Hedge Identification and Timing RulesTraps for the Unwary

The tax rules for hedging transactions have pitfalls; one of the biggest is the tax identification requirements. If a transaction is not properly identified for tax purposes, the IRS could potentially treat loss as a capital loss and gain as ordinary. This character mismatch can create real problems on audit, when it is too late to fix.

To complicate matters, a failure to identify a hedge may affect the timing of the gain or loss on the transaction. If the transaction is not timely identified, the Secs. 1092 and 263(g) straddle rules and the Sec. 1256 mark-to-market rules may apply. Further, failure to identify a hedge may trigger disclosure requirements under the tax shelter regulations if the transaction generates a large loss. Although an exception is provided for hedging transactions, it applies only to transactions that have been timely and properly identified for tax purposes.

Common Mistakes

Many taxpayers do not have proper tax identifications in place. A hedge must be clearly identified on the transaction date for tax purposes; see Regs. Sec. 1.1221-2(f)(1). An identification for book purposes is not sufficient to comply with the tax rules, unless the taxpayers books and records indicate that the identification is also being made for tax purposes; see Regs. Sec. 1.1221-2(f)(4). Taxpayers sometimes incorrectly assume that an identification for financial statement purposes is sufficient for tax purposes. Even large, sophisticated corporate taxpayers can fail to identify hedges. Further, taxpayers frequently change their hedging strategies; thus, hedge identifications or policies may not cover newly implemented hedging strategies.

The IRS has begun raising hedging issues more frequently on audit and examining whether taxpayers have proper identifications. Although the hedging rules have been in existence for a number of years, the level of audit activity has significantly increased in the past several months and could increase further over the next few years, because the IRS plans to require taxpayers to disclose hedging transactions on Schedule M3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More. The draft Schedule M-3, released by the IRS on June 23, 2005, has a separate line item (line 15) in Part II for book-tax differences associated with hedging transactions.

Timing Traps

Although many taxpayers assume that tax accounting will follow book accounting, the rules frequently differ. If a return does not reflect a hedging transaction adjustment on Schedule M-1, Reconciliation of Income (Loss) per Books With Income per Return, the taxpayer may not be using a correct accounting method. In these instances, it may benefit from a comprehensive review of its hedge accounting methods.

Tax Definition of a Hedging Transaction

Generally, a hedging transaction is a transaction that a taxpayer enters into in the ordinary course of its trade or business to manage certain risks of ordinary property, borrowings or ordinary obligations; see Regs. Sec. 1.1221-2(b). An ordinary obligation is any obligation that would produce only ordinary income or deduction. Ordinary property is any property that would only produce ordinary income or loss (rather than capital gain or loss); see Regs. Sec. 1.1221-2(c)(2). Frequently, questions arise as to whether the property being hedged is ordinary property. For example, is the taxpayer hedging sales of inventory (which qualify as ordinary property) or Sec. 1231 assets (which do not qualify as ordinary property)?

To fall within the technical definition of a hedging transaction, a transaction must either:

• Manage the risk of price changes or currency fluctuations with respect to ordinary property (e.g., inventory) held or to be held by the taxpayer; or

• Manage the risk of interest rate, or price changes or currency fluctuations with respect to current or future borrowings or ordinary obligations of the taxpayer; see Sec. 1221(b)(2)(A) and Regs. Sec. 1.1221-2(b).

The regulations take a very narrow view of risk management. Generally, they treat a transaction as managing risk only if it reduces risk.

Business Hedges that Do Not Qualify

Taxpayers may enter into a number of hedging transactions in the course of their business, some of which might not qualify as hedging transactions for tax purposes, such as:

• Hedges of a revenue stream on a capital asset (e.g., dividend payments on stock);

• Hedges of a risk associated with a Sec. 1231 asset;

• Hedges of a risk of a nonconsolidated group member (e.g., a partnership hedging the risk of an affiliated corporation); see Regs. Sec. 1.1221-2(e);

• Hedges of the currency risk of a net investment in a foreign subsidiary;

• Hedges of general business revenues or profits (e.g., weather derivatives used to hedge general business revenues, rather than the price risk of a specific ordinary asset or liability) and;

• Hedging risk by purchasing or selling stock, a debt instrument or an annuity contract.

Overview of Tax Rules

The tax rules for hedging transactions address both character and timing, and are designed to match the character and timing of a hedging transaction with the character and timing of the item being hedged.

Character: The character rules are in Sec. 1221 and Regs. Sec. 1.1221-2. They provide ordinary treatment for any income, deduction, gain or loss from a hedging transaction, as long as the transaction has been timely and properly identified; see Sec. 1221(a)(7) and (b)(2).

Timing: The timing rules of Regs. Sec. 1.446-4(b) provide that any income, deduction, gain or loss from a hedging transaction is matched with the income, deduction, gain or loss on the item being hedged. In certain circumstances, the hedge timing rules apply whether or not the transaction has been identified as a hedging transaction; see Rev. Rul. 2003-127. Special rules allowing for integration of a debt instrument with a hedge are provided in Regs. Sec. 1.1275-6.

Currency hedges: Sec. 988 provides special character and timing rules for foreign currency transactions. Under Sec. 988(a)(1), currency gain or loss generally is treated as ordinary. The normal character rules under Sec. 1221 and Regs. Sec. 1.1221-2 do not apply to Sec. 988 transactions. Nonetheless, the hedge timing rules under Regs. Sec. 1.446-4 may apply to a Sec. 988 transaction that meets the definition of a hedging transaction. A special same-day identification rule applies to Sec. 988 transactions under the hedge timing rules; see Regs. Sec. 1.446-4(d)(3).

 Hedge Identification

A same-day identification rule applies to hedging transactions. As was mentioned, a hedging transaction must be identified before the close of the day the transaction is entered into; see Sec. 1221(a)(7) and Regs. Sec. 1.1221-2(f)(1). The item being hedged must be identified no more than 35 days after the hedging transaction; see Regs. Sec. 1.1221-2(f)(2)(ii).

If an existing hedging transaction is recycled to hedge a different asset or liability, it must be re-identified on the day that it is recycled; see Regs. Sec. 1.1221-2(f)(1). Many taxpayers may neglect to identify recycled hedges.

An identification is made by placing an unambiguous statement on the taxpayers books and records identifying the transaction as a hedging transaction for tax purposes. The identification should specifically reference the tax rules. Regs. Sec. 1.1221-2(f)(4)(iv) provides a few simplified methods for making this same-day identification, including:

• Designating a particular ledger ac-count as containing only hedging transactions; and

• Placing a statement on the taxpayers books and records designating all future transactions in a particular derivative as hedging transactions.

The identification of the hedged item should describe the transaction creating the risk being hedged and the type of risk that the transaction creates. Specific identification rules are provided for identifying the hedged item when the taxpayer is hedging inventory, debt, assets that have not yet been acquired, and aggregate risk (i.e., overall hedges of interest rate, price or currency risk); see Regs. Sec. 1.1221-2(f)(3)(i)(iv).

Special care should be taken when identifying hedges of aggregate risk. According to Regs. Sec. 1.1221-2(f)(3)(iv)(B), a taxpayer needs to have a hedging program in place that is identified on its books and records. The identification needs to include an identification of the type of risk being hedged; a description of the type of items giving rise to the risk; sufficient information to demonstrate that the program is designed to reduce aggregate risk of the type identified; and if the program contains controls on speculation, an explanation of how the controls are established, communicated and implemented. Further, the taxpayer must establish a system under which individual transactions can be identified pursuant to the program.

Consequences for Failing to Make Hedge Identification

Character: If a taxpayer fails to identify a hedging transaction, the character of any gain or loss is determined without regard to the hedging rules. Consequently, any gain or loss may be capital, depending on how the transaction is treated under other tax rules; see, e.g., Letter Ruling (TAM) 200510028. Because capital losses generally cannot offset ordinary in-come, a taxpayer that fails to identify its hedging transactions could face a potential tax liability on audit. Under an anti-abuse rule, the IRS can treat any gains as ordinary, resulting in a potential character whipsaw; see Regs. Sec. 1.1221-2(g)(2)(iii).

Timing: In general, the timing rules for hedging transactions apply regardless of whether a transaction is identified as a hedge; however, there are other consequences to consider (see below). Thus, gain, loss, income or deduction on the hedging transaction is matched with the hedged item, even if the hedging transaction has not been identified; see Rev. Rul. 2003-127.

Disclosure: The tax shelter regulations require corporations to disclose any loss transaction that generates at least $10 million in any single year or $20 million in any combination of tax years (the thresholds are lower for S corporations, partnerships without corporate partners, and individuals); see Regs. Sec. 1.6011-4(b)(5)(i). Rev. Proc. 2004-66, Section 4.03(5), provides an exception from the disclosure rules for loss transactions identified as hedging transactions.  An unidentified hedging transaction may trigger the disclosure requirements if it generates large enough losses (and does not otherwise fit within another exception from the loss disclosure rule).

Other consequences: Failing to identify a hedging transaction can have other repercussions. The straddle rules under Secs. 1092 and 263(g) and the Sec. 1256 mark-to-market rules provide exceptions for identified hedging transactions. Sec. 1092 defers losses on a position in actively traded property to the extent that there is built-in gain in an offsetting position. Sec. 263(g) requires interest and carrying charges to be capitalized if they are allocable to personal property that is part of a straddle. Under Sec. 1256, certain contracts (such as regulated futures contracts, foreign currency contracts, nonequity options and dealer equity options) are marked to market, and any capital gain or loss is treated as 60% long-term and 40% short-term. It is important to identify a transaction to remove it from the operation of these rules. Taxpayers with positions in actively traded property (such as commodities and nonfunctional currency) may have exposure if they fail to identify their hedging transactions.

Taxpayer Relief

Taxpayers who have neglected to make an identification might be able to argue that the failure was merely inadvertent. If the failure to identify was inadvertent and other requirements are met, gain or loss on the hedge is treated as ordinary. The hedging regulations provide an exception for inadvertent errors; see Regs. Sec. 1.1221-2(g)(2)(ii). To meet this exception, the transaction must also meet the definition of a hedging transaction, and all of the taxpayers hedging transactions in open years must be treated as hedging transactions on original or amended returns. The regulations provide no guidelines for demonstrating whether an error was inadvertent.

Although there is little guidance under this exception, the IRS has issued a few letter rulings allowing taxpayers to rely on it; see Letter Ruling 200052010. Thus, there is no guarantee that, on audit, the IRS will allow a taxpayer to rely on this exception.

From Helen Yanchisin, J.D., and Jo Lynn Ricks, J.D., LL.M., Washington, DC