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August 2, 2011

With the continued volatility of today’s business and economic environment, hedging strategies designed to deal with these uncertainties remain a smart business move. With fuel and raw material prices fluctuating widely over the past few years and in many cases reaching record highs, businesses are recognizing the increased need for managing their price risk, not to mention currency and interest rate risk. Unfortunately, due to the complexity of the associated tax rules, many tax departments do not fully appreciate (or more likely, have the time to appreciate) the need to put in place the hedge identification and documentation processes required under the Internal Revenue Code (the “IRC”). In fact, even sophisticated tax departments might not be fully aware of the hedging activity that is occurring at their company.

If yours is not well-versed in the regulations governing the identification and documentation of hedges for tax purposes or is not aware of the hedging activity that is being conducted, your company’s hedging may actually be creating a substantial tax exposure. Such exposure makes developing an adequate tax risk management policy for your company’s hedges another smart business move. Although hedge identification for tax purposes appears to be a relatively simple matter in theory, companies with very active trading operations can be faced with significant challenges from a practical standpoint. Nevertheless, tax departments must take heed of the hedge identification and documentation rules and convey to their trading and executive brethren the importance of complying with the tax requirements. Failing to do so could turn an otherwise successful transaction into a loser — from losing tax treatment as ordinary income/loss to impacting the timing of income/loss inclusion.

Hedging Basics

Section 1221(b)(2)(A) defines a hedging transaction for tax purposes as:

“Any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily — (i) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer, (ii) 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 (iii) to manage such other risks as the Secretary may prescribe in regulations.”

In other words, hedging transactions must manage risk with respect to ordinary property in the normal course of business. Property is ordinary property only if a sale or exchange of the property by the taxpayers could not produce capital gain or loss under any other circumstances. Therefore, a litmus test of sorts to determine compliance with the ordinary property requirement involves looking first at the type of income generated upon the sale of the related asset (see the two seminal cases, Corn Products Refining Co. v. CIR and Arkansas Best Corp. v. CIR, and the subsequent regulations under Section 1221). If the sale of the underlying asset results in ordinary income, the hedge gain/loss would generally be ordinary in nature. A typical example would be hedging the price risk associated with your inventory.

To satisfy the requirement that a hedge be made in the normal course of business, a hedge transaction must be one aimed at furthering the taxpayer’s trade or business.

Finally, a hedging transaction must be entered into to manage risk, which as defined in the Treasury Regulations generally means a transaction that reduces the taxpayer’s risk. Therefore, no speculative activity will qualify as a hedge.

Hedging Benefits and Potential Pitfalls

Hedge classification allows for the ordinary treatment of gains/losses that result from transactions made with the intent to shield companies from certain risks (e.g., price risk, currency risk, interest rate risk, etc.) resulting from normal operations. This treatment of gains and losses (i.e., ordinary vs. capital in nature) allows companies to match ordinary gain/loss from operations to ordinary loss/gain resulting from a hedge, or vice versa.

Aside from the tax character benefits of a hedge classification, companies benefit from the timing of hedging transactions by avoiding Section 475 treatment of their transactions in certain circumstances. Section 475 calls for companies to mark securities held for investment to market at year end, recognizing gain/loss at that time. By avoiding this treatment, companies can match gains/losses resulting from a hedge to that of the item being hedged and fully realize the benefit of hedging when they need it most. However, take note that in certain cases the appropriate tax treatment might differ as the timing of inclusions of gains/losses for tax purposes must “clearly reflect income.”

The timing of hedge gain or loss can vary according to the item being hedged and certain tax elections; however, one overarching principle applies in all cases - the timing of such income or loss must clearly reflect income in accordance with IRC Section 446 and the Treasury regulations thereunder.

Below are a few examples of what would generally be considered the "clear reflection of income" for widely used hedges:

  • For hedges of inventory purchases, recognition of hedge gain or loss in the period that the cost of inventory is taken into account.
  • For hedges with respect to risk from items marked-to-market, mark-to-market treatment of the hedge.
  • For hedges related to debt instruments, recognition of gain or loss by reference to the terms of the debt agreement.
  • For hedges aimed at managing aggregate risk, consider the mark-and-spread method.

As illustrated above, the treatment of hedging transactions for tax presents a substantial benefit to taxpayers. However, if a hedge is not properly identified and documented, it may lose its classification and result in unfavorable tax treatment. A few possibilities are discussed below.

  • Section 1256 contracts: If not properly identified, a hedge instrument could qualify as a Section 1256 contract (e.g., regulated futures contracts, nonequity options, etc.). Under this treatment, the contract would be treated as sold for its fair market value at year-end (i.e., marked-to-market) and any resulting gain or loss would be classified as 40 percent short-term and 60 percent long-term capital gain.
  • Sections 1092 and 263(g) straddle rules: An unidentified hedge instrument may also be viewed as a straddle subject to Sections 1092 or 263(g) treatment. In this case, the taxpayer will not be able to recognize loss with respect to one position without recognizing gain from the related offsetting position and may also be required to capitalize associated interest and carrying charges.

To help avoid some of these pitfalls, you should look to your company’s risk management policy and establish proper hedge identification and documentation policies and procedures. A comprehensive risk management policy is essential for companies in general, and developing one provides an opportunity to explicitly detail tax hedging policies and classify certain types of transactions as “tax hedges” as required by the IRC and regulations thereunder. Regularly auditing compliance with the risk management policy and the identification/documentation of hedge transactions will help keep the tax department apprised of the trading activity occurring within the organization. It will also minimize tax exposure upon IRS audit.

Risk Management Policy Considerations

When drafting a risk management policy that governs your company’s hedging activity, it is important to note that identifying a hedge solely for book purposes does not satisfy the requirement to identify a hedge for tax purposes — it will not constitute compliance. Thus, it is important to include a tax-specific section detailing your company’s policies for identifying and documenting hedge transactions for tax purposes and specifically referencing the applicable tax rules. After doing this, don’t just let the risk management policy collect dust. With continuing volatility in the markets, companies are frequently engaging in new hedging strategies to reduce their risk. The hedge identification policies and procedures should be reviewed regularly to ensure that any new or modified hedging strategies are properly classified and identified as tax hedges.

Furthermore, a developed risk management strategy and policy that incorporates these tax requirements will make it easier to comply with the rules governing the identification and documentation of tax hedges, discussed below, and provide a mechanism for ensuring internal compliance. Both these things will serve you well in the event of an IRS audit.

Identification and Documentation Rules

First, a company must identify a hedging transaction for tax purposes before the end of the day on which the transaction is entered into (i.e., specific identification). Companies may consider designating certain accounts for which all transactions are hedges, segregating all hedges into one trading “book,” or simply attaching an identifying memo or flag to each trade’s electronic transaction record. The identification can be done on a transaction-by-transaction basis, but is most easily accomplished, particularly for active traders, through an aggregate hedging identification program that is clearly and properly documented. Not only does this document your identification processes for tax purposes, it serves as a notice of relevant tax requirements to the rest of your organization.

Additionally, “substantially contemporaneous identification” of the transaction (i.e. the risk) being hedged must be made within 35 days of entering into the hedging transaction. This, too, is most effectively accomplished through governing principles outlined in a risk management policy. Clearly outlining the types of hedging transactions the company will enter into and the risks that it hedges will provide the tax department with a better understanding of the relevant trading activity of the company and will ease the burden of compliance for the tax department in satisfying the tax requirements.

If a taxpayer incorrectly identifies a non-hedging transaction as a hedge, gains on the transaction will still be treated as ordinary. Of course, failure to identify a bona fide hedge could result in treatment of losses as capital in nature, thereby subjecting them to the associated limitations on use. This double standard presents a potential whipsaw situation where all gains could be treated as ordinary and all losses as capital, illustrating the importance of diligence with regard to hedge transaction identification.

Fortunately, the regulations do mitigate such harsh treatment in certain cases. For example, a taxpayer may recognize ordinary gain or loss if the failure to correctly identify a hedge was an inadvertent error and the company has consistently identified and treated similar transactions as hedges. With that being said, wise tax counsel would tell you not to rely on potential mitigation provisions. Ignorance or neglect of these rules likely will not provide you protection, especially in the current environment, where the IRS has shown increased interest in financial derivative transactions and the government is faced with record revenue shortfalls.

Alvarez & Marsal Taxand Says:

Highly volatile commodity prices and swinging currency and interest rates suggest that businesses will continue to hedge risk and more will likely join the ranks.

In order to make sure that you are fully hedging your risks, it is important to ensure that your hedge transactions are properly identified and documented for tax purposes. The best bet for effectively doing so is incorporating such policies and procedures into your company’s risk management policy and educating your trading and executive management of the importance of meeting these requirements.

In particular, we recommend the following:

  1. Make the tax department part of the risk management process.
  2. Confirm that the requisite tax identification and documentation requirements are addressed in the company’s risk management policy.
  3. Review (and revise) the risk management policy on a regular basis to ensure compliance and understand the trading activity occurring within the company.
  4. Review exceptions to the risk management policy and determine whether they are covered by the existing tax identification processes.
  5. Make updates/changes to tax identification procedures as necessary.

Although the process can be complex, ensuring timely identification and proper documentation of hedges for tax purposes can make sure that, when your company decides to hedge its risk, the tax department isn’t risking substantial tax exposures.


Mark Young
Managing Director, Houston

Jurgen Ooshthuizen, Senior Associate, contributed to this article

For More Information on This Topic, Contact:

Layne Albert
Managing Director, New York

Robert Filip
Managing Director, Seattle

David Zaiken
Managing Director
Houston / San Francisco

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