Both issuers and holders of debt instruments may enter into hedging transactions in an effort to minimize or manage risk on such debt. As a general matter, separate financial instruments are taken into account separately for federal income tax purposes. Current Treasury regulations, however, permit the integration of certain debt instruments (“qualifying debt instruments”) and certain hedges (“section 1.1275-6 hedges”) provided specified requirements are satisfied. This integration permits “a more appropriate determination of the character and timing of income, deductions, gains or losses than would be permitted by separate treatment of the components.”19 The integrated transaction is subsequently taken into account for federal income tax purposes, rather than the separate components of the transaction. The integration regulations affect only the taxpayer who holds or issues the qualifying debt instrument and enters into the 1.1275- 6 hedge.
In order for a qualifying debt instrument and 1.1275-6 hedge to be integrated for tax purposes, certain requirements must be satisfied. A qualifying debt instrument is any debt instrument, including a synthetic debt instrument arising from an integrated transaction, other than (i) a tax-exempt obligation; (ii) a debt instrument subject to certain original issue discount rules based on possible acceleration of principal; or (iii) a contingent debt instrument issued for nonpublicy traded property. A 1.1275- 6 hedge is any financial instrument or combination of financial instruments (including a forward or futures contract, an option, a notional principal contract, a debt instrument but not stock) if the combined cash flows of the financial instrument and qualifying debt instrument permit the calculation of a yield to maturity, or the right to the combined cash flows would qualify as a variable rate debt instrument20 that pays interest at a qualified floating rate or rates. A taxpayer may only integrate a qualifying debt instrument and a 1.1275-6 hedge if the following requirements are satisfied:
- Certain identification requirements must be satisfied on or before the date the taxpayer enters into the 1.1275-6 hedge, including entering and retaining the following information in the taxpayer’s books and records: (a) the date the qualifying debt instrument was issued or acquired and the date the 1.1275-6 hedge was entered into; (b) a description of the qualifying debt instrument and the 1.1275-6 hedge; and (c) a summary of cash flows and accruals resulting from the integrated transaction;
- No parties to the 1.1275-6 can be related (or, if the parties are related, the party providing the hedge must use mark-to-market accounting for the hedge and all similar or related transactions);
- Both the qualifying debt instrument and the 1.1275-6 hedge are entered into by the same individual, partnership, trust, estate, or corporation;
- If the taxpayer is a foreign person engaged in a U.S. trade or business and issues or acquires the qualifying debt instrument or enters into the 1.1275-6 hedge through such trade or business, all items of income and expense associated with the qualifying debt instrument or hedge would have been effectively connected with the U.S. trade or business throughout the term of the qualifying debt instrument;
- Neither the qualifying debt instrument nor the 1.1275-6 hedge can have been part of an integrated transaction that was terminated by the taxpayer under the legging out rules within 30 days immediately preceding the issue date of the synthetic debt instrument; 6. The qualifying debt instrument must be issued or acquired on or before the date of the first payment on the 1.1275- 6 hedge or issued or acquired after, but substantially contemporaneously with, the date of the first payment on the 1.1275-6 hedge; and
- Neither the 1.1275-6 hedge nor the qualifying debt instrument can be part of a straddle prior to the issue date of the synthetic debt instrument.
Assuming a qualifying debt instrument and section 1.1275-6 hedge qualify for integration for federal income tax purposes, the resulting “synthetic debt instrument” has the same cash flows as the combined cash flows of the two instruments. Regardless of the aforementioned integration requirements, the Treasury regulations include an antiabuse provision that authorizes the IRS to treat a qualifying debt instrument and a financial instrument as an integrated transaction if the combined cash flows on the qualifying debt instrument and financial instrument are substantially the same as the combined cash flows required for the financial instrument to be a 1.1275-6 hedge.
Once a qualifying debt instrument and 1.1275-6 hedge are integrated, the resulting synthetic debt instrument is treated as a single instrument and, as noted above, neither the qualifying debt instrument nor the 1.1275-6 hedge are subject to the Internal Revenue Code or Treasury regulations that would apply on a separate basis.