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Business Taxation of Hedging Transactions Part II: Common Situations
by: Andie Kramer of ASKramer Law  -  
Thursday, April 11, 2024

What is the “tax character” of a hedge?

A taxpayer receives ordinary gain or loss on qualified hedges that have been properly identified in accordance with Treasury Regulation § 1.1221-2. This allows a taxpayer to ensure that its income is properly characterized from a tax perspective. A taxpayer must match the tax character of gain and loss on its tax hedges with the ordinary income and loss on hedged items.[1] There are several U.S. tax law scenarios related to the use of derivatives in hedging transactions for purposes of managing and potentially reducing certain risks that bear further scrutiny—so let’s look at some common situations.

When do written options and fixed-to-floating price hedges meet tax hedge definitions?

Treasury Regulations specifically identify written (short) options and fixed-to-floating price hedges in addressing “risk reduction.” We are told that a written option may reduce risk. For example, in appropriate circumstances, a written call (put) option on assets either held or to be held by a taxpayer may be defined as a hedging transaction.

With respect to fixed-to-floating hedges, the regulations note that under the principles of Treas. Reg. § 1.1221-2(d)(1)(ii)(A), a transaction that economically converts a price from a fixed price to a floating price may reduce risk. For example, a business that carries a fixed cost for its inventory may be exposed to additional risk if the price at which the inventory can be sold varies according to market conditions. For such a taxpayer, a transaction that can convert its fixed price to a floating price may meet the Treasury’s acceptable definition of a “hedging transaction.”

Can “gap hedges” be defined as tax hedges?

Yes. Insurance companies often use “gap hedges” to help manage the “gap” between the interest rate exposures on their capital asset investments that are used to fund their ordinary obligations and insurance liabilities. To manage the resulting gap, an insurance company must be able to tie the hedge to its ordinary obligations and liabilities. This is because tax hedges are limited to transactions that manage ordinary obligations, or liabilities, and anticipated obligations and liabilities. Supporting an appropriate hedge identification depends on all of the facts and circumstances. The Preamble to the Treasury Regulations says, for example, that “whether a gap hedge qualifies as a liability hedge is a question of fact and depends on whether [the hedge] is more closely associated with the liabilities than with the assets.”[2] If an insurance company’s hedges are more closely associated with its liabilities, tax hedge treatment is available. If, on the other hand, its hedges are more closely associated with its investment assets, the transaction would not qualify as a tax hedge.

Can a business hedge a future debt issuance that it anticipates at the time of the hedge?

Yes. A taxpayer can hedge interest rate risk on a debt instrument that it anticipates issuing in the future—as long as the hedge meets the tax hedge definition, and the taxpayer properly identifies the anticipatory debt instrument.[3]

Can a “treasury lock agreement” be treated as a tax hedge?

Yes. A treasury lock agreement, also known as a forward rate agreement or FRA, is an over-the-counter (OTC) bilateral agreement to exchange interest rate payments based on an agreed-upon notional principal amount. The treasury lock defines the interest rate to be paid at maturity of the lock agreement. Typically, one party pays a fixed interest rate while the other party pays a floating rate. Borrowers often enter into treasury locks to fix future borrowing costs, while lenders often seek to lock in specific interest rates in the event that market rates fall while the treasury lock is in place.

Treasury locks can qualify as tax hedges if they meet the tax hedge requirements at Internal Revenue Code §§ 1221(a)(7) and 1221(b)(2), and Treas. Reg. § 1.1221-2(b). To qualify as a tax hedge, the treasury lock must be reasonably expected to manage the taxpayer’s risk; it must be identified before the close of the day on which it is entered into; and the hedged item (anticipated debt issuance) must be identified on a substantially contemporaneous basis with the hedge. “Reasonable expectation” is a term that can be hard to define and harder to prove, but taxpayers need to pay attention to this requirement.

Must a taxpayer manage 100 percent of its risk with respect to a hedged item?

No. A taxpayer “may hedge all or any portion of its risk for all or any part of the period during which it is exposed to the risk.”[4] For example, a manufacturer holds one hundred units of a commodity that is an ordinary asset in its hands and that is exposed to price fluctuations for a 180-day period. The manufacturer can hedge none, all, or anywhere between zero and one hundred units of that commodity.

Once a taxpayer enters into a hedge, must the taxpayer keep the hedge open for the full period during which it is exposed to the risk on the hedged item?

No. A taxpayer can enter into and terminate tax hedges as frequently as it wishes.[5] A taxpayer can engage in so-called dynamic hedging, for example, where it enters into and closes out hedges based on the extent to which it wants to manage its risk. “The fact that a taxpayer frequently enters into and terminates positions (even if done on a daily or more frequent basis) is not relevant to determining whether these transactions are hedging transactions. Thus, for example, a taxpayer hedging the risk associated with an asset or liability may frequently establish and terminate positions that hedge that risk, depending on the extent the taxpayer wishes to be hedged.”[6]

Can a taxpayer enter into a transaction that counteracts a hedging transaction?

Yes. A taxpayer can close out an open hedge, or enter into a transaction that counteracts the hedge. If a transaction is entered into primarily to offset all or part of a qualified tax hedge, the counteracting transaction qualifies as a hedging transaction.[7]

Can a taxpayer “recycle” an open hedge that was used to hedge an asset or liability so that it may hedge a different asset or liability?

Yes. A taxpayer can use an open derivative position that previously hedged the risk associated with one hedged item to subsequently hedge another hedged item.[8] Referred to as “recycling,” the taxpayer must identify the recycled hedge in a timely manner.[9]

Are hedging losses treated as reportable transactions under the tax shelter regulations?

An exception from the reportable tax shelter transaction rules is available for properly identified hedging transactions.[10] If a transaction is not properly identified and it does not qualify for another exception from the reportable loss reporting rules, the reportable loss disclosure rules may apply to corporate taxpayers with losses of at least $10 million in a single tax year, or $20 million in a combination of tax years.

[1] Treas. Reg. § 1.446-4.

[2] T.D. 8985, 2002-1 C.B. 707.

[3] PLR 9706002 (Oct. 24, 1996).

[4] Treas. Reg. § 1.1221-2(d)(7)(i).

[5] Treas. Reg. § 1.1221-2(d)(7)(ii).

[6] Id.

[7] Treas. Reg. § 1.1221-2(d)(3).

[8] Treas. Reg. § 1.1221-2(d)(4).

[9] See Identification Requirements, below.

[10] Rev. Proc. 2004-66, § 4.03(5).

Read Part I

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