Hedging Currency Exposure When Investing in Non-U.S. Debt Instruments– June 09, 2021 by Ken Fu

U.S. taxpayers who invest in debt instruments not denominated in U.S. dollars are often interested in hedging the currency exposure of these types of investments. This is commonly accomplished with an investment into a forward contract, futures contract, options contract or other instrument denominated in the respective foreign currency.

Tax, Timing and Economic Substance

Both the debt instrument and the instrument used for hedging currency risk qualify as “Section 988 transactions.” Among other things, this means that the currency portion of the overall gain/loss upon disposition may be ordinary in character and in an amount based on certain netting rules. A general application of these tax rules could mean a mismatch of character and/or timing of income recognition when separate components of the hedge are disposed of at different times.

IRC Sec. 988(d) and Reg. Sec. 1.988-5 attempt to alleviate the mismatch and preserve economic substance in the tax treatment of these hedging transactions. Upon entering the debt instrument and the corresponding hedge position(s), the taxpayer may designate these to be a “qualified hedging position.” The two positions are then treated as a single integrated transaction with the currency gain/loss recognition on both the debt instrument and the hedge position tied together.

Private Letter Rulings and Proposed Treatments

As currency exposure hedging strategies do not all strictly take the form prescribed above, and the frequency at which such transactions may be entered and closed may render the administrative burden of identifying and tracking qualified hedge positions cumbersome and impractical. Reg. Sec. 1.988-5(e) allows a taxpayer to propose an equitable tax treatment and seek an advance ruling from the IRS Commissioner to bless the tax consequences of a specific currency exposure hedging strategy.

One example of the IRS Commissioner approving the tax treatment on a proposed hedging system is found in Letter Ruling 202038001. The requesting taxpayer sought to track the performance of an unrelated third-party index consisting of a large number of non-U.S. denominated debt instruments while minimizing the risk of foreign currency rate fluctuations. The taxpayer would enter monthly resetting forward contracts to reduce the currency exposure on the debt instruments. The taxpayer proposed an approach whereby only the aggregate net realized currency gains/losses of each currency at year end, after offset with the corresponding aggregate unrealized currency gains/losses, would be recognized each year. No specific positions would be identified as “qualified hedge positions” and the taxpayer would account for the hedge on the currency exposure on an aggregate basis. The IRS Commissioner approved this foreign currency hedging method as a reasonable approach to track the performance of a third-party index while reducing economic exposure to foreign currency risk.

Other Tax Considerations

Beyond the currency hedges of IRC Sec. 988(d) and Reg. Sec. 1.988-5, other tax provisions may be applicable to currency hedging transactions with similar tax results. Consider the straddle provisions of IRC Sec. 1092. Two or more positions are considered offsetting positions of a tax straddle when holding one position provides for “substantial diminution” of the risk of loss from holding the other. When two or more positions constitute a straddle, any realized loss from the disposition of one position is deferred to the extent of unrealized gain on the offsetting position still held. However, it is important to note that the straddle rules apply regardless of the taxpayer’s investment intent and may have other tax consequences, including cessation of holding period accumulation while the straddle is in effect.

As different tax rules may overlap in this area and may not necessarily be consistent with the economic reality of a given trading strategy, taxpayers should consider their options when entering these types of hedging strategies.

Contact Ken Fu at kfu@cohencpa.com or a member of your service team to discuss this topic further.

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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.