New hedging regulations designed to minimize "character" mismatch for tax purposes.

The IRS recently issued final Regs. Sec. 1.1221-2 on the tax treatment of hedging transactions commonly encountered in business situations. The regulations are intended to standardize the tax treatment of investments used to hedge ordinary income property or the taxpayer's borrowings. In general, the regulations prescribe that ordinary income or loss would result from the hedging transactions and also establish timing rules for recognition of any gain/loss.

Background

The regulations are an outgrowth of the controversies that have arisen since 1988 as the result of the Supreme Court's decision in Arkansas Best Corp., 485 US 212 (1988), which created the possibility that losses from hedging activities could result in capital loss treatment, while ordinary income was recognized on the property being hedged. This created a potential whipsaw for taxpayers, since corporate taxpayers can only deduct capital losses against capital gains (noncorporate taxpayers are entitled to deduct capital losses in excess of capital gains up to $3,000 each year). The whipsaw possibility was obliterated to a large extent by the Tax Court decision in Federal National Mortgage Association (FNMA), 100 TC 541 (1993), in which losses sustained on certain interestrate futures, short sales of Treasury securities and put options on Treasury futures were allowed as ordinary, since they were an "integral part" of a system by which FNMA purchased and held mortgages. Note: The mortgages were found by the Tax Court to be ordinary income property in the hands of FNMA.

Types of hedging transactions

For purposes of the regulations, a hedging transaction is a transaction entered into to reduce the risk of price changes or currency fluctuations with respect to ordinary income property, or to reduce the risk of interest rate or price changes or currency fluctuations with respect to borrowings or ordinary obligations.

The regulations are of significant importance to a wide range of taxpayers using bedging techniques for business purposes, e.g., mortgage bankers hedging interest-rate risks; dealers in physical commodities (grain, oil, coffee, metals, etc.) hedging their commodity price risks; and any number of industries that hedge their price risks for raw materials (including supply hedges). Also, since liability hedges are covered by the regulations, any taxpayer managing the interest-rate risks of its existing or anticipated borrowings (including conversion of fixed to floating interest rates) would be covered.

However, if most or all of the assets held by a taxpayer are capital assets, the final regulations are of limited importance. For example, most investment partnerships hold their assets as "capital" assets. Therefore, the investment manager's use of short sales, futures, options, forwards or other types of contracts would not fall under the hedging regulations, and the tax treatment of these contracts would be governed by the traditional tax rules. Thus, for example, an interest-rate swap used to hedge another interest-rate swap would not be a hedging transaction (unless the taxpayer is a dealer in swaps). However, if the same swap is used to economically convert the taxpayer's cost of borrowing from a fixed rate to a floating rate, it would be considered a hedging transaction. Note: Even in the absence of hedging transaction treatment, periodic payments under an interest-rate swap would be treated as ordinary income or expense. However, termination payments, generally treated as capital, may be treated as ordinary under the hedging transaction rules if the swap is properly identified. Further, the new rules may affect the timing of the income or expense recognition.

In the same vein, acquisition of an "investment" is not considered a hedging transaction, even if the acquisition has the collateral effect of reducing risk that exists in a taxpayer's business. For example, assume that a taxpayer issues floating rate debt and at the same time purchases a debt instrument with a comparable floating rate. Even though risk is reduced, the long instrument is not acquired primarily for risk reduction and is not considered a hedging transaction.

The regulations acknowledge that hedging is generally performed on an aggregate or global basis. If a taxpayer hedges a particular asset or liability, or a pool of assets or liabilities, and the hedge is undertaken as part of a program to reduce the overall risk of a taxpayer's operation, the taxpayer does not need to show that the particular hedge reduces its overall risk.

Character

Gains and losses on properly identified hedging transactions will be ordinary. Note: Periodic payments on notional principal contracts, such as interest-rate or commodity swaps, will be treated as ordinary income or expense, in any event. However, if a notional principal contract is used as a hedge, the taxpayer may wish to identify the contract as such, to avoid the straddle rules of Sec. 1092. Further, termination payments would normally be treated as capital, absent identification.

Timing

The final regulations address in great detail the timing of any gain or loss incurred on the hedging transaction. The method used must reasonably match the timing of income from the hedging transaction with the timing of income from the item being hedged. In many cases, this may result in a deferral of the recognition of the gain or loss on the transaction. For example, if a series of futures contracts or options is used to hedge an interest-rate risk from a taxpayer's issuance of fixed interest-rate debt, any gain or loss on the hedging transactions should be accounted for using a constant yield method over the instrument's life. Similarly, a hedge of inventory must be accounted for in the same time period as if it were an adjustment to cost, and a hedge of anticipated sales must be accounted for in the same period as if it were an adjustment to the sales price.

If the hedge cannot be associated with a particular purchase or sale transaction (i.e., a hedge of aggregate risk), the taxpayer may use the mark and spread approach. This method requires a mark-to-market of the hedging transactions at least quarterly, with the resulting gain or loss spread over the time period for which risk was reduced.

Two simplified methods are allowed:

* Inventory cost: Accounting for hedging realized gains and losses on both purchases and sales as part of inventory cost. This is not available for taxpayers on the last in, first out (LIFO) method of inventory costing.

* Mark-to-market: Take hedging gains or losses on a mark-to-market basis, instead of being treated as an element of cost or sales proceeds (even if inventory being hedged is not marked to market). However, this method is not available for taxpayers using LIFO or the lower of cost or market methods of inventory costing. Further, it may only be used if items are held in inventory for "short" periods of time.

Consolidated groups

It is a common business practice to operate a "hedging center" within a consolidated group in order to centralize its risk management function, with the center entering into hedges with unrelated parties for the group's remaining net risk. The regulations recognize this fact and treat the members of a consolidated group as though they were divisions of a single corporation.

In lieu of the general rule, consolidated groups may elect separate entity treatment of their hedges. In such case, intercompany hedges can qualify as hedging transactions, provided the position of the member whose risk is being hedged would qualify as a hedging transaction if that member entered into the same transaction with an unrelated party and the position of the other member to the hedging transaction is marked to market under that member's accounting method. Thus, the assumption is that the separate entity election will be made only by a group whose intercompany hedging activity is done by a member that uses a mark-to-market method of accounting.

Identification

The regulations provide detailed rules for proper identification of both the hedging transactions and the items being hedged (inventory, borrowings, anticipated purchases or sales, etc.). If the taxpayer engages in hedges of aggregate risk, the taxpayer needs a written description of the hedging program, detailing how the program was designed to reduce aggregate risk, and, if the program contains controls on speculation, those controls need to be explained.

For identification of the hedging transactions themselves, they must be identified by the close of the business day on which the transaction was entered. The accounts (or trade tickets) must be clearly marked. In general, these identification rules are similar to the longstanding identification rules contained in Sec. 1256, which deals with hedges involving regulated futures contracts, and in Sec. 1092, which deals with the hedging exception to the loss straddle rules.

Effective dates

In general, the change must be made for transactions entered into on or after Oct. 1, 1994, and msut be made for the first tax year including that date.

From Craig Haber, CPA, J.D., and Israel A. Press, CPA, New York, N.Y.