Interest-rate hedging produces qualifying partnership income

Plain-English summary

A publicly traded partnership used interest-rate swaps, caps, forward locks, and Treasury locks to manage borrowing costs for its pipeline, transportation, marketing, and terminal operations. Ordinary swaps and caps were notional principal contracts whose payments were measured by interest rates and therefore tracked qualifying interest income. Forward-starting swaps, forward locks, and Treasury locks were ordinary and routine transactions used for the same interest-rate risk-management purpose. The IRS ruled that income from all four transaction types was qualifying income under IRC § 7704(d)(1). It did not decide whether the transactions could be integrated with related debt or whether the partnership met the overall 90 percent qualifying-income test.

Ruling snapshot

• Question: Did income from the partnership's four types of interest-rate hedging transactions count as qualifying income?
• Outcome: Approved, income from all four transaction types qualified.
• Key authorities: IRC § 7704(c), (d); Treas. Reg. §§ 1.446-3, 1.7704-3(a).

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201636039                                             Third Party Communication: None
Release Date: 9/2/2016                                        Date of Communication: Not Applicable
Index Number: 7704.00-00, 7704.03-00
                                                              Person To Contact:
-------------------------------------                         --------------------, ID No. ----------------
------------------------------------------------------        Telephone Number:
----------------------------                                  --------------------
----------------------------------                            Refer Reply To:
                                                              CC:PSI:B03
                                                              PLR-141519-15
                                                              Date:
                                                              June 08, 2016




Company             =     ------------------------------------------------------------------------------------------
                          ------------------------------

State               =     ------------


Dear --------------:

      This letter responds to a letter dated December 22, 2015, submitted on behalf of
Company by Company’s authorized representative, requesting a ruling that income
derived from interest rate swaps, interest rate cap transactions, forward lock
transactions, and Treasury lock transactions is qualifying income within the meaning of
§ 7704(d)(1) of the Internal Revenue Code (Code).

                                                     FACTS

      Company is a publicly traded partnership organized under the laws of State.
Company has not elected to be taxed as an association for federal tax purposes.
Company is not engaged in a “financial or insurance business” within the meaning of
§ 7704(d)(2)(A). Company has two primary business segments: (i) pipelines and
transportation; and (ii) wholesale marketing and terminalling.

       In order to finance asset acquisitions and conduct the operations of its business,
Company periodically issues both fixed-rate and floating-rate debt securities. To
manage its exposure to interest rate movements, Company enters into interest rate
swaps, interest rate caps, forward locks, and treasury locks (together, the “Financial
Transactions”). In some cases, the Financial Transactions entered into by Company
are integrated with the related debt instruments under § 1.1275-6 of the Income Tax
PLR-141519-15                                  2

Regulations. Company is requesting a ruling only on Financial Transactions that are
not integrated.

The Financial Transactions

1. Interest Rate Swaps

        An Interest Rate Swap allows Company to swap a floating rate cash flow for a
fixed rate cash flow (a “floating-to-fixed swap”) or a fixed rate cash flow for a floating
rate cash flow (a “fixed-to-floating swap”). In a floating-to-fixed swap, Company agrees
to pay a counterparty a fixed interest rate on a notional principal amount. The
counterparty agrees to pay Company a floating interest rate (determined by reference to
an established index, usually the London Interbank Offered Rate, or “LIBOR”) on the
notional principal amount. If the floating rate for a given month exceeds the fixed rate,
the counterparty owes Company an amount equal to the difference between the two
rates multiplied by the notional principal amount. If, instead, the fixed rate exceeds the
floating rate, the Company owes the counterparty an amount equal to the difference
between the two rates multiplied by the notional principal amount. A fixed-to-floating
swap operates in the same manner, except that Company pays the counterparty the
difference between the two rates multiplied by the notional principal amount when the
floating rate exceeds the fixed rate, and receives a similar amount when the fixed rate
exceeds the floating rate. The settlement periods under these swaps can start
immediately after executing the transaction (a Spot-Starting Swap), or they can start on
a predetermined future date (a Forward-Starting Swap).

2. Interest Rate Caps

       When Company wants to put an upper limit on a floating interest rate associated
with a floating rate debt instrument, it may enter into an Interest Rate Cap. In an
Interest Rate Cap, Company pays a counterparty an upfront fixed payment. The
counterparty agrees to pay Company an amount equal to a floating index rate,
determined by reference to some established index, less the specified interest rate cap
rate, multiplied by a notional principal amount if, and only if, the floating index rate
exceeds a specified cap rate on a specified payment date.

3. Forward Locks

       To lock in a spot interest rate for a period prior to the issuance of its fixed-debt
securities (a Forward Lock), Company agrees to pay the counterparty a fixed interest
rate on a notional principal amount. The counterparty agrees to pay Company an
amount equal to a floating index rate, determined by reference to some established
index, multiplied by the notional principal amount for a fixed period that begins on the
date of the anticipated debt issuance. If the index rate exceeds the fixed interest rate
on the date of issuance of the debt securities, the counterparty owes Company an
PLR-141519-15                                 3

amount equal to the excess of the index interest rate over the fixed interest rate
multiplied by the notional principal amount over the term of the forward lock. If, instead,
the fixed rate exceeds the floating index rate on the date of issuance of the debt
securities, Company owes the counterparty the excess of the fixed rate over the floating
index rate multiplied by the notional principal amount over the term of the forward lock.
The amounts the parties owe to each other over the term of the forward lock are
calculated and netted on the anticipated date of issuance of the debt securities.

       Converting an expected floating-rate debt securities offering into a fixed rate
instrument operates in a similar manner as exchanging a floating rate cash flow for a
fixed rate flow, except its effective date is in the future because its terms coincide with
an expected floating-rate debt issuance and not an existing floating-rate debt issuance.

4. Treasury Locks

        To minimize the risk of an interest rate increase in the time period between
Company’s decision to issue debt and the actual issuance of the debt (the “exposure
period”), Company may enter into Treasury Lock agreements, whereby the counterparty
agrees to purchase U.S. Treasury bonds from Company at a contract price that values
the Treasury bonds using an interest rate equal to the prevailing interest rate on
Treasury bonds in effect on the date of the agreement. If the prevailing interest rate on
Treasury bonds increases during the exposure period, Company is entitled to receive a
payment from the counterparty that is effectively equal to the excess of the contract
price over the lower market price at which Company could purchase Treasury bonds as
a result of the increase in prevailing Treasury bond interest rates (offsetting Company’s
increased cost of issuing its debt resulting from the increase in prevailing Treasury Bond
interest rates). If the prevailing interest rate on Treasury bonds decreases during the
exposure period, Company is required to make a payment to the counterparty that is
effectively equal to the excess of the higher market price at which Company would have
to purchase Treasury bonds as a result of the decrease in prevailing Treasury bond
interest rates over the contract price (offsetting Company’s decreased cost of issuing its
debt resulting from the decrease in prevailing Treasury bond interest rates).

        While not the intended result, Company may settle a Treasury Lock prior to the
issue date for its debt securities if, in its judgment, the risk of an unfavorable movement
in interest rates had declined or doing so would maximize its income from the Treasury
Lock and thereby effectively minimize the interest cost of the anticipated issuance of
debt securities.

                                           LAW

       Section 7704(a) provides generally that a publicly traded partnership shall be
treated as a corporation.
PLR-141519-15                                 4

       Section 7704(b) provides that the term “publicly traded partnership” means any
partnership if (1) interests in such partnership are traded on an established securities
market, or (2) interests in such partnership are readily tradable on a secondary market
(or the substantial equivalent thereof).

       Section 7704(c)(1) provides, in part, that § 7704(a) shall not apply to any publicly
traded partnership for any taxable year if such partnership met the gross income
requirements of § 7704(c)(2) for such taxable year and each preceding taxable year
beginning after December 31, 1987, during which the partnership (or any predecessor)
was in existence.

       Section 7704(c)(2) provides that a partnership meets the gross income
requirements of § 7704(c)(2) for any taxable year if 90% or more of the gross income of
such partnership for such taxable year consists of qualifying income.

       Section 7704(d)(1)(A) provides that, except as otherwise provided in § 7704(d),
the term “qualifying income” includes interest.

        Section 7704(d)(2) provides that interest shall not be treated as qualifying income
if (A) such interest is derived in the conduct of a financial or insurance business, or
(B) such interest would be excluded from the term “interest” under § 856(f).

        Section 1.7704-3(a)(1) provides, in part, that for purposes of § 7704(d)(1),
qualifying income includes income from notional principal contracts (as defined in
§ 1.446-3) and other substantially similar income from ordinary and routine investments
to the extent determined by the Commissioner. Income from a notional principal
contract is included in qualifying income only if the property, income, or cash flow that
measures the amounts to which the partnership is entitled under the contract would give
rise to qualifying income if held or received directly by the partnership.

      Section 1.7704-3(a)(2) provides, in part, that qualifying income described in
§ 1.7704-3(a)(1) does not include income derived in the ordinary course of a trade or
business.

       Section 1.446-3(c)(1) defines a notional principal contract as a financial
instrument that provides for the payment of amounts by one party to another at
specified intervals calculated by reference to a specified index upon a notional principal
amount in exchange for specified consideration or a promise to pay similar amounts.

      Section 1.446-3(c)(1) further provides that this definition of a notional principal
contract includes interest rate swaps and interest rate caps.
PLR-141519-15                                 5

       In order to qualify under § 1.7704-3(a)(1), the Financial Transactions must qualify
as income from a notional principal contract as defined in § 1.446-3 or as other
substantially similar income.

       Interest Rate Swaps (except for Forward-Starting Swaps) and Interest Rate Caps
are specifically included in the definition of a notional principal contract in § 1.446-3 and
therefore produce income from a notional principal contract. However, income from a
notional principal contract is included in qualifying income only if the property, income,
or cash flow that measures the amounts to which the partnership is entitled under the
contract would give rise to qualifying income if held or received directly by the
partnership.

       Payments due under an Interest Rate Swap or an Interest Rate Cap are
measured by reference to an interest rate or interest rate index and would give rise to
interest income if held or received directly by Company.

       Although a Forward-Starting Swap, Forward Lock, and Treasury Lock are not
among the instruments specifically listed in the definition of a notional principal contract,
they are ordinary and routine transactions and, in this case, are entered into for the
same purpose as a notional principal contract, that is to lock in an interest rate or
manage the risk of interest rate movements on Company's borrowings. Section 1.7704-
3(a)(1) provides that the Commissioner may determine that income and gain from
ordinary and routine investments substantially similar to notional principal contracts may
also constitute qualifying income for purposes of § 7704(d)(1). It is therefore
unnecessary to determine whether the Forward-Starting Swaps, Forward Locks, and
the Treasury Locks meet the definition of a notional principal contract in § 1.446-3.

                                      CONCLUSION

       Based solely on the facts and representations submitted, we conclude that the
income Company derives from each of the four types of Financial Transactions is
qualifying income within the meaning of § 7704(d)(1) and § 1.7704-3(a)(1).

       Except for the specific ruling above, we express or imply no opinion concerning
the federal tax consequences of the facts of this case under any other provision of the
Code. Specifically, we express or imply no opinion as to whether Company's Financial
Transactions can be integrated with the related debt instruments under § 1.1275-6, as
well as to whether Company is taxable as a partnership for federal tax purposes. We
also express or imply no opinion as to whether the Forward-Starting Swaps, Forward
Locks, or the Treasury Locks meet the definition of a notional principal contract in
§ 1.446-3. Finally, no opinion is expressed or implied as to whether Company meets
the 90 percent gross income requirement of § 7704(c) in any taxable year.
PLR-141519-15                                  6

      The ruling contained in this letter is based upon information and representations
submitted by Company and accompanied by a penalty of perjury statement executed by
an appropriate party. While this office has not verified any of the material submitted in
support of the ruling request, it is subject to verification on examination.

       This ruling is directed only to the taxpayer requesting it. However, in the event of
a technical termination of Company under § 708(b)(1)(B), the resulting partnership may
continue to rely on this ruling in determining its qualifying income under § 7704(d)(1).
Section 6110(k)(3) of the Code provides that it may not be used or cited as precedent.

         In accordance with the Power of Attorney on file with this office, a copy of this
letter is being sent to your authorized representative.


                                       Sincerely,



                                       Holly Porter
                                       Chief, Branch 3
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)




Enclosures (2)
      Copy of this letter
      Copy for § 6110 purposes


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