Hedge identification and timing rules - traps for the unwary.

• Author: Yanchisin, Helen

The tax rules for hedging transactions have pitfalls; one of the biggest is the tax identification requirements. Ira transaction is not properly identified for tax purposes, the IRS could potentially treat loss as a capital loss and gain as ordinary. This character mismatch can create real problems on audit, when it is too late to fix.

To complicate matters, a failure to identify a hedge may affect the tinting of the gain or loss on the transaction. If the transaction is not timely identified, the Secs. 1092 and 263(g) straddle rules and the Sec. 1256 mark-to-market rules may apply. Further, failure to identify a hedge may trigger disclosure requirements under the tax shelter regulations if the transaction generates a large loss. Although an exception is provided for hedging transactions, it applies only to transactions that have been timely and properly identified for tax purposes.

Common Mistakes

Many taxpayers do not have proper tax identifications in place. A hedge must be clearly identified on the transaction date for tax purposes; see Regs. Sec. 1.1221-2(f)(l).An identification for book purposes is not sufficient to comply with the tax rules, unless the taxpayer's books and records indicate that the identification is also being made for tax purposes; see Regs. Sec. 1.1221-2(f)(4). Taxpayers sometimes incorrectly assume that an identification for financial statement purposes is sufficient for tax purposes. Even large, sophisticated corporate taxpayers can fail to identify hedges. Further, taxpayers frequently change their hedging strategies; thus, hedge identifications or policies may not cover newly implemented hedging strategies.

The IRS has begun raising hedging issues more frequently on audit and examining whether taxpayers have proper identifications. Although the hedging rules have been in existence for a number of years, the level of audit activity has significantly increased in the past several months and could increase further over the next few years, because the IRS plans to require taxpayers to disclose hedging transactions on Schedule M3, Net Income (Loss) Reconciliation for Corporations With Total Assets of $10 Million or More. The draft Schedule M-3, released by the IRS on June 23, 2005, has a separate line item (line 15) in Part II for book-tax differences associated with hedging transactions.

Timing Traps

Although many taxpayers assume that tax accounting will follow book accounting, the rules frequently differ. If a return does not reflect a hedging transaction adjustment on Schedule M-l, Reconciliation of Income (Loss) per Books With Income per Return, the taxpayer may not be using a correct accounting method. In these instances, it may benefit front a comprehensive review of its hedge...