Bond index fund may use portfolio-level currency hedge accounting

Plain-English summary

A regulated investment company held foreign-currency bonds to track a public index and used rolling one-month currency forwards to mirror the index's hedging method. Because the portfolio contained many bonds, the fund hedged aggregate exposure by currency rather than matching each contract to a specific bond. The proposed method aggregated realized and unrealized currency gains and losses, deferred realized amounts to the extent of offsetting unrealized amounts, and recognized remaining net realized currency gain or loss as ordinary. Special rules ended deferral when a hedged bond left the portfolio in a nonrecognition transaction. The IRS exercised its discretion under Treasury Regulation § 1.988-5(e) to approve the method because it reduced genuine currency exposure, tracked a third-party public index, applied to a publicly available bond fund, and was supported by internal controls.

Ruling snapshot

• Question: Could the index-tracking bond fund use its proposed aggregate method for timing, character, and amount of currency gains and losses?
• Outcome: approved
• Key authorities: IRC § 988(b), (c), (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: 201728003
Third Party Communication: None
Release Date: 7/14/2017
Date of Communication: Not Applicable
Index Number: 988.05-00
Person To Contact:
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Telephone Number:
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Refer Reply To:
CC:INTL:B05
PLR-108474-17
Date:
April 17, 2017

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

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 foreign currency contracts entered into for the purpose of hedging the right to receive foreign currencies on such bonds.

FACTS

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. 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 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 Index Creator. Under Index Creator’s hedging method, the currency return on the foreign currency denominated
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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, while managing the cost of rolling currency hedges.

To track the performance of the Index, 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 Index Creator’s hedging method. Any deviation from Index Creator’s hedging method creates tracking error in Taxpayer’s portfolio returns relative to the Index’s returns. Taxpayer seeks to minimize such tracking error. Therefore, Taxpayer enters into forward contracts in an amount and manner that tracks Index Creator’s hedging method as closely as possible.

Consistent with Index Creator’s hedging method and in light of the large number of foreign currency denominated bonds in both the Index and held by Taxpayer, 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, Taxpayer aggregates the market values of all of its bonds that are denominated in that currency at the beginning of each monthly hedging cycle. Taxpayer also includes any foreign currency cash balances held by Taxpayer as part of the foreign currency exposure being hedged by the monthly forward contracts.

Taxpayer rebalances its portfolio monthly to reflect new issuances and other additions of foreign currency denominated bonds to the Index, as well as upcoming maturities and other deletions of constituent bonds from the Index. To match the return of the Index, Taxpayer enters into foreign currency forward contracts with respect to each currency in which the bonds in Taxpayer’s portfolio are denominated. Each month, Taxpayer enters into the forward contracts at the current forward exchange rate. The forward contracts have approximately a one-month duration and provide for settlement at expiration. The notional amount of the forward contracts in each currency is based on the fair market value of the bonds denominated in the same currency and any accrued interest thereon.

As the forward contracts expire and are settled at the end of each month, Taxpayer rolls its forward contract positions by entering into new one-month forward contracts to hedge its foreign currency exposure with respect to the foreign currency denominated bonds held for the following month. If Taxpayer buys or sells foreign
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currency denominated bonds during the month, it adjusts the notional amount of its hedge so that, on a prospective basis, it would not be over- or under-hedged relative to the value in which the foreign currency bonds are denominated.

Pursuant to Treas. Reg. §1.988-5(e), Taxpayer requests to use the following method to determine the timing, character and amount of foreign currency gain or loss on its foreign currency denominated bonds and foreign currency contracts. Under its proposed method, 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) Taxpayer will mark to market all of the forward contracts that are outstanding as of year-end. Taxpayer will determine 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 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) Taxpayer will determine 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) Taxpayer determines the gross amount of foreign currency gain or loss (as determined for financial statement purposes) which 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) 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) Taxpayer then will compare its net realized foreign currency gain or loss to its net unrealized foreign currency gain or loss, and defer 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). Taxpayer will treat as ordinary income or loss any excess net
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realized foreign currency gain or loss that is not offset (deferred) under this calculation and recognize it in the current taxable year.

4) If, in a nonrecognition transaction (e.g., under Code sections 311(a) and 852(b)(6)), 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, 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 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 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 that 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.

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 is realized only to the extent of the total gain or loss realized on the transaction. The gain or loss realized is recognized in accordance with the general principles of the Code.
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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 Taxpayer (or its service providers), Taxpayer seeks to track the performance of the Index as created by Index Creator. Consistent with that objective, Taxpayer enters into foreign currency forward contracts in an amount and manner that tracks Index Creator’s hedging method as closely as possible. This hedging method is designed to reduce 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 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 that is being hedged has been designed to track the performance of an index created by a third party, which includes minimizing the effect of foreign currency gains and losses.
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2) The underlying assets that are being hedged under Taxpayer’s foreign currency hedging method are bonds which are part of a publicly available investment fund.

3) Taxpayer’s proposed hedging 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.

4) Taxpayer has a process and internal controls and procedures in place to ensure that it achieves the results of mirroring the Index.

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

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 representative.

Sincerely,

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