Bond index fund may use portfolio-level tax method for currency hedges

Plain-English summary

A regulated investment company tracked an index of foreign-currency bonds whose currency exposure was offset with rolling one-month forward contracts. Because the fund held many bonds, it hedged its aggregate exposure to each currency rather than pairing each forward contract with a particular bond. Its proposed tax method aggregated realized and unrealized currency gains and losses, deferred realized amounts to the extent of offsetting unrealized amounts, and recognized unmatched amounts as ordinary income or loss. Special rules would end deferral when a bond was distributed in a nonrecognition transaction. The IRS used its authority under Treasury Regulation section 1.988-5(e) to approve the method. It emphasized that the public fund tracked a third-party index and used the hedges to reduce currency risk on its bond returns.

Ruling snapshot

• Question: May the index-tracking fund use its proposed portfolio-level method to determine the timing, character, and amount of currency gain or loss on bonds and forward hedges?
• Outcome: approved
• Key authorities: IRC § 988(b), (c), and (d); Treas. Reg. §§ 1.988-2(b)(8) and 1.988-5(e)

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Washington, DC 20224

Number: 201704013
Third Party Communication: None
Release Date: 1/27/2017
Date of Communication: Not Applicable
Index Number: 988.05-00
Person To Contact:
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Refer Reply To:
CC:INTL:B05
PLR-122647-16
Date:
November 01, 2016

X = -------------------
Taxpayer = --------------------------------------------------------------- Index = ----------------------------------------------------------------------------------------------
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Index Creator = ---------------------------
Trust = ------------------------------------
State A = --------------

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

This is in response to your letter, dated X, requesting permission, pursuant to Treas. Reg. § 1.988-5(e), to use the method described below to determine the timing, character and amount of foreign currency gain or loss on foreign currency denominated bonds and forward contracts entered into for the purpose of hedging the right to receive foreign currencies on such bonds.

FACTS

The Taxpayer is a series of Trust, a State A statutory trust that is registered with the Securities and Exchange Commission (the “SEC”) under the Investment Company Act of 1940, as amended, as an open-end management investment company. The Taxpayer has qualified and expects to qualify each year as a “regulated investment company” under Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”).

As provided in its prospectus and other public offering materials available to investors and in its public filings with the SEC, Taxpayer seeks to track the performance of the Index, which has been created by the Index Creator. The Index measures, in U.S. dollars, the performance of specified foreign currency denominated bonds after applying a foreign currency hedging method. The bonds included in the Index are selected, and the foreign currency hedging method has been created, by the Index
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Creator. Under the Index Creator’s hedging method, the currency return on the foreign currency denominated bonds in the Index is offset (relative to the U.S. dollar) by rolling one-month forward contracts on those currencies. No adjustment is made to the hedge during the month to account for changes in the market value of the constituent bonds in the Index. The forward contracts are reset monthly to adjust the Index’s relative positions in the foreign currency denominated bonds and forward contracts, including to account for the intra-month changes in market value of the foreign currency denominated bonds. The hedging method is designed to reduce economic exposure to the foreign currency risk associated with the foreign currency denominated payments received on the bonds.

To track the performance of the Index, the Taxpayer invests in a sampling of foreign currency denominated bonds included in the Index and also enters into rolling monthly forward contracts to offset the effect of foreign currency rate fluctuations on the values of those foreign currency denominated bonds in the manner prescribed by the Index Creator’s hedging method. Any deviation from the Index Creator’s hedging method creates tracking error in the Taxpayer’s portfolio returns relative to the Index’s returns. The Taxpayer seeks to minimize such tracking error. Therefore, the Taxpayer enters into forward contracts in an amount and manner that tracks the Index Creator’s hedging method as closely as possible.

Consistent with the Index Creator’s hedging method and in light of the large number of foreign currency denominated bonds in both the Index and held by the Taxpayer, the Taxpayer does not execute its currency hedges on a bond-by-bond basis. Rather, in order to determine the appropriate notional amount of forward contracts needed to hedge each relevant currency in its portfolio, the Taxpayer aggregates the market values of all of its bonds that are denominated in that currency. The Taxpayer also includes any foreign currency cash balances held by the Taxpayer as part of the foreign currency exposure being hedged by the monthly forward contracts.

For tax purposes, the Taxpayer accounts for the forward contracts and foreign currency components of the foreign currency denominated bonds for each taxable year under its tax accounting method. Under its tax accounting method, the Taxpayer determines its net realized foreign currency gain and loss in its portfolio by aggregating the foreign currency gain and loss realized in its different holdings during the year, including those generated from (i) foreign currency denominated bonds disposed of or with respect to which principal or interest payments were received during the year, (ii) non-U.S. dollar cash positions disposed of during the year and (iii) forward contracts closed or marked to market during the year.. Each year, for purposes of determining the amount of realized foreign currency gain and loss:

1) The Taxpayer marks to market all of the forward contracts that are outstanding as of year-end. The Taxpayer determines gain or loss arising from the foreign currency component of each foreign currency denominated bond sold during the year by limiting such gain or loss to the overall amount
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of gain or loss on the sale, applying the netting rule of Section 988(b)(1) and (b)(2) and Treas. Reg. § 1.988-2(b)(8).
2) The Taxpayer determines its net unrealized foreign currency gain and loss in its
portfolio by aggregating the unrealized (“built-in”) foreign currency gain and loss
in its foreign currency denominated bonds and non-U.S. dollar cash positions
held at the end of the year. Each year, for purposes of determining the amount
of unrealized foreign currency gain and loss: (a) the Taxpayer disaggregates the
foreign currency component embedded in each foreign currency denominated
bond retained at year-end from the bond’s other economic components; and (b)
the Taxpayer does not net the unrealized gain or loss arising from the foreign
currency component of a bond against the unrealized loss or gain arising from
the bond’s other components. Instead, it will measure the amount of unrealized
foreign currency gain or loss on each bond on a gross basis.
3) The Taxpayer then compares its net realized foreign currency gain or loss to its
net unrealized foreign currency gain or loss, and defers any net realized foreign
currency gain or loss to the extent of offsetting net unrealized foreign currency
loss or gain. These deferred amounts are treated as realized on the first day of
the following taxable year (and included in the realized foreign currency gain and
loss amount for purposes of that following year’s netting calculation). The
Taxpayer treats as ordinary income or loss any excess net realized foreign
currency gain or loss that is not offset (deferred) under this calculation and
recognizes it in the current taxable year.
4) If, in a nonrecognition transaction (e.g. under Code Sections 311(a) and
852(b)(6)), the Taxpayer disposes of a foreign currency denominated bond with
unrealized foreign currency gain or loss with respect to which realized foreign
currency loss or gain has been (or otherwise would be) deferred under the above
mechanisms, the Taxpayer will: (a) terminate the deferral of (and recognize) the
realized foreign currency gain or loss to the extent of the corresponding
unrealized foreign currency loss or gain in the distributed foreign currency
denominated bond; and (b) recognize the corresponding unrealized foreign
currency loss or gain in the distributed foreign currency denominated bonds. In
calculating the Taxpayer’s net realized and unrealized foreign currency gain and
loss, the foreign currency component of each item of the foreign currency
denominated bond (whether, for instance, such item is interest, market discount,
or gain or loss) is included in the Taxpayer’s realized foreign currency gain or
loss amount in the year such item is required to be taken into account under
applicable realization provisions of the Code.

                                          LAW

    Section 988(d)(1) of the Code provides that, to the extent provided in regulations,

if any section 988 transaction is part of a 988 hedging transaction, all transactions which are part of such 988 hedging transaction shall be integrated and treated as a single transaction or otherwise treated consistently for purpose of this subtitle.
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   Section 988(c)(1)(A) provides that the term “section 988 transaction” includes the

acquisition of a debt instrument if the amount which the taxpayer is entitled to receive or is required to pay by reason of such transaction is denominated in terms of a nonfunctional currency.

   Section 988(b)(1) provides that the term “foreign currency gain” means any gain

from a section 988 transaction to the extent such gain does not exceed gain realized by reason of changes in exchange rates on or after the booking date and before the payment date. Section 988(b)(2) provides that the term “foreign currency loss” means any loss from a section 988 transaction to the extent such loss does not exceed the loss realized by reason of changes in exchange rates on or after the booking date and before the payment date.

    Treas. Reg. §1.988-2(b)(8) provides that when a nonfunctional currency

denominated debt instrument is paid or disposed of, pursuant to Section 988(b)(1) and (2), the sum of any exchange gain or loss with respect to the principal and interest of any such debt instrument shall be realized only to the extent of the total gain or loss realized on the transaction. The gain or loss realized shall be recognized in accordance with the general principles of the Code.

    Section 988(d)(2) of the Code provides that the term “988 hedging transaction”

means any transaction entered into by the taxpayer primarily to manage risk of currency fluctuations with respect to property which is held or to be held by the taxpayer, or to manage risk of currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred, by the taxpayer and is identified by the Secretary or the taxpayer as being a 988 hedging transaction.

   Treas. Reg. §1.988-5(e) provides that in his sole discretion, the Commissioner

may issue an advance ruling addressing the income tax consequences of a taxpayer's system of hedging either its net nonfunctional currency exposure or anticipated nonfunctional currency exposure. The ruling may address the character, source, and timing of both the section 988 transaction(s) making up the hedge and the underlying transactions being hedged. The procedures for obtaining a ruling shall be governed by such pertinent revenue procedures and revenue rulings as the Commissioner may provide. The Commissioner will not issue a ruling regarding hedges of a taxpayer's investment in a foreign subsidiary.

                                       ANALYSIS

   As described in its prospectus and other offering materials that are filed publicly

with the SEC and/or otherwise made publicly available by the Taxpayer (or its service providers), the Taxpayer seeks to track the performance of the Index as created by Index Creator. Consistent with that objective, the Taxpayer enters into foreign currency forward contracts in an amount and manner that tracks the Index Creator’s hedging
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method as closely as possible. This hedging method is designed to reduce the Taxpayer’s economic exposure to the foreign currency risk associated with the foreign currency denominated payments it receives on its bond portfolio.

RULING

Based on the information submitted and the representations made, we rule as follows:

Under the authority provided in Treas. Reg. §1.988-5(e), we grant the Taxpayer permission to use the tax accounting method described above for determining the timing, character and amount of foreign currency related gain or loss on foreign currency denominated bonds and the forward contracts entered into for the purpose of hedging the right to receive foreign currencies on such bonds for the following reasons:

1) The investment fund which is being hedged has been designed to track the performance of an index created by a third party.

2) The underlying assets which are being hedged under the Taxpayer’s foreign currency hedging method are bonds which are part of a publicly available investment fund.

3) The tax accounting method is a foreign currency hedging method designed for the purpose of reducing economic exposure to the foreign currency risk associated with the foreign currency denominated payments received on the bonds which might adversely affect returns on the fund to the public investors.

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 request for the ruling, it is subject to verification on examination.

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.
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This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is being sent to your authorized representatives.

Sincerely,

Steven D. Jensen
Senior Counsel, Branch 5
Office of the Associate Chief Counsel
(International)