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Business Taxation of Hedging Transactions Part IV: Tax Timing

What are the tax accounting rules for hedges?

Whether or not a qualified tax hedge is properly identified, it must be tax accounted for under a method that clearly reflects income.[1] The timing of gains and losses on hedges must match the timing of income and loss reporting on the hedged items. Aggregate tax hedgers must provide in their Aggregate Programs robust descriptions of the tax accounting methods used for each type of hedge that is part of its Aggregate Program. In addition, the Aggregate Program’s documentation must contain enough detail to sufficiently demonstrate how the clear reflection of income requirement is met.

Which transactions must be tax accounted in a way that clearly reflects income?

As a general matter, a taxpayer must compute all of its taxable income in a way that clearly reflects income. This requirement also applies to qualified tax hedges. Under Treas. Reg. § 1.446-4, a taxpayer must clearly reflect income, regardless of whether the taxpayer properly identified the hedging transaction.[2] A taxpayer cannot avoid the requirement to clearly reflect income by simply failing to identify as a hedge.

Can more than one method of tax accounting clearly reflect income?

Yes. As long as a taxpayer’s hedge accounting method meets the matching requirement to clearly reflect income, the taxpayer has flexibility to adopt an appropriate tax accounting method[3] provided it meets Treas. Reg. § 1.446-4(c).

Do generally accepted accounting principles (GAAP) clearly reflect income for purposes of tax hedge accounting?

No. Although GAAP might clearly reflect taxable income, it might not reasonably match taxable gain and loss on the hedge with that of the hedged item. Regardless of GAAP, a taxpayer must follow the clear reflection of income requirements set out in Treas. Reg. § 1.446-4.

Must all hedges be tax accounted for on the same method?

No. A taxpayer can adopt different methods of tax accounting for different types of hedges if they clearly reflect income and meet two additional conditions.[4] First, once an accounting method is adopted, it must be consistently applied; and second, an accounting method can only be changed with IRS consent.[5]

When is a tax accounting method assumed to have been adopted for hedges?

A taxpayer has adopted a tax accounting method when it has accounted for a “material item” in the same way on two or more consecutively filed tax returns. In this situation, the item “represents consistent treatment of that item” for purposes of satisfying Treas. Reg. § 1.446-1(e)(2)(ii)(a).[6] If a hedge is correctly accounted for in the first year, however, a taxpayer is treated as having adopted an accounting method after the first year.[7] Once a method is adopted, it must be consistently applied and can only be changed with IRS consent.[8]

What happens if the IRS determines that a taxpayer’s method of tax accounting does not clearly reflect income?

If a taxpayer’s accounting method does not clearly reflect income, the IRS can recompute taxable income in a manner that clearly reflects income. Unless the taxpayer can successfully contest this treatment at audit, on appeal, or in subsequent litigation, it must use the IRS’s method to tax account for its hedging gain or loss. To change the method of tax accounting the taxpayer uses for its hedges, it must first obtain IRS consent.[9]

Can a taxpayer change from an impermissible method of tax accounting to a permissible method without first obtaining IRS consent?

No. The taxpayer must obtain consent from the IRS consent in advance of making any tax accounting changes.[10]

What tax timing rules apply to hedges of aggregate risks?

A taxpayer that hedges its risks on an aggregate basis must adopt a tax accounting method that clearly reflects income.[11] As a result, the timing of income, deduction, gain, or loss with respect to hedges must reasonably match that of the items being hedged.[12]

What are the tax timing requirements for hedges of debt instruments?

Hedges of debt instruments, whether held or to be held by the taxpayer, are tax accounted by reference to the period or periods to which the hedge relates.[13] For a debt instrument that provides interest at a fixed or qualified floating rate, constant yield principles generally clearly reflect income.[14] This means that hedging gain or loss is taken into account as if the gain or loss “adjusted the yield of the instrument over the term to which it relates.”[15] For a hedge of an anticipated fixed rate borrowing, gain (loss) is taken into account as if it increased (reduced) the issue price for the debt instrument.[16] It is treated as an adjustment to the debt instrument’s issue price, and it is taken into account over the term of the hedge. If the hedge is entered into but the anticipated debt issuance or obligation is not consummated, the taxpayer will take into account gain or loss from the hedge on a “when realized” basis.[17]

What tax accounting methods are provided in the Treasury Regulations for hedges of inventory?

Four accounting methods are provided in the Treasury Regulations for inventory hedges—the general method, mark-and-spread, and two simplified methods:

(1) General method Gain or loss on hedges of inventory purchases can be taken into account in the same time period as income or loss on the hedged item as if the gain or loss were an element of the cost of the inventory.[18] Gain or loss on hedges of inventory sales can be taken into account as if the gain or loss were an element of the sales proceeds.[19] For specifically identified hedges, this method is easy to comply with because it allows for hedging gain or loss to be taken into account as if it were an element of the cost incurred in (or sales proceeds from) that particular transaction. An aggregate hedger, on the other hand, might not be able to take hedging gains or losses into account directly as part of the cost incurred in (or sales proceeds with respect to) an inventory transaction (an aggregate hedger might not be able to match the hedge with a particular inventory purchase or sale).[20]

(2) Mark-and-spread method To match an inventory hedge to the timing of aggregate hedged items, a taxpayer may account for the hedge under the mark-and-spread method. Mark-and-spread is permissible for an aggregate inventory hedger. With mark-and-spread, a taxpayer periodically marks the hedge to market no less frequently than quarterly, taking the resulting gain or loss into account over the period in which the hedge is intended to reduce the taxpayer’s risk exposure to the hedged item.[21] Gain or loss from marking the hedge to market is then spread over the period that such gain or loss would have been taken into account as if it had been an increase or decrease to inventory cost or gross sales proceeds in that period.

(3) Simplified inventory method Inventory hedgers that do not use the last-in-first-out (LIFO) method of accounting for inventory take into account realized gains or losses on hedges of inventory purchases and sales when they would be taken into account as if the gains or losses were elements of inventory cost during the period realized.[22]

(4) Simplified mark-to-market method Marking hedges to market to take gain or loss into account immediately might clearly reflect income even if the hedged inventory is not on mark-to-market. Mark-to-market hedge accounting might only be appropriate if inventory is not accounted for under the LIFO method or the lower-of-cost-or-market method, and only if the inventory items are held for a short period of time.[23]

[1] Treas. Reg. § 1.446-4.

[2] Rev. Rul. 2003-127.

[3] Treas. Reg. § 1.446-4(c).

[4] Rev. Rul. 2003-127.

[5] Rev. Rul. 2003-127.

[6] Rev. Rul. 2003-127 citing Rev. Rul. 90-38, 1990-1 C.B. 5-7.

[7] Rev. Rul. 2003-127.

[8] Rev. Rul. 2003-127.

[9] Treas. Reg. § 1.446-1(b)(1).

[10] See Rev. Proc. 97-27, 1997-1 C.B. 680 for the procedure to obtain consent.

[11] Treas. Reg. § 1.446-4(b).

[12] Treas. Reg. § 1.446-4(e)(1).

[13] Treas. Reg. § 1.446-4(e)(4).

[14] Id.

[15] Id.

[16] Id.

[17] Treas. Reg. § 1.446-4(e)(8)(i).

[18] Treas. Reg. § 1.446-4(e)(3)(i).

[19] Id.

[20] Treas. Reg. § 1.446-4(e)(1)(i).

[21] Treas. Reg. § 1.446-4(e)(1)(ii).

[22] Treas. Reg. § 1.446-4(e)(3)(ii)(A).

[23] Treas. Reg. § 1.446-4(e)(3)(ii)(B).

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© 2024 ASKramer Law
by: Andie Kramer of ASKramer Law
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