Some companies currently face two concurrent challenges—first, how to accelerate the utilization of otherwise non-deductible capital loss carryovers for tax purposes and second, how to guard against the impact of rising interest rates.

Companies (“C corporations” for tax purposes) sometimes incur capital losses they can’t deduct. Capital losses are deductible only against capital gains—they can be carried back three years and forward five years when they expire worthless. Oftentimes, companies don’t expect to generate sufficient gains to fully utilize their losses. For financial reporting purposes, management frequently takes a valuation allowance, having decided it’s more likely than not that the losses will never be deductible. A cursory review of company filings reveals that U.S. public companies collectively possess billions of dollars of capital loss carryovers that are currently expected to expire worthless.

Since December 2016, the Federal Reserve raised its federal funds target rate 150 basis points, interest rates have been rising along the yield curve, and many investors and business executives believe the normalization of the U.S. Treasury yield curve will continue. The effects of rising rates can be deleterious. A company’s capital structure might include debt or liabilities tied to a floating rate; should rates increase, the cost of servicing these liabilities escalates. A company might hold investments earning a fixed return; a rise in rates negatively impacts their value.

Should a company possess non-deductible capital losses and wish to protect against increasing interest rates, management may wish to pay particularly close attention to which tool it selects to help manage this risk. Here’s why.

There are many tools to choose from to defend against the possibility of rising rates, such as options, forwards, futures, and swaps, among others. Each, however, can result in 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 (“UST”) with a fairly short maturity and which trade at a premium to par.

A short sale of a UST is economically equivalent to a pay-fixed/receive-floating interest rate swap—that is, as rates rise, the company is protected. This strategy is intriguing for another reason. Unlike an interest rate swap which generates ordinary income or loss, if structured properly, the short sale of a UST will generate both capital gain and interest expense.

Although interest rates have been rising, many USTs were issued years ago when interest rates were considerably higher than they are today. These USTs trade at a premium over par. By shorting a premium UST, the investor generates capital gain—as rates rise and the UST is “pulled to par”—and interest expense, as the investor makes “in lieu of” coupon payments to the lender of the UST. The gain generated on closing out the short UST position is short-term capital gain, while the “in lieu of” coupon payments are interest expense, which is 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 has the effect of transforming otherwise non-deductible capital loss carryovers into currently deductible ordinary expense.

The strategy also has two other salient benefits in addition to protecting against the harmful effects of rising interest rates.

First, sound corporate governance recognizes that management has a duty to prudently manage a company’s assets, including making the determination if deferred tax assets (DTA) such as capital losses can be utilized in the interests of shareholders, creditors, and other stakeholders. This solution empowers companies wishing to protect against rising rates to also utilize their DTAs, thereby contributing to good corporate governance.

Second, most investors believe—and the literature supports the view—that companies that actively plan for and manage their tax attributes by improving future after-tax cash flows enhance shareholder value.

In sum, for companies with non-deductible capital loss carryovers that also desire protection against rising interest rates, selling U.S. Treasuries short delivers the same protection as a swap—but at a significantly lower after-tax cost.

It’s worth noting that this technique can also be employed by individual investors who wish to protect against rising interest rates while accelerating the deductibility of capital loss carryovers (that would otherwise expire upon death) and charitable deduction carryovers (that would otherwise expire after five years).

Thomas J. Boczar is CEO of Intelligent Edge Advisors. He can be reached at tboczar@intelligent-edge.com or (212) 308-3345.


Jeff Markowski is managing director at Intelligent Edge Advisors. He can be reached at jmarkowski@intelligent-edge.com or (212) 308-3343 ext. 234.