Turbulent currency markets affect retailers.

The recent volatility in the European currency markets underscores the importance of managing currency risks associated with foreign merchandise purchases. Although decisions on whether and how to hedge risk are ultimately determined by overall economic factors, recent changes in the financial accounting rules and the complex tax rules relating to foreign currency transactions create planning opportunities and difficulties of their own.

Retailers may hedge foreign purchases through the use of currency forwards, futures, options or other complex derivative instruments. Under SEC and FASB accounting rules, currency forwards and futures must generally be revalued on a quarterly basis if they are used to hedge anticipated purchases rather than firm commitments. This can cause dramatic earnings swings (especially in a volatile market) that distort a company's overall financial picture. No revaluation is required if an option is used as a hedge. At the same time, however, options are typically more costly. As a result, many purveyors of currency derivatives have been marketing complex derivatives that look and sound like options, but cost and act like forwards. The SEC has now addressed this situation by pronouncing that those complex currency options must also be revalued on a quarterly basis unless they are used to hedge firm commitments.

Complex tax rules can also create tax reporting results that do not reflect the overall economics involved with hedging strategies. Tax reporting can become even more complex when transactions are denominated in currencies of high inflation economies, such as many of the South American countries. Potential pitfalls under the current maze of tax rules addressing foreign currency transactions relate primarily to mismatches in the timing and/or character of income or loss between the foreign currency hedge and the purchase order or payable being hedged. Some pitfalls can be avoided through a solid understanding of the tax rules, proper planning and the use of available elections.

In general, derivative currency products based on enumerated currencies are "marked to market" at year-end and the net gain or loss is included in taxable income for that tax year. This timing rule can force the recognition of large taxable gains due to currency fluctuation that do not reflect the overall economic picture. The acceleration of taxable income is exacerbated by the tax inventory capitalization rules. If the hedged inventory item is purchased at an inflated price (due to an increase in the foreign currency's value), the higher inventory value can increase the absorption ratio applied to capitalize other indirect costs.

Generally, the mark-to-market rule applies to hedging instruments dealing with the following currencies: Japanese yen, British pound, Australian dollar, French franc, Swiss franc, German mark, Canadian dollar and European Currency Unit.

Taxable income from certain hedging instruments - specifically, currency futures and options traded on U.S. exchanges - will be treated as capital gain or loss, with an election available for ordinary gain or loss treatment. For a corporation, capital losses may offset only capital gains. Since a retailer's ultimate sale of merchandise will generate ordinary income, a capital loss from a currency position can prove unusable. Thus, the election for ordinary treatment is typically advisable. No election is needed for currency forwards or over-the-counter currency option contracts; they automatically receive ordinary gain or loss treatment (which matches the retailer's profit on product sales).

In certain circumstances, retailers may be able to identify foreign currency hedges (along with foreign denominated payables or purchase orders) as Sec. 988 hedging transactions. As such, the payable and foreign currency hedge will be treated as a single integrated transaction, with gains or losses on the hedge treated as adjustments to the payable, avoiding the risk of adverse character and timing mismatches. This election requires that a record be established at the time the hedge is entered into, including detailed information and indicating that the transaction is being identified in accordance with Regs. Sec. 1.988-5(b)(3). In the absence of proper identification, the IRS can apply integrated treatment at its discretion, which could well be done only if it results in higher tax.