Taxation of business hedges: an analysis of the new regulations

Allen J. Klein

Table of Contents

I. Background

     A. Pre-Corn Products Rulings and Cases

        1. Extra-Statutory Character Rule
        2. Even or Balanced Position Requirement

     B. The Corn Products Case


     C. The Arkansas Best Case


     D. The FNMA Case

II. The Final Regulations

     A. Definition of "Hedging Transaction"

        1. "Normal Course" of Taxpayer's Trade or
           Business
        2. "Risk Reduction" of Price, Interest Rate, or
           Currency Changes
        3. Ordinary Property, Ordinary Obligation, or
           Borrowing

     B. Indentification Requirements

        1. General Identification Requirements
        2. Special Identification Requirements
           a. Anticipatory Asset Hedges
           b. Inventory Hedges
           c. Hedges of Existing Debt
           d. Hedges of Debt to be Issued
           e. Hedges of Aggregate Risk

     C. Misidentification


     D. Nonidentification


     E. Timing of Hedging Gains and Losses

        1. General Rule
        2. Specific Guidance
           a. Aggregate Risk
           b. Inventory
              i. General Method
              ii. Alternative Methods
           c. Debt Instruments
           d. Items Marked to Market
           e. Notional Principal Contracts
III. The Proposed Consolidated Regulations

     A. Hedges With Unrelated Third Parties


     B. Hedges Between Consolidated

        Group Members

     C. Special Timing and Identification

        Requirements

     D. Effective Date

On July 13, 1994, the Internal Revenue Service published final regulations under sections 446(b) and 1221 of the Internal Revenue Code prescribing rules relating to the character and timing of gain or loss from hedging transactions (hereinafter referred to as "the final regulations").(1) At the same time, the IRS issued proposed regulations also under sections 446(b) and 1221 relating to the character and timing of gain or loss from certain hedging transactions entered into by members of a consolidated group (hereinafter referred to as "the proposed consolidated regulations").(2)

The final regulations and the proposed consolidated regulations bring order to the taxation of business hedges--an area that has been described as in "legal chaos"--by providing constructive and comprehensive guidance.(3) The final regulations generally adopt the rules of the proposed and temporary regulations published by the IRS on October 18, 1993, addressing the taxation of business hedges (hereinafter referred to as "the 1993 temporary regulations"); the final regulations, however, have been changed to address concerns raised in the public comments.(4) The final regulations are supplemented by the proposed consolidated regulations, which contain a set of "sensible and flexible" rules that substantially diminish the tax distortion that would otherwise exist with regard to certain hedging transactions entered into by members of a consolidated group.(5)

I. Background

Since 1934, the Internal Revenue Code has generally treated gain or loss from sales and exchanges of property as capital gain or loss, with explicit statutory exceptions for gain or loss from sales and exchanges of inventory and business equipment, but not for gain and loss from sales and exchanges of hedges. Notwithstanding this statutory capital asset rule, there was a series of rulings and cases dating back to the 1930s that treated hedging transactions as a form of "business insurance" and that provided for ordinary gain or loss treatment. These cases were followed by the Corn Products case(6) and its progeny which characterized gain or loss from a transaction by reference to the relationship between the transaction and the taxpayer's ordinary business activities and which provided ordinary gain or loss treatment if such relationship was sufficiently close.(7) These cases and rulings controlled the treatment of common business hedging transactions until the Supreme Court in Arkansas Best Corp. v. Commissioner(8) left unsettled the treatment of most business hedging transactions. The 1993 temporary regulations were issued in an effort to provide a clear and workable set of rules that would replace the rulings and cases that were effectively vitiated by the Supreme Court's decision in Arkansas Best.

A. Pre-Corn Products Rulings and Cases

The early rulings and cases established the criteria for determining whether a transaction constituted a hedging transaction. To a large extent, the final regulations adopt the approach reflected in these early cases and rulings.

1. Extra-Statutory Character Rule

In 1936, in General Counsel Memorandum 17322, the IRS considered the character of gains and losses realized by manufacturers from (1) future sales contracts entered into to protect against the decline in value of stores of raw materials and (2) future purchase contracts entered into to protect against an increase in the price of raw materials to be acquired to meet existing production commitments.(9) In each case, the IRS characterized the futures contracts as essentially equivalent to business insurance and concluded that they produced ordinary income or loss for tax purposes.(10)

2. Even or Balanced Position Requirement

Commissioner v. Farmers & Ginners Cotton Oil Co. involved a manufacturer of crude cottonseed oil that was concerned, as a consequence of its limited storage facilities, that it would be forced to sell its product in a down market.(11) Unable to enter into futures transactions in crude cottonseed oil--at the time there was no futures market in crude cottonseed oil--the taxpayer attempted to hedge the risk that the market price of the crude cottonseed oil would drop by entering into futures sales contracts for refined cottonseed oil. When the market failed to drop, the taxpayer closed out some of its futures contracts, incurring losses that it reported as ordinary losses. The IRS asserted that because the futures were for refined oil, and the taxpayer's inventory was of crude oil, the transaction did not create an even or balanced position; hence, the IRS reasoned, there was no hedge. The Board of Tax Appeals, however, held for the taxpayer on the ground that "[the] only purpose which the petitioner had in buying futures in refined oil was to attempt to avoid loss upon the crude oil which it was manufacturing." The Fifth Circuit reversed, adopting the IRS's position of requiring an even or balanced position for classification as a hedging transaction.(12)

B. The Corn Products Case

The extra-statutory rule under which gain or loss from a hedging transaction was treated as ordinary income or loss under the business insurance rationale was rendered irrelevant by the Corn Products case, which generally provided that if a transaction had a sufficient nexus to the taxpayer's trade or business, it would generate ordinary income or loss.(13) If a transaction in the nature of a hedging transaction had such a nexus to the taxpayer's trade or business, it would generate ordinary income or loss even if there were no even or balanced position.

In Corn Products, the taxpayer, a manufacturer of various products derived from corn, had limited storage facilities and was concerned that increases in the price of corn would force it to raise its prices to its customers and cause it to risk losing market share to non-corn-based alternatives. To hedge against this risk, the taxpayer purchased corn futures. Realizing substantial gain from its futures transactions in 1940, the taxpayer took the position that, because it was not under a fixed commitment to sell its products at a fixed price, its futures transactions were not true hedges and its gains should be treated as capital gain. The Tax Court reasoned that the taxpayer's corn futures program "was an integral part of its manufacturing business," and held that the taxpayer's gains were taxable as ordinary income.(14) The Second Circuit affirmed, stating that although the taxpayer's futures transactions were not true hedges, they were "used for essentially the same purpose and in the same manner as true hedges."(15) Apparently troubled by the extra-statutory character rule, the Second Circuit reached its decision by first treating the hedging transactions as part of the taxpayer's inventory purchasing system and then including the futures contracts within the inventory exception to the capital asset rule. The Supreme Court affirmed, basing its decision not on the Second Circuit's inventory rationale or on the presence of the even or balanced position creating a true hedge, but on the ground that the futures transactions were entered into to protect the taxpayer's profits from "everyday operations," which profits would of course be taxed at ordinary income rates.(16)

The Supreme Court's decision in Corn Products represented a victory for the IRS, but over time, the Corn Products doctrine provided taxpayers the opportunity to "game" the IRS: where taxpayers derived gains from the assets, they could take the position that the assets were capital assets under the statutory capital asset rule, but where they realized losses from the assets, they would argue the assets were ordinary in nature under the extra-statutory character rule. This, of course, led to the Supreme Court's decision in the Arkansas Best case that, by rejecting the extra-statutory character rule, unsettled years of law regarding the tax consequences of common business hedging transactions.

C. The Arkansas Best Case

In Arkansas Best,(17) the taxpayer was a bank holding company that acquired bank stock in a series of separate purchases. The taxpayer initially acquired a sizable block of shares and subsequently supplemented that block when the bank was in financial distress and in need of additional capital. Later, the taxpayer sold the bank stock, realizing a loss which it reported as an ordinary loss. The Tax Court held that, under the Corn Products doctrine, the loss on the stock purchased when the bank was in distress was an ordinary loss on the ground that the taxpayer purchased the stock to preserve its business reputation. The court continued, however, that the taxpayer's loss on the initial block of stock was capital in nature. The Eighth Circuit reversed the Tax Court's decision that the loss on the initial block was ordinary in nature. It said that it could find a basis for neither the Corn Products doctrine nor a special rule for business reputation in the Code and, hence, that the stock was a capital asset under the statutory capital asset rule. Thus, none of the loss qualified for ordinary loss treatment.

The Supreme Court upheld the Eighth Circuit, in effect abandoning (by reinterpreting) its four-decade old decision in Corn Products. The Supreme Court stated:

We conclude that Corn Products is properly inter-

preted as standing for the narrow proposition that

hedging transactions that are an integral part of a

business' inventory-purchase system fall within

the inventory exclusion of section 1221. Arkansas

Best, which is not a dealer in securities, has never

suggested that the Bank falls within the inventory

exclusion. Corn Products thus has no application

to this case.(18)

After Arkansas Best, gain or loss from hedges against changes in the price or value of inventory held or to be held--i.e., assets described in section 1221(1)--and hedges against changes in the value of accounts or notes receivable acquired or to be acquired in the ordinary course of the taxpayer's business for services rendered or from the sale of inventory--i.e., assets described in section 1221(4)--apparently still qualified for ordinary income or loss treatment. In the IRS's view, however, gain or loss from other hedging transactions was capital gain or loss, even though such treatment would distort the results of many common business hedging transactions.(19)

Arkansas Best also affected the treatment of some hedging transactions by causing them to be subject to the rules of sections 1092 and 1256. These rules, which are not applicable to hedging transactions that generate ordinary income or loss, require that section 1256 contracts be marked to market annually and that gain or loss be treated as 60-percent long-term capital gain or loss and 40-percent short-term capital gain or loss; in addition, the loss on a position that is part of a straddle must be deferred until gain on any other position that is part of the straddle is recognized.(20)

D. The FNMA Case

The IRS first used the Arkansas Best decision to support the position that losses from business hedges should be treated as capital loss in the FNMa, or Fannie Mae, case.(21) Federal National Mortgage Association (FNMA) is a private corporation organized by Congress to purchase residential mortgages.(22) During the years in controversy, FNMA funded purchases by, among other things, borrowing money. FNMA was therefore highly sensitive to changes in its costs of funds; its profit margin was largely tied to the spread between the rate at which it borrowed and the yield on its mortgage portfolio. To hedge against its significant exposure to interest rate risk, FNMA entered into a number of different types of hedging transactions including selling short interest rate futures, selling short Treasury Securities, and using both put and call options on various securities.

The IRS argued that FNMA's hedge positions were capital assets under section 1221 and that gain or loss from such assets should be treated as capital gain or loss. The Tax Court rejected the IRS's position, reasoning that, to FNMA, the mortgages were assets described in section 1221(4) and the hedge positions were an integral part of the system by which FNMA purchased such assets.(23)

II. The Final Regulations

The final regulations establish that property that is part of a hedging transaction is not a capital asset.(24) The final regulations then address (1) what kinds of transactions qualify as hedging transactions; (2) how these transactions must be identified on the taxpayer's books; (3) the consequences of identifying as a hedging transaction a transaction that does not qualify as a hedging transaction; and (4) the consequences of failing to identify as a hedging transaction a transaction that qualifies as a hedging transaction.

A. Definition of "Hedging Transaction"

The first step in applying the final regulations to a transaction is to determine whether a particular transaction constitutes a "hedging transaction." The final regulations adopt without change the basic definition of a "hedging transaction" contained in the 1993 temporary regulations. Hence, a "hedging transaction" is a transaction in the "normal course" of the taxpayer's trade or business that is entered into primarily either (1) to reduce the risk of price changes or currency fluctuations with respect to "ordinary property" that is held or to be held by the taxpayer or (2) to reduce the risk of interest rate or price changes or currency fluctuations with respect to "borrowings" made or to be made or "ordinary obligations" incurred or to be incurred by the taxpayer.(25)

Although the final regulations adopt many case law principles, they also establish an "exclusivity" rule governing the character and timing of gain or loss from hedges for federal income tax purposes.(26) This rule confirms that the final regulations supersede and preempt existing case law addressing the character and timing of gain or loss from hedging transactions. Thus, if a particular transaction does not satisfy the final regulations' definition of a "hedging transaction," the transaction is not entitled to ordinary income or loss treatment. Since ordinary income treatment can only be afforded under the final regulations, the threshold determination is whether a particular transaction constitutes a "hedging transaction."

1. "Normal Course" of Taxpayer's Trade or Business

The first aspect of the definition of hedging transaction is the requirement that the taxpayer enter into the transaction in the "normal course" of its trade or business. Unlike the 1993 temporary regulations, the final regulations contain guidance on the meaning of the term "normal course." Under the final regulations, a hedging transaction will be considered to be in the "normal course" of a taxpayer's trade or business if the transaction is made "in furtherance of a taxpayer's trade or business."(27) The final regulations further provide that hedges relating to an "expansion of an existing business" or the "acquisition of a new trade or business" will be considered to be within the "normal course" of a taxpayer's trade or business.(28)

In deference to the decision of the Supreme Court in Arkansas Best, the Preamble to the final regulations states that the gain or loss from the disposition of stock acquired to protect the goodwill or business reputation of the acquirer or ensure availability of goods does not constitute a transaction in the "normal course" of a taxpayer's trade or business.(29) Notwithstanding the limiting language of the Preamble, the definition of the term "normal course" is quite broad and should permit a substantial number of business hedging transactions to qualify for hedging transaction treatment under the final regulations.

2. "Risk Reduction" of Price, Interest Rate, or Currency Changes

The second aspect of the definition of the term "hedging transaction" is the requirement that the transaction be entered into primarily to reduce the taxpayer's risk with respect to price changes, interest rate changes, or currency fluctuations. Under the final regulations, the risk reduction requirement can be met by satisfying either a "macro" risk reduction test or a "micro" risk reduction test.(30) Under the macro risk reduction test, a hedge will satisfy the risk reduction requirement if it reduces the taxpayer's "enterprise risk"--i.e., the overall risk of the taxpayer's operations taken as a whole. Alternatively, the macro risk reduction test is satisfied if the hedge reduces the taxpayer's risk with respect to a particular transaction and can reasonably be expected to reduce the taxpayer's overall risk.(31)

Under the 1993 temporary regulations, there was concern that a transaction that economically converted an interest rate or price from a fixed to a floating rate or price would not qualify as a hedging transaction because the transaction may have increased, rather than reduced, the taxpayer's risk. The final regulations addressed this concern by providing that such a transaction "may" reduce risk, but provide no guidance regarding the circumstances under which this would occur.(32)

3. Ordinary Property, Ordinary Obligation, or Borrowing

The third aspect of the hedging transaction definition is the requirement that the hedge relate to certain items--"ordinary property," "ordinary obligations" or "borrowings." The final regulations generally follow the 1993 temporary regulations with regard to the meaning of these terms with one major exception involving non-inventory supplies.

As a general rule, property is "ordinary property" if a sale or exchange of it by the taxpayer could not produce capital gain or loss, regardless of the holding period.(33) The rationale is that it is imoproper to provide ordinary treatment for gain or loss from a hedging transaction under circumstances in which sales or exchanges of the assets that are hedged could generate capital gain or loss.(34) Thus, section 1231(b) assets generally do not qualify as ordinary property.(35)

Under an important exception to the general rule, hedges of "non-inventory supplies" (e.g., jet fuel used by airlines) qualify as hedging transactions notwithstanding the fact that isolated sales of such supplies would produce capital gain or loss. The final regulations define the term "non-inventory supplies" as supplies purchased for consumption in the taxpayer's trade or business that are not otherwise described under section 1221.(36) Hedges of non-inventory supplies will not qualify as hedging transactions, however, if the taxpayer sells more than a "negligible amount" of such supplies in a particular taxable year.(37) The final regulations provide no guidance on the meaning of "negligible amount," but they do contain a transition rule for certain non-inventory supply hedges under which gain or loss from such hedging transaction will be treated as ordinary gain or loss so long as the taxpayer sold no more than 15 percent of the supplies in any open tax year.(38)

The definition of the term "ordinary obligation" generally is the same as in the 1993 temporary regulations. An obligation is an "ordinary obligation" if the "performance or termination by the taxpayer could not produce capital gain or loss." Moreover, although the term "borrowing" is not defined in the final regulations, the term should be construed to include any borrowing incurred in the taxpayer's trade or business. The final regulations state that the determination whether a hedge of a taxpayer's borrowing qualifies as a hedging transaction is to be made without regard to the use of the proceeds of the borrowing. Thus, a liability hedge should not fail to qualify as a hedging transaction merely because the proceeds of the borrowing being hedged are used to purchase a capital asset.

Under the final regulations, a global hedge (i.e., a hedge that relates to a pool of assets or liabilities) can qualify as a hedging transaction so long as all, or all but a de minimis amount, of the risk is with respect to ordinary property and ordinary obligations and borrowings. The final regulations, however, do not define what constitutes de minimis for this purpose.

B. Identification Requirements

In order for a transaction to qualify as a hedging transaction, the taxpayer must comply with certain identification requirements. Although these requirements do not raise significant substantive issues, they do impose significant compliance burdens. The identification requirement contains both general rules that apply to all hedging transactions and special rules that only apply to specific types of hedges.

1. General Identification Requirements

In general, to qualify as a hedging transaction, each transaction must be identified as a hedging transaction on the taxpayer's books before the close of the day on which the taxpayer enters into the transaction. To qualify, the identification of the hedging transaction must be unambiguous. In this regard, an identification made for book or regulatory pruposes will not satisfy this requirement unless the taxpayer's books also indicate that the identification is being made for tax purposes.

In addition to identifying the hedging transaction, the taxpayer must identify on its books the item, items, or aggregate risk being hedged. Under the 1993 temporary regulations, such identification was required to be made before the close of the day on which the taxpayer entered into the hedging transaction. The final regulations relax this rule, requiring only that the item, items, or aggregate risk being hedged be identified substantially contemporaneously with entering into the hedging transaction. In this regard, the final regulations state that an identification made more than 35 days after entering into the hedging transaction is not substantially contemporaneous. It does not necessarily follow, however, that an identification made within 35 days of entering into the hedge will always satisfy the substantially contemporaneous identification requirement.

2. Special Identification Requirements

In addition to the general identification requirements, the final regulations (like the 1993 temporary regulations) impose additional identification requirements on several types of hedging transactions.

a. Anticipatory Asset Hedges. Entries identifying anticipatory asset hedges must specify the expected date of acquisition of the assets and the number or quantity of assets the taxpayer expects to acquire.

b. Inventory Hedges. Under the final regulations, entries identifying inventory hedges must specify the "type or class" of inventory to which the transaction relates. For example, if the taxpayer is hedging a supply of raw material, the identification must make that clear and identify the particular material. If the hedging transaction relates to specific purchases or sales, the identification must include the expected dates of the purchases or sales and the amounts to be purchased or sold. If a taxpayer fails to meet this identification requirement, the transaction will fail to qualify for hedging treatment and, consequently, may result in a tax character "whipsaw."

c. Hedges of Existing Debt. If a taxpayer that is holding or has issued a debt obligation hedges less than the full adjusted issue price of the debt or hedges part or all of the debt for less than the full term of the debt, the identification must identify (1) the debt, (2) the amount of the debt being hedged, and (3) the term of the debt being hedged. In contrast, if the hedging transaction is for the full adjusted issue price and full term of the debt, the taxpayer is only required to identify the debt.

d. Hedges of Debt to be Issued. Entries identifying hedges of debt to be issued must specify the expected date of issuance of the debt, the expected maturity (or maturities) of the debt, the total expected issue price of the debt (or issue of debt), and the expected interest provisions.

e. Hedges of Aggregate Risk. In the case of a global hedge, the identification must show what interest rate, currency, and price risks are being aggregated. The entry must also disclose the method of determining the aggregate risk.

C. Misidentification

With several important modifications and clarifications, the final regulations generally adopt the provisions of the 1993 temporary regulations relating to the consequences of identifying as a hedging transaction a transaction that fails to qualify as a hedging transaction and of identifying a transaction that would otherwise qualify as a hedging transaction in a fashion that fails to satisfy the identification requirement. In each case, gain from the transaction is treated as ordinary income and loss from the transaction is treated as either ordinary or capital in accordance with general tax principles. This rule creates a potential whipsaw effect since the gain from the transaction will always be treated as ordinary but the loss may be treated as capital. This potential whipsaw puts considerable pressure on taxpayers to distinguish hedging transactions from non-hedging transactions and to identify hedging transactions properly.

The final regulations, unlike the 1993 temporary regulations, contain a relief provision from this whipsaw rule for certain "inadvertent" identification errors. A misidentified transaction is not subject to the whipsaw rule if (1) the transaction is not a hedging transaction; (2) the identification of the non-hedging transaction as a hedging transaction was due to inadvertent error; and (3) all of the taxpayer's non-hedging transactions in all open years are treated under the tax rules applicable to non-hedging transactions. The final regulations do not provide guidance on the meaning of the term "inadvertent."

D. Nonidentification

The final regulations also generally adopt the rules contained in the 1993 temporary regulations on the consequences of failing to identify as a hedging transaction a transaction that would otherwise qualify as a hedging transaction. If a transaction that satisfies the substantive requirements for hedging transaction treatment is not identified as a hedging transaction, it is not treated as a hedging transaction. Accordingly, gain or loss from the transaction is treated as ordinary or capital under general tax principles and without regard to the final regulations. The final regulations, however, contain a relief provision applicable to an "inadvertent" failure to identify a transaction as a hedging transaction. This relief provision applies only if (1) the failure was due to inadvertent error, and (2) all of the taxpayer's other hedging transactions in all open years are being treated as hedging transactions. Here, too, there is no guidance regarding the meaning of the term "inadvertent."

In addition, under an anti-abuse provision, if a taxpayer fails to identify a transaction as a hedging transaction, and there is "no reasonable basis for treating the transaction as other than a hedging transaction," any gain from the transaction will be treated as ordinary income. In determining whether there was a reasonable basis for the taxpayer's treatment of the transaction, the IRS will consider not only whether the transaction was a hedging trasaction as defined in the final regulations, but also the taxpay's treatment of the transaction for book or other purposes and the taxpayer's treatment of similar transactions.

E. Timing of Hedging Gains and Losses

1. General Rule

The final regulations embrace the fundamental principle that the method of accounting used for a hedging transaction must clearly reflect income. To satisfy this requirement, gain or loss from the hedging transaction must be taken into account in the same taxable year as the year in which gain or loss on the items being hedged is taken into account. Since the match is of (1) gain or loss on the hedging transaction to (2) gain or loss on the items being hedged, the final regulations do not affect the timing of the gain or loss on the items being hedged.

The final regulations recognize that there may be more than one method of accounting that satisfies the clear reflection of income requirement. They thus permit different methods of accounting to be used for different types of hedging transactions and for transactions that hedge different types of items. Because the generally accepted accounting principles (GAAP) addressing the treatment of hedging transactions for financial accounting purposes are in a state of development, the application of GAAP principles for tax purposes will not necessarily satisfy the clear reflection of income standard of the final regulations. The Preamble, however, does state that most taxpayers should nonetheless satisfy the clear reflection standard in the final regulations by accounting for their hedging transaction in accordance with GAAP.(39) Once a method of accounting is adopted, however, that method must be applied consistently and can only be changed with the consent of the IRS. The final regulations provide specific guidance on applying the clear reflection principle and the matching standard to various kinds of hedging transactions.

2. Specific Guidance

a. Aggregate Risk. Unlike the 1993 temporary regulations, the final regulations contain guidance on accounting for gain or loss from transactions entered into to hedge an aggregate risk. The application of the matching requirement is difficult in the case of a hedge of an aggregate risk because such a hedge generally does not relate to one specific item. Nonetheless, the final regulations require that the timing of income, deduction, gain or loss from the hedging transaction be matched with the timing of the aggregate income, deduction, gain or loss from the items being hedged.

The final regulations provide that a "mark-and-spread" method may be an appropriate means of achieving the required matching. Under the mark-and-spread method, the taxpayer is required to mark to market its hedging transactions at regular (at least quarterly) intervals and to recognize any mark-to-market gain or loss over the periods during which the hedging transactions are intended to reduce risk. Presumably, gain or loss is measured and spread on a transaction-by-transaction basis. Although the periods during which the hedging transactions are intended to reduce risk may change, the final regulations require that the periods be reasonable and consistent with the taxpayer's hedging policies and strategies.

b. Inventory. The final regulations prescribe three methods by which a taxpayer can account for its gains and losses from hedging inventory.

i. General Method. The general method distinguishes between two kinds of hedging transactions involving inventory. The first type of inventory hedging transaction is a sales hedge--a hedge against a decrease in the price of existing inventory. If a taxpayer that has 100x barrels of oil in inventory enters into a short forward contract for the sale of 40x of barrels of oil at a fixed price, such taxpayer has entered into a sales hedge. Under the general method, gain or loss from a sales hedge is recognized and matched with the recognition of the sales proceeds from the underlying inventory that was hedged.

The other kind of inventory hedging transaction is a purchase hedge--a hedge against an increase in the price of inventory to be acquired in the future. If a manufacturer enters into a long futures contract or forward contract for the purchase of raw material at a fixed price, such taxpayer has entered into a purchase hedge. Under the general method, gain or loss from a purchase hedge would be taken into account as if the gain or loss were an element of the cost of the inventory.

As with hedges of aggregate risk, a taxpayer may not be able to associate hedges of inventory purchases or sales with particular purchases or sales of inventory. The final regulations address this by making available to taxpayers the mark-and-spread method. Under this method, hedging transactions are marked to market at regular intervals as in the case of hedges of aggregate risk, but the mark-to-market gain or loss that is spread to each period under the mark-and-spread rule "is taken into account when it would be if it were an element of cost incurred (purchase hedges), or an element of proceeds from sales made (sales hedges), during that period."

ii. Alternative Methods. The final regulations recognize that in certain circumstances it may be appropriate for a taxpayer to account for its hedging transactions under "other simpler, less precise" methods. Neither of these alternative methods is available to taxpayers that use LIFO.

Under the first alternative method, a taxpayer may take into account gains and losses on hedges of inventory purchases and hedges of inventory sales as if the gains and losses were elements of current period inventory costs. The other alternative method is to mark hedges to market. This alternative is available even where the inventory that is being hedged is not marked to market so long as (1) the inventory is not accounted for under either the LIFO or the lower of cost or market methods, and (2) the inventory is held only for short periods of time.

c. Debt Instruments. Gain or loss from a transaction that hedges a debt instrument issued or to be issued by a taxpayer, or a debt instrument held or to be held by a taxpayer, must be accounted for by reference to the terms of the debt instrument and the period or periods to which the hedge relates. A hedge of an instrument that provides for interest to be paid at a fixed rate or qualified floating rate, for example, generally is accounted for using constant yield principles. Thus, assuming the instrument remains outstanding, hedging gain or loss is taken into account in the same periods in which it would have been taken into account if such gain or loss were an adjustment to the yield of the instrument over the term to which the hedge relates. For example, assume that a taxpayer borrows $1,000 for a term of five years at a floating rate and simultaneously enters into a hedging transaction that has the effect of fixing that rate. Under the final regulations, the taxpayer may account for the hedging transaction by accounting for the interest on its borrowing at the fixed rate.

d. Items Marked to Market. If the taxpayer hedges an item that is marked to market under the taxpayer's method of accounting, marking the hedge to market clearly reflects income.

e. Notional Principal Contracts. Treas. Reg. [sections] 1.446-3 provides detailed rules for determining the timing of income and deductions from interest rate swaps, caps, collars, floors, and other notional principal contracts. The timing regulations contained in Treas. Reg. [sections] 1.446-4 do not generally override these notional principal contract regulations. If a notional principal contract is used as a hedge, however, the final regulations will override the notional principal contract regulations if, viewing the transaction as a whole, application of the notional principal contract regulations does not clearly reflect income.

For example, assume that a taxpayer borrows funds at a fixed rate and enters into an interest rate swap under which the taxpayer makes floating rate payments and receives fixed rate payments. Assume that the taxpayer disposes of the swap before the maturity of the debt obligation and, because interest rates have risen, the taxpayer must make a lump-sum termination payment to its counterparty to be relieved of its swap obligations. Under the notional principal contract regulations, the termination payment generally would be deductible by the taxpayer in the year in which it was made. If the transaction qualifies as a hedging transaction, however, the final regulations will override the notional principal contract regulations and require the payment to be amortized over the remaining term of the debt.

III. The Proposed Consolidated Regulations

A. Hedges With Unrelated Third Parties

Many consolidated groups structure their hedging activities through a single group member ("hedging member"). Because transactions entered into by the hedging member typically hedge the risk of another consolidated group member ("operating member"), the transactions would not, as a technical matter, reduce the "taxpayer's risk" and consequently would not satisfy the risk reduction aspect of the hedging transaction definition. For example, assume that operating member ("O") and hedging member ("H") are members of a consolidated group. Further assume that O's business operations give rise to interest rate risk "A." Finally, assume that H enters into position "D" with a third party to hedge O's position with regard to A. The question is whether H can account for its position D as a hedging transaction. Because H's position D reduces risk incurred by O (rather than risk incurred by H), it would not reduce "the taxpayer's [i.e., H's] risk," and consequently would not constitute a hedging transaction under the final regulations.

The proposed consolidated regulations solve this risk reduction problem by permitting members of a consolidated group to account for their hedging transactions under a single-entity method. Under the single-entity method, each member of the consolidated group is treated as a division of a single company for purposes of applying the hedging rules. Accordingly, the risk of an operating member will be attributed to the hedging member, thereby satisfying the risk reduction aspect of the hedging transaction. Returning to the above example, under the single-entity method, O's risk A is treated as H's risk, and therefore D is a hedging transaction (assuming the other hedging requirements are satisfied) with respect to risk A.

B. Hedges Between Consolidated Group Members

It is also common for members of a consolidated group to engage in hedges among themselves. For example, operating members often will engage in hedging transactions with a hedging member in order to transfer their risks to the hedging member. Under the single-entity method, a hedging transaction between members of a consolidated group would not be qualify as a hedging transaction because the transaction would not reduce the risk of the group taken as a whole.

Returning to the above example, assume that rather than H's entering into a hedge with a third party, O enters into a hedging transaction with H to transfer its risk A to H. O's position in the intercompany transaction is "B," and H's position in the contract is "C." Further assume that H then enters into position "D" with a third party to reduce the interest rate risk it has with respect to its position. Under the single-entity approach, O's risk A is treated as H's risk, and therefore D is a hedging transaction with respect to risk A. The intercompany transaction B-C, however, is not a hedging transaction because it does not reduce the risk of the group taken as a whole; rather, it merely shifts the risk A from the operating member, O, to the hedging member, H. Consequently, the intercompany transaction B-C is treated as a deferred intercompany transaction under section 1502.

The proposed consolidated regulations permit members of a consolidated group to make an election to account for all of their hedging transactions using a separate-entity method. Under this method, each member of the group is treated as a separate entity, there is no attribution of one member's risk to another, and an intercompany transaction can qualify as a hedging transaction if the transaction otherwise qualifies as a hedging transaction and the position of the other member is marked to market under such member's method of accounting. If the other member does not utilize a mark-to-market method, the intercompany transaction is subject to the rules under section 1502. In the above example, if H marks C to market under its method of accounting and B would be a hedging transaction with respect to O if O had entered into that transaction with an unrelated party, then the B-C transaction is a hedging transaction with respect to O. In addition, D would be treated as a hedge of C if it satisfies the requirements of a hedging transaction.

A separate-entity election is binding on all members of the group. Such an election is made by attaching a statement to the consolidated return for the first taxable year in which the election would be effective. Once made, the election cannot be revoked without the consent of the IRS.

C. Special Timing and Identification Requirements

The timing and identification requirements under the separate-entity method generally piggyback the requirements contained in the final regulations. Hence, each member of the group must comply with the timing and identification requirements "without regard to the fact that the taxpayer is a member of a consolidated group."

Under the single-entity method, however, the identification and timing principles are modified to account for the fact that members of the group are treated as divisions of a single corporation. The identification rules require that a member engaging in a hedging transaction with an unrelated party identify both the hedging transaction and the underlying item being hedged, even if the item relates to another member of the group. The timing rules contained in the proposed consolidated regulations require that the hedging member and the operating member recognize income, deduction, gain or loss arising from the transaction at the same time.

D. Effective Date

In general, the proposed consolidated regulations apply on a purely prospective basis and will be effective for transactions entered into 60 days after the final regulations are published in the Federal Register. The prospective nature of the effective date has generated significant controversy. Specifically, several public comments submitted contend that the proposed consolidated regulations should apply retroactively to all "open tax years."

--Notes--

(1)The final regulations containing the character rules for hedging transactions (including certain identification requirements) appear at Treas. Reg. [sections] 1.1221-2. See T.D. 8555, 59 Fed. Reg. 36360 (July 18, 1994), reprinted at 1994-33 I.R.B. 9. The final regulations containing the timing rules for hedging transactions appear at Treas. Reg. [sections] 1.446-4. See T.D. 8554, 59 Fed. Reg. 36356 (July 18, 1994), reprinted at 1994-33 I.R.B. 4.

(2)The proposed consolidated regulations containing the character and timing rules for certain hedging transactions entered into by a member of a consolidated group appear at Prop. Reg. [sections] 1.1221-2(d)-(f) and Prop. Reg. [sections] 1.446-4(e)(9). See Notice of Proposed Rulemaking, 59 Fed. Reg. 36394 (July 18, 1994), reprinted at 1994-33 I.R.B. 19.

(3)See New York State Bar Association Tax Section Committee on Financial Instruments, Report on Proposed and Temporary Regulations on Character and Timing of Gains and Losses from Hedging Transactions (March 4, 1994).

(4)See generally Unofficial Transcript of IRS Hearing on Hedging Transactions, 94 TNT 16-36 (Jan. 25, 1994).

(5)See Comment from D. Garlock to Commissioner of Internal Revenue, dated Sept. 26, 1994, reprinted at 94 TNT 196-25 (Oct. 5, 1994).

(6)Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955).

(7)For a detailed discussion of the historical development, see generally Kleinbard & Greenberg, Business Hedges After Arkansas Best, 43 Tax Law Review 393 (1988).

(8)Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988).

(9)G.C.M. 17322, XV-2 C.B. 151 (1936).

(10)See also Ben Grote v. Commissioner, 41 B.T.A. 247 (1940), nonacq., where the Board of Tax Appeals rejected the IRS's argument that the taxpayer, a wheat farmer who bought and sold wheat futures on the Chicago Board of Trade, was speculating in the futures market rather than hedging because he never actually took delivery of, or delivered, wheat under the contracts; the court held that the taxpayer entered the futures market to protect himself against the risk of changes in the price of wheat and therefore was entitled to ordinary loss treatment.

(11)120 F.2d 772 (5th Cir. 1941).

(12)See also Estate of Makransky v. Commissioner, 5 T.C. 397 (1945) (the Tax Court held that the taxpayer, a manufacturer of wool suits, did not enter into a hedging transaction when it entered into futures purchase contracts for wool before it had binding commitments for the sale of the suits it intended to manufacturer with the wool); Stewart Silk Corp. v. Commissioner, 9 T.C. 174 (1947) (the Tax Court rejected the IRS's position that a taxpayer could establish an even or balanced position only with respect to its entire inventory and held that the taxpayer, a manufacturer of silk cloth that entered into futures sales contracts covering approximately one-third of its inventory had entered into hedging transactions), acq.; Fulton Bag & Cotton Mills v. Commissioner, 22 T.C. 1044 (1954) (the Tax Court held that a transaction otherwise qualifying as an inventory hedge qualified as a hedging transaction notwith-standing the fact that the taxpayer failed to close out its futures position simultaneously with the sale of its inventory), acq.

(13)Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), aff'g 215 F.2d 513 (2d Cir. 1954), aff'g 20 T.C. 503 (1953).

(14)20 T.C. 503 (1953).

(15)215 F.2d at 516.

(16)350 U.S. at 52.

(17)Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), aff'g, 800 F.2d 215 (8th Cir. 1986), rev'g in part, 83 T.C. 640 (1984).

(18)485 U.S. at 977.

(19)For example, suppose a company that typically borrowed on a fixed rate basis anticipated that it would issue debt three months hence and was concerned about the possibility of an increase in prevailing interest rates during the three months prior to its borrowing. Assume the company entered into a short futures positions to lock in its cost of borrowing. Suppose that between the date the company entered into the futures contract and the date it incurred the debt, interest rates went down, not up. Having entered into the hedging transaction, the company would have been in the same economic and tax position had it not entered into the hedge and had interest rates not changed. As an economic matter, the company's interest expense would have been reduced but it would have sustained a loss on the hedge. Before Arkansas Best, the company's interest deduction would have been lower, but it would have reported an ordinary loss on the hedge. After Arkansas Best, the company would still have been in the same economic position as interest rates had not changed, but it would not have been in the same tax position, for the loss on the swap would have been a capital loss.

(20)Under section 1256(g), the term "section 1256 contracts" is defined to include regulated futures contracts, foreign currency contracts, non-equity options, and certain equity options. Under section 1092(c)(1), the term "straddle" is defined as "offsetting positions with respect to personal property." Moreover, under section 1092(c)(2), positions are "offsetting" if there is a "substantial diminution" of risk of holding the first position by virtue of holding the second position. The term "personal property" is defined under section 1092(d)(1) as any personal property that is actively traded. Finally, the term "position" is defined in section 1092(d)(2) as "an interest (including a futures or forward contract or option) in personal property."

(21)100 T.C. 541 (1993).

(22)For a more detailed analysis of this case, see Note, Tax Treatment of Business Hedges: Federal National Mortgage Ass'n v. Commissioner and Temporary Regulations Section 1.1221-2T, 47 Tax Lawyer 525 (Winter 1994).

(23)Section 1221(4) provides that the term "capital asset" does not include accounts or notes receivable acquired in the ordinary course of the taxpayer's trade or business for services rendered or from the sale of inventory or property held by the taxpayer primarily for sale to customers in the ordinary course of the taxpayer's trade or business.

(24)Treas. Reg. [sections] 1.1221-2(a)(1).

(25)Treas. Reg. [sections] 1.1221-2(b).

(26)Treas. Reg. [sections] 1.1221-2(a)(3).

(27)Treas. Reg. [sections] 1.1221-2(c)(4).

(28)Id.

(29)See 59 Fed. Reg. at 36362.

(30)Treas. Reg. [sections] 1.1221-2(c)(1).

(31)The final regulations illustrate the risk reduction concept by providing two examples of transactions that do not satisfy the "risk reduction" requirement. See Treas. Reg. [sections] [sections] 1.1221-2(c)(1)(vii) and 1.1221-2(c)(3).

(32)Treas. Reg. [sections] 1.1221-2(c)(1)(ii)(B).

(33)Treas. Reg. [sections] 1.1221-2(c)(5)(i).

(34)Preamble to Final Regulations, 59 Fed. Reg. at 36362.

(35)Under a special transition rule, hedges of section 1231 assets may qualify for hedging treatment if they were entered into during taxable years that ended prior to July 18, 1994, and were still open as of September 1, 1994, and if the following conditions are met: (1) sales of section 1231 assets did not give rise to net gain treated as capital gain; (2) all of the hedges of the section 1231 assets would otherwise satisfy the definition of hedging transaction if the section 1231 assets were ordinary property; and (3) the taxpayer consistently treats all the hedges of section 1231 assets as hedging transactions. Treas. Reg. [sections] 1.1221-2(g)(3)(i).

(36)Treas. Reg. [sections] 1.221-2(c)(5)(ii).

(37)Id.

(38)Treas. Reg. [sections] 1.1221-2(g)(3)(ii). The transition rule applies to all non-inventory supply hedging transactions entered into during all taxable years that ended prior to July 18, 1994, and were open for assessment as of September 1, 1994.

(39)See 59 Fed. Reg. at 36356.

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