of Treas. Reg. �1.954-2(g)(2)(ii)(B)(1)(i)-(iii) and thus the entire hedge gain should be treated as non-subpart F? Is there any argument that the gain on the hedges should be similarly apportioned? Any argument that Treas. Reg. �1.861-9T(b)(1) can apply to gains as well as losses? (�Any expense or loss . . . incurred . . ..�). If not, any argument that Treas. Reg. �1.861-9T(b)(6) applies? (�This paragraph (b)(6) shall only apply where the hedge and the borrowing are in the same currency and shall not apply to the extent otherwise provided in section 988 and the regulations thereunder.�). See e.g., 1998 Field Service Advice 268 (Sep. 28, 1998). In this advice, the Service stated, �A�s liability was denominated in U.S. dollars, and the D Swap entitled it to receive U.S. dollars at a rate of P. Therefore, the D Swap hedge and U.S. dollar borrowing were denominated in the same currency.� Nevertheless, the advice dealt with a loss on the swap, not a gain, and so it was not clear from the advice whether the Service really needed to reach the issue we discuss here or whether it simply applied Treas. Reg. �1.861-9T(b)(1) Example 2.

34. 34 Questions?