PLR 1315008: Interest-rate hedging income qualifies as publicly traded partnership income

Plain-English summary

The IRS ruled that income earned by a publicly traded limited partnership from treasury locks, interest rate swaps, forward-start interest rate swaps, and interest rate caps was qualifying income under section 7704. The partnership used these transactions to manage interest-rate risk connected with its debt and requested the ruling only for transactions that could not be integrated with related debt instruments under the applicable regulation. The IRS concluded that the income qualified under the rules for interest and notional principal contracts. The ruling did not address whether the transactions could be integrated with the debt securities or whether the partnership was otherwise taxable as a partnership.

Ruling snapshot

• Question: Was income from the partnership's specified interest-rate hedging transactions qualifying income under section 7704?
• Outcome: Approved, on the submitted facts and representations.
• Key authorities: IRC § 7704(d); Treas. Reg. §§ 1.7704-3, 1.446-3, and 1.1275-6; IRC § 6110(k)(3).

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201315008 Third Party Communication: None
Release Date: 4/12/2013 Date of Communication: Not Applicable
Index Number: 7704.03-00
Person To Contact:
----------------------------------------------------- -----------------------, ID No. -------------------
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------------------------ Telephone Number:
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Refer Reply To:
CC:PSI:B03
PLR-138812-12
Date: January 4, 2013

                                                LEGEND

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

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

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

  This letter responds to a letter dated September 5, 2012, submitted on behalf of

Company, requesting that income derived from treasury locks, interest rate swaps,
forward-start interest rate swaps, and interest rate caps 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, through affiliated operating limited partnerships and limited liability
companies that are disregarded entities or partnerships for federal tax purposes,
engages in a variety of activities, including terminaling and storage services for
petroleum products and by-products and natural gas services.

   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
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
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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. The amounts the parties owe to each other
are netted and settled periodically according to the swap’s terms.

  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
equal to the excess of the excess interest rate multiplied by the notional principal
amount over the term of the forward lock. On the other hand, if the fixed rate exceeds
the floating index rate on the date of issuance of the debt securities, Company owes the
counterparty the excess of the fixed rate over the floating index rate multiplied by the
notional principal amount over the term of the forward lock. The amounts the parties
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owe to each other over the term of the forward lock are calculated and netted on the
anticipated date of issuance of the debt securities.

   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.

    When Company wants to put an upper limit on a floating interest rate associated

with a floating rate debt instrument, it may enter into an interest rate cap. In an interest
rate cap, Company will pay a counterparty an upfront fixed payment. The counterparty,
typically a financial institution, agrees to pay Company an amount equal to a floating
index rate, determined by reference to some established index, multiplied by a notional
principal amount if, and only if, the floating index rate exceeds a specified cap rate on a
specified payment date.

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

swaps, and interest rate caps 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, forward-start
interest rate swap, or interest rate cap 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
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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
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 and interest rate caps. 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 or interest rate cap 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, forward-start
interest rate swap, and interest rate cap 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, forward-start interest rate swaps, or
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interest rate caps can be integrated with the related debt securities under § 1.1275-6, as
well as to 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.

  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,



                                  James A. Quinn
                                  Senior Counsel, Branch 3
                                  Office of the Associate Chief Counsel
                                  (Passthroughs & Special Industries)

Enclosures (2):

  Copy of this letter
  Copy for § 6110 purposes