Temporary and proposed hedging regulations.

On February 4, 1994, Tax Executives Institute submitted the following comments on the temporary and proposed regulations relating to business hedging. The temporary and proposed regulations were issued under sections 1221 and 446 in response to both the Tax Court's decision in Federal National Mortgage Association v. Commissioner (Fannie Mae) and the congressional directive to the Treasury Department that the Treasury and IRS study the tax issues arising from the United States Supreme Court decision in Arkansas Best v. Commissioner. TEI's comments were prepared under the aegis of its Federal Tax Committee whose chair is Michael A. DeLuca of Household International Corporation. Contributing to the development of TEI's comments were Donald N. Adler of Dean Witter / Discover Co., Philip G. Cohen of Unilever USA Inc., Stephen P. Kaplan of Society Corp., Roger D. Wheeler and James Aretakis of General Motors, and Clement Wydra of Diamond Shamrock.

On October 18, 1993, the Internal Revenue Service issued Treasury Decision 8493,(1) promulgating temporary regulations under sections 1221, 1233, and 1234 of the Internal Revenue Code. Simultaneously, the IRS issued a notice of proposed rulemaking (FI-46-93) declaring that the text of the temporary regulations serve as proposed rules for purposes of adopting final regulations.(2) Assuming certain administrative requirements are met, the temporary and proposed regulations treat gain or loss arising from defined business "hedging transactions" as ordinary in character under section 1221. In a related action, the IRS issued a notice of proposed rulemaking under section 446 (FI-5493)3 addressing the manner and timing of recognition of gain or loss realized on hedging transactions. The temporary and proposed regulations were published in the Federal Register on October 20, 1993 (58 Fed. Reg. 54037, 54075, and 54077, respectively), and in the Internal Revenue Bulletin (1993-35 I.R.B. 16, 22, and 24, respectively) on November 8, 1993.(4) A public hearing on the regulations was held on January 19, 1993.

I. Background

Tax Executives Institute is the principal association of business tax executives in North America. The Institute's approximately 4,700 members represent more than 2,400 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the deve]opment and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the temporary and proposed regulations relating to the income tax treatment to be accorded to hedging transactions.

II. Overview

For many years, transactions involving the acquisition of property by businesses to hedge against price changes of other assets and liabilities were characterized upon disposition as giving rise to ordinary income or loss. The preamble to the temporary regulations explains that the legislative history of the Internal Revenue Code of 1954 expressly notes that business hedges were accorded ordinary treatment under existing law and that Congress declared its intent to continue that treatment? Under the widely accepted interpretation of the United States Supreme Court decision in Corn Products,(6) the tax treatment of transactions entered into as business hedges depended upon the motive underlying the transaction: gains or losses were characterized as ordinary or capital in nature depending upon whether the transactions were undertaken for ordinary business or speculative investment purposes.(7) In Arkansas Best Corp. v. Commissioner,(8) however, the Supreme Court narrowed the orthodox exegesis of Corn Products, holding that a taxpayer realized a capital loss on the sale of shares of a company even though acquisition of the shares may have been motivated by business exigencies.

In the aftermath of the Arkansas Best decision, the courts, the IRS, and taxpayers have struggled to divine the extent to which property or positions acquired in "hedging transactions" either fall within one of the enumerated statutory exceptions contained in section 1221 or are otherwise properly excluded from the definition of a capital asset. Initially, the IRS interpreted Arkansas Best restrictively to hold that only positions resulting in or possibly resulting in the acquisition of "inventory" assets qualified for ordinary treatment. This view spawned a number of disputes because the IRS challenged the accounting treatment for hedging transactions that taxpayers had considered to be well settled. In addition, disputes arose because of uncertainty concerning the proper treatment of derivative financial products for which no specific statutory or regulatory guidance exists. The proliferation of these financial products to better manage various business risks exacerbated the number, complexity, and scope of controversies between the government and taxpayers.

In Federal National Mortgage Ass'n v. Commissioner (Fannie Mae),(9) the Tax Court rejected the IRS's narrow interpretation of the treatment of business hedges, concluding that the various transactions undertaken in that case were integrally related to the taxpayer's business of buying and selling mortgages and that the character of the hedge transactions should match the ordinary gain or loss treatment accorded the hedged property. Following on the heels of the Fannie Mae decision, Congress--in the Conference Report to the Omnibus Budget Reconciliation Act of 1993--directed the Treasury Department to study the tax treatment of hedging transactions and report its findings and recommendations to the congressional tax writing committees. In response to the congressional directive and the Fannie Mae decision (as well as the underlying uncertainty created by Arkansas Best), the IRS issued the temporary and proposed regulations.(18)

TEI commends the Treasury and IRS for responding to the need for guidance on the income tax treatment of business hedging transactions. The widespread use of derivative financial products and the complexity of the tax law on matching of character and timing of income or loss for business hedges has engendered far too much controversy to be resolved through a case-by-case examination and litigation approach. The muchneeded guidance will bring certainty to the treatment of many routine transactions and enhance compliance generally. Thus, TEI believes that the temporary and proposed regulations represent a solid cornerstone upon which comprehensive guidance on the tax treatment of hedges and derivative financial products can be erected.

We regret, however, that the regulations are flawed in certain respects. By failing to address important issues, adopting positions that conflict with economic or practical business realities, and encumbering taxpayers with excessive administrative requirements, the regulations threaten to impede efficient risk-management practices and leave the door open for substantial continuing controversy between taxpayers and the government. We believe that the comments and recommendations that follow effectively address these flaws and will enable the IRS to improve its framework.

III. Definitions of Key Terms

Temp. Reg.[sections]1.1221-2T(a)(1) excludes from the definition of "capital asset" any property that is part of a "hedging transaction." Temp. Reg.[sections] 1.1221-2T(b)(1) defines "hedging transactions" as transactions entered into in the normal course of the taxpayer's trade or business primarily to reduce the risk of either (i) price or currency changes with respect to "ordinary property" held or to be held by the taxpayer or (ii) interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer. Temp. Reg.[sections] 1.1221-2T(b)(2) in turn defines "ordinary property" as any property the sale or exchange of which could not produce capital gain or loss regardless of the taxpayer's holding period at the time of its sale or exchange. Similarly, "ordinary obligation" is an obligation the performance or termination of which by the taxpayer could not produce capital gain.or loss. The net effect of the rules is to characterize the gain or loss on dispositions of certain property as ordinary rather than capital.

A. Definition of Hedging

Transaction Too Narrow

The definition of a "hedging transaction" is drawn from section 1256(e) of the Code,(11) which posits an exception to the general mark-to-market timing rule of section 1256(a) for "hedges." The legislative history of section 1256 makes abundantly clear the prevailing understanding among Congress, Treasury, and tax practitioners that "business hedges" are generally ordinary in character and that transactions involving hedges were not the target of the section 1256 rules. Also, Congress clearly stated that it did not intend for the section 1256 rules to curtail the use of futures transactions for commercial hedging purposes.(2) In other words, section 1256 was enacted to provide clear timing rules to prevent perceived abuses involving tax straddles by professional commodity traders. The business hedge exception in 1256(e) should not be viewed as a limit on the Treasury's authority to clarify the treatment of the character of hedges, nor should the Treasury adopt a restrictive view of section 1221 that effectively contravenes congressional intent (and its assumptions) in enacting this hedging exception.(13)

TEI submits that the Treasury should focus on providing rules requiring consistent character treatment for a hedge position and the property, activity, or income being hedged. Regrettably, the temporary regulations adopt a different approach because the scope of the term "ordinary property" is unduly limited to property that can never produce capital gain or loss on a sale or exchange of the property. The narrow definition denies hedging treatment to a substantial number of transactions entered into for ordinary business purposes involving property that may, in some limited circumstances, give rise to a transaction that is capital in nature even though the cost of the underlying item is usually recovered through ordinary deductions (e.g., supplies).

B. The Need to Expand

Breadth of Regulations

Temp. Reg. [sections] 1.1221-2T(a)(3) provides that "property, a short sale, or an option serves a hedging function only if the property, short sale, or option is part of a hedging transaction as defined" in the regulations. (Emphasis supplied.) Thus, the IRS has propounded a rule that purports to be the exclusive means of characterizing and identifying qualified tax hedges. We submit, however, that the regulations must be substantially broadened in order to accommodate routine commercial transactions; otherwise, necessary and legitimate hedges will be denied their proper accounting treatment. As they stand, the temporary and proposed regulations narrowly focus on prosaic liability and inventory-type hedges. This restricted focus fails to reflect that hedging transactions are undertaken to manage the risk of loss associated with many different types of assets and liabilities. These commonplace transactions merit ordinary tax treatment as hedges as long as they are properly identified as business hedges. The following comments focus on specific problems that flow from the temporary and proposed regulations' restrictive view.

1. Consumed Supplies. Under the temporary regulations, the cost of a hedge for purchased supplies that are not considered inventory under sections 1221(1) and 471 (because they are not sold directly to customers or incorporated as raw materials in property sold to customers) will be treated as giving rise to capital gain or loss, even though the cost of the supplies themselves will likely be recovered through ordinary deductions as the supplies are consumed.(14) TEI submits that hedges incurred to fix the price of ordinary costs of doing business, such as supplies, are an absolute necessity; excluding these transactions from ordinary treatment will compel businesses either to forgo risk management practices that should be encouraged or to adopt alternative hedging strategies that are less efficient than exchange-traded transactions.(15) Since the capital-asset characterization of supplies consumed in providing services is based in large part on longstanding IRS policy,(6) we believe the IRS possesses ample authority to modify that policy and treat supply hedges as ordinary.

Thus, we believe that the proposed and temporary regulations' treatment of the "business hedge" of consumed supplies is improper and recommend that the regulations be revised to adopt a rule that permits the cost of a hedge to be recovered as an ordinary deduction (and taxes gains in a consistent fashion) where the "hedged" property cost will likely be recovered through ordinary deductions. Taxpayers most likely will be willing to enter into closing agreements, advance determinations, or similar arrangements with the IRS to define the scope of a tailor-made hedging program for recurring supply hedges. The Tax Court in Fannie Mae implicitly approved of such agreements.

2. Notes or Accounts Receivable. Since the temporary and proposed rules provide the exclusive means to achieve hedging treatment and ordinary gain or loss characterization, the regulations should clarify the treatment of receivables held as ordinary assets under section 1221(4). In Fannie Mae, the Tax Court found that such receivables qualify for hedging treatment. In the absence of any statement including such receivables as "ordinary property" capable of being hedged, needless confusion and controversy may arise. We recommend the regulations state that receivables held as ordinary assets under section 1221(4) are treated as ordinary property, and that, by logical extension, hedging of interest-rate risks relating to such assets will be accorded ordinary treatment.

3. Income Stream Hedges. The proliferation of derivative financial products permits taxpayers to enter into hedges of streams of ordinary income. The income stream, or the "fruit" of a capital asset, is often viewed by corporate treasurers in isolation from the underlying capital asset "tree." Hedges of income streams (being entirely a product of modern financial engineering), however, do not fit within the classical hedging analysis of Corn Products or Arkansas Best. Nevertheless, such modern hedging practices should be recognized and encouraged by the Treasury. For example, taxpayers such as banks and insurance companies often enter into a transaction or series of transactions designed, in the aggregate, to protect their net interest spread or hedge the income stream of a capital asset (which asset will be used to fund an insurance or annuity risk). Indeed, the Tax Court decision in Fannie Mae implicitly embraces the concept of income stream hedges. We believe such hedges should be encouraged.

TEI recognizes that the hedging of income streams may require special rules to produce a matching of the hedged item and the hedge position, particularly where there is an early disposition of the underlying capital asset producing the hedged income stream. TEI is willing to work with the IRS to devise such rules for income stream hedges including, for example, a mark-to-market regime for the hedge upon early disposition of the property being hedged.

4. Foreign Exchange Hedging in Pre-1987 Tax Years. Temp. Reg. [sections] 1.1221-2T(b)(2) states that the temporary rules apply to transactions involving foreign exchange contracts in tax years preceding the effective date of section 988. The results under section 988 and the temporary hedging regulations, however, are not necessarily equivalent, and the rationale for the departure from both economic reality and consistent tax treatment for equivalent transactions involving hedging of foreign exchange risks is neither explained nor apparent. For example, assume a taxpayer undertakes to purchase a piece of equipment to be used in its trade or business and simultaneously enters into a foreign currency forward contract (because the contract price was denominated in a foreign currency) to "fix" the price of the equipment in U.S. dollars. Under the temporary and proposed regulations, a taxpayer will not be permitted to claim an ordinary loss (gain) with respect to the foreign currency hedge or, alternatively, to increase (decrease) the basis of the asset. This exclusion from ordinary treatment for hedging is inconsistent with section 1221(2) and creates a capital loss exposure, contrary to the result under section 988. TEI recommends that the regulations be revised to permit the exchange gain or loss with respect to the foreign currency hedging contract to be treated as an adjustment to the purchase price of the asset.(17)

5. Section 1231 Assets. Under Temp. Reg. [sections] 1.1221-2T(b)(2), assets used in a trade or business--section 1231 assets--are excluded from the scope of property capable of being hedged. TEI questions the refusal to extend non-capital treatment to hedges of this type of property. Indeed, we question whether the IRS has the authority to refuse to extend ordinary treatment to such assets in view of the explicit exception from the definition of capital assets accorded to section 1231 assets by section 1221(2). TEI submits that businesses should be able to enter into hedges of these types of assets without being whipsawed between ordinary gains and capital losses from the hedging activity.(18)

There are several means to cure the incongruent treatment of hedges of section 1231 assets. One option would be to permit capital gain and ordinary loss treatment for hedges of this group of assets. Although this proposal would be consistent with the treatment accorded section 1231 property in general, we realize that the proposal perpetuates asymmetrical tax treatment--albeit one that shifts the balance in favor of the taxpayer and away from the current formulation of the character rules. Alternatively, the IRS could adopt a rule that maintains ordinary gain or loss treatment, which would be consistent with the ordinary nature of the amortization or depreciation deduction accorded trade or business assets. Finally, the IRS could consider a "lookback" approach that characterizes hedges of section 1231 assets in the same manner as the gains or losses are reported on Forms 4797 (Sales of Business Property) and 4562 (Depreciation and Amortization).

For example, assume a taxpayer reports $100 of ordinary gain (from recapture of prior deductions), $100 of capital gains, and $800 of related amortization or depreciation deductions. In this case, the gain or loss on properly identified hedges of the 1231 assets would be allocated 90 percent ordinary and 10 percent capital.(9) The lookback proposal permits consistent matching of the character of the hedge and the hedged item. Furthermore, the approach should allay concerns about whipsaws by either the government or the taxpayer because all of the information necessary to allocate the hedging gains and losses will be available on the return and related workpapers. Any of these results would produce a better result than the proposed regulations.

C. Risk Management as the

Linchpin of a "Hedge"

Transaction

The principal reason that commercial enterprises enter into transactions involving options, futures, short sales, and other derivative financial products is to manage a perceived risk that a reasonable business person deems unacceptable. Business taxpayers typically do not acquire positions in financial instruments or commodities futures with a speculative purpose. Indeed, most companies adopt policies that restrict corporate treasurers from engaging in speculative transactions. Furthermore, financial accounting rules forthrightly distinguish hedges from speculative positions and set forth separate rules for the recognition of income or expense with respect to each category of transactions. Corporate treasurers operating under the constraint of a "no speculation" policy must establish to the satisfaction of internal auditors and independent accountants that all positions taken, either separately or in combination with other transactions, comply with the stated corporate policy.

Under Temp. Reg.[sections] 1.12212T(b)(1), a transaction does not qualify as a hedge, unless the hedge position "reduce[s] the risk" of price changes, etc. The narrow focus on risk reduction will exclude a large number of prudent risk-management transactions from hedging treatment. TEI recommends that the regulations permit taxpayers to manage their business and economic risks in the most prudent fashion without regard to whether the transaction is, for example, to convert floating interest rate assets or liabilities into fixed rate assets or liabilities or viceoversa (i.e., fixed to floating rate hedges or even floating to floating basis hedges). In addition, the ability to obtain hedge treatment should not depend upon whether a taxpayer is fully or partially hedged with respect to the underlying risk. Furthermore, it should not matter whether a taxpayer's choice of a contract month varies from the date when it anticipates selling or actually sells a commodity or other property being hedged, or whether the contract or commodity chosen is a "perfect" hedge of the taxpayer's property or obligation? Taxpayers neither should be discouraged from engaging in proven risk-management strategies because of unclear regulations nor should their business decisions be second-guessed by revenue agents armed with an unduly narrow "risk-reduction" standard.

Finally, under Temp. Reg. [sections] 1.1221-2T(a)(1), the term "capital asset does not include property that is part of a hedging transaction." Interpreted broadly, this statement should extend ordinary hedging treatment to combinations of transactions that may not individually reduce risk, but that are part of a series of transactions that, in combination, manage a taxpayer's risks. For example, an interest-rate "collar"--i.e., the simultaneous purchase of an interest rate cap option and the sale of an interest rate floor option--should be accorded hedging treatment. The premium received on the sale of the floor option is simply a means of reducing the cost of a premium to be paid in connection with the interest rate cap. A taxpayer entering into a collar is willing to give up potential gains with respect to a decline in interest rates in exchange for a lower cost of capping its interest rate risk. TEl recommends that the regulations be clarified, by way of an example, to show that combinations of positions will qualify for hedging treatment, even if all of the individual components of the position may not "reduce risk."

D. Centralized Hedging

Temp. Reg. [sections] 1.1221-2T(b)(1) provides that a hedge must reduce a taxpayer's risk with respect to property or obligations held or to be held by the taxpayer. The preamble states that "... because a hedging transaction must reduce the taxpayer's risk, the regulation does not apply where a taxpayer hedges the risk of a related party.(21) The IRS invites comments on the scope of the definition and its application to transactions between related parties. We believe the limitation is wrong-headed.

Affiliated groups sometimes establish a separate corporate entity through which the group will engage in various treasury functions, including hedging transactions with respect to the assets or liabilities of other members of the affiliated group. In many cases, the entity will subject itself to securities law and marketexchange requirements to qualify as a direct participant on an exchange, thereby eliminating the need to execute transactions through third parties and thereby saving considerably on fees. In other corporate groups, all hedging activity is centralized in the group's parent (or principal operating company's) corporate treasury function. Whether executed through a corporate parent or a separate subsidiary, global hedging activities minimize the group's administrative costs by permitting it to centralize its expertise in the evaluation of, and pricing, execution, and accounting for, various financial products employed to hedge group-wide activities. Centralized hedging also permits the group to offset one member's risk exposure with an existing counter position of another member, thereby reducing the amount of the hedging position and the attendant hedging cost of the group.

To enable taxpayers to minimize hedging costs and avoid artificial structuring of hedging transactions to comply with administrative requirements, the regulations should permit one member of a group to hedge the net position, property, or obligations of all members of the corporate group. Financial accounting rules generally permit a corporate group to account for "net" hedges of transactions, property, or obligations of other members of the corporate group. In addition, the preamble to the proposed regulations under section 446 states that hedge accounting employed by taxpayers for financial accounting purposes will generally satisfy the clear reflection of income standard for accounting for hedges. An unnecessary and confusing inconsistency will arise between tax and financial accounting for hedging transactions, however, unless the group is permitted to aggregate (or disaggregate) its hedging transactions regardless of the entity in which the property, position, or obligation to be hedged is held or to be held. At a minimum, therefore, the definition of "taxpayer" should be expanded to permit all related parties that comprise an affiliated group of corporations filing a consolidated tax return to be treated as the "taxpayer" for hedging purposes. The location of the hedge and the property or obligation to be hedged within an affiliated group filing a consolidated return should be irrelevant.(22) In addition, the IRS should consider amending the rules to cover hedging of all related party property or obligations.

E. Related Party Loans

Intercompany loans are important for taxpayers that centralize their hedging operations, and they should be permitted to hedge the risks associated with the loans. Gains or losses on the hedge of the nonfunctional currency exchange rate risk on intercompany loans are ordinary in nature under section 988. In a somewhat surprising departure from the section 988 treatment, the temporary and proposed regulations exclude related party assets and liabilities from the umbrella of the ordinary property definition. TEI recommends that, at minimum, related party loans should be treated as ordinary property.

IV. Identification of Hedges

Under Temp. Reg. [sections] 1.12212T(c)(1), a taxpayer entering into a hedging transaction must identify the transaction as a hedge before the close of the day on which the taxpayer enters into the transaction. The identification must be made on, and retained as part of, the taxpayer's books and records and must specify both the hedge and the item, items, or aggregate risk that is being hedged. In addition, Prop. Reg. [sections] 1.1221-2(c) sets forth additional identification rules for specific types of hedges.

A. Increased Compliance

Burdens

The temporary and proposed regulations significant]y increase compliance burdens for taxpayers desirous of ordinary treatment for hedging transactions. Prior to the issuance of the temporary regulations, no specific identification was necessary in order to obtain ordinary treatment for a hedging transaction.(23) While sameday identification is necessary to be excluded from the mark-to-market timing rules under section 1256's hedging exception, the rules of section 1256 have not generally been interpreted as requiring an identification or description of the hedged item. The temporary and proposed regulations thus represent a significant and, we believe, unwarranted expansion of the identification requirements.

Although an identification requirement for the hedge transaction or property is justified to prevent whipsaws against the government, TEI questions whether identification of the hedged item is necessary.(24) Taxpayers engaged in regular day-to-day hedging of constantly shifting positions have, by necessity, devised standardized identification procedures for their hedge transactions. Typically, these procedures do not require corporate treasury personnel to devote more than a few minutes to the identification of the transaction. Exactly why same-day description of the hedged item is necessary is not entirely apparent, because identification of the hedging transaction alone should prevent taxpayers from using hindsight to recharacterize gains as capital to whipsaw the government.(25)

In the event that the regulations continue to require identification of the hedged property, the same-day identification requirement should be substantially modified. We believe taxpayers should be given substantial leeway to "match" the hedge transaction to the hedged item and, consequently, recommend that taxpayers be permitted to identify the property being hedged as late as the earlier of (i) 30 days following the close of a quarter- or year-end, or (ii) the issuance of financial statements for that period. This proposal will permit taxpayers sufficient time to comply with the identification requirement using the same procedures to segregate and account for hedges and speculative positions employed to comply with generally accepted accounting requirements.

For some taxpayers actively engaged in commodity and financial futures transactions, even the modified proposed requirement will be difficult to meet. For them, any requirement to match the hedge transaction with the hedged item may be literally impossible to comply with because the underlying positions change so rapidly. In such circumstances, we recommend that taxpayers be permitted to avail themselves of reverse identification procedures akin to those adopted in Rev. Rul. 93-7626 in respect of the mark-to-market identification rules under section 475 for securities dealers. Under this proposed procedure, a taxpayer would treat all transactions as hedges and would be required to identify affirmatively the positions that are not to be treated as hedges. Adoption of TEI's proposal would temper excessive accounting requirements, reduce the likelihood of taxpayer identification errors, and minimize the government's examination burden?

B. Misidentification

Whipsaw

Under Temp. Reg. [sections] 1.12212T(d)(2)(iii), where the IRS determines that a hedge of ordinary property has not been properly identified, it may unilaterally treat gain from the misidentified position as ordinary and treat a loss as capital. On the other hand, where property (or a position with respect to property) is improperly identified as being a hedge of ordinary property, a taxpayer is bound by its misidentification and must report gain or loss as ordinary irrespective of whether the underlying property to be hedged is held by the taxpayer (or is not "ordinary property").(28) Temp. Reg. [sections] 1.12212T(d)(2)(ii) provides limited relief to taxpayers in the event of an inadvertent failure to identify a hedging transaction; there is no parallel provision to accord relief, however, to the inadvertent designation of a nonhedging transaction as a hedging transaction.

The preamble to the temporary regulations seeks to justify the oneway nature of the misidentification rule as necessary to prevent taxpayers from obtaining a benefit to which they are not entitled under the substantive rules? TEI rejects that rationale and submits that the temporary and proposed rule inappropriately penalizes misidentifications caused by good faith disputes about whether a position constitutes a hedge. The regulations should be revised to include the equivalent of a reasonable cause exception whereby taxpayers may establish that mistakes were made in misidentifying or not identifying hedges. Neither form of error should trigger an ordinary gain/capital loss whipsaw against the taxpayer?

V. Proposed Regulations

Under Section 446

on Timing

Under Prop. Reg. [sections] 1.446-4, the accounting for hedge transactions must clearly reflect income. To clearly reflect income, an accounting method must reasonably match the recognition of income (loss) on a hedge with the loss (income) on the item being hedged. Furthermore, a taxpayer may employ different accounting methods for different types of hedging transactions and for transactions that hedge different types of items. The professed goal of the proposed rules is to provide taxpayers with flexibility in accounting for hedging transactions, subject to special restrictions for certain transactions.(31)

A. Clear Reflection

of Income Standard

The regulations require recognition of income or expense from a hedging transaction over the term of the hedged item. No specific guidance is provided on the manner of recognition. We applaud the IRS for recognizing that the wide variety of commercial hedging transactions requires that taxpayers be afforded substantial latitude in the selection of proper accounting methods for hedging transactions. Nonetheless, the absence of any safe harbors is not entirely comforting to taxpayers desiring certainty with respect to their tax return positions, especially (or particularly) given the propensity of revenue agents to challenge (or second guess) accounting methods under the clear reflection standard. In particular, we believe the regulations should address whether a taxpayer employing the specific timing rules under Treas. Reg. [sections] 1.446-3 for notional principal contracts (NPCs) will satisfy the general clear reflection standard set forth in Prop. Reg. [sections] 1.446-4(e)(4).(32) We recommend that the regulations clarify that taxpayers that employ an NPC to hedge a liability and that otherwise comply with the rules of Treas. Reg. [sections] 1.446-3 will be deemed to clearly reflect income. Guidance in the form of safe harbors or Revenue Procedures may also be necessary with respect to other forms of futures transactions or derivative financial products to provide taxpayers certainty in respect of their accounting for hedges.

B. Safe Harbors for Clear

Reflection of Income

Standard

The preamble to the proposed timing regulations states that "hedge accounting methods employed by most taxpayers for financial accounting purposes will satisfy the clear reflection standard of paragraph (b) [of Prop. Reg. [sections] 1.446-4] because financial accounting attempts to match related items of income and expense."(33) The preamble then declares, however, that financial accounting treatment is not determinative for purposes of recognizing the income or expense from hedges because the financial accounting statement standards are in a state of "development."

Since tax and financial accounting have different objectives, it may not be proper for Treasury to adopt a rule requiring taxpayers to follow their financial statement accounting for hedge transactions. Nonetheless, TEI submits that--where they consistently follow their financial accounting treatment for hedges--taxpayers should be accorded a presumption that their method of accounting for hedges clearly reflects income. To avoid confusion among taxpayers and revenue agents alike, the regulations should include a statement similar to that contained in the preamble: Taxpayers that consistently follow their financial statement accounting treatment for hedges are presumed to employ a method that clearly reflects income. In addition, the regulations should include a safe harbor for taxpayers employing a mark-to-market method for recognition of hedging gains and losses where that method will properly match the income or ex pease from the hedged property.

C. Aggregate or

Rolling Risks

No guidance is provided it the proposed regulations on the rec ognition of gains or losses on hedges of aggregate risks. Similarly, no guid ance is provided in respect of "rolling" risks or other arrangements whet the term of the risk is undefined. (34) We urge the Treasury to provide guidance through examples, in respect of the timing of recognizing such income or expense.

D. Integration as an Option

The proposed regulations do not permit integration as an acceptable method of matching income (loss) from the hedging activity with the loss (gain) from the property being hedged. The preamble, however, invites comments on whether current law provides authority to the IRS to require or permit integration. TEI believes that, in prescribing the temporary and proposed regulations to match the character and timing of recognition of hedge transactions with the underlying property, the IRS has already moved far down the path toward integrating the separate transactions. The principal remaining issue to resolve to permit full integration is whether the source of the income or loss is domestic or foreign. In the event that the Treasury remains uncertain of its authority to permit integration, we recommend that it seek legislative authority to permit integrated treatment.

VI. Conclusion

TEI is pleased to have the opportunity to submit its views on the subject of the temporary and proposed regulations relating to business hedging transactions. These comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is Michael A. DeLuca. If you have any questions concerning these comments, please call either Mr. DeLuca of Household International, Inc. at [phone] or Jeffery P. Rasmussen of the Institute's professional tax staff at [phone].

Notes

1 1993-35 I.R.B. 16.

2 1993-35 I.R.B. 22. FI-46-93 also sets forth additional proposed regulations under sections 1221, 1233, and 1234, prescribing special identification requirements for certain types of hedging transactions.

3 1993-35 I.R.B. 24.

4 For convenience' sake, the temporary and proposed regulations under section 1221 are referred to as "the temporary regulations." The proposed regulations under section 446 and the proposed regulations under section 1221 issued apart from the temporary regulations are referred to as the "proposed regulations." Specific provisions are cited as "Temp. Reg. [sections]" or "Prop. Reg. [sections]," as appropriate. References to page numbers are to the temporary and proposed regulations (and their preambles) as published in the Internal Revenue Bulletin.

5. 1993-35 I.R.B. at 17. The preamble documents other instances where congressional action was premised on its understanding that business hedging transactions are outside the scope of the definition of capital assets and, thus, give rise to ordinary income or loss.

6 Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955).

7 See also Rev. Rul. 82-204, 1982-2 C.B. 192, which acknowledges an extra-statutory exception to the capital asset definition was established in Corn Products.

8 485 U.S. 212 (1988).

9 100 T.C. No. 36 (June 17, 1993).

10 See Letter dated October 18, 1993, from Secretary of the Treasury, Lloyd K. Bentsen, to Senator Daniel P. Moynihan and Representative Dan Rostenkowksi, reprinted in Bureau of National Affairs, Daily Tax Report, Special Supplement S-2 (October 19, 1993).

11 The rules in the temporary and proposed regulations are modeled upon the language contained in section 1256(e)(2)(A), which was enacted as part of the Economic Recovery Tax Act of 1981.

12 See S. Rep. No. 97-144, 97th Cong., 1st Sess. 146 (1981), which states:

Because of the importance of the commodities markets, particularly in the agricultural and commercial sectors, it is critical that the efficiency of those markets be preserved. The liquidity of these markets must be maintained. Thus, for example, the Committee has included an exception to the rules for hedging transactions.

In another portion of the same report, commercial and speculative hedges are distinguished, as follows:

[A] hedging transaction means an identified transaction which the taxpayer executes in the normal course of his or her trade or business primarily to reduce certain risks and which results in only ordinary income or loss. Hedging transactions are varied and complex. They may be executed in a wide range of property and forms, including options, futures, forwards, and other contract rights and short sales.

A hedging transaction may be executed to reduce the risk of price change or of currency fluctuations with respect to property which is held or to be held by the taxpayer and which, if disposed of, whether by sale, exchange, lapse, cancellation, or otherwise, at a gain, produces ordinary income .... Transactions which result in capital gains or losses do not qualify for the hedging exemption. Speculation in commodity futures contracts, for example, does not qualify for this exemption... because futures speculation always produces only capital gains or capital losses.

Id. at 159.

13 In Fannie Mae, the Tax Court specifically rejected a number of IRS contentions regarding the scope of section 1221, citing the need to interpret that section in light of the enactment of section 1256(e). Specifically, the court stated:

[W]e do not agree with respondent's contention that the hedges related to the issuance of petitioner's debentures could not come within any exception to section 1221 since debentures are not assets, but rather liabilities. We note that respondent's position is inconsistent with section 1256(e) in which hedging transactions are specifically excepted from being marked to market under section 1256(a). Hedging transactions include, inter alia, transactions that 'reduce risk of interest rate or price changes . . . with respect to borrowings made or to be made' in the normal course of a taxpayer's business so long as the gains or losses would be treated as ordinary. [Citation omitted.] It strikes this Court as odd that Congress would provide an exception to the marked to market regime that would effectively serve no purpose, if, as respondent claims, property serving to hedge a borrowing were not excepted under section 1221.

100 T.C. No. 36, as reprinted in Bureau of National Affairs, Daily Tax Report, K-16 (June 18, 1993) (emphasis added).

14 See Treas. Reg. [sections] 1.162-3.

15. This is the so-called jet-fuel supply problem identified by Treasury Secretary Bentsen in his transmittal letter to Representative Rostenkowski and Senator Moynihan. The problem, though, is not an industry issue. Nearly all energy-intensive businesses, such as transportation or manufacturing businesses, employ commodity futures transactions to reduce their risk of increases in business costs.

16 See Rev. Rul. 78-382, 1978-2 C.B. 111; Rev. Rul. 75-407, 1975-2 C.B. 196; and Rev. Rul. 74-527, 1974-2 C.B. 42.

17 Section 988 was enacted to provide "certainty of tax treatment for foreign currency hedging transactions that are fast becoming commonplace... and to insure that such a transaction is taxed in accordance with its economic substance. No inference is intended as to the proper treatment of these transactions under present law." H.R. Report 99-841, 99th Cong., 2d. Sess. II-665 (1986). TEI submits that the "economic substance" of hedges of foreign exchange risks associated with purchases of equipment is better achieved for tax purposes through an adjustment to the equipment cost. Arguably, the enactment of section 988 clarified the law to permit integration of the foreign exchange contract with the equipment. (See Montfort of Colorado v. Commissioner, 561 F. 2d 190 (10th Cir. 1977), where the Circuit Court permitted a taxpayer to account for gains and losses from hedges of inventory as part of the cost of the inventory) Finally, the "no inference" statement from the Conference Report implies that IRS may apply the section 988 rules retroactively.

18 For example, coal, timber, oil, and natural gas are generally considered section 1231 assets until severed from the ground. At the time of severance, these resources generally become inventory assets under section 1221(1). Taxpayers should be able to enter into anticipatory hedges of future sales income.

19 The last proposal, however, depends upon de-linking the actual item being hedged and the hedging transaction. This is a proper result because taxpayers should be able to identify asset or liability hedges through a "hedge account."

20 Thus, for example, "proxy hedging" should also be permissible. "Proxy hedging" involves the substitution of one property or position for another type of property as the hedge vehicle. That is, because the most direct form of hedge is either unavailable or too costly to employ, another type of property is substituted because a taxpayer knows from experience that the price of the direct and indirect hedge positions are correlated.

21 1993-35 I.R.B. 17.

22 To prevent abuse, the corporation engaging in the hedge transaction under our proposal would remain subject to the requirements to identify and keep records of the hedge and the hedged property or obligation (should the latter requirement of the temporary and proposed regulations be continued).

23 See, for example, the Fannie Mae decision where the taxpayer was permitted to treat certain positions as hedges despite not specifically identifying the transactions as a hedges.

24 In enacting section 1256, Congress specified that regulations should minimize identification requirements. See S. Rep. No. 144, 97th Cong., 1st Sess. 159 (1981), which states:

Regulations should allow taxpayers to minimize bookkeeping requirements in as many cases as practicable. In situations where hedging transactions are numerous and complex, but opportunities for manipulation of transactions to obtain deferral or conversion of income are minimal, it generally is unnecessary to require taxpayers to identify and match in their records hedging activities with hedged properties.

25 In order to obtain integrated accounting treatment under section 988(d) and Treas. Reg. [sections] 1.988-5, taxpayers are required to identify both the hedging transaction and the hedged debt on the same day. In a similar vein, same-day identification for both the hedge and hedged item may properly be a prerequisite to obtain integrated accounting treatment under sections 446 and 1221. In the absence of integrated accounting treatment for hedges, though, the sameday identification of both sides of the transaction is excessive and, under the Fannie Mae decision, unnecessary.

26 1993-35 I.R.B. 11.

27 Our proposal is similar to other proposals that would permit taxpayers to elect to use so-called hedge accounts, whereby all transactions identified and accounted for in the hedge account are deemed ordinary. Transactions specifically identified and accounted for outside of the "hedge account" would remain capital assets.

28 Temp. Reg. [sections] 1.1221-2T(d)(1).

29 Preamble 1993-35 I,R.B. 16, 18.

30 The IRS should also consider adopting a similar reasonable cause exception for misidentifications under section 1256ff)(1).

31 For example, a method of accounting incorporating gains or losses of hedging transactions into the cost of inventory would not be acceptable under Prop. Reg. [sections] 1.446-4(e)(2)(ii)(B) where the taxpayer employs the last-in, first-out method of accounting for inventory.

32 "The rules of [sections] 1.446-3 govern the timing of income and deductions with respect to a notional principal contract unless, because the notional principal contract is used as a hedge, the application of those rules would not result in the matching that is needed to satisfy the clear reflection standard of [sections] 1.446-4(b) of this section." Prop. Reg. [sections] 1.446-4(e)(4) (emphasis added). TEI questions how often non-dealers will enter into a notional principal contract in any case other than as a hedge of a particular business risk.

33 Preamble, 1993-35 I.R.B. at 25.

34 Such hedging practices may be used in connection with repeated and continual purchases of inventory or machinery.