Gains & Losses
The IRS recently signaled its increasing interest in the tax treatment of hedging transactions, particularly with regard to proper taxpayer identification. Although the rules are clear, the existence of the inadvertent error rules has arguably contributed to taxpayer apathy concerning the potentially onerous results of failing to properly identify hedge activity for tax purposes.
In e-mailed advice (Chief Counsel Advice (CCA) 201046015), the IRS reversed its position set forth in a previous CCA (201034018) with regard to the same taxpayer and agreed that the inadvertent error rules of Regs. Sec. 1.1221-2(g)(2)(ii) could apply to a Sec. 1256 contract. The reversal was based on the taxpayer’s claim that the previously issued advice failed to take into consideration Sec. 1256(f)(2), which states that Sec. 1256(a)(3), the 60/40 capital gain/loss rule, could not be applied to “ordinary income property,” thus allowing the taxpayer to acquire ordinary treatment pursuant to Sec. 1221(a)(7). This result is good news for taxpayers, but perhaps the more important news is a clearly stated view that ignorance of the hedging rules will not be sufficient to qualify as inadvertent error. Given this position, a brief review of the identification rules and the potential remedy for inadvertent error is in order.
The big stick in the hedge identification rules is the potential for taxpayer whipsaw by treating all gains as ordinary and all losses as capital in the case of abusive situations where a taxpayer is intentionally failing to follow the identification rules. For example, a taxpayer with a capital loss carryforward could attempt to cause a capital gain by intentionally failing to identify a transaction as a hedge when it would otherwise clearly qualify.
Absent falling into the abusive transaction category, a hedge will be a capital asset unless it is clearly identified as a hedging transaction. Ordinarily a corporate taxpayer would prefer ordinary income treatment because there is no tax rate differential between ordinary income and short-term capital gains, and capital losses can be difficult to use. The CCA refers to this fact and notes that Treasury could have written the rules from the standpoint that presumed identification as hedges unless the taxpayer opted out. Instead, the rules require clear identification in order for hedges to be treated as such, with limited exceptions for inadvertent errors.
Making the Identification
A hedging transaction is any transaction entered into in the normal course of a taxpayer’s trade or business primarily to accomplish one of the following:
- To manage risk of price changes or currency fluctuations with respect to “ordinary property” that is held or to be held by the taxpayer;
- To manage 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; or
- To manage such other risks as Treasury may prescribe in regulations (Sec. 1221(b)(2)).
Clear identification as a hedge before the close of the day on which the “taxpayer acquired, originated, or entered into the transaction” is required (Regs. Sec. 1.1221-2(f)(1)). This rule is relaxed by Regs. Sec. 1.1221-2(f)(2)(ii), which states that the identification must be made “substantially contemporaneously.” Regs. Sec. 1.1221-2(f)(1) states that “identification is not substantially contemporaneous if it is made more than 35 days after entering into the transaction.”
To identify the transaction as a hedge, the taxpayer must include the “item, items, or aggregate risk” being hedged (Regs. Sec. 1.1221-2(f)(2)(i)). This requirement includes identifying the transaction creating the risk as well as the type of risk. The identification of the hedging transaction must be “unambiguous” (Regs. Sec. 1.1221-2(f)(4)(ii)). Thus, identification must be made for book or regulatory purposes as well as for tax purposes. Once proper identification has been made, the records must be retained as part of the taxpayer’s book. Properly identifying the hedge for book purposes alone is not sufficient for tax purposes; thus, a specific statement regarding the tax treatment is necessary.
Effects of Improper or Failed Identifications
If a taxpayer identifies a transaction as a hedging transaction, the identification is binding with respect to gain, regardless of whether all the requirements of Regs. Sec. 1.1221-2(f) are satisfied. Therefore, gain from the transaction will be treated as ordinary income. However, if the taxpayer identifies the transaction as a hedge when it actually is not, identification itself does not necessarily make a loss ordinary and could potentially create a capital loss, giving rise to the whipsaw effect mentioned earlier. Regs. Sec. 1.1221-2(g)(1)(ii) provides some relief from the whipsaw for inadvertent errors. Under this provision, the character of the gain is determined as if the transaction had not been identified if the following apply:
- The transaction is not a hedging transaction.
- The identification of the transaction as a hedging transaction was due to inadvertent error.
- All the taxpayer’s transactions in all open years are being treated on either original or amended returns in a manner consistent with the rules.
Under the anti-abuse rule in Regs. Sec. 1.1221-2(g)(2)(iii), if the “taxpayer has no reasonable grounds for treating the transaction as other than a hedging transaction, then gain from the transaction is ordinary.” In determining whether there is a reasonable basis for the taxpayer’s treatment of the transaction, the IRS will consider the following factors:
- Is the transaction a hedging transaction?
- How was the transaction treated for financial accounting or other purposes?
- How did the taxpayer treat similar transactions?
In short, ignoring the law will most likely result in the IRS’s claiming that all the gains are ordinary and all the losses are capital. Unless the taxpayer can produce capital gains to offset the capital losses, the losses will expire with no benefit to the taxpayer. In an effort to avoid this situation, the IRS has indicated that mere ignorance of the law will not qualify as an inadvertent error. However, if the taxpayer does not identify a hedge, favorable treatment is still possible if the taxpayer is consistent regarding the treatment of similar transactions from prior years. Without consistency it will appear as if the taxpayer failed to identify a transaction as a hedge in hopes of getting capital gain treatment, which the IRS will not allow.
Factors in Considering Inadvertent Error Standard
It is not surprising that a failure to know about or understand the hedge identification rules will not meet the inadvertent error standard. The extensive accounting guidance and complexity surrounding hedging transactions implies a need to consider the tax effects of the same transactions. In the most recent CCA, the IRS noted a few factors, although it did not weight them or suggest that the list was exhaustive. In this case, the taxpayer was unable to demonstrate to the examining agent’s satisfaction that:
- The particular exchange-traded contracts were intended to be identified as tax hedges;
- Reasonable efforts were made to understand the tax rules and requirements applicable to tax hedges; or
- Once informed, prompt efforts were made to correct past identification failures or protect against future identification errors.
Other subjective factors that may be considered could include the sophistication of the taxpayer’s treasury and tax functions, the formality of its book hedging policies, and the frequency of similar identification errors.
The IRS has indicated an increased emphasis on proper tax treatment for hedges. Taxpayers should take action to ensure that identifications are made timely and are consistent with the identification rules, as the claim for inadvertent error may be more difficult to sustain than in the past.
Kevin Anderson is a partner, National Tax Services, with BDO USA, LLP, in Bethesda, MD.
For additional information about these items, contact Mr. Anderson at (301) 634-0222 or firstname.lastname@example.org.