Have you ever packed an umbrella on a sunny day, and then it actually rained? You were likely glad you planned ahead, “just in case.” Have you ever complained about the high cost of car insurance, only to be hit by a careless driver? You were likely glad you paid the premiums and avoided a much more substantial financial loss.
In their simplest forms, these are examples of hedges, a type of “insurance policy” that helps manage and mitigate losses. In the business world, hedges—through various types of derivatives such as futures, options or swaps—are widely used by many companies in multiple industries. For example, oil and gas and agricultural companies often hedge against the risk of declining commodity prices, while airline and food production companies often hedge against the risk of rising commodity prices. Companies that incur debt often use hedges to manage the risk of interest rate changes. In fact, companies can—and do—use hedges not only to avoid losses in an unfavorable business environment, but also to protect profit and manage cash flows in a favorable business environment. After all, the purpose of these hedges is to better manage operation of the company and control the variables in its operating environment, not to speculate.
In accounting, hedge effectiveness is the extent to which a hedge transaction results in offsetting changes in fair value or cash flow that the transaction was intended to provide. If a derivative is designated as a hedging transaction, and it’s deemed highly effective, the unrealized gain or loss from the hedging transaction can be recorded as other comprehensive income in the current period instead of running through the income statement, according to Accounting Standards Codification Topic 815, Derivatives and Hedging. However, tax consequences associated with these hedges differ from the financial accounting treatment.
For tax purposes, companies can designate derivatives as hedging transactions. The “effectiveness” of a hedge for tax purposes is merely a matter of whether the gain or loss generated by the hedging transactions has the same income tax treatment as the underlying hedged business transactions, and thus is used to offset the income tax effect.
What does that mean? Let’s look at one example. Assume the price of oil rises during the year after Company ABC enters into a crude oil swap contract. At the end of the year, ABC is expected to have higher proceeds from oil sales due to rising prices, which are recognized as ordinary income for income tax purposes. ABC also would generate losses from its swap contract during this same period. This is consistent with the purpose of the derivative, which is to hedge against losses from falling oil prices—like packing an umbrella on a sunny day. Ideally, these derivative losses can be netted against the increased oil revenue (ordinary gain) in the tax return, as the company intended. However, if these swaps transactions weren’t properly designated as hedging transactions for tax purposes, the losses are instead treated as capital losses. What’s the problem here? For tax purposes, capital losses only can offset capital gains, and thus the hedging losses can’t be used to offset the oil sales income in the current period. Moreover, if the capital losses exceed the company’s capital gains, the excess loss can’t be deducted and must be deferred to future years—and may even expire depending on the type of taxpayer. The gain and loss don’t match here, and thus won’t offset in this example.
To avoid this type of mismatch with respect to the hedging transaction for tax purposes, the taxpayer must properly designate its hedging transactions in accordance with Internal Revenue Code (IRC) Section 1221 (a)(7):
In general … the term ‘capital asset’ means property held by the taxpayer (whether or not connected with his trade or business), but does not include … any hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered.
In plain English, that means a company can exclude these contracts from capital assets as long as it clearly identifies the derivative transactions it enters into as hedging transactions for tax purposes. This must happen on the same day it enters into the contract, and all documentation must be maintained. Failure to do so will result in all gains from the derivatives classified as ordinary gains and all losses classified as capital losses.
For a derivative transaction to qualify for the benefit of having both gains and losses treated as ordinary gains and losses, these requirements must be met:
- The transaction must be a hedging transaction according to IRC section 1221(b)(2). Hedging transaction – In general, for purposes of this section, the term “hedging transaction” means any transaction entered into by the taxpayer in the normal course of the taxpayer’s trade or business primarily—(i) to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer, (ii) to manage 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, or (iii) to manage such other risks as the Secretary may prescribe in regulations.
- A hedging transaction must be clearly identified or designated as a hedging transaction for tax purposes on the day the transaction was entered into.
- The item or items (transaction and its risk) being hedged must be clearly identified or designated substantially contemporaneous with entering into the hedging transaction (within 35 days, according to the regulations).
- The identification or designation of the hedging transaction and the item(s) being hedged must be retained as part of the company’s books and records.
Don’t underestimate the importance of properly identifying and designating these hedge transactions for tax purposes. In this current environment, where oil and gas prices have recovered from the valley of February 2016, most hedges likely will have losses. Failure to satisfy the above requirements can result in capital losses from your hedges that only can be used if you have offsetting capital gains.
Have you designated yet?
If you have any questions on this topic or are interested in finding out more, contact your trusted BKD advisor—we’re here to help.