A Critical Analysis of the Taxation of Business Hedging and the Case for Comprehensive Congressional Legislation
Background Paper No. 7
Executive Summary The importance of the business hedge as a financial risk management tool has increased dramatically in recent years and continues to do so. Beginning with the worldwide inflation of commodity prices in the 1970s, the uncertainty about long-term commodity costs has made large segments of U.S. business very sensitive to pricing volatility and the need to hedge that risk. The savings and loan disaster highlighted interest-rate risks in the financial industry and the consequences of the failure to match through hedging long-term financial assets with short-term funding. Also, as U.S. international business has grown, companies have faced tremendous volatility in foreign exchange rates. The trouble with the European Exchange Rate Mechanism has recently underlined the importance of hedging foreign currency exposure.
To meet the needs to manage interest rate, foreign currency, and commodity price risks, the futures, options, and derivatives markets have expanded tremendously. According to the Futures Industry Association, the volume of futures and option contracts traded on U.S. futures exchanges has increased from 275 million contracts in 1987 to more than 364 million contracts in 1992. Similarly, the total amount of U .S. interest rate and currency swaps outstanding at year-end has increased from $0.41 trillion in 1987 to $1 .35 trillion in 1992, while on a worldwide basis, the increase has been from 0.87 trillion in 1987 to $4.7 trillion at year-end 1992.
The economic purpose of a hedge, whether in the simplest or most sophisticated form, is to balance gain and loss through a transaction in which the value of the hedge will change inversely to the value of the hedged asset or liability. To accomplish this objective the income tax treatment of both sides of the transaction must be symmetrical. Otherwise, the after-tax gain and loss from the transaction may not be in balance.
For many years, based on the U.S. Supreme Court’s 1955 decision in Corn Products Refining Co. v. Commissioner, 350 U .S. 46, a hedging transaction received symmetrical income tax treatment. The offsetting gain or loss resulting from each side of the transaction were taxed as ordinary gain or loss.
In 1988, the ordinary income tax characterization of gain or loss resulting from a hedge was placed in serious doubt by the Supreme Court’s decision in Arkansas Best Corp . v. Commissioner, 485 U.S. 212. That case created uncertainty as to whether the gain or loss from a hedge is treated as ordinary or capital for tax purposes. This distinction is important. If the gain or loss from the hedge is capital, the after-tax result of the hedging transaction may not be in balance, in which case the economic purpose of the transaction is frustrated.
Unless there is a clear rule regarding the tax treatment accorded the many different forms of business hedging, taxpayers engaged in hedges cannot determine with reasonable certainty the after-tax cost of their efforts to manage the risk of loss resulting from cost fluctuations in the worldwide market place. Such uncertainty has a direct and substantially adverse impact on the commerce of the United States.
As pointed out in the Conference Report on OBRA 1993, uncertainty in the tax treatment of business hedges follows from the Supreme Court’s decision in the Arkansas Best case and recent Tax Court litigation. While the foregoing is correct, the uncertainty regarding taxation of business hedges has its origins in Congress’s failure in 1934 to deal with business hedging when it defined the term “capital asset” in connection with distinctions drawn in the Internal Revenue Code (“Code”) between the taxation of capital gain or loss and ordinary income . To date, Congress has failed to correct this omission in a comprehensive way. Rather, to the extent that Congress has dealt with the taxation of hedging, it has done so on a piecemeal basis.
On October 18, 1993, the Treasury issued temporary and proposed Treasury Regulations in an attempt to resolve the uncertainty created by the Supreme Court’s decision in Arkansas Best. These regulations are generally regarded as a welcome step in the right direction. Based on the tax law as interpreted by the Supreme Court in Arkansas Best, the Treasury has possibly gone as far as it can without new legislation in resolving by regulation the problem concerning the ordinary income characterization of gains and losses from business hedges.
As pointed out by the Treasury, its regulations do not resolve the existing tax characterization problem for all business hedges. In addition, important questions regarding the scope of the tax relief provided by the new regulations remain unresolved. This paper concludes that the remaining unresolved issues regarding business hedges are important and should not be left to a continued lengthy and uncertain litigation process. Rather, Congress should hold hearings and, acting on the suggestion by the Secretary in his letter of October 18, 1993, to the House Ways and Means and Senate Finance Committees, consider comprehensive legislation that fully deals with all aspects of the taxation of business hedges. Such legislation should be based on economic substance, recognizing that gain or loss generated by a hedge of price, interest, or currency risks is part of an ordinary and necessary business transaction designed to manage and minimize those risks.