Between the hedges.

In Arkansas Best (1988), the U.S. Supreme Court ruled the term capital assets includes property owned - except for enumerated statutory exclusions (including inventory) - regardless of whether the property is acquired and held for a business motive or as an investment.

Although the Court broadened the definition of capital assets, it seemed to conclude gains and losses on inventory hedges also would be ordinary in nature when the hedging operation is "an integral part of an inventory purchase system." Thus, if a textile manufacturer uses future sales contracts to protect against market price declines in cotton, losses sustained on the hedge will be ordinary.

Capital losses are particularly distasteful to corporations because (1) they can be used only to offset capital gains and (2) net capital losses have a limited life.

Now, however, it appears the Internal Revenue Service is taking a hard line with hedging transactions and will regard all hedging losses as capital in nature, even when the taxpayer is hedging inventory. This position was made clear earlier this year in a letter from an IRS official to the Secretary of Agriculture about the tax treatment of crop hedging instruments.

Observation: The IRS position seems erroneous - at least with respect to inventory hedges. In addition to being inconsistent with the U.S. Supreme Court's ruling in Arkansas Best, the IRS long has acknowledged incentory hedging creates ordinary losses because (1) it assures ordinary operating profits and (2) it is "common trade practice" and therefore regarded as a form of insurance and not a capital asset transaction.

We expect inventory hedges will be ultimately vindicated.