Section 988 Hedging Impacted By Economic Problems

Lending or borrowing in foreign currency subjects a U.S. company to foreign currency risk, which can be reduced or eliminated using a hedge. For tax purposes, the debt instrument and the hedge usually are two separate properties and the usual tax rules that are applicable to the debt instrument and the hedge may result in timing and character mismatches. To eliminate these issues, a company may designate the hedging instrument or instruments and the debt as a section 988 hedging transaction. A section 988 hedging transaction integrates the hedge with the debt instrument to create a synthetic debt instrument denominated in a currency other than the debt’s currency. For example, a bond that pays in Euros may be turned into a synthetic U.S. dollar bond when it is integrated with an appropriate pay Euro/receive U.S. dollars swap contract.

The effect of the section 988 hedging transaction is to treat for federal income tax purposes the transactions as if they were a single synthetic debt instrument issued in another currency. This treatment is for the taxpayer that has entered into the transaction and does not affect the tax treatment of any of the other parties to the transactions. In addition to coordinating timing and character, other benefits of a section 988 hedging transaction are that neither the qualifying debt instrument nor the hedge will be subject to the section 1092 straddle rules, the section 1256 mark-to-market rules, or the section 263(g) capitalization rules.

To qualify as a section 988 hedging transaction, the rules of the Treasury regulations1 must be met, including a requirement that the transaction be identified as a qualified hedging transaction before the close of the day that the hedge is entered into. The synthetic debt instrument will remain in place so long as the qualifying debt and the hedge remain in place.