The importance of proper and timely hedge identification.

• Author: Callender, Jeff

Many Fortune 1000 companies, as well as many private enterprises, engage in hedging activities to manage the risk of price, currency, or interest rate fluctuations. Many companies enter into interest rate swaps to hedge the interest rate risk on debt they have issued. With the current economic turmoil in the financial services industry, companies may be holding an instrument where the counterparty has sought bankruptcy protection or changed ownership, triggering or permitting the early termination of a hedge. Further, many taxpayers issued floating-rate debt and entered into an interest rate swap to effectively convert the floating-rate debt into fixed-rate debt. With the recent drop in interest rates, taxpayers may choose to terminate these swaps to prevent further losses.

In general, failure to properly identify a hedge for tax purposes may expose a taxpayer to ordinary treatment of gains and capital treatment of losses (i.e., character whipsaw). An early termination, where termination payments could result in significant and unexpected capital loss, typically increases the magnitude of this general exposure. In an environment in which early terminations may have unexpectedly been triggered, taxpayers that have not properly identified their hedges for tax purposes should evaluate remediation strategies as soon as possible. The timing effects of hedging transactions, even with improper identification procedures, should also be considered.

Treatment of Hedging Transactions

Sec. 1221(a)(7) and Regs. Sec. 1.1221-2 present the character rules for tax hedges. These rules provide ordinary treatment for any income, deduction, gain, or loss from a qualified hedging transaction provided the hedge is timely and properly identified. If a hedge is not properly identified as a qualified tax hedge, under an anti-abuse rule (Regs. Sec. 1.1221-2(g)(2)(iii)), the IRS can treat any gains from the unidentified hedge as ordinary. The character of the loss is what it would have been under general tax principles. Therefore, to the extent the losses on an unidentified hedge are treated as capital under general tax principles, the taxpayer could have capital loss and ordinary gains, potentially resulting in a character whipsaw. Consequently, failure to identify a hedge for tax purposes may change the character of the gain or loss when the hedge is terminated early.

Proper tax identification requires the taxpayer to identify:

* The transaction as a hedge on the...