This letter responds to a letter dated August 22, 2011, submitted on behalf of Company, requesting that income derived from treasury locks, interest rate swaps, and forward-rate interest swaps is qualifying income within the meaning of § 7704(d)(1) of the Internal Revenue Code.
Company is a publicly-traded limited partnership organized under the laws of State. Company has not elected to be taxed as an association for federal tax purposes. Company conducts its business through affiliated operating limited partnerships and limited liability companies that are disregarded entities or partnerships for federal tax purposes.
Company is principally engaged in the transportation, storage and marketing of refined petroleum products and natural gas. In order to obtain funds for asset acquisitions and to conduct its operations, Company periodically issues debt securities. The interest rate payable on these securities is a function of the prevailing interest rate on a U.S. Treasury bond of the same maturity as Company’s proposed debt issue, and of Company’s credit rating. In the time period between Company’s decision to issue debt and its actual issuance (the exposure period), Company is at risk that its cost for such debt capital will be increased by an increase in interest rates on U.S. Treasuries. To minimize this risk, Company
enters into treasury locks – an arrangement in which an unrelated party agrees to purchase U.S. Treasury bonds from Company at a price certain and with an interest rate equal to the rate in effect on the date of agreement. If the prevailing rate on Treasury bonds increases during the exposure period, Company then can purchase Treasuries at a lower market price for sale to the counterparty, thus realizing a gain that offsets Company’s increased cost of debt capital. If, however, the prevailing Treasury rate decreases during the exposure period, upon settlement of the treasury lock Company realizes a loss that offsets the lower cost of issuing its debt. (Generally, no Treasury bonds are actually purchased and delivered; the parties settle on a net basis.)
Company’s capital structure includes both fixed and floating rate debt. At a given time, Company may determine that market conditions favor paying a floating rate when it has a fixed rate debt outstanding. At other times, Company may determine that market conditions favor paying a fixed rate when it has a floating rate debt outstanding.
In either case, Company may engage in an interest rate swap.
To obtain a cash flow at a floating rate in exchange for one at a fixed rate, Company will agree to pay to an unrelated party, typically a financial institution, a fixed interest rate on a notional principal amount.
In return, the counterparty agrees to pay Company a floating index rate, determined by reference to some established index, on the notional principal amount. If the index rate for a given month exceeds the fixed rate, the counterparty owes Company an amount equal to the excess interest rate multiplied by the notional principal amount. If, however, the fixed rate exceeds the index rate in a month, Company owes the counterparty. Amounts owing are netted at settlement, which occurs at the end of the interest rate swap’s term.
Exchanging a floating rate cash flow for a fixed rate flow operates in a similar manner, except that Company will pay the counterparty a floating interest rate on a notional principal amount, and it will receive fixed rate payments in return.
As an alternative to interest rate swaps, Company may desire to lock in a current rate with respect to a future issuance, in which case, one of its available options is to enter into a forward-start interest rate swap. To lock in a spot interest rate for a period prior to the issuance of its fixed-debt securities (a forward lock), Company will agree to pay a counterparty a fixed interest rate on a notional principal amount. The counterparty, typically a financial institution, would agree 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 amount equal to the excess of the excess interest rate multiplied by the notional principal amount over the term of the forward lock.
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 term coincides with an expected floating-rate debt issuance and not an existing floating-rate debt issuance.
In some cases, the treasury locks, interest rate swaps, and forward-start interest rate swaps entered into by Company may be integrated with the related debt instruments under § 1.1275-6 of the Income Tax Regulations. Company is requesting a ruling to apply only where a treasury lock, interest rate swap, or forward-rate interest swap can not be so integrated.