Taxation of business hedges: an analysis of the new regulations.

• Author: Klein, Allen J.

Table of Contents

1. Background A. Pre-Corn Products Rulings and Cases 1. Extra-Statutory Character Rule 2. Even or Balanced Position Requirement B. The Corn Products Case C. The Arkansas Best Case D. The FNMA Case II. The Final Regulations A. Definition of "Hedging Transaction" 1. "Normal Course" of Taxpayer's Trade or Business 2. "Risk Reduction" of Price, Interest Rate, or Currency Changes 3. Ordinary Property, Ordinary Obligation, or Borrowing B. Indentification Requirements 1. General Identification Requirements 2. Special Identification Requirements a. Anticipatory Asset Hedges b. Inventory Hedges c. Hedges of Existing Debt d. Hedges of Debt to be Issued e. Hedges of Aggregate Risk C. Misidentification D. Nonidentification E. Timing of Hedging Gains and Losses 1. General Rule 2. Specific Guidance a. Aggregate Risk b. Inventory i. General Method ii. Alternative Methods c. Debt Instruments d. Items Marked to Market e. Notional Principal Contracts III. The Proposed Consolidated Regulations A. Hedges With Unrelated Third Parties B. Hedges Between Consolidated Group Members C. Special Timing and Identification Requirements D. Effective Date On July 13, 1994, the Internal Revenue Service published final regulations under sections 446(b) and 1221 of the Internal Revenue Code prescribing rules relating to the character and timing of gain or loss from hedging transactions (hereinafter referred to as "the final regulations").(1) At the same time, the IRS issued proposed regulations also under sections 446(b) and 1221 relating to the character and timing of gain or loss from certain hedging transactions entered into by members of a consolidated group (hereinafter referred to as "the proposed consolidated regulations").(2)

   The final regulations and the proposed consolidated regulations bring order to the taxation of business hedges--an area that has been described as in "legal chaos"--by providing constructive and comprehensive guidance.(3) The final regulations generally adopt the rules of the proposed and temporary regulations published by the IRS on October 18, 1993, addressing the taxation of business hedges (hereinafter referred to as "the 1993 temporary regulations"); the final regulations, however, have been changed to address concerns raised in the public comments.(4) The final regulations are supplemented by the proposed consolidated regulations, which contain a set of "sensible and flexible" rules that substantially diminish the tax distortion that would otherwise exist with regard to certain hedging transactions entered into by members of a consolidated group.(5)

1. Background

   Since 1934, the Internal Revenue Code has generally treated gain or loss from sales and exchanges of property as capital gain or loss, with explicit statutory exceptions for gain or loss from sales and exchanges of inventory and business equipment, but not for gain and loss from sales and exchanges of hedges. Notwithstanding this statutory capital asset rule, there was a series of rulings and cases dating back to the 1930s that treated hedging transactions as a form of "business insurance" and that provided for ordinary gain or loss treatment. These cases were followed by the Corn Products case(6) and its progeny which characterized gain or loss from a transaction by reference to the relationship between the transaction and the taxpayer's ordinary business activities and which provided ordinary gain or loss treatment if such relationship was sufficiently close.(7) These cases and rulings controlled the treatment of common business hedging transactions until the Supreme Court in Arkansas Best Corp. v. Commissioner(8) left unsettled the treatment of most business hedging transactions. The 1993 temporary regulations were issued in an effort to provide a clear and workable set of rules that would replace the rulings and cases that were effectively vitiated by the Supreme Court's decision in Arkansas Best.

   1. Pre-Corn Products Rulings and Cases

      The early rulings and cases established the criteria for determining whether a transaction constituted a hedging transaction. To a large extent, the final regulations adopt the approach reflected in these early cases and rulings.

      1. Extra-Statutory Character Rule

         In 1936, in General Counsel Memorandum 17322, the IRS considered the character of gains and losses realized by manufacturers from (1) future sales contracts entered into to protect against the decline in value of stores of raw materials and (2) future purchase contracts entered into to protect against an increase in the price of raw materials to be acquired to meet existing production commitments.(9) In each case, the IRS characterized the futures contracts as essentially equivalent to business insurance and concluded that they produced ordinary income or loss for tax purposes.(10)

      2. Even or Balanced Position Requirement

         Commissioner v. Farmers & Ginners Cotton Oil Co. involved a manufacturer of crude cottonseed oil that was concerned, as a consequence of its limited storage facilities, that it would be forced to sell its product in a down market.(11) Unable to enter into futures transactions in crude cottonseed oil--at the time there was no futures market in crude cottonseed oil--the taxpayer attempted to hedge the risk that the market price of the crude cottonseed oil would drop by entering into futures sales contracts for refined cottonseed oil. When the market failed to drop, the taxpayer closed out some of its futures contracts, incurring losses that it reported as ordinary losses. The IRS asserted that because the futures were for refined oil, and the taxpayer's inventory was of crude oil, the transaction did not create an even or balanced position; hence, the IRS reasoned, there was no hedge. The Board of Tax Appeals, however, held for the taxpayer on the ground that "[the] only purpose which the petitioner had in buying futures in refined oil was to attempt to avoid loss upon the crude oil which it was manufacturing." The Fifth Circuit reversed, adopting the IRS's position of requiring an even or balanced position for classification as a hedging transaction.(12)

   2. The Corn Products Case

      The extra-statutory rule under which gain or loss from a hedging transaction was treated as ordinary income or loss under the business insurance rationale was rendered irrelevant by the Corn Products case, which generally provided that if a transaction had a sufficient nexus to the taxpayer's trade or business, it would generate ordinary income or loss.(13) If a transaction in the nature of a hedging transaction had such a nexus to the taxpayer's trade or business, it would generate ordinary income or loss even if there were no even or balanced position.

      In Corn Products, the taxpayer, a manufacturer of various products derived from corn, had limited storage facilities and was concerned that increases in the price of corn would force it to raise its prices to its customers and cause it to risk losing market share to non-corn-based alternatives. To hedge against this risk, the taxpayer purchased corn futures. Realizing substantial gain from its futures transactions in 1940, the taxpayer took the position that, because it was not under a fixed commitment to sell its products at a fixed price, its futures transactions were not true hedges and its gains should be treated as capital gain. The Tax Court reasoned that the taxpayer's corn futures program "was an integral part of its manufacturing business," and held that the taxpayer's gains were taxable as ordinary income.(14) The Second Circuit affirmed, stating that although the taxpayer's futures transactions were not true hedges, they were "used for essentially the same purpose and in the same manner as true hedges."(15) Apparently troubled by the extra-statutory character rule, the Second Circuit reached its decision by first treating the hedging transactions as part of the taxpayer's inventory purchasing system and then including the futures contracts within the inventory exception to the capital asset rule. The Supreme Court affirmed, basing its decision not on the Second Circuit's inventory rationale or on the presence of the even or balanced position creating a true hedge, but on the ground that the futures transactions were entered into to protect the taxpayer's profits from "everyday operations," which profits would of course be taxed at ordinary income rates.(16)

      The Supreme Court's decision in Corn Products represented a victory for the IRS, but over time, the Corn Products doctrine provided taxpayers the opportunity to "game" the IRS: where taxpayers derived gains from the assets, they could take the position that the assets were capital assets under the statutory capital asset rule, but where they realized losses from the assets, they would argue the assets were ordinary in nature under the extra-statutory character rule. This, of course, led to the Supreme Court's decision in the Arkansas Best case that, by rejecting the extra-statutory character rule, unsettled years of law regarding the tax consequences of common business hedging transactions.

   3. The Arkansas Best Case

      In Arkansas Best,(17) the taxpayer was a bank holding company that acquired bank stock in a series of separate purchases. The taxpayer initially acquired a sizable block of shares and subsequently supplemented that block when the bank was in financial distress and in need of additional capital. Later, the taxpayer sold the bank stock, realizing a loss which it reported as an ordinary loss. The Tax Court held that, under the Corn Products doctrine, the loss on the stock purchased when the bank was in distress was an ordinary loss on the ground that the taxpayer purchased the stock to preserve its business reputation. The court continued, however, that the taxpayer's loss on the initial block of stock was capital in nature. The Eighth Circuit reversed the Tax Court's decision that the loss on the initial block...