IRS approves a currency-hedging accounting method for a bond index fund

Plain-English summary

A proposed regulated investment company planned to track an index of foreign-currency-denominated bonds whose methodology uses rolling one-month currency forwards. Rather than hedge each bond separately, the fund would aggregate its exposure by currency and enter forwards designed to follow the index's hedging method. Its proposed tax accounting method would aggregate realized and unrealized currency gains and losses, defer realized amounts to the extent of offsetting unrealized amounts, and recognize the remaining ordinary gain or loss. Special rules would end the deferral when a hedged bond was disposed of in a nonrecognition transaction. Exercising its discretion under Treas. Reg. § 1.988-5(e), the IRS permitted the method because the fund was designed to track an unrelated third party's public bond index and the hedges were intended to reduce currency risk while closely following that index.

Ruling snapshot

• Question: Could the fund use its proposed method to determine the timing, character, and amount of currency gain or loss on foreign-currency bonds and related forward contracts?
• Outcome: approved (the IRS granted permission to use the proposed currency-hedging tax accounting method)
• Key authorities: IRC §§ 311(a), 852(b)(6), 988; Treas. Reg. §§ 1.988-2(b)(8), 1.988-5(e)

Full text (IRS public release)

 Internal Revenue Service                                       Department of the Treasury
                                                                Washington, DC 20224

 Number: 202038001                                              Third Party Communication: None
 Release Date: 9/18/2020                                        Date of Communication: Not Applicable
 Index Number: 988.05-00
                                                                Person To Contact:
 ------------------------------------------------------------   ------------------, ID No. -----------------
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 --------------------                                           Refer Reply To:
 ------------------------------------                           CC:INTL:B05
                                                                PLR-104599-20
                                                                Date:
                                                                June 25, 2020




X                  =       -----------------------
Taxpayer           =       ----------------------------------------------------------------
Index              =       ------------------------------------------------------------------------------------------
                           ---------------------------------------
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 will be 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 will elect to be, 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 will seek to track the
performance of the Index, which has been created by the Index Creator, a third party
who is unrelated to the Taxpayer. 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
PLR-104599-20                                                     2

foreign currency hedging method has been created, by the Index Creator. Under the
Index Creator’s foreign currency 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 Index Creator’s foreign currency 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 will invest in a sampling of
foreign currency denominated bonds included in the Index, and will enter 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 foreign currency hedging method. Any deviation from the Index
Creator’s hedging method will create so-called “tracking error” in the Taxpayer’s
portfolio returns relative to the Index’s returns. The Taxpayer will seek to minimize such
tracking error. Therefore, the Taxpayer intends to enter into forward contracts in an
amount and manner that tracks the Index Creator’s foreign currency hedging method as
closely as possible.1

        Consistent with the Index Creator’s foreign currency hedging method and in light
of the large number of foreign currency denominated bonds in the Index and that are
expected to be held by the Taxpayer, the Taxpayer will 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 will aggregate the projected market values of all of its bonds that are
denominated in that currency. The Taxpayer also will include 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 will account for the forward contracts and foreign
currency components of the foreign currency denominated bonds for each taxable year
under its proposed tax accounting method. Under its proposed tax accounting method,
the Taxpayer will determine 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

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PLR-104599-20                                 3

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 will mark to market all of the forward contracts that are
          outstanding as of year-end. The 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 sections 988(b)(1) and
          (b)(2) of the Code and Treas. Reg. § 1.988-2(b)(8).

       2) The 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) the Taxpayer will
          disaggregate 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 will not net the unrealized gain
          or loss arising from the foreign currency component of a foreign currency
          denominated bond against the unrealized loss or gain arising from the foreign
          currency denominated bond’s other components. Instead, it will measure the
          amount of unrealized foreign currency gain or loss on each foreign currency
          denominated bond on a gross basis.

       3) The 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 will be treated as realized on
          the first day of the following taxable year (and will be included in the realized
          foreign currency gain and loss amount for purposes of that following year’s
          netting calculation). The Taxpayer will treat as ordinary income or loss any
          excess net realized foreign currency gain or loss that is not offset (deferred)
          under this calculation and will recognize it in the current taxable year.

       4) If, in a nonrecognition transaction (e.g., under sections 311(a) and 852(b)(6)
          of the Code), 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
PLR-104599-20                                 4

          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) will be 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.

       Section 988(c)(1)(A) of the Code 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) of the Code 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) of the Code 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 sections 988(b)(1) and
(2) of the Code, 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
PLR-104599-20                                 5

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 will seek to track the performance of the Index as created by
Index Creator. Consistent with that objective, the Taxpayer will enter into foreign
currency forward contracts in an amount and manner that tracks the Index Creator’s
foreign currency hedging 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 proposed 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 currency denominated payments 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 an unrelated third party, which
          incorporates a foreign currency hedging method.

       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 proposed 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 and to track the Index Creator’s foreign currency
          hedging method as closely as possible.

      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
PLR-104599-20                                             6

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 this ruling 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)

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