IRS hedging rules: it's all in the timing.

The recently adopted Internal Revenue Service rules on hedging transactions certainly are welcome but, on examination, seem to do little more than capitulate to the decision on hedging rendered by the Tax Court in FNMA v. Commissioner on June 17, 1993.

In general, the new rules provide for ordinary treatment (rather than capital treatment) of property--including options and short sales--that is part of a hedging transaction. For this purpose, such transactions are entered into by taxpayers, in the normal course of business, primarily to reduce the risk of either

1. Price changes or currency fluctuations affecting "ordinary property."

2. Interest rate or price changes or currency fluctuations that have an effect on borrowings or "ordinary obligations."

The IRS's decision to adhere to the FNMA case stems from the definition of ordinary property, which is property that does not produce a capital gain or loss when sold or exchanged. Thus, eligible hedged items are limited to property within the exceptions to tax code section 1221 (such as inventory and accounts receivable) as well as specialized properties (such as debt securities held by a bank) that are capital assets but, nevertheless, produce an ordinary gain or loss on sale.

Specifically excluded from the tax code's definition of hedging transactions are hedges of (1) depreciable property used in a trade or business, (2) dividend streams, (3) the overall profitability of a business unit, (4) ordinary income produced by a capital asset and (5) noninventory supplies, such as jet fuel purchased by airlines.

To attain beneficial treatment for hedging transactions entered into after December 31, 1993, taxpayers must identify the transactions (in their books and records) before the close of the day the transaction is entered into. This identification must specify both the hedging transaction and the item being hedged.

Observation: The rules require that the accounting method used for hedging transactions must reflect income clearly. The method must "reasonably match" the timing of income from hedging transactions with that of the income (or deduction) from the items that are being hedged.

For example, a transaction that edges inventory may be accounted for by treating realized gains or losses as if they were adjustments to the inventory's cost (when anticipated purchases of inventory are edged) or selling price (when anticipated sales are hedged).

These timing rules will be effective only for transactions entered into more than 60 days after the final regulations are published. However, the principal rules characterizing hedging gains and losses as ordinary are effective for all open years.