New hedging regulations designed to minimize "character" mismatch for tax purposes.

• Author: Haber, Craig

The IRS recently issued final Regs. Sec. 1.1221-2 on the tax treatment of hedging transactions commonly encountered in business situations. The regulations are intended to standardize the tax treatment of investments used to hedge ordinary income property or the taxpayer's borrowings. In general, the regulations prescribe that ordinary income or loss would result from the hedging transactions and also establish timing rules for recognition of any gain/loss.

Background

The regulations are an outgrowth of the controversies that have arisen since 1988 as the result of the Supreme Court's decision in Arkansas Best Corp., 485 US 212 (1988), which created the possibility that losses from hedging activities could result in capital loss treatment, while ordinary income was recognized on the property being hedged. This created a potential whipsaw for taxpayers, since corporate taxpayers can only deduct capital losses against capital gains (noncorporate taxpayers are entitled to deduct capital losses in excess of capital gains up to $3,000 each year). The whipsaw possibility was obliterated to a large extent by the Tax Court decision in Federal National Mortgage Association (FNMA), 100 TC 541 (1993), in which losses sustained on certain interestrate futures, short sales of Treasury securities and put options on Treasury futures were allowed as ordinary, since they were an "integral part" of a system by which FNMA purchased and held mortgages. Note: The mortgages were found by the Tax Court to be ordinary income property in the hands of FNMA.

Types of hedging transactions

For purposes of the regulations, a hedging transaction is a transaction entered into to reduce the risk of price changes or currency fluctuations with respect to ordinary income property, or to reduce the risk of interest rate or price changes or currency fluctuations with respect to borrowings or ordinary obligations.

The regulations are of significant importance to a wide range of taxpayers using bedging techniques for business purposes, e.g., mortgage bankers hedging interest-rate risks; dealers in physical commodities (grain, oil, coffee, metals, etc.) hedging their commodity price risks; and any number of industries that hedge their price risks for raw materials (including supply hedges). Also, since liability hedges are covered by the regulations, any taxpayer managing the interest-rate risks of its existing or anticipated borrowings (including conversion of fixed to floating...