VI. Integration of Reference Obligation and Total Return Swaps
If the party receiving the return on a bond also owns the reference obligation (the bond), that party may be able to integrate the reference obligation and the total return swap for tax purposes. In order to qualify for integration treatment, the total return swaps must be a hedge is any financial instruments, including a notional principal contract, where the combined cash flows of the qualifying debt instrument and the financial instrument permit the calculation of a yield to maturity, or the right to the combined cash flows qualify as a variable rate debt instrument that pays interest at the qualified floating rate or rates. Furthermore, the resulting synthetic debt instrument must have the same term as the remaining term of the qualifying debt instrument. Thus, to qualify for integration treatment, the combined cash flows to the receiver in the swap (party receiving the return on a bond) must permit the calculation of a yield to maturity. This can be accomplished by structuring the swap agreement so that the payments to the receiver are based on a fixed or interest-like rate and the term of the total return swap coincides with the maturity of the reference obligation.
Integration permits the receiver to treat, for tax purposes, the total return swap and the reference obligation as a single combined debt obligation. The character and timing of the receiver’s income are treated as if the receiver continued to own the reference obligation with the yield adjusted to the return promised by the payer. Furthermore, the integration will ensure that the straddle rules do not apply (straddle rules are discussed below).
VII. Special Timing Rules
Hedge timing rules are special timing rules which apply to taxpayers who enter into notional principal contracts in order to hedge exposure to the underlying reference asset. The rules allow the taxpayers to match the timing of income of the notional principal contract and the item hedged (underlying reference asset) the Rules impact the timing of recognition of income of the notional principal contract, as well as the character of that income. To qualify under the hedge timing rules, the property being hedged must be a non-capital asset in the hands of the hedger. The underlying reference obligation in a total return swap is a capital asset in the hands of a non-dealer, thereby precluding the application of the rules. Furthermore, a dealer who holds the underlying reference obligation in inventory (hence a non-capital asset) is specifically excluded from the rules (see dealer character rules, below). Integrated transactions are also excluded.
An example of how the hedge timing rules apply to credit derivatives would be an option on credit spread (hereinafter: OCS). An issue of yet to issue notes can hedge any increases in the credit risk premium that may occur prior to the issuance. The notes being hedged are not capital assets in the hands of the issuer and are thus subject to the hedge timing rules. Under the rules, the issuer would be able to offset the gain or loss on the OCS with gain or loss on the notes over the life of the notes.
VIII. Straddle Rules
Total return swaps may constitute “offsetting positions” for tax law purposes and are thus subject to special treatment. The IRS does not allow a loss to be taken on one of the positions in a straddle to the extent of unrecognized gain in any other offsetting position. The straddle rules effectively prevent the recognition of a loss on the sale of one position until an offsetting position with an unrecognized gain is recognized.
A “straddle” is defined as offsetting positions with respect to personal property. An “offsetting position” is a position that is held and substantially diminishes the taxpayer’s risk of loss with respect to another position. “Personal property” is any property of a type that is actively traded. A total return swap (notional principal contract) constitutes personal property if contracted based on the come or substantially similarly specified indices are purchased, sold, entered into on an established financial market. An “established financial market” includes”:
- a national securities exchange;
- an inter-dealer quotation system;
- a domestic board of trade;
- a foreign regulated securities exchange or board of trade;
- an inter-bank market; and
- an inter-dealer market.
Over the past few years, an inter-bank market in credit derivatives has developed. Products such as total return and credit default swaps are now traded by institutional brokers such as Prebon Yamane Inc. As this market is fairly new, the question as to whether such trading is sufficient to constitute “active trading” for the purpose of the straddle rules have not arisen. If credit derivatives are considered actively traded property, the taxpayer would also have to hold an offsetting position (e.g another credit derivative or debt instrument_ with property that is also actively traded in order for the straddle rules to apply.