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Bad news for hedgers.

Do you hedge price, interest rate or foreign currency risk with futures, options or swaps?

If an IRS agent hasn't already asked you that question, he soon will. And if the answer is yes, you are likely to face a serious and expensive problem. The IRS announced in July that only long positions that are a surrogate for the taxpayer's inventory are entitled to the ordinary treatment traditionally accorded to business hedging transactions. Other hedges will give rise to capital losses, which are allowable only to the extent of reported capital gains. For most corporations, this means that hedging losses will never be allowable.

If the IRS persists in its view, most commercial hedgers will give up exchange-traded futures and options as hedging vehicles. Without the commercial hedgers, these markets will suffer as volume and liquidity declines. Commercial hedgers may initially switch to the swap market, where the tax treatment is supposedly more favorable. The tax rules relating to swaps, however, are only proposed rules and, thus, not binding on revenue agents, some of whom have already proposed treating swaps like a series of cash-settled forward contracts. This would mean that losses incurred in swaps used as hedges would also be disallowed. As the IRS begins to attack alternative hedging vehicles, such as swaps and caps, the swap dealers that lay off their risks in the futures markets will find their business dropping off, with a further reduction in the exchange-traded futures and option markets. As a result, many businesses will cease hedging altogether. This will increase their risks and cost of capital, thereby, decreasing the global competitiveness of U.S. business.

According to the IRS, a hedge must be part of the taxpayer's inventory purchase system and must be a substitute or surrogate for inventory to receive favorable, ordinary treatment.

It is possible for a long forward or futures position to be part of an inventory acquisition system and a substitute for inventory. "[N]either a short position nor a put is a transaction to acquire inventory, and neither can be a substitute or surrogate for inventory." IRS brief, FNMA v. Commissioner, pages 99- 100.

In short, most of the hedges that prudently run businesses have historically used are no longer valid under the position outlined in the IRS's brief. Hedges the IRS will now disallow include those entered into by: the farmer who hedges his crop in the ground by entering into short futures contracts (short positions can never be surrogates); the airline that hedges its jet fuel costs in the futures markets (an airline has no inventory, it sells services); the manufacturer that hedges debenture offerings against interest rate fluctuations (debt outstanding is not inventory); the exporter who hedges against foreign currency fluctuations (foreign currency is property, but not inventory); the mortgage banker that hedges mortgages in the pipeline by buying put options on Treasury bonds (long put options can never be surrogates for inventory because they are contracts to sell not contracts to buy inventory). Some taxpayers have already heard the bad news in the form of hostile audits and litigation. For others, the bad news will soon come.

The IRS insists that this position is required by Arkansas Best, a Supreme Court case decided in March 1988. In Arkansas Best, a case that had nothing to do with hedging, the Supreme Court explicitly rejected the doctrine that had been the basis for favorable treatment for business hedges since 1955. For more than four years, the business community waited to hear the Department of Treasury's interpretation of the case. Some were fearful that the Treasury might adopt an extreme literalist approach, while others were hopeful that somehow the Treasury would find a way to preserve legitimate business hedges. Positive Treasury action was rumored, then denied.

Meanwhile, the first case in which a hedging issue was squarely raised was docketed by Fannie Mae with the tax court. The trial was postponed several times in hopes that the Treasury would clarify its interpretation of Arkansas Best in a way that would preserve the ordinary character of most, if not all, of Fannie Mae's hedges. This did not happen, so the trial proceeded with briefs filed in July and September.

What seemed at risk in the four years from 1988 to 1992 were liability hedges. Most tax practitioners believed that all hedges of inventory would continue to receive favorable, ordinary treatment. There was less certainty about other asset hedges, although many thought it possible that any asset hedge would continue to receive ordinary treatment. Liability hedges were of particular concern because there appeared to be no asset to which the hedge could be tied.

The position the IRS announced in July and in September is much more extreme than anyone expected, going well beyond the liability hedges at issue in the Fannie Mae case. Until those briefs were filed, taxpayers had hoped that attacks on business hedges asserted by some revenue agents and some IRS litigators represented nothing more than the unauthorized activities of a few over zealous employees and that these actions would be reversed when the policymakers in Washington, D.C. reviewed the issue.

The IRS brief in FNMA dashed all those hopes. All briefs filed with the tax court are reviewed in the IRS's national office before they are filed. It now appears that the position taken in the briefs in the Fannie Mae case represents the views of the IRS as an institution. Revenue agents are now being instructed to follow the position laid out in these briefs.

About the only hedging issue that has not yet been negatively addressed by the IRS to date is the "section (f)(1) whipsaw" issue. This "whipsaw" issue is so-called-because IRC section 1256(f)(1) provides that taxpayers that erroneously identified transactions as hedging transactions would be penalized for those erroneous identifications by having only hedging losses, but not hedging gains, recharacterized as capital.

Taxpayers identify transactions as hedges to escape mark-to-market treatment that applies to futures contracts, most exchange options and foreign currency options. Taxpayers also identify transactions as hedges to escape the various loss deferral rules that apply to straddle transactions. Many taxpayers made hedging identifications based on the now repudiated Corn Products doctrine and still more have made hedging elections assuming that any inventory hedge would still be a good tax hedge. The IRS did not raise the whipsaw issue in FNMA but it is being raised in other audits and has not been rejected by the national office.

If the whipsaw is applied against taxpayers, the results will be catastrophic. A hedging program would be pulled apart, all gains would be ordinary, all losses capital. An active hedging program which overall, resulted in small losses could be recharacterized under the whipsaw to produce substantial ordinary income and even larger unusable capital losses. Not only would taxpayers lose the effective integration of matching the character of the hedging items to the things being hedged; they would also lose the benefit of accounting for only the net gain or loss in their hedging programs.

Businesses seeking certainty and a sound economic basis for the taxation of their hedging transactions now face the unpleasant prospect of years of expensive and inconclusive litigation. No one can know what the Supreme Court meant to say about hedging until that court finally addresses that issue directly. If past experience is any guide, no definitive answer will be forthcoming in this century. The policymakers at the IRS and the Treasury have made it clear that they have no intention of trying to resolve the issue administratively Despite the huge impact on all sectors of the U.S. economy, the business community has to date failed to impress Congress with the importance of this issue. The legislative front is further complicated by the "pay as you go" rule that applies to tax legislation-a fix of a problem this big may require a huge offsetting revenue raiser, a prospect that would be politically unappealing.

The time has come to do two things. First, it is imperative that U.S. businesses confront the damage that the IRS' perverse view of hedging would do to U.S. competitiveness. Denial has characterized the past four years. This was perhaps understandable when the IRS had not articulated its position. Now, however, the IRS has clearly stated its position and the danger is clear and present. Second, it is imperative that U.S. businesses mount an effective campaign to remove this major impediment to risk management. It is not enough to bemoan the sad state of affairs. The business community must work with the IRS, Treasury and Congress to adopt workable rules that remove the tax disincentives to traditional hedges. And they must work to persuade the courts, the government and the public that the IRS position in the Fannie Mae case is short-sighted and ultimately crippling to the American economy.

Phoebe A. Mix is of counsel to the Chicago-based law firm of Coffield, Ungaretti & Harris.
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Author:Mix, Phoebe A.
Publication:Mortgage Banking
Date:Jan 1, 1993
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