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MARCH/APRIL 2000
Developments in the United States
New Tax Act Requires Taxpayers to
Modify Hedging Programmes
Peter J. Connors1
The 1999 Tax Act contains a relatively obscure amendment to Section 1221 of the Internal Revenue Code that
will have a profound impact on the taxation of derivative
instrument transactions.
since the bank’s gain or loss on the loan would be ordinary
under Section 582.
II. THE BUSINESS HEDGING REGULATIONS
I. BACKGROUND
Section 1256 of the Code provides that certain contracts
(known as Section 1256 contracts) must be marked-tomarket at year-end. Gain or loss is accorded capital treatment, with 60 per cent of gain being long-term capital gain
and 40 per cent of gain being short-term capital gain. The
contracts that are considered Section 1256 contracts
include:
– regulated futures contracts;
– foreign currency contracts;
– non-equity options; and
– dealer equity options.
So, for example, a futures contract to purchase gold must
be marked-to-market. Similarly, a listed currency option
would also be marked-to-market.
Section 1256(e) contains an exception from the mark-tomarket requirement for “hedging transactions” that
“reduce risk” of price change or currency fluctuations with
respect to property held or expected to be held by the taxpayer, or with respect to interest rate movements on existing and expected borrowings or obligations. Under
another provision, losses on positions that are part of a
straddle are deferred to the extent of unrecognized gain in
offsetting positions. This means that if there is a loss in a
foreign currency contract that is held to offset currency
exposure on a foreign currency borrowing, the loss will be
deferred to the extent of unrecognized foreign currency
gain in the loan. Under yet another provision, Section
263(g), interest expense and carrying charges allocable to
property that is part of a straddle must be capitalized.
Under Section 1256(e), once it is determined that a transaction qualifies as a hedging transaction, the hedge is
exempt from the straddle rules of Section 1092 and the
interest capitalization rules of Section 263(g). In order to
qualify for the exception, where the item being hedged is
property, the gain or loss on both the underlying transaction and the hedge must be treated as ordinary (rather than
capital) gain or loss. For example, an interest rate swap
acquired to convert the interest rate on a floating rate loan
to a fixed rate loan would qualify as a hedging transaction,
Treasury regulations under Section 1221 (also known as
the business hedging regulations) presently address the
character of gain or loss from hedging transactions.2 Consistent with the Section 1256(e) exception, the present
Treasury regulations under Section 1221 apply to hedges
that meet a standard of “risk reduction” with respect to
ordinary property held (or to be held) or certain liabilities
incurred (or to be incurred) by the taxpayer and that meet
certain identification and other requirements. Once it is
determined that a transaction qualifies as a hedge, the asset
is not considered a capital asset under Section 1221.3 If a
transaction is a valid hedging transaction, the accounting
method used by a taxpayer to report that hedging transaction must clearly reflect income. Also, the regulations
impose adverse consequences on taxpayers that either
improperly identify a transaction as a hedge or fail to identify a transaction as a hedge where it clearly should have
been identified. Finally, the present regulations take the
position that that hedges of non-inventory supplies purchases may be considered hedges of ordinary property if
the taxpayer sells only a negligible amount of the item.4
In determining whether a derivative reduces risk, all the
facts and circumstances must be considered, suggesting
that “enterprise risk” – namely, the risk of the entire enterprise – must be reduced. The regulations state that a transaction that converts an interest rate or price from a fixed
price or rate to a floating price or rate, may reduce risk. As
an example, the regulations describe the situation in which
a taxpayer’s income varies with interest rates. In this situation, the present regulations state that the position that a
taxpayer may be at risk if it has a fixed rate liability. Similarly, as another example, a taxpayer with a fixed cost for
its inventory may be at risk if the price at which the inventory can be sold varies with a particular factor. In these situations, the regulations state that a transaction that converts
an interest rate or price from fixed to floating may be a
1. Baker & McKenzie, New York. Mr Connors can be reached at 1-212-891
3928.
2. See Reg. §1.1221-2.
3. Rosenthal and Price, “FAS 133 and Tax – An Unhappy Marriage Awaiting
a Counselor”, 1 Derivatives and Financial Instruments 4 (1999).
4. See Reg. §1.1221-2(c)(5)(ii).
© 2000 IBFD Publications BV
MARCH/APRIL 2000
DFI
hedging transaction.5 If a floating rate or price risk did not
exist, the transaction would not meet the risk reduction
requirement.
The determination of whether a transaction is a hedge also
becomes relevant in Section 475,6 relating to hedges
entered into by dealers and traders in securities and in Section 988, relating to foreign currency transactions. In addition, the hedging definition contained in the present regulations is the basis for determining whether transactions
are bona fide hedges in the determination of foreign personal holding company income, currently under the Controlled Foreign Corporation rules.7
III. THE 1999 TAX ACT
Section 1221 contains a listing of assets that do not qualify
for capital asset treatment. Previously, although there were
regulations defining a hedging transaction under Section
1221, there was no specific mention of hedging transactions in Section 1221 itself. The 1999 Tax Act adds three
categories to the list of assets which will not be considered
capital assets under Section 1221. The new categories are:
(1) commodities derivative financial instruments held by
commodities derivatives dealers;
(2) “hedging transactions”; and
(3) supplies of a type regularly consumed by the taxpayer
in the ordinary course of a taxpayer’s trade or business.
The change for commodity derivatives dealers insures that
these dealers will receive ordinary gain or loss on their
transactions. The specific addition to Section 1221 regarding both hedging transactions and supplies serves, in part,
to allay fears that the Treasury Department may have
exceeded its authority in adopting the Section 1221 hedging regulations.
While the new statute generally parallels the Treasury regulations under Section 1221 in defining a hedging transaction, the new law makes a significant modification to the
definition contained in those regulations. Under the present Treasury regulations, a hedging transaction must
“reduce risk”. Under the new statute, the “risk reduction”
standard is broadened to cover “management of risk” with
respect to ordinary property held (or to be held) or certain
liabilities incurred (or to be incurred), and the definition of
a hedging transaction includes a transaction entered into
primarily to manage “such other risks” as the Secretary
may prescribe in regulations. Thus, it should now be possible for a company to hedge into a floating rate, if that is
consistent with management’s view of interest rate movements, even if it has no underlying floating exposure. In
the past, it may have been necessary to hedge into a fixed
rate regardless of management’s views or policies.
It is also possible that in light of the broad statutory grant,
future Treasury regulations will address hedging in
instances where Treasury previously felt constrained by
the language of the statute. The insurance area may be one.
For example, insurance companies typically enter into
hedging transactions to manage interest rate risk relating
to their investment portfolios. However, since insurance
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companies’ hedges relate to capital assets, they are not eligible for hedge treatment under the current regulations.
The new risk management standard is more consistent
with Financial Accounting Standard 133, Accounting for
Derivative Instruments and Financial Transactions,
which, with its heavy emphasis on a transactional
approach to measuring whether a derivative is effective in
reducing risk, does not impose any requirement that enterprise risk be reduced.
The new statutory provision also grants authority to Treasury to issue regulations prescribing the consequences of
misidentification and non-identification of hedging transactions, thereby clarifying the validity of certain identification provisions of the present regulations. Under the present Treasury regulations, if a transaction is not identified
as a hedging transaction when it should be, the absence of
identification is binding; any loss claimed cannot be an
ordinary loss and if the taxpayer has no reasonable
grounds for treating the transaction as other than a hedging
transaction, any gain must be treated as ordinary income.
Similarly, if a transaction is incorrectly identified as a
hedging transaction, gain must be treated as ordinary
income, but loss will be accorded capital loss treatment.
Both alternatives create adverse consequences for identification and non-identification mishaps. For example, under
the present regulations, if one incorrectly identifies a
transaction as a hedge that converts an asset into a floating
asset, gain on the hedge will be ordinary, but any loss of
the hedge will be a capital loss. Moreover, since the transaction was not properly identified as a hedge, the straddle
exception for losses and the exception for interest capitalization expense will not be available. Thus, it is critical
that one makes a proper determination as to whether a
transaction is a hedge at the outset.
Finally, changes were also made in the definitions of
hedge for purposes of Sections 475 and 988. Under these
provisions, a hedge is one that manages (rather than
reduces) the taxpayer’s risk of interest rate, price changes
or currency fluctuations, as the case may be.
IV. THE EFFECTIVE DATE
The new statute is effective for any instrument held,
acquired or entered into, any transaction entered into and
supplies held or acquired on or after the date of enactment. As a result, taxpayers will need to promptly modify
their hedging policies and procedures to take into account
the new hedging definition, even before implementation
of FAS 133 is completed at the beginning of 2001. Similarly, the IRS will need to promptly modify its present
regulations and clarify how the risk management standard
is to be framed and whether it is to be extended to other
regulations applicable to hedging-type activities.
5. See Reg. §1.1221-2(c)(1)(ii)(B).
6. For a detailed discussion of Sec. 475, see Caginalp, Connors and Handler,
“Tax Management Portfolio No. 543, The Mark-to-Market Rules of Section
475”, BNA (2000).
7. See Reg. §1.954-2(a)(4)(ii).
© 2000 IBFD Publications BV