Companies often incur capital losses they can’t deduct. Such losses are deductible only against capital gains, and they can be carried back only three years and forward just five years, when they expire worthless.
So, in many cases companies don’t expect to generate sufficient gains to fully utilize their losses. For financial reporting purposes, management frequently just takes a valuation allowance — in other words, it writes off the losses.
But there is a better strategy available to many of these companies — and it not only will help soak up capital losses, it also will provide protection against rising interest rates.
The strategy I’m talking about is a short sale of U.S. Treasuries. Allow me to explain.
Since December 2016, the Federal Reserve has raised its Fed Funds target rate 150 basis points. Interest rates have risen along the U.S. Treasury yield curve, and many investors believe the yield-curve normalization will continue.
Rising rates can have deleterious effects. A company’s capital structure might include debt or liabilities tied to a floating rate, and should rates increase, the cost of servicing these liabilities escalates. Or, a company might hold investments earning a fixed return, in which case a rise in rates negatively impacts their value.
There are many tools management can choose from if it expects rates to rise. These include options, forwards, futures, and swaps, among others. However, they can have very different tax consequences. For companies with capital-loss carryovers, perhaps the simplest and most tax-efficient approach is to establish a short position in U.S. Treasuries (USTs) with fairly short maturities that are trading at a premium to par.
A short sale of USTs is economically equivalent to a pay-fixed-rate/receive-floating-rate swap. That is, as rates rise, the company is protected. This strategy is intriguing for another reason as well: Unlike an interest-rate swap that generates ordinary income or loss, if structured properly the UST short sale will generate both a capital gain and interest expense.
Although interest rates have been rising, many USTs were issued years ago when interest rates were much higher than they are today. These USTs trade at a premium over par. By shorting premium USTs, the investor generates capital gain (as rates rise and the UST is “pulled to par”) as well as interest expense (as the investor makes “in lieu of” coupon payments to the lender of the USTs).
The gain generated on closing out the short UST position is short-term capital gain, while the “in lieu of” coupon payments are an interest expense that’s deductible without limitation against any form of income, including operating income.
A company’s capital loss carryover is deductible against the capital gain generated by closing out the short position, while the interest expense generated by the strategy is deductible against the company’s ordinary income. Therefore, the strategy effectively converts an otherwise non-deductible capital loss carryover into a currently deductible ordinary expense.
In addition to protecting against the harmful effects of rising interest rates, this strategy has two other benefits.
First, sound corporate governance recognizes that management has a duty to prudently manage a company’s assets. That includes making a determination as to whether deferred tax assets (DTAs) such as capital losses can be utilized in the interests of shareholders, creditors, and other stakeholders. This solution permits a company wishing to protect against rising rates to also utilize its DTAs, thereby contributing to sound corporate governance.
Second, most investors believe, and the literature supports the view, that companies increase shareholder value when they actively plan for and manage their tax attributes by improving future after-tax cash flows.
In sum, for companies with non-deductible capital loss carryovers that also desire protection against rising rates, selling U.S. Treasuries short delivers the protection of a swap but at a significantly lower after-tax cost.