The Tax Hedging Rules Revisited

Abstract

As more and more taxpayers (businesses and individuals) are exposed to market risks (including but not limited to fluctuations in interest rates, foreign currency exchange rates and prices), management of such risks has become more and more important for a growing number of taxpayers. To mitigate the potential impact of such market risks, taxpayers enter into hedging transactions (mostly derivatives) to manage such risks. Typically, to manage the risk effectively, the hedging transactions would involve offsetting (i.e., long and short) positions with respect to the same or similar property, so that normally, when one position appreciates the other depreciates (and vice versa). In addition, hedging transactions frequently involve periodic payments (for example, periodic swap payments) either made or received by the taxpayer, depending on movement in market prices or interest rates. Furthermore, a termination payment (again, either made or received by the taxpayer) is typically made when the transaction matures or terminated earlier.

From a tax perspective, taxpayers seek effective matching of character and timing of income and deductions from the hedging transaction (both periodic and termination payments) and the hedged item; otherwise, the economic benefit of the risk management strategy will be offset (and perhaps completely negated) by the tax inefficiency created as a result of the mismatch. As I argue in this article, our government should encourage taxpayers to exercise risk management and therefore, should accommodate tax efficiency by reducing the potential for character and timing mismatches. As of now, however, the U.S. federal income tax regime pertaining to hedging transactions limits the availability of the matching principle in certain ways, the result of which is that many transactions with a purpose of risk management remain outside the scope of the tax hedging rules. The current U.S. tax hedging rules suffer from several flaws and are not accommodating enough to many taxpayers. An immediate reform of the tax hedging rules is necessary.