The inadvertent-error exception to identifying hedging transactions

Editor: Mary Van Leuven, J.D., LL.M.

In the normal course of their trade or business, taxpayers often enter into hedging transactions within the meaning of Sec. 1221(b)(2) to manage risk. Perhaps they have a floating-rate loan and want to hedge the interest rate risk, so they enter into an interest rate swap to economically convert the variable rate into a fixed rate. To manage the risk of price changes, taxpayers may acquire exchange-traded derivatives or enter into forward currency contracts to hedge the risk of currency fluctuations. Hedges can also be used to manage risks related to the expansion of a current business or the acquisition of a new one. Taxpayers may enter into hedging transactions to manage either existing or anticipated risk.

A Sec. 1221(b)(2) hedging transaction is any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily to (1) manage 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) manage the risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made by the taxpayer or ordinary obligations incurred or to be incurred by the taxpayer (Sec. 1221(b)(2) (A)). Further, a hedging transaction can manage an aggregate risk of interest rate changes, price changes, or currency fluctuations if all but a de minimis amount of the risk is with respect to ordinary property, ordinary obligations, or borrowings (Regs. Sec. 1.1221-2(c)(3)).

To match the timing and character of the ordinary items and borrowings being hedged, ordinary treatment of gains and losses on qualifying hedging transactions can be obtained, but contemporaneous identification must be made for each hedge. Under the rules of Sec. 1221(a)(7), hedging transactions must be clearly identified as such before the close of the day on which the transaction was entered into, acquired, or originated. An existing hedging transaction that is reused to hedge a different item or borrowing must also be properly identified on the date of the change.

The taxpayer entering into the hedging transaction must clearly identify the item(s) being hedged, which generally involves stating the transaction that creates risk and the type of risk being managed. More specific details may be required under Regs. Sec. 1.1221-2(f), depending on the type of hedge.

A system for identification may also be established by the taxpayer, so long as the identification is unambiguous and timely. Financial accounting designation is not enough; the hedge identification must state that the identification is made for tax purposes.

But what happens if the hedging transaction is not timely identified? Perhaps identification was properly made when an interest rate swap was entered into to hedge the interest rate risk on a borrowing. The note was later deemed reissued under the significantmodification rules and the swap was maintained, but no new hedging transaction was identified in the taxpayer’s books and records. What if the taxpayer regularly identifies its hedging transactions timely and properly but missed one during a phase of personnel changes? What happens if the taxpayer is a foreign entity that only recently started operating in the United States and was unaware of the requirements? Missed, late, or incomplete identifications are frequent, caused by a number of reasons, and are almost always without malicious intent on the taxpayer’s part. Tax character whipsaw rules could come into play, where the IRS can treat gross gains from the misidentified hedging transaction as ordinary, while gross losses maintain the tax character that would apply absent the hedging rules, which could be capital. The straddle rules under Sec. 1092 could apply to defer losses. Losses could become reportable (see Rev. Proc. 2013-11); mark-to-market tax accounting could apply (see Sec. 1256(e)); and book-tax differences could arise.

Luckily, some relief is provided regarding character. Regs. Sec. 1.1221-2(g) (2)(ii) allows a taxpayer to treat gain or loss from the hedging transaction as ordinary, provided the failure to identify the transaction was due to inadvertent error, among other things. But what errors count as “inadvertent”?

The term is not defined in the Code or regulations. The IRS has provided little guidance and only in the form of somewhat unsatisfying letter rulings and Chief Counsel Advice memorandums (CCAs), a few of which are presented below. Letter rulings and CCAs represent the IRS’s analysis of the law as applied to a taxpayer’s specific facts. These types of written determinations are not intended to be relied on by third parties and may not be cited as precedent (Sec. 6110(k)(3)). They do, however, indicate the IRS’s position on the issues addressed.

In Letter Ruling 200051035, issued Sept. 26, 2000, the IRS determined that, in the absence of a specific definition, “the term ‘inadvertent error’ should be given its ordinary meaning” and that “[t]he ordinary meaning of the term ‘inadvertence’ is ‘an accidental oversight; a result of carelessness’ ” (citing Black’s Law Dictionary 762 (7th ed. 1999)). In this ruling, the IRS determined that the taxpayer’s failure to identify an interest rate swap to convert a floating-rate borrowing to a fixed rate was inadvertent, so payments made to terminate the swap agreement could be treated as ordinary deductions. The underlying loan document required the taxpayer to be protected against changes in interest rate reductions by entering into a hedge. Further, the notional principal amount of the swap was approximately equal to the outstanding loan balance on the underlying debt. The failure to identify the hedge was later discovered, and the tax matters partner prepared a file memorandum further indicating the taxpayer’s desire to treat the swap contract as a hedging transaction. This was a win for the taxpayer, which, it must be said, had “good” facts.

In CCA 200851082, issued Sept. 2, 2008, the IRS stated that the taxpayer “should bear the burden of proving inadvertence, and its satisfaction should be judged on all surrounding facts and objective indicia of whether the claimed oversight was truly accidental. The size of the transaction, the treatment of the transaction as a hedge for financial accounting purposes, the sophistication of the taxpayer, its advisers, and counterparties, among other things, are all probative.” This CCA apparently made the task of qualifying for the inadvertenterror exception a more holistic exercise. But the scope of the exception seemingly narrowed a few years later.

In CCA 201046015, issued July 14, 2010, the IRS, expressing its desire of “passing along a few additional observations,” confirmed that the burden to show inadvertent error lay with the taxpayer and that all facts and circumstances are relevant, including the taxpayer’s book treatment of the transactions, as well as any failure to promptly address nonidentified hedging transactions or to establish hedging identification procedures once the taxpayer was made aware of its deficiencies.

The IRS also made clear its view that ignorance of the law was no excuse and that the inadvertent-error rule “is not intended to eviscerate” the identification requirement. The IRS also took a dim view of corporate taxpayers that “would normally find it advantageous to identify their otherwise qualifying tax hedges unless perhaps they hope to avoid or game the hedge timing rules or hope to generate capital gains that can absorb capital losses.” The IRS added that it saw “no compelling policy justification for reading the inadvertent error rule as an open-ended invitation for taxpayers to brush aside establishing hedge identification procedures, knowing that inattention to the rules or even unsound judgment (as seems to be the case here) can be fixed on an as needed basis.” The IRS clearly did not appreciate the facts and circumstances that presented themselves in that case. This was a loss for the taxpayer, who, it must be said, had “bad” facts.

While the above authorities are useful in that they seem to establish some outer parameters of the scope of the inadvertent-error exception (i.e., “good” facts are good, and “bad” facts are bad), most taxpayers, of course, have facts that are neither “good” nor “bad” but are somewhere in between. How should these taxpayers approach the inadvertent-error exception? If taxpayers make a good-faith effort to comply with the hedge identification rules, then most unidentified hedges would likely have at least an argument for inadvertence. Given what is potentially at stake here, however, the IRS would do well to issue further, clearer guidance (perhaps through a set of examples) on what actually constitutes an inadvertent error. The time for clarity is now.

Editor notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C. Contributors are members of or associated with KPMG LLP. For additional information about these items, contact Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained in these articles is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the authors only, and do not necessarily represent the views or professional advice of KPMG LLP.