WELCOME GUIDANCE ON HEDGES

By James Gregory, Esq., and Viva Hammer, Esq., Price Waterhouse LLP

In PLR 9706002, dated October 24, 1996, the IRS considered whether certain "Treasury Lock" agreements entered into by taxpayer were hedging transactions within the meaning of section 1.1221-2 of the regulations and, if so, what constituted the proper accounting treatment of such transactions.

The specific issue addressed in PLR 9706002 was whether the timing rules found in regulations section 1.446-4(a) apply to a hedging transaction that the taxpayer failed to identify under regulations section 1.1221-2(e). The IRS pointed out that section 1.1221-2(b) defining "hedging transaction" does not require the identification described under section 1.1221-2(e) in order for a transaction to be considered a "hedging transaction." The ruling explains that the identification is relevant only to the character of the transaction and whether the taxpayer is entitled to receive ordinary income or loss treatment. Thus, the failure to properly identify a transaction as a hedge will not cause a hedging transaction to be something other than a hedging transaction. Accordingly, the IRS concluded that regulations section 1.446-4 timing rules apply to a transaction within the definition of "hedging transaction" under section 1.1221-2(b) of the regulations even though the taxpayer had failed to identify the hedge for purposes of determining the character of the items of income, deduction, loss, or gain from such transaction.

Observation: It should be noted that the taxpayer did not request a ruling concerning the character of gain or loss from the transaction and the IRS did not address this issue. Instead, the taxpayer represented that it would report income from the transaction as ordinary. Accordingly, there was no need for the IRS to consider whether the failure of the taxpayer to identify the hedging transaction was "inadvertent" within the meaning of section 1.1221-2(f) of the regulations. Whether failure to identify is inadvertent may be relevant in other situations, however, such as, for example, in the case of a taxpayer who realizes a loss on a hedging transaction that it wishes
to characterize as ordinary rather than capital.

Background

The taxpayer, a limited partnership owning real estate, leases, and mortgages, intended to issue fixed rate debt in order to finance acquisitions and business operations. To protect against increases in interest rates and to lock in its obligations on the fixed rate debt instrument, the taxpayer entered into a forward rate agreement with a bank and two interest rate swap agreements with another company (together the Treasury Lock Agreements or the agreements). The net effect of the agreements was that the taxpayer was able to lock in its projected interest obligations on its proposed debt issuance. Taxpayer represented that the sole purpose of this arrangement was to reduce the taxpayer's interest rate risk regarding the intended debt offering.

Although the taxpayer intended to treat the transaction described above as a "hedging transaction" under section 1.1221-2(b) of the regulations and to account for the transaction under section 1.446-4(e)(4) of the regulations, the taxpayer neglected to identify the agreements as hedging transactions for tax purposes in its books and records on the date of the agreements and failed to specifically identify the proposed issuance of debt as the hedged item within 35 days of the date of the agreements as provided for by section 1.1221-2(e) of the regulations.

Law and Analysis

IRC section 1221 defines the term "capital asset" and regulations section 1.1221-2(a)(1) provides that property that is part of a "hedging transaction" is not a capital asset. Moreover, regulations section 1.1221-2(b) defines the term "hedging transaction" to include a transaction entered into in the normal course of a taxpayer's business "primarily to reduce risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer."

Regulations section 1.1221-2(e)(1) requires that hedging transactions be identified on the date they are entered into and section 1.1221-2(e)(2) requires that the item, items, or aggregate risk being hedged must be identified "substantially contemporaneously" with the entering into of the hedging transaction, but in no event more than 35 days after entering into such transaction. Section 1.1221-2(f)(1) provides specific rules regarding how to properly identify hedging transactions.

An identification is binding with respect to the character of any gains realized with respect to the transaction (i.e., gains would be ordinary). An identification is not necessarily binding, however, with respect to any losses resulting from such transaction. Under regulations section 1.1221-2(f)(2), subject to certain exceptions noted below, if there is no identification, the transaction will not be treated as a hedging transaction. A taxpayer may still receive ordinary gain or loss treatment despite its failure to identify such transaction as a "hedging transaction," however, if the following requirements are satisfied: (i) the transaction is otherwise within the definition of a "hedging transaction" under regulations section 1.1221-2(b); (ii) the failure to identify such transaction as a "hedging transaction" was due to "inadvertent error"; and (iii) all of the taxpayer's hedging transactions in all open years are treated on either original or amended tax returns, if necessary, as provided under section 1.1221-2(a)(1).

Regulations section 1.446-4(a) governs the timing of income and other items from hedging transactions as defined in section 1.1221-2(b) whether or not the character is determined thereunder. Section 1.446-4(b) provides that the accounting method applied to hedging transactions must clearly reflect income and therefore must reasonably match the timing of items from the hedge with items from the instrument being hedged. The hedge is properly accounted for by reference to the terms of the debt instrument being hedged.

Observation: Thus, for example, items of income, deduction, gain, or loss on a hedging transaction relating to a debt instrument are properly taken into account in the same periods in which they would be taken into account if the yield on the debt instrument was adjusted accordingly using constant yield principles. That is, gain or loss from the hedging transaction is taken into account in the same periods it would be taken into account if the issue price of the hedged debt instrument had been adjusted.

Ruling

The IRS pointed out that regulations section 1.1221-2(b) defining hedging transaction does not require the identification described under section 1.1221-2(e) in order for a transaction to fall within the definition. The ruling instead explains that the identification is relevant only to the character of the transaction and whether the taxpayer is entitled to receive ordinary income or loss treatment. Thus, the failure to properly identify a transaction as a hedge will not cause a hedging transaction to be something other than a hedging transaction. Accordingly, the IRS concluded that the regulations section 1.446-4 timing rules apply to a transaction otherwise within the definition of hedging transaction under regulations section 1.1221-2(b) even though the taxpayer had failed to identify the hedge for purposes of determining the character of the items of income, deduction, loss, or gain from such transaction. *