IRS increases focus on tax hedge identification rules.

• Author: Dinkjian, John

The IRS recently signaled its increasing interest in the tax treatment of hedging transactions, particularly with regard to proper taxpayer identification. Although the rules are clear, the existence of the inadvertent error rules has arguably contributed to taxpayer apathy concerning the potentially onerous results of failing to properly identify hedge activity for tax purposes.

In e-mailed advice (Chief Counsel Advice (CCA) 201046015), the IRS reversed its position set forth in a previous CCA (201034018) with regard to the same taxpayer and agreed that the inadvertent error rules of Regs. Sec. 1.122l-2(g)(2)(ii) could apply to a Sec. 1256 contract. The reversal was based on the taxpayer's claim that the previously issued advice failed to take into consideration Sec. 1256(f) (2), which states that Sec. 1256(a)(3), the 60/40 capital gain/loss rule, could not he applied to "ordinary income property," thus allowing the taxpayer to acquire ordinary treatment pursuant to Sec. 1221(a) (7). This result is good news for taxpayers, but perhaps the more important news is a clearly stated view that ignorance of the hedging rules will not be sufficient to qualify as inadvertent error. Given this position, a brief review of the identification rules and the potential remedy for inadvertent error is in order.

The Risk

The big stick in the hedge identification rules is the potential for taxpayer whipsaw by treating all gains as ordinary and all losses as capital in the case of abusive situations where a taxpayer is intentionally failing to follow the identification rules. For example, a taxpayer with a capital loss carry forward could attempt to cause a capital gain by intentionally failing to identify a transaction as a hedge when it would otherwise clearly qualify.

Absent falling into the abusive transaction category, a hedge will be a capital asset unless it is clearly identified as a hedging transaction. Ordinarily a corporate taxpayer would prefer ordinary income treatment because there is no tax rate differential between ordinary income and short-term capital gains, and capital losses can be difficult to use. The CCA refers to this fact and notes that Treasury could have written the rules from the standpoint that presumed identification as hedges unless the taxpayer opted out. Instead, the rules require clear identification in order for hedges to be treated as such, with limited exceptions for inadvertent errors.

Making the Identification

A hedging...