Foreign-currency linked structured notes are a fast-growing segment of the structured products market. The federal income tax treatment of such a note depends on its specific terms. Foreign-currency linked structured notes typically do not bear a current coupon and are, consequently, treated as either “Type 1” notes (principal-protected, treated as debt for tax purposes) or “Type 2” notes (non-principalprotected, with a tax treatment that depends on the specific terms of the note).1 This difference is significant as it will determine whether a holder should include income currently or can adopt “wait and see” taxation (i.e., no current inclusion of income). In addition, special rules address the federal income tax treatment of transactions in which the taxpayer is entitled to receive an amount determined by reference to the value of one or more nonfunctional currencies (a “Section 988 Transaction”). Any gain or loss from a Section 988 Transaction is generally treated as ordinary instead of capital in nature. Below, we discuss three examples of foreigncurrency linked structured notes that have recently been offered on a regular basis by various issuers.
Example 1. Under the terms of a note, investor pays $100 to the issuer at inception, at which time $100 equals €75, in exchange for the payment at maturity of a U.S. dollar equivalent amount (determined at maturity) of the sum of (1) €75; and (2) a eurobased compounded rate of return applied to €75, less a certain fee. Investor’s functional currency is the U.S. dollar.
The IRS addressed the federal income tax treatment of the note described in Example 1 in Revenue Ruling 2008-1 (“Ruling”). In the Ruling, the IRS held that, even though there is a significant possibility that the payment at maturity as determined in U.S. dollars may be significantly less than the payment at inception as determined in U.S. dollars, the note is a euro-denominated debt instrument for federal income tax purposes (i.e., a Type 1 note) and that such characterization is not affected by whether the note is privately offered, publicly offered or traded on an exchange. As a result, the interest accruing on the note is taxable to the investor on a current basis, and any income realized by the investor is taxed as ordinary income to the extent such income is attributable to accrued interest or foreign currency gain.
Example 2. Investor purchases a twoyear note at original issue for $100. The note pays interest in U.S. dollars at the rate of 4% compounded semiannually. At maturity, the investor is entitled to an amount equal to $100 plus the equivalent of the excess, if any, of (a) the value of the FTSE 100 index determined and translated into U.S. dollars on the last business day prior to the maturity date, over (b) £2,150, the “stated value” of the FTSE 100 index, which is equal to 110% of the average value of the index for the six months prior to the issue date, translated at the exchange rate of £1 = $1.50. Investor’s functional currency is the U.S. dollar.
The note described in Example 2 is “principal protected” as determined in U.S. dollars and is, therefore, treated as a debt instrument for federal income tax purposes (i.e., a Type 1 note). Further, because the contingent payment at maturity is determined by reference to the FTSE 100 index and not by reference to the value of a nonfunctional currency, an investment in the note is not a Section 988 Transaction. Nevertheless, because the note is subject to the rules governing “contingent payment debt instruments,” any gain realized by the on a sale investor is treated as ordinary income and not capital gain.
Example 3. Pursuant to the terms of a note, investor pays $100 to the issuer at inception, at which time one euro equals 130 Japanese yen and 2.6 Brazilian reais. At maturity, after a term of three years, the issuer will pay the investor $100 plus or minus $100 times the average change in the exchange rates, since the inception date, between (i) the euro and the Japanese yen; and (ii) the euro and the Brazilian real.
Because the payment at maturity on the note described in Example 3 is not determined by reference to a single nonfunctional currency, there is, depending on the term of the note and the volatility of the relevant exchange rates, a significant possibility that the payment at maturity may be significantly less than the payment at inception as determined in either U.S. dollars, euros or Brazilian reais. As a result, the note is not principal protected in any currency and is not treated as a debt instrument for federal income tax purposes (i.e., the note is treated as a Type 2 note). The investor therefore is not required to include income on a current basis. Because the amount of the payment at maturity is determined by reference to the value of nonfunctional currencies, the transaction is considered a Section 988 Transaction with the result that any gain or loss with respect to the note is treated as ordinary rather than capital. However, the special rules under Section 988 include a provision pursuant to which a taxpayer may elect capital treatment with respect to certain Section 988 Transactions. Although not clear, an investor in a note as described in Example 3, may be entitled to elect capital treatment with respect to any gain or loss realized. Such an election must be made by the investor by clearly identifying the investment in the notes on his books and records on the date he acquires the note as being subject to the election and by meeting certain other requirements set forth in applicable U.S. Treasury regulations under Section 988.