The importance of proper and timely hedge identification.

Many Fortune 1000 companies, as well as many private enterprises, engage in hedging activities to manage the risk of price, currency, or interest rate fluctuations. Many companies enter into interest rate swaps to hedge the interest rate risk on debt they have issued. With the current economic turmoil in the financial services industry, companies may be holding an instrument where the counterparty has sought bankruptcy protection or changed ownership, triggering or permitting the early termination of a hedge. Further, many taxpayers issued floating-rate debt and entered into an interest rate swap to effectively convert the floating-rate debt into fixed-rate debt. With the recent drop in interest rates, taxpayers may choose to terminate these swaps to prevent further losses.

In general, failure to properly identify a hedge for tax purposes may expose a taxpayer to ordinary treatment of gains and capital treatment of losses (i.e., character whipsaw). An early termination, where termination payments could result in significant and unexpected capital loss, typically increases the magnitude of this general exposure. In an environment in which early terminations may have unexpectedly been triggered, taxpayers that have not properly identified their hedges for tax purposes should evaluate remediation strategies as soon as possible. The timing effects of hedging transactions, even with improper identification procedures, should also be considered.

Treatment of Hedging Transactions

Sec. 1221(a)(7) and Regs. Sec. 1.1221-2 present the character rules for tax hedges. These rules provide ordinary treatment for any income, deduction, gain, or loss from a qualified hedging transaction provided the hedge is timely and properly identified. If a hedge is not properly identified as a qualified tax hedge, under an anti-abuse rule (Regs. Sec. 1.1221-2(g)(2)(iii)), the IRS can treat any gains from the unidentified hedge as ordinary. The character of the loss is what it would have been under general tax principles. Therefore, to the extent the losses on an unidentified hedge are treated as capital under general tax principles, the taxpayer could have capital loss and ordinary gains, potentially resulting in a character whipsaw. Consequently, failure to identify a hedge for tax purposes may change the character of the gain or loss when the hedge is terminated early.

Proper tax identification requires the taxpayer to identify:

* The transaction as a hedge on the day the hedge is acquired, originated, or entered into; and

* The item or risk being hedged within 35 days after entering into the hedging transaction (Regs. Sec. 1.1221-2(f)).

The regulations provide detailed rules for identification of the hedge and the hedged item. In addition, the taxpayer must also describe the method of tax accounting chosen to properly match the timing of income, deduction, gain, or loss from the hedge with the timing of income, deduction, gain, or loss from the item being hedged.

Caution: Identification for financial accounting purposes alone is not sufficient for tax purposes.

Taxpayers must also comply with the timing rules for hedges under Regs. Sec. 1.446-4. Generally income, deduction, gain, or loss from the hedge must match the timing of the income, deduction, gain, or loss from the item being hedged. Thus, early termination of the hedge when the debt is still in place may result in spreading the gain or loss over a longer period rather than recognizing the entire gain or loss in the year of termination (Rev. Rul. 2002-71).

Early Termination of Hedges

In the case of an early termination, evaluating the transaction under general tax principles could result in capital loss treatment, which may need to be spread over some period of time. For example, many interest rate swaps that taxpayers do not identify as hedges qualify as notional principal contracts (NPCs) (see Regs. Sec. 1.446-3(c)(1)). Payments under an NPC that are not termination payments are ordinary in character whether or not the swap has been identified as a tax hedge (Prop. Regs. Secs. 1.162-30 and 1.1234A-1; Letter Rulings 9824026 and 9730007). Conversely, gain or loss from the termination of an NPC is capital under Sec. 1234A and Prop. Pegs. Sec. 1.1234A-1, provided the NPC is a capital asset in the taxpayer's hands. Thus, if the taxpayer had not terminated the NPC early, it would not have recognized a capital gain or loss.

Potential Remediation

Taxpayers who have failed to make a proper tax identification may obtain relief for character issues under the inadvertent error exception. Relief may apply if:

1. The transaction qualifies as a tax hedge;

2. Failure to identify was caused by inadvertent error; and

3. Gain or loss from all the taxpayer's hedging transactions has been or will be treated as ordinary on its tax returns (including on amended returns if necessary) for all open years. The remediation of timing issues may involve filing a Form 3115, Application for Change in Accounting Method, to correct improper tax accounting methods for future years.

Reportable Transactions

The tax shelter regulations require corporations to disclose any loss transaction that generates at least $10 million in any single tax year or $20 million in any combination of tax years. (The thresholds are lower for S corporations, partnerships without corporate partners, and individuals.) Rev. Proc. 2004-66 provides an exception from the disclosure rules for loss transactions that are properly identified as hedging transactions (Rev. Proc. 2004-66, [section] 4.03(5)). A hedging transaction that a taxpayer does not identify may trigger the disclosure requirements if it generates large enough losses (and does not otherwise fit within another exception from the loss disclosure rule).

From Jeff Callender, CPA, New York, NY, Jo Lynn Ricks, J.D., LL.M., Washington, DC, and Samantha Chan, J.D., Washington, DC