Terminating Debt Instrument Hedges

Rev. Rul. 2002-71 clarifies when to account for gain or loss from a termination of a swap used to hedge a debt instrument. It generally provides that when the swap hedges the entire term of the underlying debt instrument, the gain or loss should be spread over the remaining term of the hedged debt. If the swap hedges only a portion of the debts term, however, the gain or loss is spread over the remaining portion of the term hedged, that was the remaining term of the swapnot over the entire remaining debt term.

Many taxpayers enter into interest-rate swaps to hedge debt instruments. For instance, a taxpayer with a floating-rate borrowing may enter into a swap that essentially converts the borrowing into a fixed-rate borrowing. Under the swap, the taxpayer makes fixed-rate payments to its counterparty in return for receiving the floating rate under the swap; in practice, however, the payments are typically netted.

If market interest rates rise, the taxpayer will have a built-in gain on the swap. If the taxpayer terminates the swap at that time, the taxpayer will receive a payment from its counterparty, representing the present value of anticipated future payments under the swap. Under the normal rules for accounting for swaps under Regs. Sec. 1.446-3, the termination payment would be recognized on the termination of the swap. The hedge timing rules, however, preempt the normal rules and would require the spread of gain over the term that the debt was hedged.

Under Regs. Sec. 1.446-4(e)(4), gain or loss from a hedging transaction must be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge relates. Generally, the gain or loss is properly accounted for under constant-yield principles, as though it adjusted the yield of the debt instrument over the term to which the hedge relates.

Rev. Rul. 2002-71 addressed a situation in which an interest-rate swap hedged only a portion of the debt instruments entire term. It provided two examples involving five-year swaps used to hedge debt instruments with a 10-year term. In both examples, the taxpayer terminated the swap at the end of the second year. The ruling held that gain or loss from terminating the swap is neither spread over the entire term of the debt instrument nor accounted for entirely in the termination year. Instead, the gain or loss must be spread over years three through five (i.e., the remaining period to which the terminated hedge relates). If the debt instrument is retired before the end of the fifth year, the ruling holds that the remaining balance of the gain or loss should be accounted for at that time.

In light of this ruling, it may be advisable for taxpayers to review their treatment of interest-rate swaps and determine if they have been under- or overreporting gain or loss from terminated hedged transactions. Some taxpayers may be accounting for the gain or loss by spreading it over the entire remaining term of the hedged debt instrument, even though the hedging transaction relates to a shorter period of time. Others may be accounting for the gain or loss entirely in the year the transaction is terminated, rather than spreading it over the period originally hedged. If taxpayers reported the transactions incorrectly, they might find it appropriate to file an amended return or an application to change accounting method.

In reviewing hedging transactions, it is also advisable to assess whether they were properly identified, as required by Regs. Sec. 1.1221-2(f). Although the hedge timing rules do not require identification, that is necessary to obtain ordinary treatment under the rules on the character of a hedging transaction. Absent an effective identification for tax purposes, gain or loss from terminating a swap could be treated as a capital gain or loss.

From Jo Lynn Ricks, J.D., LL.M., and Helen Yanchisin, J.D., Washington, DC