Effective date of proposed consolidated group hedging regulations.

In November 1994, Tax Executives Institute submitted comments to the Internal Revenue Service on proposed regulations that will permit affiliated groups of corporations filing consolidated returns either to aggregate their risk positions and hedge the net exposure within one or more hedging centers or to make a separate-entity election in respect of the group's hedging activities. TEI's comments, which are reprinted in the November-December 1994 issue of The Tax Executive, recommended that the proposed rules be made retroactive to the date of promulgating the temporary and proposed hedging regulations (essentially, January 1, 1994). At the Institute's December 2, 1994, liaison meeting and in subsequent conversations, however, IRS officials expressed concerns about TEI's recommendation concerning retroactive application. TEI addressed these concerns in the following letter to Michael S. Novey, Counsel to the IRS Assistant Chief Counsel (Financial Institutions and Products) and to Mary Heath, Tax Specialist in the Treasury's Office of Tax Legislative Counsel, which was filed on June 2. The Institute's comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Michael A. DeLuca of Household International, Inc. Contributing substantially to the development of the letter was Lynne A. Brzezenski, also of Household International Inc.

Thank you for the opportunity to discuss the proposed consolidated group hedging regulations(1) and, in particular, issues arising in connection with proposals from commentators (including TEI) to apply those regulations on a retroactive basis. This letter discusses several alternatives that TEI believes will mitigate IRS and Treasury's concerns that retroactive application of the proposed regulations may either (i) adversely affect some taxpayers or (ii) unduly expose the fisc to risk of loss from taxpayer selectivity.

Background

Prior to the issuance of the final hedging regulations,(2) significant controversies arose between the IRS and taxpayers about the fundamental definition of, and requirements for, a hedging transaction for tax purposes -- especially in the aftermath of the 1988 U.S. Supreme Court decision in Arkansas Best Corp. v. Commissioner.(3)

In Federal National Mortgage Association v. Commissioner,(4) the Tax Court upheld the taxpayer's characterizations of certain transactions as hedging positions that generated ordinary gains or losses.(5) After that decision, the Treasury and IRS embarked upon a different course, developing temporary and proposed regulations that were issued in October 1993.(6) The temporary and proposed hedging regulations -- which deal generally with characterization and timing issues, as well as administrative requirements for identifying hedges -- reversed the IRS's prior litigating position concerning the nature of a hedging transaction for tax purposes.(7) Upon promulgation of the final hedging regulations, that portion of the temporary and proposed regulations setting forth the definition of a hedging transaction became effective retroactively for all open tax years.

Proposed Consolidated Hedging Regulations

The preamble to the proposed consolidated hedging regulations states that "[b]ecause a hedging transaction must reduce the taxpayer's own risk, the [final hedging] regulations do not apply where a taxpayer hedges the risk of another taxpayer, even if that other taxpayer is a related party."(8) As summarized in the preamble, commentators had suggested that the IRS should expand its definition of a hedging transaction to include the hedging of a related party's risk. The commentators explained that many consolidated groups centralize their hedging operations in a single entity or a small number of entities to create economies of scale, and net the risks of various business units for purposes of entering into positions with third parties to hedge the net exposures of the consolidated group.(9)

Consistent with these suggestions, the proposed hedging regulations provide a general rule that, for purposes of section 1221 of the Internal Revenue Code, the risk of one member of a consolidated group is to be treated as a risk of the other members of the group as if all the members of the group were members of a single corporation. Thus, the members of a consolidated group are aggregated into one entity for purposes of determining whether a particular transaction is a hedging transaction under section 1221.

The proposed consolidated hedging regulations also provide that taxpayers may elect out of the general rule requiring aggregation of members' risks by making a "separate entity" election. The separate-entity election creates valid intercompany hedging transactions only if one side of an intercompany hedge position is subject to mark-to-market accounting treatment under the member's method of tax accounting. Once made, the separate-entity election cannot be revoked without the consent of the Commissioner.

The proposed regulations set forth an effective date that is 60 days subsequent to the date final regulations are published in the Federal Register.

Discussion

General Policy Considerations. Based on prior discussions at the December 1994 TEI-IRS liaison meeting and subsequent conversations, TEI understands that the IRS does not object in principle to retroactive application of the proposed consolidated hedging regulations. Indeed, in principle, the fundamental definition of a consolidated hedging transaction should apply equally well prospectively and retroactively. As was the case with the retroactive application of the definition of a hedging transaction set forth in the final hedging regulations (Treas. Reg. [subsections] 1.1221-2(a) to -2(c)), retroactive application of the proposed hedging regulations will avoid artificial distinctions between identical transactions based solely on the date such transactions are effected by a taxpayer.

Our understanding is that the IRS's primary concern with retroactive application of the proposed consolidated hedging regulations lies in whether their retroactive effect will invalidate previous hedging identifications, thereby thwarting taxpayers' expectations, and, if so, whether the addition of ameliorative provisions by the IRS to the regulations to mitigate such harm may be employed selectively by taxpayers to achieve improper tax results. TEI submits that the proposals set forth below will permit the government to implement the salutary tax policy goal of retroactive application of the proposed regulations without creating the opportunity for taxpayers to employ hindsight to achieve an unwarranted tax advantage.

Conflicting Interpretations of the Temporary and Proposed Regulations. Just as taxpayers differed with the IRS's position regarding the nature of a hedging transaction for tax purposes, many taxpayers disagreed with some of the IRS's position in the temporary and proposed regulations. Specifically, the view expressed in the preamble to the temporary and proposed hedging regulations that a taxpayer could not hedge related party risks is very much at odds with economic reality and commercial practice, as well as the single-entity theory underlying the revamped consolidated return regulations.

Indeed, the preamble to the proposed consolidated hedging regulations acknowledges that prudent business practices require affiliated groups in many instances to centralize hedging activities in one or more entities in order to hedge risks on an aggregate basis without regard to the actual location of an economic risk among separate legal entities. Given these business practices and the lack of clarity in the tax law regarding the treatment of hedging transactions by a consolidated group, it is likely that different consolidated groups have taken different approaches or established different tax positions concerning their hedging activities. We believe the divergent approaches and positions should prompt the IRS to develop as accommodating a set of rules as possible.

Identification Requirements. The final hedging regulations impose a contemporaneous identification requirement, effective for hedging transactions entered into on or after January 1, 1994, and for positions entered into before January 1, 1994, that remained extant at March 31, 1994.(10) Where a taxpayer does not make a proper identification of a hedging transaction in accordance with the final hedging regulations, gain from the transaction is treated as ordinary in nature and any loss will be capital or ordinary depending on whether the transaction otherwise meets the definition of a hedging transaction.(11) Where a taxpayer fails to identify a transaction as a hedging transaction, the transaction will not be treated as a hedging transaction unless the failure to identify was attributable to inadvertent error, subject, however, to an anti-abuse rule.(12)

The anti-abuse rule in the final hedging regulations provides that if a taxpayer fails to make a proper identification of a hedging transaction for tax purposes and the taxpayer has no reasonable basis for treating the transaction as other than a hedging transaction, gain from the transaction will be ordinary. (Any loss from the transaction would be capital pursuant to Treas. Reg. [sections] 1.1221-2(f)(2)(i). The reasonableness of a taxpayer's position is determined by taking into account the taxpayer's treatment of the transaction for financial or other purposes and the taxpayer's identification of similar transactions as hedging transactions.

Given (i) the requirement in the final hedging regulations that taxpayers make proper contemporaneous identification of hedging transactions, and (ii) the lack of clarity regarding the treatment of hedging transactions by a consolidated group, the retroactive application of the proposed consolidated hedging regulations could invalidate many taxpayers' prior, good-faith hedging identifications. As a result, retroactive application of the proposed hedging regulations would also require the IRS to permit taxpayers to employ some form of remedial action to mitigate unanticipated tax consequences.

Illustrative Fact Patterns. In order to analyze the problems posed by retroactive application of the proposed hedging regulations, we considered the three most likely situations of affected consolidated group taxpayers. Our analysis centers around the two types of transactions subject to the contemporaneous identification requirements of the final hedging regulations -- (i) hedging transactions effected after January 1, 1994, and (ii) transactions effected prior to January 1, 1994, that remained in place as of March 31, 1994 (hereinafter referred to as "transition period hedging transactions").

Group A: Group A taxpayers believe that a valid hedging transaction for tax purposes includes only those transactions in which the risk-holding member directly hedged its own risks by entering into an offsetting position with a third party or another member of the group that operated as a hedging center (HC). HC then entered into risk-reducing positions with third parties to hedge its own separate net risks. Members of the group timely identified the separate legs of each transaction as constituting a hedge transaction for tax purposes.

Group B: Despite the prospective effective date of the proposed hedging regulations, Group B taxpayers believe that the "aggregate approach" (i.e., the risk of one member of the group is a risk of all of the members of the group) is permitted for tax purposes. Group B taxpayers -- generally, though not always, through an HC -- timely identified each risk-reducing position entered into with a third party and also identified the risk held by related members as constituting a hedge transaction for tax purposes.

Group C: Group C taxpayers believe that, while the aggregate approach was desirable from a business perspective, a valid hedging transaction could only be achieved for tax purposes where the member with the risk entered into a risk-reducing transaction with a third party or another member of the group that was an HC. Group C taxpayers may have determined in a number of different situations, however, that they were precluded from entering into risk- reducing positions between HC and the various risk-holding members, either because of business constraints or because literal compliance with the final hedging regulations imposed significant administrative costs and burdens. Accordingly, Group C taxpayers did not identify its aggregate hedging positions as hedging transactions for tax purposes.

Analysis

TEI recommends that the proposed hedging regulations be applied on a retroactive basis to all taxpayers unless the taxpayer's actions, as supported by adequate documentation, demonstrate a separate-entity approach to hedging implementation, characterization, and identification. If a taxpayer's actions document a separate-entity approach to hedging, then the taxpayer should be required to maintain that separate-entity treatment with respect to transactions undertaken prior to the promulgation of final consolidated hedging rules. Facts and circumstances to be considered in determining whether a taxpayer adopted a separate-entity approach include the presence or absence of intercompany hedging transactions; the taxpayer's treatment of the transactions for financial, regulatory, or other accounting purposes; and, most important, the taxpayer's consistency in its treatment of similar transactions.

1. Application to Group A

Effect of Retroactivity. If the general rule of the proposed hedging regulations were applied retroactively, Group A would have failed to properly identify its transition period hedging transactions for tax purposes. On a prospective basis, Group A's method of identifying its hedging transactions would also be inadequate unless Group A made a separate-entity election and the HC used the mark-to-market method of accounting. Alternatively, the regulations might provide that, on a prospective-only basis, Group A will be permitted to adopt the new general rule regarding aggregation of risks to obviate undertaking intercompany hedging transactions.

Remedial Actions for Transition-Period Hedges. There are two approaches that could be taken in respect of Group A's transition-period hedge transactions. Under Alternative 1, the following factors reflect the intent of Group A taxpayers to employ a separate-entity approach to hedging: (i) the presence of intercompany hedging transactions, (ii) contemporaneous identification of transition-period hedging transactions determined on a separate-entity basis, and presumably, (iii) additional non-tax documentation or data evidencing a separate-entity approach to managing Group A's hedging activities and risks.

Under TEI's suggested approach, Group A taxpayers would be required to follow prior identifications of transition-period hedging transactions as long as the identifications were effected on a reasonable and consistent basis. (These taxpayers would remain subject to the general anti-abuse rule in the final hedging regulations.) Taxpayers in Group A would be treated as having made a separate-entity election for transition-period hedging transactions without the added requirement in the proposed regulations that an HC (or other member) employ the mark-to-market method of tax accounting for the hedge transactions. This "deemed separate-entity election" could be terminated at a date specified in the new regulations unless Group A taxpayers affirmatively elect to continue separate-entity treatment.

COMMENT: The suggested

approach "locks" taxpayers

into their prior hedging identifications

and provides taxpayers

with the anticipated

tax results. It thereby precludes

undue advantage being

conferred upon Group A

taxpayers while empowering

them to modify their tax position

and identification

methods for prospective

transactions without approval

or notice to the IRS.

Under Alternative 2, Group A taxpayers would be deemed to have made a separate-entity election for transition-period hedging transactions and for transactions effected subsequent to the issuance of the revised final hedging regulations. As a result, Group A taxpayers would be required to continue separate-entity treatment for hedging transactions entered into subsequent to the date the proposed hedging regulations are promulgated in final form unless the Commissioner consents to revocation of the separate-entity election. In effect, the taxpayer's approach to hedging would be treated as tantamount to having adopted a "method" of accounting.

Revocation of the separate-entity approach to hedging could be as simple as requiring a taxpayer to include a revocation statement in its tax return for the year the proposed regulations are promulgated in final form. Alternatively, taxpayers in Group A could be required to submit a formal written request to the IRS requesting permission to alter its separate-entity treatment. Should taxpayers in Group A fail to properly revoke the separate-entity election, they would be treated as having made a separate-entity election for all transactions effected after the date the proposed regulations are finalized.

COMMENT: The Alternative

2 remedial approach also

"locks" a taxpayer into its prior

hedging identifications

and provides taxpayers with

the anticipated tax results.

Taxpayers, however, would

not be able to modify the

treatment of subsequent

hedging transactions without

approval from, or notice to,

the IRS.

Under Alternatives 1 and 2, separate-entity treatment would also apply for hedging transactions that were closed in open taxable years and that were not subject to the contemporaneous identification requirements of the extant final hedging regulations as long as the taxpayer characterized similar transactions in a consistent and reasonable fashion. The taxpayer's treatment of such transactions for financial, regulatory, or other accounting purposes would be relevant to this determination.

2. Application to Group B

Effect of Retroactivity. If the general rule of the proposed hedging regulations were applied retroactively to taxpayers in Group B, the hedging identifications originally made for transition-period hedges would be effective, thereby validating the taxpayer's assumption about the application of the hedging rules to aggregate or net risk positions. The result is thus consistent with Group B's original intent for tax purposes. On a prospective basis, Group B's method of hedging identification would similarly be consistent with the general rule of the proposed hedging regulations.

Remedial Actions. No remedial action would be necessary for Group B taxpayers if the general rule of the proposed regulations were made effective on a retroactive basis. This would be true for transition-period hedging transactions as well as for transactions closed prior to the commencement of the transition period.

3. Application to Group C

Effect of Retroactivity. If the general rule of the proposed hedging regulations were applied retroactively to taxpayers in Group C, they would have failed to identify their hedging transactions properly for tax purposes. Under the rules of the extant final hedging regulations, any transaction that should be treated as a valid hedging transaction for tax purposes but for the failure of the taxpayer to satisfy the identification requirements will not be treated as a hedging transaction unless such failure was due to inadvertent error.(13) On a prospective basis, however, Group C taxpayers would be able to identify their hedging transactions properly.

Remedial Actions. The general rule of the proposed hedging regulations should apply retroactively to Group C taxpayers as well. Problems arise, however, because Group C taxpayers did not take any affirmative action to indicate a separate-entity approach to its hedging activities, nor did they effect any intercompany hedging transactions. In addition, Group C taxpayers likely do not possess any non-tax documentation that would indicate an intent to adopt a separate-entity approach to hedging activities.

In order to remedy the lack of identification, Group C taxpayers should be afforded a window period to identify transition-period hedging transactions as hedging transactions for tax purposes. The remedial window period rules could contain limitations similar to the limitations set forth in the mark-to-market transition rules at Treas. Reg. [sections] 1.475(b)-2T(b)(2)(ii) (relating to dealers in securities), to require consistency of treatment by the taxpayer. Moreover, if Group C taxpayers fail to identify transition-period hedging transactions properly within the remedial window period, the rules of Treas. Reg. [sections] 1.1221-2(f) -- including the anti-abuse rule -- would apply to such transactions.

Conclusion

TEI's suggested approach requires taxpayers to accept the tax consequences of their affirmative hedging identifications, subject to the anti-abuse rules of the extant final hedging regulations. Where taxpayers did not make affirmative hedging identifications, taxpayers should be permitted a window period within which to undertake remedial action to make hedging identifications under the general rule of the proposed hedging regulations, subject to limitations based on reasonableness and consistency.

TEI is pleased to have the opportunity to express these comments, which were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Michael A. DeLuca of Household International. If you have any questions concerning these comments, please call Mr. DeLuca at [phone] or Jeffery P. Rasmussen of the Institute's legal staff at [phone]. (1) FI-34-94, 1994-33 I.R.B. 19. (2) Treas Reg. [subsections] 1.1221-2(a)-(c), hereinafter referred to as the "final hedging regulations." (3) 485 U.S. 212 (1988). See Kleinbard & Greenberg, Business Hedges After Arkansas Best, 43 Tax Law Review 393 (1988); Klein & Hendrick, Taxation of Business Hedges: An Analysis of the New Regulations, 46 The Tax Executive 481 (Nov.-Dec. 1994). (4) T.C. 541 (1993). (5) See Alexander & Fuller, Tax Court Moves Toward Resolving Ordinary vs. Capital Treatment for Hedging, 79 Journal of Taxation 204 (October 1993). (6) FI-46-93, 1993-2 C.B. 613, and FI-54-93, T.D. 8493, 1993-2 C.B. 255. (7) See IRS Reverses Position On Hedges, Says Gain, Losses Are Ordinary, 200 BNA Daily Tax G-5 (October 19, 1993); Fischl, Price & Hemphill, Hedging: Now a Less Risky Business, Tax Notes 1497 (December 20, 1993). (8) 1994-33 I.R.B. 19. (9) Id. (10) Treas. Reg. [sections] 1.1221-2(g)(1). (11) Treas. Reg. [sections] 1.1221-2(f)(1). (12) Treas. Reg. [sections] 1.1221-2(f)(2).