Why Companies Must Properly Account For Hedging Transactions In Today’s Market

By:

Jared A. Hermann is a senior associate in the Washington National Tax Practice of PricewaterhouseCoopers LLP, where he focuses on international tax and financial products.

As the global business market continues to expand, companies are now more than ever directly and indirectly affected by changes in market conditions, and as a result, the importance of hedging transactions as a risk management tool has increased dramatically.  This article provides a high-level summary of the general principles relating to hedging transactions and discusses why companies must properly identify their hedging transactions for tax purposes. 

Whether it is due to fluctuations in prices, interest rates, or currency exchange rates, changes in market conditions (i.e., market risks) can have a significant adverse impact on a company’s financial performance.  To mitigate the potential impact of these market risks, companies will enter into certain types of transactions, each with the intended purpose of managing one of these risks.  These transactions (i.e., hedges) are each designed to counter-balance or offset the risk of loss associated with the underlying business transaction (i.e., item or items being hedged), which will produce income taxed as ordinary income.  In order for a hedge to effectively accomplish this counterbalancing objective, the hedge must have the same income tax treatment as the underlying business transaction.  This treatment is allowed under the U.S. federal income tax system, but only if the hedge meets the definition of a hedging transaction under section 1221 and the regulations promulgated thereunder and is identified in accordance with such rules.  

For example, a company that issues a floating rate debt obligation in the ordinary course of its business is subject to interest rate risk on that debt, which the company can mitigate by entering into a floating to fixed interest rate swap to hedge against such risk.  If, however, that company does not properly identify the interest rate swap as a hedging transaction for tax purposes, the company may encounter a character mismatch, whereby gains are treated as ordinary income and losses are treated as capital losses.  If losses relating to a hedging transaction are treated as capital losses, such losses would not be deductible against ordinary business profits, and even worse, if these capital losses exceed a company’s capital gains, the excess loss cannot be deducted currently.

Therefore, in order for a taxpayer to avoid a character mismatch with respect to its hedging transactions, the taxpayer must adhere to the rules under section 1221(a)(7) and Treas. Reg. § 1.1221-2.[1]  In essence, the taxpayer must clearly identify each hedging transaction as such for tax purposes before the close of the day on which it is acquired, originated, or entered into and must account for income, gain, loss, or deduction resulting from the hedging transaction in a manner that clearly reflects income and reasonably matches the timing of income, gain, loss, or deduction resulting from the item or items being hedged.[2]  These rules are explained in more detail below.

Qualification for Tax Hedge Treatment

A hedging transaction is defined under current law as any transaction that is entered into in the normal course of a taxpayer’s trade or business with the intended purpose of primarily managing one of several enumerated risks.  These risks include, inter alia: (i) risk of price changes or currency fluctuations with respect to ordinary property that is held or will be held by the taxpayer; or (ii) 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.[3] 

There are many different types of transactions that may be used to manage these risks, such as forward contracts, futures, options, etc.  Whether a particular transaction manages risk in accordance with Treas. Reg. § 1.221-2 is determined by examining all of the facts and circumstances surrounding the taxpayer’s business and the transaction.[4]  It should be noted, however, that a transaction undertaken for speculative purposes will not be treated as a hedging transaction.[5]  Accordingly, to qualify as a hedging transaction, the transaction must be entered into with the primary purpose of managing risk associated with a particular ordinary asset or ordinary obligation.[6]

Identification

To qualify for the beneficial tax treatment afforded tax hedging transactions, a hedging transaction must be clearly identified as a hedging transaction for tax purposes no later than the close of the day on which the transaction was entered into.[7]  The regulations also require that the item or items being hedged must be identified substantially contemporaneous with (i.e., within 35 days of) entering into the hedging transaction.[8]  The identification of a hedged item will typically involve first identifying a transaction that creates risk and then identifying the type of risk that the transaction creates.[9]  The purpose of allowing 35 days for an identification to be made is to allow taxpayers to identify an item or items being hedged at the same time taxpayers are preparing their monthly reports for nontax purposes.[10]   

Both the identification of the hedging transaction and the hedged item or items must be made on, and retained as part of, the taxpayer’s books and records, where the presence of such identifications is unambiguous.[11]  If a taxpayer satisfies these requirements and a transaction is properly identified as a hedging transaction, any gain or loss arising from the transaction will be treated as ordinary gain or loss. 

The importance of making a proper identification of a hedging transaction cannot be overstated.  This is because making an identification of a transaction as a hedging transaction is binding, but only with respect to gain--meaning that if a taxpayer identifies a transaction as a hedging transaction, any gain from the transaction, regardless of whether or not the transaction qualifies as a hedging transaction, will be treated as ordinary.[12]  If, however, a taxpayer identifies a transaction as a hedging transaction and the transaction results in a loss, the character of the loss is determined under general tax principles (i.e., the character of the loss may be either capital or ordinary) if the transaction does not qualify as a hedging transaction.[13]  In contrast, if a transaction is not identified in accordance with the requirements set forth under Treas. Reg. § 1.1221-2(f), the transaction will be treated as not qualifying as a hedging transaction and the character of the resulting gain or loss will be determined under general tax principles.[14]

Applying the identification rules to the example mentioned above, it is easy to see why a company would be concerned about properly identifying a hedging transaction.  This is because if the hedging transaction (i.e., the floating to fixed interest rate swap) were to be terminated and result in a capital loss, such loss would not be appropriately offset against the item or items being hedged (i.e., the floating rate debt obligation) since any income or deduction resulting from the hedged item would be ordinary (a capital loss is not deductible against ordinary business profits). 

Timing

Income, gain, loss, or deduction resulting from properly identified hedging transactions must “reasonably match” the timing of income, gain, loss, or deduction resulting from the item or items being hedged.[15]  The regulations indicate that taking gains and losses into account in the period during which they are realized may clearly reflect income in the case of some hedging transactions, but not all, and that for any given type of hedging transaction there may be more than one method of accounting that satisfies the clear reflection of income requirement.[16]  Therefore, a taxpayer may adopt different methods of accounting for different types of hedging transactions as well as for transactions that hedge different types of income, so long as the accounting method chosen for that type of hedging transaction satisfies the clear reflection of income requirement. 

Note, however, that once a taxpayer adopts a method of accounting, the taxpayer must apply that method consistently and may only be changed with the consent of the Commissioner of the IRS.[17]  Furthermore, similar to the recordkeeping requirements relating to the identification rules discussed above, the timing rules require that the taxpayer also include in its books and records a description of the accounting method used for each type of hedging transaction.[18]

Why does this matter?

Although these rules may appear at first glance to be cumbersome and complex, companies are more than willing to adhere to such requirements if doing so means that they will be able to effectively counter-balance or offset the risk of loss associated with the underlying business transaction being hedged.  Otherwise, it would be economically inefficient for a company to hedge against certain market risks associated with a business transaction if the hedge and the item or items being hedged were to result in opposing tax treatments (i.e., capital and ordinary treatment).  Therefore, unless and until the rules relating to hedging transactions are simplified, companies will continue to meticulously follow the identification and accounting requirements set forth under section 1221, section 446, and the regulations promulgated thereunder.  

[1]       Unless otherwise indicated, all section references in this opinion letter are to the Internal Revenue Code of 1986, as amended (the “Code”), and the Treasury regulations promulgated thereunder.

[2]       We note for completeness that the timing rules set forth under Treas. Reg. § 1.446-4, discussed below, generally are not dependent on whether a taxpayer appropriately makes a hedge identification.  In general, these timing rules apply to the timing of income, gain, loss, or deduction produced by a hedging transaction as defined under Treas. Reg. § 1.1221-2, regardless of whether a proper identification is made or not.  See Treas. Reg. § 1.446-4(a).

[3]       Section 1221(b)(2)(A); Treas. Reg. § 1.1221-2(b), (d); see also Treas. Reg. § 1.1221-2(c)(2) (providing that property is ordinary property to a taxpayer only if a sale or exchange of the property by the taxpayer could not produce capital gain or loss under any circumstances and that an obligation is an ordinary obligation if performance or termination of the obligation by the taxpayer could not produce capital gain or loss).

[4]      Treas. Reg. § 1.1221-2(c)(4)(i), (ii); Treas. Reg. § 1.1221-2(d) (identifying transactions that manage risk).

[5]       Treas. Reg. § 1.1221-2(c)(4)(i), (d)(1)(i).

[6]      We note for completeness that the rules discussed herein apply to tax hedging transactions that are entered into with the purpose of hedging an ordinary asset and, therefore, do not apply to all accounting and business hedges, per se. 

[7]       Section 1221(a)(7); Treas. Reg. § 1.1221-2(f)(1), (4)(ii)

[8]      Treas. Reg. § 1.1221-2(f)(1), (2), (4)(ii).

[9]      Treas. Reg. § 1.1221-2(f)(2)(i); see also Treas. Reg. § 1.1221-2(f)(3) (providing specific requirements for certain types of hedges).

[10]     T.D. 8555, 1994-2 C.B. 180 (July 18, 1984).

[11]      Treas. Reg. § 1.1221-2(f)(4).  The regulations further state that the identification of a hedging transaction for financial accounting regulatory purposes is not unambiguous unless the books and records indicate the identification is also being made for tax purposes.  Id.

[12]      Treas. Reg. § 1.1221-2(g)(1)(i); see also Treas. Reg. § 1.1221-2(g)(1)(ii) (providing an exception for transactions that are not hedging transactions, but that were identified as such by the taxpayer due to inadvertent error).

[13]      Id.

[14]     Treas. Reg. § 1.1221-2(g)(2)(i); see also Treas. Reg. § 1.1221-2(g)(2)(ii) (providing an exception for transactions that are hedging transactions, but that were not identified as such by the taxpayer due to inadvertent error) and (iii) (providing an anti-abuse rule whereby the gain from a hedging transaction will be treated as ordinary if the taxpayer does not properly identify a transaction but has no reasonable grounds for treating the transaction as other than a hedging transaction). 

[15]      Treas. Reg. § 1.446-4(b).

[16]     Treas. Reg. § 1.446-4(b), (c).

[17]      Treas. Reg. § 1.446-4(c).

[18]     Treas. Reg. § 1.446-4(d).

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