PLR 1208021: Interest-rate hedging income qualifies for publicly traded partnership income test

Plain-English summary

The IRS ruled that income from treasury locks, interest rate swaps, and forward-start interest rate swaps was qualifying income under the publicly traded partnership rules. The partnership used these transactions to manage interest-rate risk connected with its debt. The ruling treated the swap-related income as qualifying because its cash flows were measured by reference to interest and would be treated as interest income if received directly, while the other hedging transactions were common and routine investments substantially similar to notional principal contracts. The ruling did not address whether the instruments could be integrated with related debt securities or whether the partnership's operating income separately qualified.

Ruling snapshot

• Question: Does income from specified interest-rate hedging transactions count as qualifying income for a publicly traded partnership?
• Outcome: Approved, the specified hedging income qualifies
• Key authorities: IRC §§ 7704, 1275, 446, and 856; Treas. Reg. §§ 1.7704-3, 1.446-3, and 1.1275-6

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201208021 Third Party Communication: None
Release Date: 2/24/2012 Date of Communication: Not Applicable
Person To Contact:
Index Number: 7704.03-00 ----------------------, ID No. -----------------
Telephone Number:
---------------------
--------------------------------------------------- Refer Reply To:
------------------------------- CC:PSI:B03
----------------------------- PLR-135081-11
------------- Date:
--------------------------- November 01, 2011

                                                   LEGEND

Company = -------------------------------------------------------------------------------------------------
-----------------------

State = -------------

Dear --------------:

    This letter responds to a letter dated August 22, 2011, submitted on behalf of

Company, requesting that income derived from treasury locks, interest rate swaps, and
forward-rate interest swaps is qualifying income within the meaning of § 7704(d)(1) of
the Internal Revenue Code.

                                                   FACTS

    Company is a publicly-traded limited partnership organized under the laws of

State. Company has not elected to be taxed as an association for federal tax purposes.
Company conducts its business through affiliated operating limited partnerships and
limited liability companies that are disregarded entities or partnerships for federal tax
purposes.

    Company is principally engaged in the transportation, storage and marketing of

refined petroleum products and natural gas.

    In order to obtain funds for asset acquisitions and to conduct its operations,

Company periodically issues debt securities. The interest rate payable on these
securities is a function of the prevailing interest rate on a U.S. Treasury bond of the
PLR-135081-11 2

same maturity as Company’s proposed debt issue, and of Company’s credit rating. In
the time period between Company’s decision to issue debt and its actual issuance (the
exposure period), Company is at risk that its cost for such debt capital will be increased
by an increase in interest rates on U.S. Treasuries. To minimize this risk, Company
enters into treasury locks – an arrangement in which an unrelated party agrees to
purchase U.S. Treasury bonds from Company at a price certain and with an interest
rate equal to the rate in effect on the date of agreement. If the prevailing rate on
Treasury bonds increases during the exposure period, Company then can purchase
Treasuries at a lower market price for sale to the counterparty, thus realizing a gain that
offsets Company’s increased cost of debt capital. If, however, the prevailing Treasury
rate decreases during the exposure period, upon settlement of the treasury lock
Company realizes a loss that offsets the lower cost of issuing its debt. (Generally, no
Treasury bonds are actually purchased and delivered; the parties settle on a net basis.)

    Company’s capital structure includes both fixed and floating rate debt. At a given

time, Company may determine that market conditions favor paying a floating rate when
it has a fixed rate debt outstanding. At other times, Company may determine that
market conditions favor paying a fixed rate when it has a floating rate debt outstanding.
In either case, Company may engage in an interest rate swap.

   To obtain a cash flow at a floating rate in exchange for one at a fixed rate,

Company will agree to pay to an unrelated party, typically a financial institution, a fixed
interest rate on a notional principal amount. In return, the counterparty agrees to pay
Company a floating index rate, determined by reference to some established index, on
the notional principal amount. If the index rate for a given month exceeds the fixed rate,
the counterparty owes Company an amount equal to the excess interest rate multiplied
by the notional principal amount. If, however, the fixed rate exceeds the index rate in a
month, Company owes the counterparty. Amounts owing are netted at settlement,
which occurs at the end of the interest rate swap’s term.

  Exchanging a floating rate cash flow for a fixed rate flow operates in a similar

manner, except that Company will pay the counterparty a floating interest rate on a
notional principal amount, and it will receive fixed rate payments in return.

    As an alternative to interest rate swaps, Company may desire to lock in a current

rate with respect to a future issuance, in which case, one of its available options is to
enter into a forward-start interest rate swap. To lock in a spot interest rate for a period
prior to the issuance of its fixed-debt securities (a forward lock), Company will agree to
pay a counterparty a fixed interest rate on a notional principal amount. The
counterparty, typically a financial institution, would agree to pay Company an amount
equal to a floating index rate, determined by reference to some established index,
multiplied by the notional principal amount for a fixed period that begins on the date of
the anticipated debt issuance. If the index rate exceeds the fixed interest rate on the
date of issuance of the debt securities, the counterparty owes Company an amount
PLR-135081-11 3

equal to the excess of the excess interest rate multiplied by the notional principal
amount over the term of the forward lock.

   Converting an expected floating-rate debt securities offering into a fixed rate

instrument operates in a similar manner as exchanging a floating rate cash flow for a
fixed rate flow, except its effective date is in the future because its term coincides with
an expected floating-rate debt issuance and not an existing floating-rate debt issuance.

    In some cases, the treasury locks, interest rate swaps, and forward-start interest

rate swaps entered into by Company may be integrated with the related debt
instruments under § 1.1275-6 of the Income Tax Regulations. Company is requesting a
ruling to apply only where a treasury lock, interest rate swap, or forward-rate interest
swap can not be so integrated.

                              LAW AND ANALYSIS

   Section 7704(a) provides generally that a publicly traded partnership shall be

treated as a corporation.

   Section 7704(b) provides that the term “publicly traded partnership” means any

partnership if – (1) interests in such partnership are traded on an established securities
market, or (2) interests in such partnership are readily tradable on a secondary market
(or the substantial equivalent thereof).

   Section 7704(c)(1) provides, in part, that § 7704(a) shall not apply to any publicly

traded partnership for any taxable year if such partnership met the gross income
requirements of § 7704(c)(2) for such taxable year and each preceding taxable year
beginning after December 31, 1987, during which the partnership (or any predecessor)
was in existence. Section 7704(c)(2) provides that a partnership meets the gross
income requirements of § 7704(c)(2) for any taxable year if 90% or more of the gross
income of such partnership for such taxable year consists of qualifying income.

    Section 7704(d)(1)(A) provides, in part, that, except as otherwise provided in

§ 7704(d), the term “qualifying income” means interest. Section 7704(d)(2) provides
that interest shall not be treated as qualifying income if – (A) such interest is derived in
the conduct of a financial or insurance business, or (B) such interest would be excluded
from the term “interest” under § 856(f).

   Section 1.7704-3(a)(1) provides, in part, that for purposes of § 7704(d)(1),

qualifying income includes income from notional principal contracts (as defined in
§ 1.446-3) and other substantially similar income from ordinary and routine investments
to the extent determined by the Commissioner. Income from a notional principal
contract is included in qualifying income only if the property, income, or cash flow that
measures the amounts to which the partnership is entitled under the contract would give
PLR-135081-11 4

rise to qualifying income if held or received directly by the partnership. Section 1.7704-
3(a)(2) provides, in part, that qualifying income described in § 1.7704-3(a)(1) does not
include income derived in the ordinary course of a trade or business.

   Section 1.446-3(c)(1) defines a notional principal contract to include interest rate

swaps. Section 1.446-3(c)(1) also provides, in part, that generally a notional principal
contract is a financial instrument that provides for the payment of amounts by one party
to another at specified intervals calculated by reference to a specified index upon a
notional principal amount in exchange for specified consideration or a promise to pay
similar amounts.

  Payments due under an interest rate swap are not interest. There is no

borrowing and, hence, no compensation for use of forbearance of money. However,
such payments are measured by reference to an interest rate or interest rate index and
have a cash flow that would be treated as interest income and would not be excluded
under § 856(f) if held or received directly by Company.

   Company’s treasury locks and forward-start interest rate swaps are common and

routine transactions and, like Company’s interest rate swaps, they are entered into for
the purpose of managing the risk of interest rate movements on Company’s borrowings.
Under § 1.7704-3(a)(1), the Commissioner may determine the extent to which income
from ordinary and routine investments substantially similar to income from a notional
principal contract is included in qualifying income.

                                  CONCLUSION

   Based solely on the facts and representations submitted, we conclude that the

income Company derives from the treasury lock, interest rate swap and forward-start
interest rate swap transactions is qualifying income within the meaning of § 7704(d)(1)
and § 1.7704-3(a)(1).

   Except as expressly provided herein, no opinion is expressed or implied

concerning the tax consequences of any aspect of any transaction or item discussed or
referenced in this letter. Specifically, we express or imply no opinion as to whether
Company’s treasury locks, interest rate swaps, and forward-start interest rate swaps
can be integrated with the related debt securities under § 1.1275-6, or whether income
derived by Company from transportation, storage and marketing of refined petroleum
products and natural gas is qualifying income within the meaning of § 7704(d), or
whether Company is taxable as a partnership for federal tax purposes.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3)

provides that it may not be used or cited as precedent.
PLR-135081-11 5

  In accordance with a power of attorney on file with this office, we are sending a

copy of this letter to your authorized representative.

   The ruling contained in this letter is based upon information and representations

submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the ruling request, it is subject to verification on examination.

                                 Sincerely,



                                 Richard T. Probst
                                 Senior Technician Reviewer, Branch 3
                                 Office of the Associate Chief Counsel
                                 (Passthroughs & Special Industries)

Enclosures (2):

  A copy of this letter
  A copy for § 6110 purposes

cc: