Acquisition currency option received special hedge integration treatment

Plain-English summary

A U.S.-dollar subsidiary bought a foreign-currency option to hedge the anticipated cost of acquiring a foreign target's shares. Ordinary integration rules did not apply because the public offer was not yet binding on target shareholders and the option expired after the acquisition's accrual date. Using its discretionary authority under Treasury Regulation section 1.988-5(e), the IRS treated the option as two instruments. The portion matching the actual acquisition payment was integrated with the share purchase, and its arm's-length premium was added to the acquired stock's basis. The remaining option portion stays subject to the general section 988 foreign-currency gain or loss rules.

Ruling snapshot

• Question: How should a foreign-currency option hedging a proposed share acquisition be treated when ordinary executory-contract integration requirements are not met?
• Outcome: Approved, with the option divided into an integrated acquisition hedge and a separate excess hedge
• Key authorities: IRC § 988; Treas. Reg. §§ 1.988-1, 1.988-5(b), 1.988-5(e)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202440005 Third Party Communication: None
Release Date: 10/4/2024 Date of Communication: Not Applicable
Index Number: 988.05-00
Person To Contact:
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Refer Reply To:
CC:INTL:BR5
PLR-104890-24
Date:
July 09, 2024

LEGEND

Amount A = ------
Amount B = ------------------
Amount C = -------------------
Amount D = ------------------
Amount E = -------------
Amount F = ------------------
Amount G = ------------
Amount H = ------------
Amount I = ------------
Bank = --------------------------------------------
Currency A = ------------------------------------------
Date A = -----------------------
Date B = ----------------------
Date C = -------------------
Date D = --------------------------
Date E = -------------------------
Date F = -------------------------
Method = --------------------------------------------------------------------------------------
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Offer = --------------------------------------------------------------------------------------
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Parent = --------------------------------------------------------------------------------------
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Subsidiary = --------------------------------------------------------------------------------------
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Target = --------------------------------------------------------------------------------------
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Dear -----------------------:

This letter responds to a letter dated Date A, requesting a ruling pursuant to Treas. Reg.
§1.988-5(e) regarding the U.S. federal income tax treatment of a hedge of Subsidiary’s
foreign currency exposure with respect to the acquisition of all issued and outstanding
equity interests in Target pursuant to Method (the “Target Share Acquisition”).

The rulings contained in this letter are based on information and representations
submitted by you and your representatives and accompanied by a penalties of perjury
statement executed by the appropriate party. While this office has not verified any of
the materials submitted in support of the ruling request, it is subject to verification on
examination.

                                              FACTS

Parent represents the following facts:

Parent is the common parent of an affiliated group of corporations that files a
consolidated Form 1120, U.S. Corporation Income Tax Return (the “Consolidated
Group”). Subsidiary is wholly owned by Parent through members of the Consolidated
Group. Each of Parent and Subsidiary’s functional currency (as defined in section
985(b) of the Internal Revenue Code (“Code”)) is the United States dollar (“USD”).
Parent and Subsidiary are calendar year taxpayers that use the accrual method of
accounting.

Subsidiary was formed on Date B to acquire Target. Before Date C, Subsidiary did not
have any assets or activities unrelated to the Target Share Acquisition, did not have any
Currency A hedges (including Currency A deposits) other than the Option (as defined
below), and did not engage in speculative trading with respect to any foreign currency.

On Date D, Subsidiary issued an Offer to acquire Target shares pursuant to the Target
Share Acquisition (the “Offer Announcement”). Under the terms of the Offer
Announcement, Subsidiary would acquire all outstanding Target shares in exchange for
a cash payment of Amount A per Target share. Employees holding options that would
become exercisable upon the Target Share Acquisition could either gross settle the
options (paying the strike price and receiving a gross payment of Amount A per
optionable Target share) or “cash cancel” the options (receiving a net payment, per
optionable Target share, of Amount A less the strike price). The Offer Announcement
valued the issued and to be issued equity interests of Target at Amount B, but the
precise amount of Subsidiary’s total Currency A exposure from the Target Share

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Acquisition could not be determined in advance due to the remote possibility that the
Target Share Acquisition would not occur and (if the Target Share Acquisition did occur)
uncertainty as to the manner in which employees would elect to settle their options.
The Offer was binding on Subsidiary to the extent accepted, ratified, and approved by
Target shareholders and applicable courts, but the Target Share Acquisition would not
occur unless it was approved by a vote of the Target shareholders.

On Date D, Subsidiary acquired an option (the “Option”) from Bank to hedge against the
anticipated Currency A exposure resulting from the Offer Announcement made earlier
that day. Under the terms of the Option, Subsidiary had the option to receive Amount C
of Currency A from Bank in exchange for Amount D of USD. The premium paid for the
Option was Amount E, and the Option had an expiration date of Date C.

The Target Share Acquisition became effective on Date E; pursuant to the Target Share
Acquisition, Subsidiary paid total cash consideration of Amount F on Date F. The
Option was terminated on Date F for a payment of Amount G. If, on Date D, Parent had
purchased an option to acquire Amount F with a settlement date of Date F, the arm’s
length premium paid for the option would have been Amount H.

Parent has determined that the Target Share Acquisition and the Option are not eligible
for hedge accounting treatment. Parent represents that, if the Target Share Acquisition
were an executory contract entered on the date of the Offer Announcement and the
Option had an expiration date ending on the accrual date of the Target Share
Acquisition, then the Option would satisfy the requirements of Treas. Reg. §1.988-5(b)
to be a hedge of the Target Share Acquisition, including:

1. The Option is an option described in Treas. Reg. §1.988-1(a)(1)(ii) and (a)(2)(iii)
   that is a “section 988 transaction” within the meaning of section 988(c)(1) of the
   Code;
2. The Option was timely identified in accordance with Treas. Reg. §1.988-5(b)(3)
   as a hedge for integration with the anticipated Target Share Acquisition;
3. The Option was entered into after the Offer Announcement and before the
   accrual date as defined in Treas. Reg. §1.988-5(b)(2)(iv) (the “Accrual Date”) in
   accordance with Treas. Reg. §1.988-5(b)(2)(i)(B);
4. The Target Share Acquisition was hedged in whole or in part with the Option
   throughout the period beginning with the date the Option was identified in
   accordance with Treas. Reg. §1.988-5(b)(3) and ending on or after the Accrual
   Date; and
5. Bank is not related to Subsidiary or to any member of Consolidated Group within
   the meaning of section 267(b) or 707(c)(1) of the Code.

Parent represents that it has not made and will not make an election pursuant to section
988(a)(1)(B) of the Code with respect to the Option and that the Option did not hedge
any transaction other than the Target Share Acquisition.

PLR-104890-24 4

                              LAW AND ANALYSIS

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 Subtitle A of the Code.

Section 988(d)(2) of the Code provides that the term “988 hedging transaction” means
any transaction that is 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(b)(2)(i) provides that a hedged executory contract is an executory
contract (as defined in Treas. Reg. §1.988-5(b)(2)(ii)) that is the subject of a hedge (as
defined in Treas. Reg. §1.988-5(b)(2)(iii)), provided that the following requirements
are satisfied: (A) The executory contract and the hedge are identified as a hedged
executory contract as provided in Treas. Reg. §1.988-5(b)(3); (B) The hedge is
entered into on or after the date the executory contract is entered into and before the
accrual date as defined in Treas. Reg. §1.988-5(b)(2)(iv); (C) The executory
contract is hedged in whole or in part throughout the period beginning with the date the
hedge is identified in accordance with paragraph Treas. Reg. §1.988-5(b)(3) and ending
on or after the accrual date; and (D) None of the parties to the hedge are related (within
the meaning of section 267(b) and section 707(c)(1)). Both the executory contract and
the hedge must be entered into by the same individual, partnership, trust, estate, or
corporation. Treas. Reg. §1.988-5(b)(2)(i)(F). Additional requirements apply in the
case of a qualified business unit with a residence outside of the United States or a
foreign person engaged in a U.S. trade or business. Treas. Reg. §1.988-5(b)(2)(i)(E)
and (G).

Treas. Reg. §1.988-5(b)(2)(ii) provides generally that an “executory contract” is an
agreement entered into before the accrual date to pay nonfunctional currency (or an
amount determined with reference thereto) in the future with respect to the purchase of
property used in the ordinary course of the taxpayer's business, or the acquisition of a
service (or services), in the future, or to receive nonfunctional currency (or an amount
determined with reference thereto) in the future with respect to the sale of property used
or held for sale in the ordinary course of the taxpayer's business, or the performance of
a service (or services), in the future. A contract to buy or sell stock is also considered to
be an executory contract. On the accrual date, the agreement ceases to be considered
an executory contract and is treated as an account payable or receivable. The accrual
date is defined as the date when the item of income or expense (including a capital
expenditure) that relates to an executory contract is required to be accrued under the
taxpayer’s method of accounting. Treas. Reg. §1.988-5(b)(2)(iv).

PLR-104890-24 5

Treas. Reg. §1.988-5(b)(2)(iii)(A) provides that the term “hedge” includes an option
contract described in Treas. Reg. §1.988-1(a)(1)(ii) and (2)(iii), but only if the option’s
expiration date is on or before the accrual date. The premium paid for an option that
lapses is integrated with the executory contract.

Treas. Reg. §1.988-5(b)(3)(i) provides that a taxpayer must establish a record and,
before the close of the date the hedge is entered into, the taxpayer must enter into the
record a clear description of the executory contract and the hedge and indicate that the
transaction is being identified in accordance with Treas. Reg. §1.988-5(b)(3).

Treas. Reg. §1.988-5(b)(4)(i) provides that if a taxpayer enters into a hedged executory
contract, amounts paid or received under the hedge by the taxpayer are treated as paid
or received by the taxpayer under the executory contract, or any subsequent account
payable or receivable, or that portion to which the hedge relates. Also, the taxpayer
recognizes no exchange gain or loss on the hedge. If an executory contract, on the
accrual date, becomes an account payable or receivable, the taxpayer recognizes no
exchange gain or loss on the payable or receivable for the period covered by the hedge.

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 are 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.

Absent an advance ruling to the contrary under Treas. Reg. §1.988-5(e), Subsidiary is
required to treat the Option as a separate section 988 transaction that is not integrated
with the Target Share Acquisition. The Option is not eligible for integration with the
Target Share Acquisition under §1.988-5(b) for two reasons. First, at the time the
Option was acquired, there was no executory contract within the meaning of Treas.
Reg. §1.988-5(b)(2)(ii) because the Offer Announcement was not binding on the Target
shareholders; if the Target shareholders had rejected the Offer, the Target Share
Acquisition would not have occurred. In addition, the Option is not a hedge within the
meaning of Treas. Reg. §1.988-5(b)(2)(iii) because the expiration date of the Option
was after the accrual date of the Target Share Acquisition.

Under the authority provided in Treas. Reg. §1.988-5(e), we have determined that
Subsidiary should be allowed to generally apply the principles of Treas. Reg. §1.988-
5(b) (with the modifications set forth below) to integrate the Option and the Target Share
Acquisition. Integration is appropriate because (i) Subsidiary’s exposure to the risk of
exchange rate fluctuations with respect to Currency A payments under the Target Share
Acquisition was substantially similar to that of a party to an executory contract; (ii) the

PLR-104890-24 6

Option reduced this risk; and (iii) the Option was timely identified as a hedge of the
Target Share Acquisition.

                                     RULINGS

Based solely on the information provided and the facts set forth above, and under the
authority provided in Treas. Reg. §1.988-5(e), we rule as follows:

1. The Option is treated as though it were two distinct transactions:

   a. An option (the “Hedge”) to acquire Amount F (the amount paid for the
   Target Share Acquisition), exercisable on Date F (the date payment was
   made for the Target Share Acquisition), which was purchased for a
   premium equal to Amount H (the arms’ length premium for such an
   option); and

   b. A separate option (the “Excess Hedge”) which was purchased for Amount
   I (the remainder of the premium paid for the Option) and was terminated in
   exchange for Amount G (the amount received upon termination of the
   Option).

2. The Target Share Acquisition is integrated with the Hedge and the principles of
   Treas. Reg. §1.988-5(b) apply to the integrated transaction (treating the Target
   Share Acquisition as an executory contract under Treas. Reg. §1.988-5(b)(2)(ii) and
   the Hedge as a hedge under Treas. Reg. §1.988-5(b)(2)(iii)). Accordingly, Amount
   H is added to the basis of the stock acquired by Subsidiary in the Target Share
   Acquisition.

3. Section 988 gain or loss with respect to the Excess Hedge is subject to the
   general rules of section 988.

                            CLOSING AGREEMENT
   

We have approved a closing agreement with Parent with respect to those issues
affecting its tax liability on the basis set forth above. In pursuance of our practice with
respect to such agreements, the agreement contains a stipulation to the effect that any
change or modification of applicable statutes enacted subsequent to the date of the
agreement and made applicable to the taxable period involved will render the
agreement ineffective to the extent that it is dependent upon such statutes.

                                    CAVEATS

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 or the method for computing exchange gain or loss for any item not addressed

PLR-104890-24 7

by these rulings. In particular, other than as provided above, no opinion is expressed or
implied about the U.S. federal income tax consequences of the Target Share
Acquisition or any related hedges, including what the accrual date is for any item.

                                 PROCEDURAL INFORMATION

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.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

Pursuant to a power of attorney on file in this office, a copy of this ruling is being
furnished to your authorized representatives.

                                           Sincerely,


                                           _________________________
                                           Raphael Cohen
                                           Senior Counsel, Branch 5
                                           Office of Associate Chief Counsel (International)

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