In the Spring issue of this journal¹, the authors discussed the issues and opportunities related to hedging nonqualified employee stock options.  Since that article was published, there have been some interesting developments that could directly impact the utilization of the hedging tools discussed previously.  Specifically, Treasury published proposed regulations governing the taxation of contingent "notional principal contracts" (swaps) and separately issued a private letter ruling², to a taxpayer who wished to identify a transaction as a hedge under Section 1221.  Both of these developments could have potential implications for employees who wish to hedge nonqualified stock options.

In our previous article, we pointed out that one of the key issues when executives hedge nonqualified options is the potential for a mismatch between the character of income generated by the employee option and the hedge.  Specifically, if the employee options appreciate in value after they are hedged, this can potentially result in a "whipsaw" of ordinary income from the options and capital losses from the hedging transaction.  We identified two potential "solutions" to this problem.  The first potential solution is to identify the hedging transactions as a hedge under Reg. 1.1221-2(b).  The recently issued PLR provides some additional support for this position.  The other potential solution is to hedge the employee options using a swap whose losses can achieve ordinary treatment.  The proposed swap regulations potentially have adverse consequences for swap participants that may make this approach less desirable.

Impact of PLR 200415009

As mentioned above, one possible solution to the "whipsaw" issue in the context of employee option hedging is for an executive to identify whatever hedging strategy is used as a hedging transaction within the meaning of Reg. 1.1221-2(b). Section 1221 allows taxpayers to treat any gain or loss from their hedge as ordinary. In addition, if a transaction is identified as a hedge under Section 1221, the recognition of income or loss from the hedge is matched with the asset or liability that is being hedged.

In order for Section 1221 to apply to hedging nonqualified options (NQOs), two conditions must be met. First, the NQOs have to be "ordinary property." Second, the hedge must be entered into in the ordinary course of the executive's business. With respect to the first issue, the recent private letter ruling provided further guidance about the application of Section 1221 when a derivative is used to hedge in the context of employee compensation. This ruling involved an employer that offered deferred compensation to its employees. The amount of the deferred compensation was based upon the performance of certain mutual funds. Rather than investing directly in the mutual funds, the firm chose to hedge its deferred compensation liability by entering into a derivatives contract with a securities dealer. The firm identified the derivatives contracts as hedging transactions pursuant to Reg. 1.1221-2(f). The ruling held that the deferred compensation obligation was an "ordinary obligation" and that the derivatives contracts qualified as hedging transactions for purposes of Section 1221.³

This ruling provides further support for the position that NQOs are "ordinary property." The ruling states that the employer's deferred compensation liability is an "ordinary obligation" under Reg. 1.1221-2(c)(2) because "an obligation is an ordinary obligation if performance or termination of the obligation by the taxpayer could not produce capital gain or loss." Although NQOs are an asset, rather than a liability, in the hands of an employee, the same analysis should apply. That is, upon exercise or other disposition of the NQOs, the employee will not produce capital gain so they should qualify as "ordinary property." The second condition that must be met in order for Section 1221 to apply in the context of hedging NQOs is that the hedge must be "entered into in the normal course of the taxpayer's trade or business primarily [t]o reduce risk of price changes..." Nothing has changed on this issue and there is still some uncertainty about whether this condition is met in the context of an employee hedging his options, which the PLR does not address.

Impact of Proposed Swap Regulations

On February 26, 2004, Treasury issued proposed regulations⁴ that could potentially have adverse consequences for swap participants. As discussed in our previous article,⁵ if an executive hedges his employee options by entering into a swap, any loss incurred will be manifested through periodic payments made by the employee to the counterparty on the swap. These payments should be treated as ordinary deductions under both the current regime as well as the proposed regulations. The proposed regulations clarify that the character of both periodic and nonperiodic payments, including any payments made at maturity of a swap, is ordinary.

The proposed regulations primarily address the timing and character of "contingent nonperiodic payments" made pursuant to a notional principal contract (a swap).⁶ A typical equity swap involves at least two types of payments between the dealer and the counterparty. For example, assume that an investor wishes to enter into a "total return swap" on XYZ stock. Economically, this is equivalent to a leveraged purchase of XYZ stock. Therefore, the investor will typically agree to make periodic payments to the dealer to reflect the cost of borrowing. In addition, the investor will agree to pay the dealer for any depreciation in XYZ stock at maturity of the contract while the dealer will agree to pay the investor an amount reflecting any appreciation in XYZ, plus an amount reflecting the total dividend income and any other distributions paid to holders of XYZ during the term of the swap. The periodic payments made by the investor are not contingent, since the rate to be paid typically will be stipulated when the contract is initiated. Because these payments are periodic and noncontingent, they would be currently deductible by the investor (and includable in the income of the counterparty). By contrast, the payment reflecting any appreciation or depreciation in XYZ⁷ is both contingent and nonperiodic. The amount to be paid (or received) by the investor cannot be determined until maturity of the swap, since it is based on the price of XYZ at maturity, so it is clearly contingent. Moreover, unlike the interest payments that are made during the life of the swap, this payment typically occurs at maturity and thus is nonperiodic. Prior to issuance of the proposed regulations, most taxpayers adopted a "wait and see" methodology whereby they only included contingent nonperiodic swap payments into income once the amount of the payment was determined (i.e., at maturity of the swap).⁸

Under the proposed regulations, taxpayers will no longer be allowed to use the "wait and see" approach. Instead, taxpayers will be required to include non-periodic payments in taxable income over the term of the swap. This new regime could create the potential for a tax on "phantom income" in the context of hedging NQOs. For example assume that an executive enters into a swap with an embedded collar on XYZ stock. Assume that the stock has a value of $100 per share when the swap is initiated, the swap is for a term of two years⁹ and that under the terms of the swap, the executive agrees to pay the swap dealer for any appreciation in XYZ stock above $120 per share and the dealer agrees to pay the executive for any decline in XYZ stock below $100 per share. Assume that after one year, XYZ drops to $75 per share. Under the proposed regulations, the executive would have to include in income an amount to reflect the increase in value of the swap.¹⁰ Now assume that price of XYZ recovers and returns to $100 per share at maturity of the swap. Under the "wait and see" method, the executive would not have recognized any income related to "contingent" payment of the swap. In the example suggested here, under the proposed regulations, the executive will be taxed at the end of the first year on a "phantom" gain. For swaps that terminate within a single tax year, the proposed regulations should not have any impact. However, for longer-term swaps, the proposed regulations have the potential to create a very undesirable tax result.

Conclusion

In our previous article about hedging nonqualified employee stock options, we identified two strategies that potentially deliver the best results on an after-tax basis. In light of the publication of proposed regulations governing the taxation of contingent swaps, there may be additional drawbacks for executives who hedge their employee options using a swap. By contrast, PLR 200415009, provides further support for the treatment of employee options as "ordinary property" under Section 1221.

Editor's Appendix: PLR 200415009

In PLR 200415009,¹¹ a corporation hedging its obligations arising from a nonqualified deferred compensation plan, asked the IRS to determine:

1. Whether the hedging derivative constituted hedging transactions under Section 1221(b)(2) and Reg. 1.1221-2(b); and

2. Whether Taxpayer's recognition of the income, deductions, gains or losses from the derivatives clearly reflected income under Reg. 1.446-4(b).

The corporation, parent of an affiliated group filing a consolidated return, planned to offer some employees the chance to participate in a nonqualified plan.¹² The plan would be unfunded and plan's obligation to a participant would be an unsecured general obligation of the parent corporation.

The plan would allow participants to defer receipt of certain compensation. The amount of future compensation payments for a participant would increase or decrease as if the deferred amounts were invested in specified mutual funds, referred to as "reference funds," or other investment assets. The amount of future compensation payments would be adjusted to reflect deemed reinvestment of any dividends or other distributions on the reference funds and investment assets. Participants would have no right to receive currently from the corporation any distribution in respect of a reference fund or investment asset. Participants could, however, periodically revise the list of available reference funds and other investment assets, and participating employees could periodically changed deemed investment allocations.

To reduce the risk of price increases on its obligations under the plan that are tied to the value of the reference funds, the parent corporation intends to enter into hedging transactions using a derivative (swap) with a counterparty. The corporation enters into the swap because it intends to invest the employees' deferral amounts in assets other than the reference funds, perhaps high-grade debt, and it wishes to reduce its risk on fluctuation in the value of the funds by paying a floating interest rate for the dividend-equivalent amounts reflected in the net asset value of the reference funds, while paying through the change in value of the plan's aggregate deferred compensation amounts.

Payments on the swaps will be calculated by reference to an amount initially equal to the sum of the aggregate compensation deferred under the plan. The sum of the aggregate deferred compensation will increase dollar-per-dollar as additional compensation amounts are deferred; and decrease as the corporation makes payments under the plan to participants.

Under the swap, the corporation would make payments at least annually to the counterparty equal to a specified spread above LIBOR multiplied by the plan's aggregate deferred compensation amount. The swaps will be reset to market periodically, but no less frequently than annually. On a reset, early termination, or expiration date, the counterparty will make a payment to the corporation equal to the excess, if any, of the published aggregate net asset values of the employees' deemed investments in the reference funds (including deemed reinvested dividends and other distributions) on that date, over the plan's aggregate deferred compensation amount. If, on the other hand, the latter number is greater than the former, it is the corporation that will make the payment to the counterparty. According to the ruling:

This reset to market has the effect of paying through in cash, on at least an annual basis, both the dividend-equivalent amounts due from Counterparty (because such amounts are reflected in the then-net asset value of the reference funds) and the change in value of the Plan's aggregate deferred compensation amounts since the Plan's inception or last reset date.

The obligations under the swap are summarized in Figure 1.

Figure 1: Swap for Employer to hedge risk of increase in market value of reference funds (including reinvestment of fund distributions) by which Employer obligations under nonqualified deferred compensation plan are determined.

            The pricing of the swap will be on-market at initiation, so neither party will make an upfront payment. On each reset date, the aggregate deferred compensation amount will be reset to the published aggregate net values of the employees' deemed investments in the reference funds (including deemed reinvested dividends and distributions) on that date. If required by the counterparty, the swaps may also provide for a rest of the spread over LIBOR as relevant market spreads change.

            The corporation plans to identify the swaps in its books and records as hedging transactions under Reg. 1.1221-2(f). The books and records will include a description of the accounting method, under Reg. 1.446-4(d), used to account for the timing of income and expenses resulting from the swaps. Income, expenses, gains, and losses from the swaps will be recognized under Reg. 1.446-4(b) as the corporation recognizes deductions for amounts paid as future compensation under the plan.

IRS Analysis. Under Section 1221(b)(2)(A), a hedging transaction is any transaction entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily to manage risks, including price changes on ordinary obligations incurred or to be incurred¹³.  An obligation, according to Reg. 1.1221-2(c)(2) is an ordinary obligation if performance or termination of the obligation by the taxpayer could not produce capital gain or loss. An employer's obligation to pay future compensation under a nonqualified deferred compensation plan is an ordinary obligation.¹⁴  

            The purchase or sale of a debt instrument, an equity security, or an annuity contract is not a hedging transaction even if the transaction limits or reduces the taxpayer's risk on ordinary property, borrowings, or ordinary obligations.¹⁵ Thus, a taxpayer's direct investment in shares of a mutual fund that might reduce the taxpayer's risk on an obligation to pay future compensation was not, in Example 2 of Reg. 1.1221-2(d)(5)(ii) made primarily to manage the taxpayer's risk and the investment did not qualify as a hedging transaction under Section 1221. The regulatory example specifically states:

Taxpayer undertakes obligations to pay compensation in the future. The amount of the future compensation payments is adjusted as if amounts were invested in a specified mutual fund and were increased or decreased by the earnings, gains and losses that would result from such an investment. Taxpayer invests funds in the shares of the mutual fund. Although the investment in shares of the mutual fund reduces the taxpayer's risk of fluctuation in the amount of its obligation to employees, the investment was not made primarily to manage the taxpayer's risk. Accordingly, the transaction is not a hedging transaction.

            The same rationale applies to certain transactions in instruments that are not themselves debt instruments but may include a debt investment. Thus, the transaction described in PLR 200415009 provided a benefit to the parent corporation that may not have come from investing directly in the reference funds.

Conclusion

            In the fact situation posed by PLR 200415009, the IRS accepted that the taxpayer was entering into the swaps to reduce risk of price fluctuations on its ordinary obligations to pay future compensation. The IRS indicated that, assuming the swaps met the risk management requirements of Section 1221(b)(2)(A) and Reg. 1.1221-2(b), and were identified properly under Reg. 1.1221-2(f), the swaps "will qualify as hedging transactions" under Section 1221(a)(7).