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Tax Court awards Fannie Mae a victory.

A long-awaited Tax Court decision in a case involving the Federal National Mortgage Association has resulted in a resounding victory for Fannie Mae.

At issue was whether losses Fannie Mae sustained when it sold its interest rate hedges were capital losses or fully deductible ordinary losses. A deficiency of approximately $130 million was involved--an amount that would have grown geometrically because, had the decision gone against Fannie Mae, the IRS would have been able to assess similar deficiencies for other "open" years (that is, years still subject to examination).

Fannie Mae used interest rate futures to hedge its interest rate risk on mortgage commitments and debenture issuances and generally suffered substantial losses on these hedges.

The IRS argued, based on its reading of Arkansas Best v. Commissioner, 485 U.S. 212 (1988), that the hedges were capital assets because (1) they did not fall literally within any of the exceptions to capital asset treatment and (2) they were not integrally related to inventory. It also held that treatment as an ordinary loss is available for short hedges as well as hedges relating to debt issuance.

In finding for Fannie Mae, the court concluded Fannie Mae's mortgages were not capitalized because the mortgages were notes receivable acquired in the ordinary course of business for services rendered. Because the hedges were integrally related to these mortgages, it followed that the hedges were treated as an ordinary loss.

Observation: The decision substantially removes the cloud of uncertainty that has prevented many taxpayers from appropriately hedging balance sheet exposures. It is of particular importance to financial institutions with assets almost entirely composed of ordinary items. All of their hedging gains and losses will presumably be treated as ordinary losses. The decision also benefits the purveyors of derivative products, including banks and brokerage firms.
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Title Annotation:Federal National Mortgage Association
Publication:Journal of Accountancy
Article Type:Brief Article
Date:Sep 1, 1993
Previous Article:Identifying a personal service corporation.
Next Article:United Kingdom threatens retaliation against California unitary tax.

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