Letter ruling addresses timing issue for nonidentified hedging transactions.

In Letter Ruling 9706002, the IRS considered whether the timing rules of Regs. Sec. 1.446-4(a) apply to a "hedging transaction" under Regs. Sec. 1.1221-2(b) that the taxpayer failed to identify as such under Regs. Sec. 1.1221-2(e).

The taxpayer in the ruling entered into a forward rate agreement and two interest-rate swap agreements, to protect against increases in interest rates and to "lock in" its obligations on a proposed fixed-rate debt instrument. The taxpayer intended to treat the transaction as a "hedging transaction" under Regs. Sec. 1.1221-2(b) and to account for the transaction in accordance with the Regs. Sec. 1.446-4(e) (4) timing rules, However, contrary to the requirements of Regs. Sec. 1.1221-2(e), the taxpayer neglected to identify the agreements as hedging transactions for tax purposes in its books and records on the date of such agreements, and failed to identify specifically the proposed issuance of debt as the hedged item within 35 days of the date of the agreements.

The significance of identifying a transaction as a "hedging transaction" under Regs. Sec. 1.1221-2(e) is that such identification is binding with respect to the character of any gains realized on the transaction (i.e., gains would be ordinary). An identification is not necessarily binding, however, for any losses resulting from such transaction. Under Regs. Sec. 1.1221-2(f)(2), if there is no identification, the transaction generally will not be treated as a hedging transaction. A taxpayer may nevertheless receive ordinary gain or loss treatment despite its failure to identify such transaction as a hedging transaction, if the following requirements are satisfied: (1) the transaction is otherwise within the definition of a hedging transaction under Regs. Sec. 1.1221-2(b), (2) the failure to identify such transaction as a hedging transaction was due to "inadvertent error" and (3) all of the taxpayer's hedging transactions in all open years are treated on either original or amended tax returns (if necessary) consistently with the principles of Regs. Sec. 1.1221-2.

Regs. Sec. 1.446-4(a) provides that the timing of income and other items from "hedging transactions" defined in Regs. Sec. 1.1221-2(b) is determined thereunder whether or not the character is determined under Regs. Sec. 1.1221-2. Regs. Sec. 1.446-4(b) provides that the accounting method applied to hedging transactions must clearly reflect income, and therefore must reasonably match the timing of items from the hedge with items from the instrument being hedged. Thus, for example, items of income, deduction, gain or loss on a hedging transaction relating to a debt instrument are properly taken into account in the same periods in which they would be taken into account if the yield on the debt instrument were adjusted accordingly using constant yield principles (i.e., gain or loss from the hedging transaction is taken into account in the same periods it would be taken into account if the issue price of the hedged debt instrument had been adjusted to reflect such gain or loss).

The letter ruling stated that Regs. Sec. 1.1221-2(b) does not require the identification described in Regs. Sec. 1.1221-2(e) for a transaction to fall within such definition; such identification is relevant only to the character of the transaction and whether the taxpayer is entitled to receive ordinary income or loss treatment. Accordingly, the Regs. Sec. 1.446-4 timing rules apply to any hedging transaction otherwise within the definition of "hedging transaction" under Regs. Sec. 1.1221-2(b), without regard to whether the taxpayer identified the hedge under Regs. Sec. 1.1221-2(e) for purposes of determining the character of the items of income, deduction, loss or gain from such transaction.

Note that the taxpayer did not request a ruling on the character of gain or loss from the transaction, and the Service did not address that issue. Instead, the taxpayer represented that it would report the income from the transaction as ordinary. Thus, there was no need for the IRS to consider whether the taxpayer's failure to identify the hedging transaction was "inadvertent" within the meaning of Regs. Sec. 1.1221-2(f)(2). However, whether failure to identify is inadvertent may be relevant in other situations, such as when a taxpayer realizes a loss on a hedging transaction that it wants to characterize as ordinary rather than capital.