By Hubert C. Raglan, LL.B., LL.M., Detroit
Editor: Mary Van Leuven, J.D., LL.M.
Taxpayers frequently seek to manage risks that arise in the ordinary course of their trades or businesses by entering into offsetting positions, usually in the form of derivatives. A taxpayer may, for example, wish to hedge the interest rate risk on its floating-rate borrowing by entering into an interest rate swap to economically convert the interest rate from a floating rate to a fixed rate. Taxpayers may enter into hedging transactions to manage either existing risk or anticipated risk.
After entering into a hedging transaction within the meaning of Sec. 1221(a)(7), the taxpayer's concern (at least from a U.S. federal income tax perspective) usually moves to the issues of character and timing. In other words: What is the character of any gains or losses from the hedging transaction? When are those gains or losses recognized? While the U.S. federal income tax rules generally provide comprehensive instruction on tax hedging transactions, ambiguity remains regarding the timing for transactions intended to hedge anticipated, but unfulfilled, transactions. This discussion explores those ambiguities.
Background
A 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, or ordinary obligations incurred or to be incurred, by the taxpayer (Sec. 1221(b)(2)(A) and Regs. Sec. 1.1221-2(b)). 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)). It is clear, then, that transactions can qualify as hedging transactions if entered into for anticipated risks, whether singular or in the aggregate.
What the regulations say
The overarching principle of the generally mandatory hedge timing rules is that the method of accounting used by a taxpayer for a hedging transaction must clearly reflect income (the clear-reflection standard) (Regs. Sec. 1.446-4(b)). For that standard to be met, the method used must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of income, deduction, gain, or loss from the item or items being hedged (the matching requirement).
Taking gains and losses into account when they are realized may clearly reflect income for certain hedging transactions but may not for others. Therefore, these timing rules necessarily contemplate a degree of flexibility, stating that there may be more than one method of accounting that satisfies the clear-reflection standard (Regs. Sec. 1.446-4(c)). Further, Regs. Sec. 1.446-4(e) provides guidance as to methods that presumably will clearly reflect income for certain enumerated hedging transactions. Notwithstanding those presumptions, the last sentence of Regs. Sec. 1.446-4(e) emphasizes that the method, as applied to the taxpayer's hedging transaction, must clearly reflect income by meeting the matching requirement.
Relevant to the present discussion is Regs. Sec. 1.446-4(e)(8), which deals with unfulfilled anticipatory transactions. This regulation, at least on its face, seems to allow less flexibility than other methods contemplated in the hedge timing rules. Specifically, the rule provides: If a taxpayer enters into a hedging transaction to reduce risk with respect to an anticipated asset acquisition, debt issuance, or obligation, and the anticipated transaction is not consummated, then any income, deduction, gain, or loss from the hedging transaction is taken into account when realized (the realization rule). Despite the apparent simplicity of this edict, it is not always obvious that a literal application of the realization rule would clearly reflect the taxpayer's income.
Example: In year 1, Taxpayer anticipated issuing fixed-rate debt in year 2, and, in order to manage the interest rate risk inherent in the expected borrowing, entered into (and appropriately identified under Regs. Sec. 1.1221-2(f)) a forward starting interest rate swap that started in year 2 and matures in year 6. Suppose further that Taxpayer decided in year 2 to never issue the anticipated debt but left the swap outstanding until year 5, when Taxpayer legally terminated the swap.
How should Taxpayer account for this transaction from a timing perspective? Clearly, when entered into, the swap qualified as a hedging transaction; it was entered into to manage the interest rate risk on an expected borrowing and was identified as such. Under a literal reading of the realization rule of Regs. Sec. 1.446-4(e)(8), Taxpayer would not recognize any gain or loss on the swap until year 5, because that is when the gain or loss on the swap was realized (i.e., the swap was terminated in year 5). Does that, however, clearly reflect the taxpayer's income?
Recall that the clear-reflection standard includes a matching requirement — a reasonable matching of the timing of income, deduction, gain, or loss from the hedging transaction with the timing of the income, deduction, gain, or loss from the hedged item. Given that in year 2 it is clear that there is no (nor will there be any) hedged item, an argument can be made that the only way to clearly reflect Taxpayer's income would be to require recognition of the swap gain or loss in year 2 (presumably by marking the swap to market, similar to the construct envisioned by Regs. Sec. 1.446-4(e)(6)).
This position, arguably, could be reconciled with the plain language of Regs. Sec. 1.446-4(e)(8) by reading the last sentence of Regs. Sec. 1.446-4(e) — which, again, makes it clear that a taxpayer's method, as applied to the taxpayer's hedging transaction, must clearly reflect income by meeting the matching requirement — as trumping the realization rule. Alternatively, Regs. Sec. 1.446-4(e)(8) could be interpreted as requiring the matching of gain or loss on the hedge with the economic but unrealized exposure on the anticipated transaction. Thus, the matching principle is achieved and the hedge gain or loss is "realized" once the anticipatory transaction is unfulfilled. Under this interpretation of the regulations, the taxpayer in the example should recognize the swap gain or loss in year 2.
Preamble language
Cutting against this interpretation, however, is the preamble to the final hedging regulations (T.D. 8554), which states that:
[When issuing the proposed regulations, the IRS] invited comments on the appropriate accounting for anticipatory hedges where the anticipated transaction is not consummated. Most commentators suggested that gains or losses be taken into account when realized. Others suggested that any gain or loss realized on the hedging transaction be taken into account at the same time it would have been taken into account if the anticipated transaction had been consummated and the timing of the gain or loss on the hedge had been matched with the timing of the gain or loss on the hedged item. Still others suggested an arbitrary spread period.
The first suggestion was adopted. The regulations provide that, if an anticipated transaction is not consummated, any income, deduction, gain, or loss on the hedging transaction is taken into account when realized.
Clearly, Treasury and the IRS contemplated alternative timing methods of accounting for unfulfilled anticipatory hedges but settled on the realization rule. Indeed, alternative methods are contemplated in Regs. Sec. 1.446-4(e) itself. Regs. Sec. 1.446-4(e)(6), for example, refers to "realized" and "mark . . . to market" as separate methods of accounting that might clearly reflect income for certain hedging transactions; there is no indication that realization was intended to include a deemed mark-to-market event (quite the contrary).
Nevertheless, the tension between the pervasive clear-reflection standard and a literal reading of Regs. Sec. 1.446-4(e)(8) requiring gain or loss to be realized remains an area in the hedge timing rules that Treasury and the IRS would do well to address. In the meantime, it seems that taxpayers may be able to argue each alternative interpretation, depending on their facts. A related issue concerns the character of any gain or loss, but that discussion is for another article.
EditorNotes
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or [email protected].
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein 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.
