Ordinary treatment now available for hedging transactions.

Pro-Taxpayer Tax Court Decision Leads to New Regs.

Significant uncertainty regarding the character of gains and losses from hedging transactions has existed since the Supreme Court's decision in Arkansas Best Corp.,(1) which appeared to severely limit when ordinary gain or loss treatment would be allowed for hedging transactions. The IRS used the decision to support the position that gains and losses from most common business hedges are subject to capital, rather than ordinary, gain or loss treatment. in Federal National Mortgage Association(2) (FNMA), however, the taxpayer prevailed in its assertion that gains and losses from hedging transactions are ordinary as long as the underlying assets being hedged are not capital assets.

FNMA caused the IRS to reconsider its position regarding the proper treatment of hedging transactions. Temporary and proposed regulations were issued in October 1993,(3) and final regulations were issued in July 1994,(4) allowing ordinary treatment for hedging transactions in which the intent is to reduce the risk of interest rate changes, price changes or currency fluctuations. The regulations also added identification requirements for hedging transactions to prevent taxpayers from recharacterizing transactions after the fact. In addition, the regulations addressed timing for reporting gains and losses.

This article examines when ordinary loss treatment will be allowed for hedging transactions, based on FNMA and the final regulations. In addition, identification and timing issues for reporting gains and losses are also addressed.

Background

Whether hedging transactions qualify for ordinary income or loss treatment depends on whether the hedging instrument is a capital asset. Sec. 1221 defines "capital asset" as property held by the taxpayer (whether or not connected with his trade or business), except for five specific categories of property (Sec. 1221(1)-(5)): inventory; depreciable business property or business real property; copyrights; trade or business accounts or notes receivable; and government publications.

* Corn Products

Despite the statutory language, an early Supreme Court decision, Corn Products Refining Co.,(5) had been interpreted as allowing ordinary income or loss treatment for any asset acquired and held for business, rather than investment, purposes. There, the taxpayer, a manufacturer of corn products, purchased corn futures to protect against rises in the price of raw corn. The Court stated that although "corn futures do not come within the literal language of the exclusions ... Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss."(6) Thus, the profits on resale of the corn futures were ordinary income, not capital gain. The Corn Products decision subsequently led to the argument that the Sec. 1221(1)-(5) exclusions were not intended to be all-inclusive, but rather, were simply meant to illustrate the types of assets that should be excluded from capital asset treatment.

* Arkansas Best

The Supreme Court gave Corn Products a much narrower reading in Arkansas Best. There, the taxpayer had purchased a majority interest in National Bank of Commerce in Dallas (Bank). During subsequent years, the taxpayer more than tripled the number of shares it owned in the Bank, although its percentage interest remained relatively stable. These additional stock acquisitions were prompted primarily by the Bank's need for additional capital; Arkansas Best Corp. continued to provide funds to the Bank for the business purpose of preserving its own reputation. If it had not provided the additional capital, the Bank probably would have failed. Later, when the Bank encountered financial difficulty, the taxpayer sold the bulk of its Bank stock and reported an ordinary loss on the additional shares it had purchased to preserve its reputation.

The taxpayer, relying on Corn Products, argued that stock purchased and held for a business purpose, without any substantial investment motive, was an ordinary asset. The Supreme Court disagreed, holding that the Corn Products decision is properly interpreted as involving an application of Sec. 1221(1)'s inventory exception. Thus, although the corn futures were not inventory, "their use as an integral part of the taxpayer's inventory-purchase system led the Court to treat them as substitutes for the corn inventory such that they came within a broad reading of property of a kind which would properly be included in inventory of the taxpayer' in [Sec.] 1221."(7)

The Supreme Court in Arkansas Best also indicated that there is no support in Sec. 1221 for the argument that all assets acquired and sold for ordinary business purposes should be given ordinary asset treatment. Rather, such assets must meet one of the five Sec. 1221 exclusions.

Arkansas Best generated a significant level of uncertainty as to the treatment of gains and losses from hedging transactions. For instance, to qualify for ordinary loss treatment, how literally must a hedging transaction fit the facts of Corn Products? Will the hedge qualify only if it is related to the management of the taxpayer's inventory? Must the hedge involve the same commodity? The Tax Court, in FNMA, addressed many of these questions.

* FNMA

FNMA is a private corporation organized under an act of Congress to provide assistance to the secondary market for home mortgages. To fulfill its purpose, FNMA purchased low-rate residential mortgages from mortgage lenders. Debt was issued to finance the purchase of such mortgages and to refund maturing obligations. FNMA's profit or loss was determined primarily by the spread between the average net yield on its mortgage portfolio and the average cost of its outstanding debt. When interest rates rose in the early 1980s, the mismatch in FNMA's rate of return on its long-term portfolio and its cost of short-term debt caused it substantial losses. In addition, FNMA was subject to interest rate risk between the time a purchase price was set for mortgages to be acquired and the actual settlement date.

FNMA employed a number of techniques during the early 1980s to reduce its interest rate risk; part of this effort included instituting a formal hedging program. Each hedge had a direct relationship to an anticipated debenture issuance, or to debt issued to purchase mortgages that were subject to commitments. FNMA engaged in three types of hedging transactions: (1) short positions in futures contracts on debt securities and call options on such contracts, (2) short sales of U.S. Treasury securities and (3) put options in futures contracts on Treasury securities. These hedges were treated as microhedges for financial accounting purposes. FNMA engaged in microhedging to offset the risk that interest rates would increase to reduce or negate its anticipated profit on a particular transaction, rather than macrohedging, which would have covered its overall interest rate risk. All the gains and losses from the hedging transactions were reported as ordinary.

The IRS's attack on such treatment took several forms. The Service argued that (1) only hedges integrally related to inventory qualified for ordinary treatment; (2) transactions arising from the taxpayer's hedging program were not true hedges; (3) assets used as a hedge had to involve the same property as was being hedged; and (4) hedges related to the issuance of debentures could not qualify for any of the Sec. 1221 exceptions because debentures are liabilities, not assets. Had the IRS prevailed on any of these issues, FNMA would have lost ordinary income or loss treatment for its hedging transactions.

The IRS argued that, under Arkansas Best, gain or loss on a hedging transaction receives ordinary treatment only if the transaction is an integral part of the taxpayer's inventory system, and that, since FNMA's hedging transactions related to mortgage notes, they were not eligible. The Tax Court disagreed, concluding that, although Corn Products involved the Sec. 1221(1) inventory exception," the Supreme Court did not preclude ordinary treatment for gains or losses from disposition of assets that were integrally related to other exceptions in Sec. 1221."(8) Therefore, to the extent that FNMA's hedging transactions were integrally related to its purchase and holding of mortgages that qualified as ordinary assets under Sec. 1221(4) (trade or business accounts or notes receivable), they could also qualify for ordinary treatment.

The IRS also contended that since FNMA entered into microhedges to hedge the interest rate risk for specific transactions, and did not enter into a comprehensive program with the business purpose of hedging each element of its interest rate risk, the transactions were not hedges. The Tax Court disagreed, ruling that the transactions were hedges, as (1) almost all of FNMA's internal documentation related to the transactions indicated an effort to hedge interest rate risk, (2) the effect of the transactions was to lock in interest rates and ensure a certain profit margin between the interest earned on assets and the interest paid on the debentures and (3) FNMA publicly reported its hedging transactions as hedges. It was not necessary that every element of its interest rate risk be hedged.

The Tax Court also rejected the IRS's argument that, for a hedge to receive ordinary treatment, it must involve the same property as that being hedged. According to the court, the emphasis in both Arkansas Best and Corn Products was on the use of a particular hedge to ensure that the price of an asset (here, FNMA's mortgage notes) would be stabilized. Therefore, it did not matter that the property used in the hedges was government securities. The court also refuted the IRS's position that only hedges involving long positions with respect to an asset were entitled to ordinary treatment. In the court's view, both long and short positions serve to stabilize the price of assets held or to be acquired.

Finally, the IRS contended that hedges related to FNMA's issuance of debentures could not qualify as an exception to capital asset treatment, because debentures are liabilities, not assets. The Tax Court disagreed, citing Sec. 1256(e)(2)(A)(ii), which states that hedging transactions include transactions that reduce the risk of interest rate or price changes with respect to borrowings made or to be made. The Tax Court determined that the hedging transactions were integrally related to FNMA's purchasing and holding of mortgages, which were ordinary assets under Sec. 1221(4).

Treatment of Hedges Under New Regs.

After FNMA, the IRS abandoned its position regarding most common business hedges. Regs. Sec. 1.1221-2(a)(1) provides that property that is part of a hedging transaction is not a capital asset, so that gain or loss on such a transaction is ordinary. This includes gains or losses on short sales or options that are part of a hedging transaction, as defined in Regs. Sec. 1.1221-2(a)(2) and (b). The types of hedging transactions that qualify for ordinary treatment under the new regulations are described below. These regulations generally apply to all open tax years, and should help to resolve pending cases.

Regs. Sec. 1.1221-2(b) defines hedging transactions as transactions that the taxpayer enters into in the normal course of its trade or business (1) for the purpose of reducing the risk of price changes or currency fluctuations with respect to ordinary property held or to be held by the taxpayer or (2) to reduce the risk of interest rate, price or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred.(9) Thus, the IRS has reversed its position, taken in FNMA, that hedging transactions related to borrowings cannot be ordinary because a liability, rather than an asset, is being hedged. In addition, there is no requirement in the regulations that the assets used as a hedge involve the same property as is being hedged, as the IRS argued in FNMA. In fact, other than as stated above, there is no specific requirement regarding the nature of the property used as a hedge.

Under Regs. Sec. 1.1221-2(c)(1), whether the hedging transaction actually reduces risk is based on all the facts and circumstances surrounding the taxpayer's business and the transaction. The risk being hedged may be the risk attributable to specific assets and liabilities, or to groups of assets and liabilities (i.e., a macrohedge), as long as the hedging transaction is reasonably expected to reduce the overall risk of the taxpayer's operations. In addition, the taxpayer may hedge all or any portion of its risk for all or any part of the period during which it is exposed to such risk. It is irrelevant how frequently the taxpayer enters into and terminates positions, even if done on a daily or more frequent basis.

However, if an asset is not acquired with the intent of reducing risk, it is not a hedging transaction, even if the net result is that the taxpayer's overall risk is reduced as a result of the transaction. Therefore, it is important to identify hedging transactions as such, and to clearly separate them from other transactions (e.g., investments or business loans).

Regs. Sec. 1.1221-2(c)(1) specifies the types of transactions that qualify as hedging transactions if they reduce risk, such as transactions that convert an interest rate or price from fixed to floating (fixed-to-floating hedges), written call and put options, transactions that counteract hedging transactions,(10) and recycling transactions, in which a hedge position for one asset or liability is later used to hedge another asset or liability.

A critical element of the definition of "hedging transaction" under the regulations is that the property or obligation being hedged must be ordinary. Under Regs. Sec. 1.1221-2(c)(5), property is ordinary if a sale or exchange of the property could not produce capital gain or loss regardless of the taxpayer's holding period when the sale or exchange occurs; an obligation is ordinary if the taxpayer's performance or termination of the obligation could not produce capital gain or loss. This definition prevents losses on hedging transactions from being treated as ordinary, while treating gains as capital. One result is that hedging transactions related to bonds held by financial institutions, which produce ordinary income or loss under Sec. 582(c), are hedging transactions under the regulations. However, the hedge of a Sec. 1231 asset, which could produce capital gain, is excluded from the definition.(11) Under Regs. Sec. 1.1221-2(c)(7), "hedging transaction" includes a transaction that reduces the aggregate risk from a pool of assets or obligations only if all of the risk, or all but a de minimis portion of the risk, is related to ordinary property or ordinary obligations. For example, a bank could hedge the aggregate interest rate risk on a pool of assets and treat the gain or loss therefrom as ordinary, as long as no more than a de minimis portion of the risk is related to capital assets.

Under Regs. Sec. 1.1221-2(c)(5)(ii), if a taxpayer sells only a negligible amount of noninventory supplies (supplies purchased for consumption in the taxpayer's trade or business that are not described in Sec. 1221(1)-(5)), then, only for purposes of determining whether a transaction to hedge the purchase of that noninventory supply is a hedging transaction, the supply is treated as ordinary property. Generally, this rule should permit ordinary treatment for gains and losses from hedges of noninventory supplies.(12)

While the regulations' definition of hedging transactions covers most business hedges, some hedges are excluded. Although transactions entered into in the normal course of the taxpayer's business primarily to reduce the risk of interest rate changes, price changes or currency fluctuations are covered, ordinary gain or loss treatment is not provided for the disposition of stock acquired to protect the goodwill or business reputation of the acquirer,(13) or to ensure the availability of goods. The regulations also do not apply when the taxpayer hedges a dividend stream or the overall profitability of a business unit.

The regulations exclude specific hedging transactions covered by other sections of the Code. For example, under Regs. Sec. 1.1221-2(a)(4), gains and losses from hedging transactions under Sec. 988 are excluded. That section addresses business hedging transactions related to foreign currency translations, and generally provides ordinary income and loss treatment. Therefore, the regulations should have little effect on hedging gains and losses related to such transactions. However, the regulations do apply to Sec. 988 transactions that predate Sec. 988's effective date (tax years beginning in 19871. Under Regs. Sec. 1.1221-2(a)(4)(ii), the regulations also do not cover certain hedging exceptions to the subpart F rules of Sec. 954, and certain hedge identification rules in the Sec. 864(e) interest allocation regulations.

Finally, the regulations do not directly address so-called "gap" hedges when, for instance, an insurance company or bank hedges the difference between its liabilities and the assets that fund them. if a gap hedge is more closely associated with assets that are capital assets, rather than liabilities, it will not qualify as a hedging transaction under the regulations. Other gap hedges, which are more closely associated with liabilities, may qualify as hedging transactions. The preamble to the regulations suggests that the IRS is likely to address this issue in the future.

Identification and Recordkeeping Requirements

For hedging transactions entered into after 1993, the regulations require detailed identification and recordkeeping.(14) The purpose is to prevent taxpayers from later recharacterizing transactions to their own advantage.

Regs. Sec. 1.1221-2(e)(1) requires a taxpayer to identify a transaction as a hedging transaction on the day it is entered into. The identification must be made on, and retained as part of, the taxpayer's books and records, and must be unambiguous. According to Regs. Sec. 1.1221-2(e)(4), the identification of a hedging transaction for financial accounting or regulatory purposes does not satisfy this requirement, unless the taxpayer's books and records indicate that the identification is also being made for tax purposes.

Regs. Sec. 1.1221-2(e)(2) provides that the taxpayer must identify the item, items or aggregate risk being hedged substantially contemporaneously with entering into the hedging transaction. Identification of an item being hedged generally involves identifying a transaction that creates risk, and the type of risk that the transaction creates. An identification is not substantially contemporaneous if it is made more than 35 days after entering into the hedging transaction.

To meet the Regs. Sec. 1.1221-2(e) identification requirements, the taxpayer may make each identification separately, or establish an unambiguous system for identifying groups of transactions. Regs. Sec. 1.1221-2(e)(4)(iv) provides the following examples. [ ] A taxpayer may make an identification by placing a hedging transaction in an account that has been identified as containing only hedges of a specified item, items or specified aggregate risk. [ ] A taxpayer can make an identification by including and retaining in its books and records a statement that designates all future transactions in a specified derivative product as hedges of a specified item, items or aggregate risk. [ ] A taxpayer can make an identification by placing a designated mark on a record of the transaction (e.g., trading ticket, purchase order or trade confirmation) or by using a designated form or a record that contains a designated legend.

Regs. Sec. 1. 1221-2(f)(1)(i) explains the effects of identification. If the taxpayer identifies a transaction as a hedge, the identification is binding with respect to gain, whether or not all of the requirements for identifying a hedging transaction (described above) are met. Therefore, the gain from any transaction identified as a hedge is ordinary. If the transaction is identified as a hedging transaction, but does not meet Regs. Sec. 1.1221-2(b)'s requirements, the character of loss is determined as though the transaction is not a hedging transaction. Thus, simply identifying q transaction as a hedge does not ensure that a loss from such transaction will be ordinary.

Regs. Sec. 1.1221-2(f)(1)(ii) provides an exception for mistakenly identified hedges. Any gain from such a transaction will be treated as though the transaction had not been identified as a hedge if the transaction is not a hedging transaction, the identification of the transaction as a hedge was due to an inadvertent error and all the taxpayer's transactions in open years are being treated on either original or amended returns consistently with the regulations.

Generally under Regs. Sec. 1.1221-2(f)(2), if a transaction is not identified as a hedge, the absence of an identification is binding and establishes that the transaction is not a hedge. Exceptions exist for inadvertent errors and anti-abuse purposes. A taxpayer may treat a transaction as a hedge, even if it has not been identified as such, if it is a hedging transaction (as defined in Regs. Sec. 1.1221-2(b)), the failure to identify the transaction was due to inadvertent error and the taxpayer has treated all hedges in open years on its original or amended returns.

The anti-abuse rule of Regs. Sec. 1.1221-2(f)(2)(iii) prevents a taxpayer from intentionally failing to identify a transaction as a hedge in an effort to have the transaction's gain or loss treated as capital. The reasonableness of the taxpayer's failure to identify a transaction is determined by taking into consideration the requirements of Regs. Sec. 1.1221-2(b), the taxpayer's treatment of the transaction for financial accounting (or other) purposes and the taxpayer's identification of similar transactions as hedges.

Regs. Sec. 1.1221-2(e)(3)(ii) and (iii) provide additional identification requirements for inventory hedges, hedges of debt, anticipatory hedges of debt instruments and assets, and hedges of aggregate risk. Hedges related to inventory require identification of the specific type or class of inventory to which the transaction relates. If the hedging transaction relates to specific purchases or sales, the identification must also include the expected dates of such purchases or sales and the amounts to be purchased or sold. If the hedging transaction relates to a debt instrument, the instrument must be specified and, if the hedge is for less than the full adjusted issue price or the full term of the debt, the amount and the term covered by the hedge must be identified.

Under Regs. Sec. 1.1221-2(e)(3)(iv), if the hedging transaction relates to aggregate risk, the identification must include a description of the risk being hedged and the hedging program under which the transaction was entered. A description of a hedging program must include an identification of the type of risk being hedged, a description of the type of items giving rise to the risk being aggregated, and sufficient additional information to demonstrate that the program is designed to reduce aggregate risk of the type identified. If the program contains controls on speculation (e.g., position limits), the description of the hedging program must also explain how the controls are established, communicated and implemented.

A taxpayer may enter into a hedging transaction to reduce the risk of price changes related to an asset that the taxpayer intends to purchase in the future, or to hedge the risk of interest rate fluctuations relating to debt that the taxpayer anticipates issuing in the future. if the hedge relates to assets that the taxpayer anticipates acquiring, Regs. Sec. 1.1221-2(e)(3)(i) requires the taxpayer to specify the expected date of acquisition and the amounts to be acquired. If the hedging transaction relates to a debt instrument to be held or issued to the taxpayer in the future, Regs. Sec. 1.1221-2(e)(3)(iii) requires the taxpayer to specify the instrument's expected amount, date of issuance, date of maturity and the interest provisions. As with existing debt, if the hedge is for less than the debt's (1) entire expected issue price or (2) full expected term, the identification must also include the amount or the term being hedged. The identification may indicate a range of dates, terms and amounts. Regs. Sec. 1.1221-2(e)(3)(iii)(b) provides an example in which a taxpayer might identify a transaction as hedging the yield on the anticipated issuance of fixed rate debt during the second half of its fiscal year, with the anticipated amount of the debt between $75 million and $125 million, and an anticipated term of approximately 20 to 30 years.

Finally, under Regs. Sec. 1. 1221-2(e)(6), any identification for purposes of Sec. 1256, which provides mark-to-market rules for certain futures, foreign currency and option contracts, meets the identification requirements of Regs. Sec. 1.1221-2(e)(1).

Timing Issues

Final regulations have also been issued under Sec. 446 dealing with timing for reporting hedging gains and losses.(15) The preamble to the proposed regulations, issued in October 1993, noted that implicit in the rules allowing ordinary gain and loss treatment for hedging gains and losses is the notion that a hedging transaction bears such a direct relationship to the asset or liability being hedged that the character of gain or loss from the hedging transaction is determined by reference to that asset or liability. The preamble concluded that because of this close relationship, the timing of gains or losses from hedging transactions should correspond with the timing of income, deduction, gain or loss from the asset or liability being hedged. The IRS was concerned about the opportunities for abuse if gains and losses from hedging transactions were reported when realized. By selectively disposing of property, or terminating a position that is part of a hedging transaction, taxpayers could recognize gain or loss on the hedging transaction in a period other than the one in which income, deduction, gain or loss is recognized from the hedged item. Consistent with this goal, the final regulations require that the method of accounting used for a hedging transaction clearly reflect the taxpayer's income. Thus, under Regs. Sec. 1.446-4(b), the timing of the income, deduction, gain or loss from hedging transactions must reasonably match the timing of the related income, deduction, gain or loss of the item being hedged.

Regs. Sec. 1.446-4(a) provides that the final regulations generally apply to hedges as defined in Regs. Sec. 1.1221-2(b) (i.e., most hedging transactions entered into in the normal course of the taxpayer's trade or business). They also apply to business hedging transactions for which the treatment of the gains or losses is not covered by Regs. Sec. 1.1221-2. Under Regs. Sec. 1.446-4(a)(1), the rules do not apply to small businesses (those meeting the gross receipts test of Sec. 448(c) for tax years ending after Sept. 29, 1993, or would have met that test if the taxpayer were a corporation or a partnership) that use the cash method or report inventory valuations under the simplified farm inventory method of Regs. Sec. 1.471-6.(16) These rules do not apply to transactions covered by Sec. 475(a), which requires mark-to-market reporting for securities and related hedging instruments held by dealers in securities.(17)

As was previously indicated, the general rule is that the timing of income, deduction, gain or loss from hedging transactions must reasonably match the timing of income, deduction, gain or loss from the item or items being hedged. With certain restrictions for specific types of transactions (described below), as long as the appropriate matching occurs, a taxpayer may choose its method of accounting for specific types of hedging transactions. Once that choice is made, however, Regs. Sec. 1.446-4(c) provides that it must be applied consistently, and can only be changed with IRS consent. In the IRS'S view, the hedge accounting method used by most taxpayers for financial accounting purposes will satisfy the requirements described above, because financial accounting attempts to match related items of income and expense. Because financial accounting standards are still in a state of development, however, the regulations do not refer to accounting standards and do not require consistent accounting methods for financial reporting and tax purposes.(18)

Under Regs. Sec. 1.446-4(d)'s recordkeeping requirements, the taxpayer's books and records must contain a description of the accounting method used for each type of hedging transaction. The description of the method used must be sufficient to show how the matching requirement is met. In addition, the books and records must contain whatever more specific identification with respect to a transaction is necessary to verify the application of the method of accounting used by the taxpayer for the transaction.

The regulations also provide specific accounting method requirements for certain types of hedging transactions, such as the following: [ ] Hedges of aggregate risk: Regs. Sec. 1.446-4(e)(1) states that hedges of aggregate risk must comply with the matching requirements described above. Even though the taxpayer may not be able to associate the hedging transaction with any particular item being hedged, the timing of income, deduction, gain or loss from the hedging transaction must be matched with the timing of the aggregate income, deduction, gain or loss from the items being hedged.

Regs. Sec. 1.446-4(e)(l)(ii) describes a "mark-and-spread" method that may be appropriate for meeting the matching requirement. Under this method, the hedging transactions are marked to market at regular intervals (at least quarterly) and the income, deductions, gains or losses resulting from marking the hedging transactions to market are spread over the period for which the hedging transactions are intended to reduce risk. [ ] Hedges of items marked to market: Regs. Sec. 1.446-4(e)(2) requires that when a transaction hedges an item that is marked to market, the hedging instrument must also be marked to market. This produces the matching of gains and losses that is the regulations' central goal. [ ] Hedges of inventory: The general rule of Regs. Sec. 1.446-4(e)(3)(i) is that inventory hedging transactions related to purchases should be accounted for in the same period as if the gain or loss were an element of the cost of inventory. If a hedging transaction hedges sales, gain or loss on the hedge should be recognized in the same time period as the related sale. If the taxpayer cannot associate hedges of inventory purchases or sales with particular purchases or sales transactions, it may be appropriate to use the rules described above for hedges of aggregate risks, except that the gain or loss is taken into account as though it were an element of cost incurred (for purchase hedges), or as though it were an element of sales proceeds (for sales hedges).

Regs. Sec. 1.446-4(e)(3)(ii) provides two examples of simplified methods of accounting for inventory hedges that may be used as long as the matching requirement is met. First, reporting gains and losses on hedges of inventory purchases and sales as adjustments to inventory cost, at the time the gains and losses are realized, may clearly reflect income for many taxpayers, but is not appropriate for taxpayers using the LIFO inventory method. Second, marking hedges to market with resulting gain or loss taken into account immediately may clearly reflect income even though the inventory being hedged is not marked to market, but only if the inventory is not accounted for under either the LIFO method or the lower-of-cost-or-market method, and only if items are held in inventory for a short time. [ ] Hedges of debt instruments: Regs. Sec. 1.446-4(e)(4) states that gains or losses from transactions that hedge debt instruments issued or to be issued by a taxpayer, or debt instruments held or to be held by a taxpayer, are accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge relates. Thus, gain or loss on the hedge of a debt instrument is taken into account as an adjustment to the yield of the debt instrument over the term to which the hedge relates. For example, gain or loss on a transaction that hedges the interest rate risk on an anticipated fixed-rate borrowing is accounted for as an increase or decrease in the issue price of the debt instrument. [ ] Notional principal contracts: Regs. Sec. 1.446-4(e)(5) provides that Regs. Sec. 1.446-3 generally governs the timing of income and deductions with respect to notional principal contracts (e.g., interest rate swap agreements, interest rate cap and floor agreements, and commodity swap and currency swap agreements). If a notional principal contract is used as a hedge, Regs. Sec. 1.446-3 only applies if there is an appropriate matching of gains and losses from the hedging instrument and the item being hedged. If not, the rules of Regs. Sec. 1.446-4 apply to require that the gains and losses from the hedging instrument match those from the item being hedged. For example, if a notional principal contract hedges a debt instrument, the method of accounting for periodic payments described in Regs. Sec. 1.446-3(c) and the methods of accounting for nonperiodic payments described in Regs. Sec. 1.446-3(f)(2)(iii) and (v) generally meet the matching requirement; the methods described in Regs. Sec. 1.446-3(f)(ii) and (iv) generally will not. [ ] Disposition of hedged asset or liability: According to Regs. Sec. 1.446-4(e)(6), if a taxpayer disposes of, or terminates an interest in, an item being hedged, but does not dispose of, or terminate, the hedging instrument, the taxpayer must match the built-in gain or loss on the hedging transaction to the gain or loss on the disposed item. For instance, the taxpayer could mark the hedge to market on disposition of the item being hedged. Any subsequent gain or loss from the hedging transaction would then be adjusted for the gain or loss recognized when the hedge was marked to market. If the hedging instrument is disposed of within a reasonable period (seven days), however, the taxpayer should match the realized gain or loss on the hedging transaction with the gain or loss on the disposed item. [ ] Recycled hedges: Under Regs. Sec. 1.446-4(e)(7), if a taxpayer enters into a hedging transaction by recycling a hedge of a particular hedged item to serve as a hedge of a different item, the taxpayer must match the built-in gain or loss at the time of the recycling to the gain or loss on the original hedged item, items or aggregate risk. Any income, deduction, gain or loss occurring after the recycling must be matched to the new hedged item, items or aggregate risk. [ ] Unfulfilled anticipatory transactions: Regs. Sec. 1.446-4(e)(8) provides that if a taxpayer enters into a hedging transaction to reduce risk with respect to an anticipated asset acquisition, debt issuance or obligation, and the anticipated transaction is not consummated, any income, deduction, gain or loss from the hedging transaction is taken into account when realized.

In summary, the intent of new Regs. Sec. 1.446-4 is to match the income, deduction, gain or loss from hedging transactions with the related income, deduction, gain or loss of the item being hedged. The Sec. 446 regulations are effective for transactions entered into after Sept. 2, 1994. Taxpayers involved in hedging transactions should review their current accounting methods for such transactions to determine the effect of these regulations.

Hedging Transactions for Consolidated Groups

The IRS has also issued proposed regulations under Sec. 1221(19) for hedging transactions between members of a consolidated group. Such regulations are necessary because many related entities centralize their hedging operations in a single entity. Generally, Prop. Regs. Sec. 1.1221-2(d) adopts a single-entity approach to consolidated groups, applying the hedging rules to one group member's transactions that hedge the risk of other group members. Under this approach, intercompany transactions would not be considered hedging transactions but, rather, would be subject to Sec. 1502, dealing with intercompany transactions and obligations. The result is that only transactions with third parties would qualify as hedging transactions.

However, a consolidated group would be allowed to elect separate-entity treatment of its hedges under Prop. Regs. Sec. 1.1221-2(d)(2) if (1) the position of the member in the transaction would qualify as a hedging transaction if it had been entered into with an unrelated party, and (2) the position of the other member in the transaction is marked to market under that member's method of accounting. Neither the hedging transaction nor any intercompany obligation with respect to it would be treated as an intercompany transaction, and any gain or loss to the member of the consolidated group would be ordinary. The separate-entity election would be made in a separate statement filed with the group's consolidated return for the tax year that includes the first date for which the election would apply, and would be irrevocable in the absence of IRS consent.

Prop. Regs. Sec. 1.1221-2(e)(5) provides identification rules that conform to the treatment of hedging transactions previously described. Thus, if the consolidated group uses the single-entity approach, identification would be made as if the members of the group were divisions of a single corporation. If a group were to make the separate-entity election, however, each member would be required to identify its hedging transactions with unrelated parties, its intercompany transactions that are treated as hedging transactions and the item, items or aggregate risk being hedged.

Finally, Prop. Regs. Sec. 1.446-4(e)(9) addresses timing issues for reporting the income, deduction, gain or loss from consolidated group hedging transactions. Under the single-entity rule, a member of a consolidated group that hedges the risk of another member would be required to match the timing of income, deduction, gain or loss from the item or items being hedged with the timing of the income, deduction, gain or loss of the hedging transaction. If a consolidated group were to make a separate-entity election, each member of the consolidated group would need to meet the matching requirements under Regs. Sec. 1.446-4(b).

Conclusion

The new hedging regulations should come as welcome news to taxpayers involved in these kinds of transactions. Although not all issues have been resolved, the IRS has essentially conceded most of the arguments it raised in the FNMA case. The main thrust of these regulations is that gains and losses from most common business hedges are eligible for ordinary income or loss treatment as long as they are appropriately identified on a timely basis. In addition, the IRS has made an initial step toward clarifying the appropriate timing for reporting income, deduction, gain and loss from hedging transactions.

(1) Arkansas Best Corp., 485 US 212 (1988)(61 AFTR2d 88-655, 88-1 USTC [para.]9210). (2) Federal National Mortgage Association, 100 TC 541 (1993). (3) FI-54-93 (10/20/93). (4) TD 8554 and 8555 (7/13/94). (5) Corn Products Refining Co., 350 US 46 1955)(47 AFTR 1789, 55-2 USTC [para.]9746). (6) Id., at 55-2 USTC 56,064. (7) Arkansas Best, note 1, 88-1 USTC at 83,401. (8) FNMA, note 2, at 576. (9) Under Regs. Sec. 1.1221-2(c)(4), transactions entered into in the normal course of business include expansion of an existing business and the acquisition of a new trade or business. (10) The preamble states that, although these types of transactions are not risk-reducing if viewed independently, they are part of the larger hedging transaction. (11) Under Regs. Sec. 1.1221-2(g)(3)(i), a special transition rule applies to certain hedges of Sec. 1231 assets entered into in tax years ended before July 18, 1994. (12) Under Regs. Sec. 1.1221-2(g)(3)(ii), special transition rules apply to hedges of noninventory supplies for tax years ended before July 18, 1994. (13) This was the case in Arkansas Best, note 1, in which ordinary loss treatment on the sale of stock was disallowed. (14) Transactions entered into before 1994 that remained in existence on Mar. 31, 1994 are also subject to these rules. (15) TD 8555, note 4. (16) However, taxpayers not required to adhere to these regulations may use a method of accounting that is consistent with them. (17) In addition, the regulations do not apply to any Sec. 988 hedging transaction if regulations already provide when gain or loss from the transaction will be taken into account; nor do they apply to the determination of the issuer's yield on an issue of tax-exempt bonds for purposes of the arbitrage restrictions of Regs. Sec. 1.148-4(h). (18) Statement of Financial Accounting Standards (SFAS) No. 52, "Foreign Currency Translation," addresses hedging issues for foreign currency transactions; SFAS No. 80, "Accounting for Futures Contracts," addresses the reporting requirements for exchange-traded futures contracts that are used for hedging transactions; and SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," addresses the treatment of hedging transactions related to certain equity securities and investments in debt securities. All of these standards require that income, deductions, gains and losses from hedging transactions match the income, deductions, gains and losses from the underlying item being hedged. However, the financial accounting treatment for many types of hedging transactions has not been addressed by the Financial Accounting Standards Board. (19) FI-34-94 (7/13/94).