Investment funds that invest globally must deal with volatility in the currency in which they agree to invest. Investment funds entering into obligations to purchase stock in a currency other than the primary currency of the investment fund have become increasingly interested in hedging these obligations to minimize the volatility risk.1 Similarly, an investment fund entering an agreement to sell stock in a currency other than that of the investment fund may be interested in hedging its right to receive cash. Without planning, these hedges may give rise to ordinary income or loss. In the case of a new investment, this income may not be reflected by the receipt of cash (i.e., "dry" or "phantom" income would result). In the case of a sale of stock, this income would be taxed as ordinary income, rather than long-term capital gain. (Ordinary income derived by individuals is taxed at significantly higher rates than long-term capital gains.) These adverse U.S. tax issues may be avoided, however, if the hedge and the purchase/sale agreement are "integrated" under the applicable rules, discussed herein. This article discusses some of the U.S. tax consequences of hedging stock purchase/sale agreements, and identifies certain practical issues and fixes.
An Example to Illustrate the Issues
On July 25, 2012, XYZ fund entered into a stock purchase agreement to purchase all of the stock of ABC, Inc. for €50 million. XYZ is a Delaware partnership and keeps its books in U.S. dollars. Most of XYZ’s transactions are denominated in U.S. dollars. On July 25, 2012, €50 million would cost $60,310,000, based on the exchange rate on that date. The sale closed on February 4, 2013, when €50 million cost $68,245,000. Had XYZ not entered into a hedge, the purchase would have cost XYZ $7,935,000 more than anticipated entirely due to the increase in the value of the euro compared to the U.S. dollar.
Thankfully, on July 25, 2012, XYZ entered into a forward contract, pursuant to which it agreed to acquire €50 million for $60,310,000 on March 29, 2013. Thus, XYZ avoided a large additional cash outlay for the same investment. It also realized a $7,935,000 foreign currency exchange gain (FX gain) on the settlement of the forward contract. Absent further planning at the time of the hedge, this FX gain would be taxable as ordinary income to U.S. taxable investors in XYZ, even though all of this gain was invested into the stock of ABC, Inc. The additional planning of which we speak, and which is the subject of this article, is the integration of hedge (here, the foreign currency futures contract) with an executory contract (here the stock purchase agreement).2
Integration Can Avoid the Recognition of FX Gain or Loss
Regulations3 provide 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." Moreover, "the taxpayer recognizes no exchange gain or loss on the hedge" for U.S. income tax purposes. The meaning of italicized words, as well as other detailed requirements, are discussed, below. However, the key consequence of this type of planning is that the hedge and the transactions effected pursuant to the executory contract are treated as a single transaction.
Turning back to our example, if the foreign currency forward contract and the stock purchase agreement had been properly identified as part of a hedged executory contract, XYZ would not have recognized foreign currency gain or loss upon receipt of the euros; and XYZ would have been treated as having paid $60,310,000 for the stock of ABC, Inc. acquired pursuant to the stock purchase agreement.
Hedged Executory Contract Definitions and Requirements
The term "hedged executory contract" is defined in the Treasury Regulations. The term itself includes several additional definitions and requirements.
Executory Contract – An executory contract is an agreement entered into before the "accrual date" (defined below) 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 trade or business, or the acquisition of 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 trade or business, or the performance of services in the future. The purchase/sale of stock and securities for investment purposes generally is not considered a trade or business. However, the regulations specifically indicate that a contract to buy or sell stock shall be considered an executory contract.4 Thus, a private equity fund may well integrate its stock purchase/sale transactions, even though its activities typically would not rise to the level of a trade or business.
For purposes of these rules, the accrual date is the date that the income, expense or capital expenditure would be accrued under the taxpayer’s method of accounting. The functional currency of a business unit generally is the currency in which a significant part of such unit’s activities are conducted, and which is used by the unit in keeping its books and records. Any other currency would be considered a nonfunctional currency. In our example, XYZ keeps its books in U.S. dollars, and a significant part of its activities are conducted in U.S. dollars. Thus, the U.S. dollar would be XYZ’s functional currency, and the euro (i.e., the currency with which stock of ABC, Inc. was acquired) was a nonfunctional currency.
Hedge – The term hedge means a deposit of nonfunctional currency in a hedging account, a forward or futures contract, or a combination thereof, which reduces the risk of exchange rate fluctuations by reference to the taxpayer’s functional currency with respect to nonfunctional currency payments made or received under the executory contract. Returning to our example, the forward contract to purchase euros (i.e., the currency of payment under the stock purchase agreement) reduces the risk of exchange fluctuations by reference to XYZ’s functional currency (i.e., the U.S. dollar). An option to purchase a nonfunctional currency also may qualify as a hedge if the expiration date is no later than the accrual date. (In this case, the premium paid for the option also would be integrated with the executory contract.) Additionally, a series of hedges may qualify as a hedge.
Additional Requirements – An executory contract that is the subject of a hedge will be considered to be a hedged executory contract only if the following additional requirements are satisfied:
Identification. The executory contract and the hedge must be identified as a hedged executory contract. Although no special form is required for this, a record must be made before the close of the date the hedge is entered into, must record a clear description of the executory contract and the hedge, and indicate that the transaction is being identified in accordance with Treasury Regulation Section 1.988-5(b)(3).
Timing. The hedge must be entered into on or after the date the executory contract is entered into and before the accrual date.
Permanent hedge. The executory contract must be hedged in whole or part5 throughout the period beginning with the date the hedge is identified and ending on or after the accrual date.
No related parties. None of the parties to the hedge may be related. Existing rules in the Code determine the relationships, and include entity relationships.
Proper reflection. If the business unit resides outside the United States, both the executory contract and the hedge must be properly reflected on the books of the same business unit.
Identity of parties. Both the executory contract and sale hedge are entered into by the same individual, partnership, trust, estate or corporation. It is not sufficient that the parties to the respective agreements are related – they must be identical.
Certain Practical Issues
The various definitions and special rules raise certain practical issues that must be taken into account in order to ensure that a hedge will be considered part of a hedge executory contract, and, thus, will not generate foreign currency exchange gain or loss. Below are some of the issues, as well as some practical tips as to how to deal with these issues.
Same-Day Identification – One of the requirements is that the hedge and the executory contract be identified as part of the hedged executory contract on the date of the hedge. In our experience, different personnel are responsible for executing hedges from those responsible for the tax function. As the identification must be made so quickly, it is very easy for this requirement to be missed. In order to avoid this, we attempt to include the identification in a long-form confirmation of the hedge, as well as the executory contract itself. It is important that the confirmation be issued the same day.
The Holding Structure Has To Be Funded in Advance – Many private equity transactions include complex holding company structures. It may not be practical to convert dollars to euros and flow the cash down a chain of holding companies on a single day in time for closing. However, once the executory contract is hedged, it must remain hedged continuously until the accrual date. This issue may be dealt with by having the nonfunctional currency deposited into a separate account that itself is identified as part of the hedged executory contract.
The Acquisition Vehicle May Not Be Able to Hedge – As mentioned above, many private equity transactions include holding company structures. It may appear that the best entity to enter into the hedge would be the company acquiring the stock of the target company. However, a hedge at that level may trigger taxable foreign currency gain or loss in that country. Moreover, as the functional currency of the acquisition vehicle may well be the currency in which payments are to be made under the stock purchase agreement, integration may not be available (which could generate earnings and profits that would support a dividend in the case of a subsequent distribution, or trigger gain if the holding company is a pass-through entity for U.S. tax purposes). To deal with these issues, a fund may enter into an agreement to purchase stock of the acquisition vehicle, and hedge this obligation, identifying such agreement and hedge as parts of the hedged executory contract.
Foreign currency hedging may make business sense for investment funds that invest globally. To avoid the recognition of foreign currency gain for U.S. income tax purposes, it often is useful to integrate these hedges with the stock purchase agreement to which the hedge relates. As identification of the hedge as part of a hedged executory contract must be done on the same day the hedge is entered into, and because there are various practical issues present in the typical investment structure, it is important to think about the hedging process well in advance of the time of the hedge. Notably, one cannot rush into the hedge and assume that the tax department can make things work from a tax standpoint after the fact.
1 Corporations making strategic stock purchases or sales also may have the same interests in hedging, and integrating their hedges. The focus of this article, however, is on investment funds that invest globally.
2 The discussion herein is equally relevant to funds based outside the United States. Investment funds typically are formed as partnerships. The income, gain, loss and expenses of partnerships flows through to investors. Accordingly, U.S. investors in foreign funds would be taxed on FX gain, and be entitled to a deduction for FX loss. We regularly advise non-U.S. investment funds regarding the integration of currency hedges to avoid adverse consequences to the U.S. investors.
3 Unless otherwise stated, all references to a "Section" are to the Internal Revenue Code of 1986, and all references to a "Regulation" are to the Treasury Regulations promulgated thereunder.
4 Interestingly, the Regulation does not refer to an agreement to purchase an interest in a partnership or limited liability company. Consider whether the general rule that a partnership is treated as the aggregate of its partners would apply in this case such that a contract to purchase/sell an interest in a partnership or limited liability company taxed as a partnership would be treated as a contract to purchase/sell the underlying assets. Unfortunately, there is no direct authority on this question.
5 I.e., the same part of the executory contract that was originally hedged.
Steven D. Bortnick
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.