FAS 133 Series Tax Guidelines and Issues Alan Munro & Richard Larkins June 15, 2000

© 2000 Arthur Andersen All rights reserved. 3 Agenda Financial Accounting for Derivatives Tax Accounting for Derivatives Derivatives- FAS 133 vs. Tax Financial Accounting for Hedges Tax Accounting for Hedges Hedges- FAS 133 vs. Tax Conclusion Questions & Answers

© 2000 Arthur Andersen All rights reserved. 4 Financial Accounting for Derivatives FAS 133- Uniform Rules Definition of "Derivative" –Derivative is a financial instrument with (i) underlying/notional amount, (ii) small initial net investment, and (iii) permits or requires net settlement. Accounting Treatment –Every derivative is recorded in the balance sheet as either an asset or liability measured at its fair value. –Changes in the derivative’s fair value must be recognized currently in earnings unless specific hedge accounting criteria are met.

© 2000 Arthur Andersen All rights reserved. 5 Financial Accounting for Derivatives (cont.) Embedded Derivatives Accounted for separately from its host contract if the economic characteristics and risks of the derivative and host contract are not “clearly and closely related.” Example: Convertible debt

© 2000 Arthur Andersen All rights reserved. 6 Tax Accounting for Derivatives Internal Revenue Code/Regulations- Patchwork Section 475 –Mandatory application to dealers in securities. –Elective application to traders in securities, and both dealers and traders in commodities. Section 1256 contracts Options (except certain exchange-traded options) Notional principal contracts Forward contracts (except certain foreign currency forward contracts) Regulated futures contracts Contingent debt (e.g., equity-linked debt)

© 2000 Arthur Andersen All rights reserved. 7 Tax Accounting for Derivatives Section 475 Requires dealers in securities to use a mark-to-market method of accounting for their securities. A dealer may elect to exempt certain securities: –held for investment –not held for sale to customers –hedges of non-mark-to-market positions Traders in securities and both dealers and traders in commodities may elect mark-to-market accounting. Broad definition of “security” including both derivative and non- derivative instruments.

© 2000 Arthur Andersen All rights reserved. 8 Tax Accounting for Derivatives Section 1256 Contracts Regulated futures contracts Exchange-traded nonequity options Exchange-traded dealer equity options Foreign currency forward contracts (only foreign currency traded in futures market)

© 2000 Arthur Andersen All rights reserved. 9 Tax Accounting for Derivatives Options Generally no gain or loss before option (i) is exercised, (ii) lapses, or (iii) is terminated. Exception: Exchange-traded nonequity options and exchange- traded dealer equity options are marked-to-market under section 1256.

© 2000 Arthur Andersen All rights reserved. 10 Tax Accounting for Derivatives Notional Principal Contracts An NPC is 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. Examples- Interest rate swaps, currency swaps, equity swaps, caps, floors, and similar arrangements. Debt instruments, futures, forwards, and options are not NPCs.

© 2000 Arthur Andersen All rights reserved. 11 Tax Accounting for Derivatives Notional Principal Contracts (cont.) Taxation of Payments Periodic Payments- recognize ratable daily portion over the period paid or received. Nonperiodic Payments- recognize ratable portion over the term of the NPC in a manner that reflects the economic substance of the contract. Termination Payments- recognize when paid or received.

© 2000 Arthur Andersen All rights reserved. 12 Tax Accounting for Derivatives Forward Contracts Subject to open transaction doctrine: not taxable before settlement. Exception: Certain foreign currency forward contracts are marked-to-market under Section 1256.

© 2000 Arthur Andersen All rights reserved. 13 Tax Accounting for Derivatives Regulated Futures Contracts Marked-to-market under Section 1256.

© 2000 Arthur Andersen All rights reserved. 14 Tax Accounting for Derivatives Contingent Debt If issued in exchange for cash or publicly-traded property: –noncontingent bond method –projected payment schedule If issued in exchange for nonpublicly-traded property: –contingent payments –use “wait and see” method

© 2000 Arthur Andersen All rights reserved. 15 Derivatives - FAS 133 vs. Tax FAS 133 vs. Tax Mark-to-Market Accounting –FAS 133- All derivatives –Tax- Section 475 (dealers or traders in securities or commodities); Section 1256 contracts Embedded Derivatives –FAS 133- often accounted for separately. –Tax- rarely accounted for separately.

© 2000 Arthur Andersen All rights reserved. 16 Derivatives - FAS 133 vs. Tax (cont.) Example Convertible Debt (convertible into common stock of the issuer at holder’s option). –FAS 133- holder would be required to bifurcate convertible debt instrument into: interest-bearing debt instrument and a call option. Call option would be marked-to-market under FAS 133. –Tax- No bifurcation- generally no tax consequences for change in value before conversion. Even if bifurcated, unless holder is securities dealer or electing trader, not marked-to-market.

© 2000 Arthur Andersen All rights reserved. 17 Financial Accounting for Hedges FAS 133 Fair value hedges Cash flow hedges Foreign currency hedges

© 2000 Arthur Andersen All rights reserved. 18 Tax Accounting for Hedges General Hedging: – Section 1221/Reg. § –Reg. § Integrated Debt Hedge: – Reg. § Foreign Currency Hedge: – Reg. §

© 2000 Arthur Andersen All rights reserved. 19 Tax Accounting for Hedges - General Hedging Definition of hedging transaction: Transaction entered into in the normal course of business to manage risk of price changes or currency fluctuation with respect to ordinary property that is held, or to be held by the taxpayer; or to manage risk of interest rate, or 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.

© 2000 Arthur Andersen All rights reserved. 20 Tax Accounting for Hedges - General Hedging (cont.) Tax treatment- Hedging transaction must be accounted for in a manner that clearly reflects income; in general, match timing of hedge profit/loss with profit/loss of the hedged item. Exceptions: Securities subject to section 475, integrated debt hedges, and foreign currency hedges. Most taxpayers simply follow GAAP, which the income tax regulations acknowledge generally clearly reflects income. After FAS 133, following GAAP may not be permissible for tax purposes.

© 2000 Arthur Andersen All rights reserved. 21 Tax Accounting for Hedges - Integrated Debt Hedge Treating hedge of interest rate risk and the hedged debt as a single synthetic debt instrument.

© 2000 Arthur Andersen All rights reserved. 22 Tax Accounting for Hedges - Foreign Currency Hedge Treating hedge of currency risk and the hedged debt or executory contract as a single integrated transaction in a single currency.

© 2000 Arthur Andersen All rights reserved. 23 Hedges - FAS 133 vs. Tax FAS 133 vs. Tax Effectiveness –FAS 133- Highly effective throughout with continuous testing. –Tax- Manage risk; determined upfront; once a hedge, always a hedge. Focus –FAS 133- Accounting for hedged item matched to hedge (i.e., derivative). –Tax- Accounting for hedge matched to hedged item. Aggregate Risk –FAS 133- Must hedge specific item or portfolio of similar items; aggregate hedges not recognized. –Tax- Hedges of aggregate risk allowed.

© 2000 Arthur Andersen All rights reserved. 24 Hedges - FAS 133 vs. Tax (cont.) FAS 133 vs. Tax Liabilities –FAS 133- Marked-to-market –Tax- Not marked-to-market Capital Assets –FAS 133- Can be hedged item –Tax- Cannot be hedged item

© 2000 Arthur Andersen All rights reserved. 25 Options for the Future Status Quo Continue to follow book for tax as much as possible - many book/tax differences; administratively difficult. Change Methods of Tax Accounting for Derivatives Utilize section 475 to mark-to-market as many derivatives as possible for tax purposes - reduce book/tax differences - must be dealer or trader in securities or commodities.

© 2000 Arthur Andersen All rights reserved. 26 What Next? Document past hedging practices. Simplify hedge identifications - blanket identification techniques. Avoid doing anything for FAS 133 that hurts tax hedging treatment, e.g., identifications of capital assets for gap hedges. File any necessary requests for Changes in Methods of Accounting with IRS.

© 2000 Arthur Andersen All rights reserved. 27 Conclusion FAS 133 implementation is going to create many more book/tax differences than before; continuing to follow book for tax purposes will be very difficult and may require permission to change methods of tax accounting. Involve tax people in FAS 133 implementation projects.

© 2000 Arthur Andersen All rights reserved. 28 Questions and Answers Questions?