On September 2, 2011, the IRS issued a Chief Counsel Advice9 (the “CCA”) in which it concluded that a taxpayer could not defer gain from a hedge with respect to debentures repurchased at a discount by the taxpayer that elected to defer cancellation of debt (“COD”) income on such debentures.

A taxpayer that repurchases its own debt at a discount realizes COD income equal to the difference between the debt’s adjusted issue price and the amount paid on repurchase. Under a provision included in the American Recovery and Reinvestment Act of 2009, COD income incurred in connection with a repurchase of debt instruments in 2009 and 2010 may be deferred for a 5-year (if reacquired in 2009) or 4-year period (if reacquired in 2010).10 After the deferral period, the taxpayer must include the deferred COD income ratably over the following five years.

As for hedging transactions, which are transactions generally entered into by a taxpayer to reduce the risk of interest rate, currency or price fluctuations with respect to its borrowings or obligations, the applicable Treasury regulations employ a matching principle where the method of accounting (i.e., the timing of income, deduction, gain or loss) selected by a taxpayer for such hedge must reasonably match the method of accounting of the items being hedged.11 Based on this matching principle, gain or loss recognized by a taxpayer on a hedging transaction must be taken into account with the terms of the debt instrument and the period to which the hedge relates. For example, in Revenue Ruling 2002-71,12 where a taxpayer entered into a swap that only hedged the initial five-years of a tenyear instrument, the ruling held gain or loss realized from the early termination of the hedge at the end of year two was required to be spread over the next three years as that was the period the hedge related to.

The facts of the CCA are as follows: the taxpayer issued junior subordinated debentures with an initial fixed rate, followed by a floating rate. Prior to the issuance of the debentures, the taxpayer entered into a 10-year swap to lock-in interest rates for the initial fixed-rate term of the instruments. The swap was intended to protect the taxpayer from interest rate changes from the inception of the swap until the completion of the issuance of the debentures. The taxpayer terminated the swap on the date of issuance of the debentures, resulting in gain realized by the taxpayer due to a termination payment by the swap counterparty. The taxpayer amortized the hedge gain over the remaining fixed rate interest period of the debentures (i.e., 10 years). The taxpayer later repurchased a percentage of the outstanding debentures, realizing COD income, and elected to defer the recognition of such COD income. The taxpayer argued that it could defer the unamortized hedge gain allocable to the repurchased debentures until the years the COD income was recognized.

The CCA concluded, despite the deferral of COD income, the taxpayer could not defer the unamortized hedge gain based on three arguments. First, the IRS argued that there was a lack of a connection between the COD income and the hedge gain with the result that, pursuant to the applicable matching principles, the hedge gain was required to be spread over the term to which the hedge relates (i.e., only the initial fixed rate term of the debentures).

Second, the COD income did not arise as a result of changes in interest rates even if it was interest rate risk that the hedge was intended to manage. Third, when the debentures were repurchased, the items being hedged were terminated, and to clearly reflect income, the unamortized hedge gain allocable to the repurchased debentures should be recognized in the year of repurchase since, in the IRS’s view, the relevant Treasury regulations do not permit the continued amortization of hedge gain once the hedged item was terminated.