January 7, 2022
IRS rules that US corporation can integrate foreign currency hedges in connection with acquiring a publicly traded foreign corporation
In PLR 202152012, the IRS issued an advance ruling under Treas. Reg. Section 1.988-5(e) allowing a US corporation to integrate its hedges of foreign currency exposure with its offer to purchase shares of a publicly traded foreign corporation if certain conditions are met. The IRS allowed this integration despite its determination that the tender offer for the foreign corporation's shares was not an executory contract as defined in Treas. Reg. Section 1.988-5(b)(2)(ii) and did not qualify for integrated hedging treatment under Treas. Reg. Section 1.988-5(b).
Parent is a publicly traded US corporation that owns Subsidiary. The functional currency of both entities is the US dollar. Subsidiary was formed to acquire Target, a publicly traded Country A foreign corporation. Parent and Subsidiary intend to acquire all of Target's outstanding shares, including all shares issued to employees under stock options that vest and become exercisable immediately before the acquisition (Employee Shares).
The acquisition will be completed within one year of the date the offering was announced (Offer Date) using one of two possible methods: (1) Method 1, which requires approval by certain percentages of shareholders by vote and value, approval by a court in Country A and the absence of a material adverse change; or (2) Method 2, which requires acceptance by more than a certain percentage of Target's shareholders and, if they accept, provides the offeror with the ability to "squeeze out" the remaining shareholders. Under Country A law, once an offer to acquire shares has been made, the offeror can revoke the offer only if a condition set forth in the announcement has not been met. Parent's offer was contingent on (1) obtaining regulatory approval; (2) the non-occurrence of a material adverse change; and (3) approval by a majority of Parent's shareholders. Under Country A law, the acquiring company can revoke its offer because of conditions (1) and (2) above only under very limited circumstances. It was considered highly unlikely that the offer would be revoked.
Parent and Subsidiary (Offerors) made an offer to acquire all Target shares under Method 1. The acquisition was supported by Target's board of directors. Under the offer, Target shareholders will receive cash by default, but can elect to receive Parent stock for their shares instead. Most Target shareholders can make or revoke the election to receive stock until the week before court approval is received, but as of the date of the offer, certain shareholders had made irrevocable elections to receive stock. Cash will be paid by Subsidiary and Parent stock will be issued to Target shareholders by Parent. Parent will contribute to Subsidiary, within two days of receipt, any Target shares received in such exchange. The Offerors are entitled to switch to Method 2 in certain circumstances but did not expect to make that switch.
As of the date of the offer, Subsidiary had a potential obligation to purchase for cash all Target shares other than those held by shareholders who had already made an irrevocable election to accept Parent shares as consideration. The cash consideration was to be paid in the functional currency of Country A (Maximum Cash Amount) and thus created foreign currency risk for Subsidiary. The Maximum Cash Amount could be reduced by events subsequent to the offer, such as the lapse of certain employee stock options or additional elections on the part of Target shareholders to accept Parent shares rather than cash. The final amount of cash to be paid under the offer, and the timing of that payment, would not be known until close to the time of the acquisition.
For Method 1, the ruling treats the Offer Date as the date on which an executory contract for the purchase of stock was entered into, and the accrual date as the date the applicable court approves the acquisition. For Method 2, the ruling treats the Offer Date as the date(s) on which the offer becomes unconditional, any subsequent date on which a Target shareholder accepts the offer during the offer period, and, if applicable, the date of the squeeze-out. Under these criteria, the ruling indicates that, with one exception, each derivative that Subsidiary acquired or would acquire will satisfy the requirements of Treas. Reg. 1.988-5(b). Furthermore, the ruling specifies that Subsidiary will (1) never hedge more than the Maximum Cash Amount; (2) reduce (or treat as sold) the portion of any hedges it holds in excess of the maximum cash required to close the acquisition, if such amount is subsequently reduced; (3) clearly identify what portion of the hedges was thus sold or treated as sold; and (4) use the hedges only to pay cash consideration for Target shares.
Law and analysis
Under IRC Section 988(d), if any IRC Section 988 transaction is a part of an IRC Section 988 hedging transaction, the transactions are integrated and treated as a single transaction. An IRC Section 988 hedging transaction is one entered into by a taxpayer to manage the risk of currency fluctuations regarding property held or to be held by the taxpayer, or borrowings or obligations outstanding or to be incurred. Under Treas. Reg. Section 1.988-5(b), if a taxpayer enters into a hedged executory contract as defined in Treas. Reg. Section 1.988-5(b)(2), the executory contract and the hedge shall be integrated.
A hedged executory contract is an executory contract, as defined in Treas. Reg. Section 1.988-5(b)(2)(ii), that is the subject of a hedge, if certain requirements are met. In particular, the hedge must be entered into on or after the date of the executory contract, and by the close of that day the executory contract and hedge must be identified as a hedged executory contract.
Treas. Reg. Section 1.988-2(b)(2)(ii) defines an "executory contract" as an agreement entered into before the accrual date to pay nonfunctional currency in the future with respect to the purchase or sale of property used in the ordinary course of the taxpayer's business, or the acquisition or performance of services in the future. The regulations further provide that notwithstanding this definition, a contract to buy or sell stock is considered an executory contract. The accrual date is defined as the date when the item of income or expense, or capital expenditure, that relates to the executory contract, is required to be accrued under the taxpayer's method of accounting. Typically, where the contract calls for the purchase of an asset, this would be the date on which the purchase of the asset is completed. On the accrual date, the agreement ceases to be considered an executory contract and is treated as an account payable or receivable.
Under Treas. Reg. Section 1.988-5(b)(4)(ii), integrating an executory contract and a hedge that at least partially hedges such contract results in the amounts paid or received under the hedge being treated as paid or received under the portion of the executory contract being hedged, or any subsequent account payable or receivable. Thus, IRC Section 988 gain or loss is not separately recognized, but instead increases (if there is a loss on the hedge) or decreases (if there is a gain on the hedge) the basis of the property acquired under the contract.
Under Treas. Reg. Section 1.988-5(e), the IRS may issue an advance ruling on the income tax consequences of a taxpayer hedging its actual or anticipated nonfunctional currency exposure.
The IRS concluded that the anticipated acquisition of Target's shares would not be an executory contract as defined in Treas. Reg. Section 1.988-5(b)(2)(ii) and would not qualify for integrated hedging treatment under Treas. Reg. Section 1.988-5(b). The IRS noted that absent an advance ruling to the contrary, Subsidiary would be required to treat the hedges as separate IRC Section 988 transactions that are not integrated with the anticipated acquisition, and foreign currency gains or losses on the hedges would be realized and recognized under the relevant timing rules. Nevertheless, the IRS determined that Subsidiary should be allowed to generally apply the principles of Treas. Reg. Section 1.988-5(b) (with certain modifications) to integrate its hedges of underlying foreign currency exposure with respect to its anticipated acquisition.
Specifically, the IRS ruled that if the acquisition is completed or terminated within one year of the Offer Date, Subsidiary can treat the anticipated acquisition as an executory contract under Treas. Reg. Section 1.988-5(b)(2)(ii) and the hedges as complying with Treas. Reg. Section 1.988-5(b)(2)(iii) as long as Subsidiary (1) meets certain conditions regarding unneeded hedges, (2) allocates a pro rata portion of the net foreign currency gain or loss from the hedges to the basis of each Target share and (3) applies certain rules if the amount of the hedges is less than the total cash consideration paid pursuant to the acquisition. In addition, if the acquisition is not completed within one year of the Offer Date, Subsidiary will treat the hedges as sold for fair market value and will recognize the resulting gain or loss as an IRC Section 988 gain or loss. Finally, the basis for Country A currency deposited in a hedging account will be determined under the first in, first out method.
Although not entirely clear, it appears that the taxpayer sought the ruling primarily because it believed the offer alone might not rise to the level of an executory contract that could be integrated with the hedging transactions.
The determination of what constitutes an executory contract within the context of stock acquisitions, especially with respect to publicly traded companies, is difficult. While the regulations provide that a contract to buy or sell stock shall be considered an executory contract, the regulations do not provide any additional guidance as to when an executory contract exists within the context of a stock purchase or sale. Additionally, there are no cases or rulings that specifically address when a stock purchase agreement will be considered an executory contract for purposes of Treas. Reg. Section 1.988-5(b).
Even though Subsidiary was a special purpose company formed to facilitate the acquisition of Target, it was Subsidiary, not Parent, that entered into the derivatives hedging the foreign currency risk. In many cases there would be practical impediments (e.g., lack of an existing International Swaps and Derivatives Association (ISDA) agreement) that would make it more difficult for Subsidiary to enter into such derivatives. It is, however, clear under the regulations that the same company must enter into the hedge and the executory contract, and this requirement was not waived under the ruling.
Given the lack of clear guidance on what constitutes an executory contract for purposes of Treas. Reg. Section 1.988-5(b) and on the same company requirement, taxpayers should consider whether an advance ruling pursuant to Treas. Reg. Section 1.988-5(e) is required to get the appropriate hedging treatment for hedges entered into with respect to a stock acquisition.