Favorable Tax Changes for Hedgers and Commodities Derivatives Dealers Raise Questions
January 2000
Background
On December 17, 1999, President Clinton signed H.R. 1180, the Tax Relief Extension Act of 1999 (the Act), which includes some important changes to the tax treatment of hedging and commodities derivative dealer activities. We are pleased that these changes are based on legislative proposals that McDermott Will & Emery drafted on behalf of the Interstate Natural Gas Association of America back in the mid-1990s.
Summary of Changes
The Act adds three new categories of ordinary assets to Code §1221:
- Commodities Derivative Financial Instruments held by a commodities derivatives dealer (Code §1221(a)(6))
- Hedging Transactions (Code §1221(a)(7))
- Supplies (Code §1221(a)(8))
Each of these new categories is described below:
Commodities Derivatives Dealer Transactions
The adoption of a statutory exception to Code §1221 for "commodities derivative financial instruments" held by a "commodities derivatives dealer" confirms the generally accepted tax treatment of such transactions. Although this characterization is consistent with the current tax and business practices of most commodities derivatives dealers, it is still beneficial to have the confirmation provided in new Code §1221(a)(6).
In addition to clarifying the tax character of commodities derivatives held by a derivatives dealer, Code §1221(a)(6) also assures that these positions are eligible to be part of a qualified hedging transaction under new Code §1221(a)(7).
Scope of Exemption
Code §1221(a)(6) provide that any commodities derivative financial instrument held by a commodities derivatives dealer is exempt from capital asset treatment and is treated as an ordinary asset. This exemption is broadly stated: if a taxpayer is a dealer in any commodities derivatives, all commodities derivatives it holds (or enters into) are ordinary assets without regard to whether they are entered into in a dealer capacity.
The only exception to ordinary treatment is if the commodities derivative that meets two requirements. First, the taxpayer must show that the derivative has "no connection with" its dealer activities. Second, the taxpayer must identify the transaction as an exempt transaction before the close of the day acquired, originated or entered into.
Commodities Derivative Financial Instrument
For purposes of new Code §1221(a)(6), a commodities derivative financial instrument includes any contract or financial instrument with respect to commodities where its value or settlement price is calculated by (or determined by reference to) a specified index. It includes swaps, caps, collars, floors, options, forward contracts, and similar contracts or instruments.
An important exception to this definition is provided for "section 1256 contracts." This means that section 1256 contracts (that is, futures contracts and exchange-traded options) relating to commodities result in capital gain or loss unless the section 1256 contracts are converted to ordinary under another Code provision (such as the hedging provisions of Code §1221(a)(7)).
Commodities Derivatives Dealer
A commodities derivatives dealer is any taxpayer that regularly offers to enter into, assume, offset, assign or otherwise terminate positions in commodities derivatives contracts with customers in the ordinary course of its trade or business. This definition tracks the definition of a "non-inventory" securities dealer under Code §475.
Although Code §1221(a)(6) and its legislative history are silent, we assume that dealer status will continue to be determined on a taxpayer-by-taxpayer basis. Thus, the dealer activities of one member of a consolidated group of U.S. corporations would not appear to be attributed to any other member of the group for purposes of applying Code §1221(a)(6). Under this interpretation, a consolidated group desiring the tax character assurances of Code §1221(a)(6) should consider having one corporate group member that is also a commodities derivatives dealer enter into all commodities derivatives on behalf of the entire corporate group. Under Code §1221(b)(3), the Treasury is authorized to prescribe regulations as are appropriate to carry out the purposes of the commodities derivatives dealer exemption in the case of transactions involving related parties, so future regulations may provide otherwise.
Hedging Transactions Exceptions
Code §1221(a)(7) provides an exception to capital asset treatment for qualifying "hedging transactions," as defined in new Code §1221(b)(2). Codifying a "hedging" exception to Code §1221 has two important consequences. First, the statutory definition of a "hedging transaction" is slightly broader than the definition in Treas. Reg. §1.1221-2, in that risk management — rather than just risk reduction — transactions can qualify as hedges. The legislative history to Code §1221(a)(7) offers no insights into the meaning of "risk management." How much of an improvement this broadening is remains to be seen.
Second, by codifying the "hedging regulations" of Treas. Reg. §1.1221-2, Congress has provided Treasury with the legislative authority to determine the tax character of qualifying and non-qualifying hedging transactions. The Treasury may have lacked such authority prior to this change.
Hedging Transactions
A "hedging transaction," defined in Code §1221(b)(2), effectively adopts the definition in Treas. Reg. §1.1221-2(b), except for the change from a risk reduction to a risk management standard.
A "hedging transaction" is any transaction entered into by a taxpayer in the normal course of its trade or business primarily to manage risks of interest rate or price changes, or currency fluctuations with respect to ordinary property that is held, or to be held, by the taxpayer, or to manage risks of interest rate, 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. The Treasury is now authorized to issue regulations extending the definition of a "hedging transaction" to the management of other risks.
Identification Requirements
Code §1221(a)(7) imposes a hedge identification requirement that is almost identical to the one set out in Treas. Reg. §1.1221-2(e). To qualify for the statutory exemption from capital asset treatment, a hedging transaction must be clearly identified before the close of the day it was acquired, originated or entered into.
The Code provides no further guidance as to the manner in which a taxpayer must satisfy its hedge identification requirements. As a result, while there are no assurances, we assume that the Treasury will incorporate most, if not all, of the hedge identification provisions currently found in Treas. Reg. §1.1221-2(e).
Character Whipsaws for Misidentified Transactions
As expected, Code §1221(b)(2)(B) authorizes the Treasury to issue regulations establishing the character of income, gains, losses, and deductions attributable to misidentified hedging transactions. Presumably this is simply intended to provide legislative support for the character whipsaw rules of Treas. Reg. §1.1221-2(f).
Under the whipsaw rules in the regulations, gains from a misidentified transaction can be treated as ordinary; however, losses will be determined without reference to whether the transaction is a surrogate for a noncapital asset, or serves as insurance against a business risk, a hedging function, or a similar function or purpose. Limited relief is provided if misidentification is due to inadvertent error.
Related Parties
The changes made by the Act do not address hedging on behalf of related parties. Code §1221(b)(3) simply provides that the Treasury will prescribe regulations appropriate to carry out the purposes of the hedging provision in the case of transactions involving related parties. Hopefully, the Treasury will simply adopt the current related party hedging regulations set forth in Treas. Reg. §1.1221-2(d) as an extension of its authority under this provision.
Recommended Changes to Existing Identification Programs
Because the definitions of a qualifying hedging transaction under Code §§1221(a)(7) and 1221(b)(2) track — except for the risk management standard — the definitions set out in Treas. Reg. §1.1221-2, we expect that the Treasury will simply incorporate all of the remaining provisions of the hedging regulations as part of its regulatory authority under the statutory hedging provision.
Doing so is important for a number of reasons, including the ability of a corporate member of an affiliated group to continue to engage in hedging on behalf of other members of that group (as is currently permitted under Treas. Reg. §1.1221-2(d)). Another reason is to address the manner in which hedging transactions need to be identified, including (with respect to aggregate hedging transactions) following the detailed hedge identification provisions currently set out in Treas. Reg. §1.1221-2(e).
We hope that the Treasury will provide an announcement shortly indicating that, absent further regulations, taxpayers can continue to rely on all of the provisions in Treas. Reg. §1.1221-2 (other than the definition of a hedging transaction in Treas. Reg. §1.1221-2(b)). Until such guidance is issued, we urge our clients to continue to follow the existing hedge identification procedures that they have already implemented.
Given the new Code provisions, we urge our clients to modify their hedge identification language to include a reference to new Code §1221(a)(7), along with the reference to Treas. Reg. §1.1221-2. Until further guidance is provided, referring to both the Code and the regulations will ensure that taxpayers have done everything possible to adequately identify a transaction as a hedging transaction.
Supply Hedging
By making supplies an ordinary asset, the Act allows supplies to be part of a qualifying hedging transaction under new Code §1221(a)(7). This means that taxpayers no longer need to prove that they sell less than a negligible amount of the supplies to be able to enter into hedging transactions relating to supplies.
Supplies Defined
"Supplies" are defined in Code §1221(a)(8) as supplies of a type regularly used or consumed by a taxpayer in the ordinary course of its trade or business. This definition would appear to exclude property that serves as a source of the supply that is, supplies do not include stock of a supplier or machinery and equipment that produces a supply. Under new Code §1221(a)(8), supplies are now exempt from capital asset treatment. Gain or loss on the disposition of supplies acquired for use in a business activity now result in ordinary income or loss.
Effective Dates
The amendments to Code §1221 are effective for (1) commodities derivative financial instruments held, acquired or entered into on or after December 17, 1999; (2) hedging transactions entered into after December 17, 1999; and (3) supplies held or acquired or entered into, on or after December 17, 1999.
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