The tax treatment of interest rate hedges—a primer

Introduction: Interest rate hedge transactions

Businesses often protect themselves against risks through hedging transactions. Businesses enter into hedges in a variety of situations. For example, businesses may hedge commodity price risk, currency exchange rate risk or interest rate risk. This article focuses on interest rate risk.   

Banks (and other lending institutions) typically make loans bearing interest at a floating rate. A business that must pay interest on its debt at a floating rate may want to hedge against increases to the floating rate. Businesses commonly utilize interest rate derivatives, such as interest rate swaps or caps as hedges.

For example, suppose a manufacturing company borrows funds from a bank under a loan agreement carrying an interest rate computed as the sum of (a) an interest rate index such as the Secured Overnight Financing Rate (SOFR) plus (b) a margin. If SOFR increases, the company’s quarterly cash interest payments will increase; if SOFR decreases, the company’s quarterly cash interest payments will decrease. The company, however, prefers fixed-rate exposure to variable-rate exposure. To effectively obtain fixed-rate exposure for all or a portion of its future interest payments, the company enters into a hedging transaction (with the same bank or a different bank or derivatives dealer).

Interest rate swaps

An interest rate swap is a contract between two parties that applies interest rates to a notional principal amount. Periodically (e.g., monthly or quarterly), one party is required to pay a fixed rate multiplied by the notional principal amount and the other party is required to pay a floating rate multiplied by the notional principal amount. The two payment amounts are netted; there is only one net payment requirement for each period. None of the notional principal amount is required at any time.

Where an obligor on floating-rate debt uses a swap to reduce its floating-rate risk, the swap requires the debtor to make fixed-rate payments to its counterparty (typically a bank or a derivative dealer, parties referred to in this article as banks), and the bank is required to make floating-rate based payments to the debtor. The floating-rate based payments that the debtor receives from the bank typically offset some or all of the floating-rate portion of the interest payment the debtor must make on its loan. As a result, the swap positions the debtor to make that portion of its required interest payments without exposure to increases in a floating-interest rate.

The bank typically does not charge its customer an upfront fee for an interest rate swap (unless one of the two—the bank or the customer—already owes a liability to the other, e.g., due to other derivatives or securities trades). Instead, the bank sets a fixed rate for the swap that it anticipates will enable it to earn a profit from the transaction. Payments are due from the bank to the debtor or vice versa for each period during the swap’s term; when the variable rate exceeds the fixed rate the bank must pay the debtor, and when the variable rate is less than the fixed rate the debtor must pay the bank.

Interest rate caps

A typical interest cap involves an upfront payment by the party looking to limit its exposure to floating interest rate increases to purchase the cap from a bank. Then, to the extent that market interest rates rise above a predetermined cap level, the bank is required to make payments to the cap purchaser. This arrangement can hedge the cap purchaser’s exposure to increases to floating interest rates while preserving its ability to benefit if rates fall.

Interest rate hedge transactions are typically memorialized in a ‘Confirmation’ (or ‘Confirm’). The Confirm in turn refers to a Master Agreement and a standard Definitions document, each of which is consistent with forms issued by the International Swaps and Derivatives Association (ISDA).

What are the primary tax ramifications of interest rate hedges?

The primary tax ramifications of interest rate hedges relate to character and timing of income and deductions. Another relevant tax question is whether or not the hedging income or expense should be characterized as interest.

Note that this article addresses tax rules only, not financial accounting rules. How the tax rules apply to a hedging transaction does not depend on financial accounting classifications or rules.

Tax regulations provide a specific definition of a ‘hedging transaction.’ Interest rate swaps and caps a taxpayer enters into to manage its interest rate risk are included in the definition.¹Not every economic hedge or risk reduction transaction qualifies as a ‘hedging transaction’ for tax purposes; typical business or investment usage of the term ‘hedge’ may include transactions that do not qualify as hedges under the tax definition. Additionally, a taxpayer’s transaction can qualify as a ‘hedging transaction’ under the tax definition only if the transaction hedges risk of either (1) the taxpayer itself or (2) a corporation that files a consolidated federal income tax return with the taxpayer.²This article addresses only interest rate hedges that meet the tax definition of ‘hedging transactions.’

Character

Interest rate hedges (like all other transactions that are hedging transactions under the federal tax definition) relate to obligations or property yielding income or deductions that are ordinary in character.¹As a result, providing ordinary character for income and deductions with respect to hedging transactions would be conceptually correct. Since income (or deduction) on the hedged item is ordinary in character, deduction (or income) on the hedge also should be ordinary.

A taxpayer’s hedging income and deductions do have uniform ordinary character if the hedging transaction is timely and unambiguously identified for tax purposes.²Without a proper tax identification, however, losses on termination of an interest rate hedge can be capital in character.³Unlike ordinary deductions, capital losses generally are deductible only to the extent of capital gains. Requiring capital loss treatment for a hedge used to manage ordinary business risks may distort a taxpayer’s taxable income; unfortunately, tax regulations may require that distorted result for a taxpayer that terminates an interest swap or cap that has not been properly and timely identified. It would remain appropriate in any event to characterize regular periodic payments on a swap or a cap as ordinary income or deductions.⁴

If an interest rate hedge is terminated early (i.e., before its originally scheduled termination date) at a gain, losses from the termination are ordinary in character only if either: (a) the hedge was properly identified, or (b) the inadvertent error exception applies (see further details below).⁵On the other hand, if a taxpayer realizes a gain on early termination of an interest rate hedge, the gain typically is characterized as ordinary income even if the hedge was not identified.⁶

Identifying hedges for federal income tax purposes

To properly identify a hedging transaction for federal income tax purposes, four requirements must be met:⁹

1. The taxpayer must identify its hedge—e.g., swap, cap or collar—as a hedging transaction for federal income tax purposes and must do so on or before the date the transaction is entered into.
2. The taxpayer must identify the underlying item, items or aggregate risk being hedged—in the case of an interest rate hedge, the interest rate risk pertaining to the debt instrument—and must do so within 35 days after entering into the hedging transaction.
3. The identification must be made on and retained as part of the taxpayer’s books and records. (It is not filed with the tax return and is not provided to the IRS.)
4. The identification must be unambiguously made for federal income tax purposes. (The taxpayer may not, for example, rely on a memorandum or identification prepared for financial accounting purposes that does not address federal income tax identification).

The hedge identification requirements are easily and frequently missed.

Hedge identifications may be made by identification statements or memoranda, by identifying one or more particular accounts on the taxpayer’s books, by identifying a particular brokerage or commodities trading account, by identifying a category of transactions or by a mark on the records of a specific transaction. A statement or memorandum setting out an ‘evergreen’ tax hedge identification (sometimes called a ‘global ID’) referring to an entire class of particular transactions is often helpful since it can serve as a tax hedge identification for all transactions in that class (e.g., swaps, futures contracts, interest rate derivatives, etc.) on a going-forward basis.¹⁰

As noted above, although failure to identify a hedge can require capital loss treatment for a loss on termination of the cap or swap, a limited exception applies if a taxpayer’s failure to identify the transaction was due to an ‘inadvertent error.’¹¹Inadvertent error involves ignorance of the tax rules or an unknowing mistake, and can often be relied upon by a taxpayer that can demonstrate an isolated good‑faith mistake (e.g., administrative oversight, employee turnover or a one-off procedural lapse). A taxpayer that has previously claimed an inadvertent error exception, however, would typically have difficulty claiming this exception a second time. The inadvertent error exception’s limited function underscores the need for strong controls and contemporaneous documentation to safeguard the ordinary character on hedge terminations.

Timing

The hedge timing rules dictate that the timing of income and deductions on a hedge must reasonably match the timing of the corresponding income and deductions on the hedged item.¹²Most interest rate hedges—swaps and caps—are notional principal contracts (NPCs) subject to a set of regulations (the NPC regulations) that govern income and deduction recognition timing.¹³The hedge timing rules state that the NPC regulations govern timing of income and deduction recognition on swaps and caps with respect to periodic payments and nonperiodic payments (defined below), since they provide the requisite reasonable match of hedge and hedged item.¹⁴Payments made or received under swaps or caps typically fall into one of the following three categories (as laid out in the regulations governing NPCs):¹⁵

1. Periodic payments: These are payments made or received under the interest rate hedge that are payable in intervals of one year or less. Periodic payments must be accrued over the relevant period to which the particular payment relates.¹⁶
   
   
2. Termination payments: These are payments that extinguish or assign the taxpayer’s rights under the NPC.¹⁷Termination payments generally are recognized as an element of gain or loss in the period they are realized.¹⁸However, a taxpayer that used the terminated NPC as a hedge should instead amortize the gain or loss over the remaining term of the terminated hedge if the hedged item (e.g., the floating-rate debt giving rise to interest rate risk hedged with the NPC) remains.¹⁹
   
   
3. Nonperiodic payments: These are all payments that are neither periodic payments nor termination payments. Nonperiodic payments include upfront premiums paid for an interest rate cap. Payments within this category generally must be amortized over the life of the swap or cap.²⁰

Importantly, failure to identify an interest rate swap or cap as a hedge for tax purposes typically has no impact on the timing of income or loss.²¹

Because the tax timing rules for interest rate hedges often diverge from the financial accounting rules, the tax treatment of interest rate hedges often results in book-tax timing differences.²²

Integration election

The tax rules allow borrowers to elect in limited circumstances to treat an interest rate hedge as if it were part of the hedged debt instrument. One result of this integration election would be that income and deductions on the hedge would be included as interest expense (or an offset to interest expense) for tax purposes. 

A common ramification of integration relates to borrowers whose interest deductions are limited under section 163(j). Suppose, for example, that a borrower enters into a swap to hedge its SOFR-based floating-rate debt. If in future periods SOFR increases, the borrower will receive swap income from the bank. If the borrower does not integrate the swap with the underlying debt, the swap income will constitute ordinary (noninterest) income, while the interest expense will be limited and potentially nondeductible under section 163(j).²³If, however, the borrower integrates the swap with the underlying debt, the borrower’s swap income will offset and reduce its interest expense.

Conversely, if in future periods SOFR decreases, the borrower will pay a swap expense to the bank. If the borrower does not integrate the swap with the underlying debt, that swap expense will constitute an ordinary (noninterest) deduction, which will not be limited under section 163(j). If, however, the borrower does integrate the swap with the underlying debt, the swap expense will be treated as interest expense and will be limited under section 163(j). This example illustrates that, for interest rate hedges, the benefits of integration often depend on how interest rates move over the life of the debt and the hedge.

An integration election is available only if a complex set of requirements (found in Reg. section 1.1275-6) are met on or before the date the borrower enters into the hedge.²⁴Those rules allow a taxpayer to integrate a debt instrument with a hedge, such as an interest rate hedge, if the combined cash flows of the debt and the hedge are substantially equivalent to those of a fixed rate (or qualified variable rate) debt instrument. When properly identified and all requirements are met, the integrated transaction is treated by the borrower (but not by the creditors) as a single synthetic debt instrument for tax purposes, rather than a separate debt instrument and hedge instrument.

Interest rate hedges are often not integrated with the underlying debt instrument, even where they are ‘identified’ as hedges for tax purposes.²⁵

¹For U.S. federal income tax purposes, a hedging transaction generally includes any transaction entered into by the taxpayer in the normal course of its business primarily to manage the risk of interest rate, price changes or currency fluctuations with respect to borrowings made or to be made or ordinary obligations incurred or to be incurred by the taxpayer. See Section 1221(b)(2)(A) and Reg. section 1.1221-2(b).
²Reg. section 1.1221-2(b) and -2(e).
³Reg. section 1.1221-2(b).
⁴Section 1221(a)(7) and Reg. section 1.1221-2.
⁵Reg. section 1.1221-2(g)(2).
⁶See Prop. Reg. section 1.162-30 and Reg. section 1.446-3(d). Derivative contracts other than swaps and caps, which taxpayers often use to hedge business risks other than floating interest rate risk, may have different results as regards the character of the income or loss they produce if the hedges are not property identified for federal income tax purposes.
⁷Reg. sections 1.1221-2(g)(2)(i) and -2(g)(2)(ii).
⁸Reg. section 1.1221-2(g)(2)(iii).
⁹Reg. section 1.1221-2(f).
¹⁰Reg. section 1.1221-2(f)(4).
¹¹Reg. section 1.1221-2(g)(2)(ii).
¹²Reg. section 1.446-4.
¹³See Reg. section 1.446-3(c).
¹⁴Reg. section 1.446-4(e)(5).
¹⁵Because most interest rate hedges—swaps and caps—are notional principal contracts (NPCs), the NPC rules govern the timing of income and deductions from interest rate hedges. The NPC rules are intended to ensure that income and deductions from NPCs are reported in a manner consistent with their economics as well as the ‘clear reflection of income’ standard of section 446. See Reg. section 1.446-3(b), (c).
¹⁶Reg. sections 1.446-3(e)(1) and 1.446-3(e)(2).
¹⁷Reg. section 1.446-3(h)(1). Note that termination payments (as for payments generally) are not limited to cash payments. Termination payments may be made in the form of a new swap or cap contract, for example. A company may terminate an existing cap or swap and concurrently enters into a new cap or swap where the company and the Bank agree to apply the termination payment on the old hedge to adjust the periodic payments on (i.e., the value of) the new hedge. In that event, the transaction typically should be treated as (i) a termination payment (on the old hedge) followed by (ii) a nonperiodic payment (on the new hedge). In that situation, consideration also should be given to whether the nonperiodic payment represents an embedded loan within the meaning of Reg. section 1.446-3(g)(4). The embedded loan rules are beyond the scope of this article. For an in-depth discussion of the embedded loan rules, see American Bar Association Section of Taxation, Comments on the Temporary and Proposed Regulations Under Sections 446 and 956. Providing Embedded Loan Treatment for Certain Notional Principal Contracts (Jan. 19, 2016).
¹⁸See Reg. section 1.446-3(h)(2).
¹⁹See Reg. section 1.446-4(b) and Rev. Rul. 2002-71.
²⁰Reg. section 1.446-3(f)(1), (f)(2). The regulations lay out multiple alternative methods of amortization. See Reg. section  1.446-3(f)(2)(iv).
²¹Reg. section 1.446-4(b), Rev. Rul. 2002-71. One exception is loss deferral under the straddle rules. The straddle rules can apply to defer recognition of a taxpayer’s losses on an unidentified hedging transaction if the taxpayer holds an offsetting built-in gain position. See generally section 1092 and Reg. section 1.1092(b). However, the straddle rules rarely apply to a borrower’s interest rate hedges. Another set of timing rules applies to the types of contracts defined as ‘section 1256 contracts.’ Section 1256 contracts may receive annual mark-to-market treatment absent hedge identification. See Sections 1256(a) and 1256(e). Section 1256 contracts do not include interest rate swaps and caps but do, for example, include foreign currency contracts and regulated futures contracts. Section 1256(b).
²²Financial accounting for derivative contracts, including swaps and caps used as interest rate hedges, generally is governed by ASC 815, Derivatives and Hedging under Accepted Accounting Principles (GAAP). This article does not address the GAAP treatment of hedges and other derivative contracts.
²³The swap income would generate an increase in the borrower’s section 163(j) adjusted taxable income (ATI), which would at most only provide an offset of 30% of the borrower’s interest expense.
²⁴The main requirements for hedge integration under Reg. section 1.1275-6 are:

1. Qualifying debt instrument and hedge: The transaction must involve a ‘qualifying debt instrument’ (which includes most standard debt instruments) and a ‘section 1.1275-6 hedge’ (which includes most swaps, caps or collars) that, when combined with the debt, enable calculation of a yield to maturity or would qualify as a variable rate debt instrument.
2. Matching terms: The hedge must be entered into substantially contemporaneously with the debt instrument and must have the same maturity (including rights to accelerate or delay payments) as the debt instrument. The synthetic instrument created by integration must have the same term as the remaining term of the qualifying debt instrument.
3. Identification requirement: The taxpayer must satisfy the identification requirements on or before the date it enters into the hedge by entering and retaining as part of its books and records an identification, including the following information: (a) the date the debt and hedge are entered into, (b) a description of both and (c) a summary of the cash flows and accruals resulting from treating them as an integrated transaction.
4. Same taxpayer: Both the debt instrument and the hedge must be entered into by the same taxpayer.
5. No recent leg-out or straddle: Neither the debt instrument nor the hedge can have been part of an integrated transaction that was terminated or ‘legged out’ within the 30 days immediately preceding the issue date of the synthetic instrument, and neither can have been part of a straddle prior to the issue date.

²⁵Regulations also permit integration of hedges of foreign currency risk with debt denominated in foreign currency. See Reg. section 1.988-5. This article does not address the tax consequences of foreign currency transactions.