Hedging Transactions

1
Hedging Transactions

• AGA/INGAA
• Tax Advocacy Workshop
• November 5, 2007

Doug Chestnut Ernst Young LLP
2
AGENDA

• Overview
• Brief background of FAS 133
• Why we might have M-1 adjustments
• Overview of FAS 133 Hedging Transactions
• Taxation of Financial Products
• Characterization
• Timing
• Character
• Source
• Q A

3
Historically

• Tax and book rules for financial products were
  similar
• Similarities minimized book/tax adjustments
• New book rules on 1/1/2001 changed this
• Now, familiarity with both sets of rules is
  necessary

4
FAS 133
FAS 133 Will Cause Book/Tax Differences
TAX

• Comprehensive definition and rules for
  derivative instruments
• Fair value gain/loss recognized in period of
  change
• Gain/loss on exposure follows hedge
• Allows investment hedges

• No comprehensive definitions/rules
• Gain/loss recognized when realized or deferred
• Gain/loss on hedge follows exposure
• Prohibits investment hedges

5
FAS 133 - General Rules

• Financial accounting rules for accounting for
  derivatives and hedging activity
• Requires fair value accounting for all
  derivatives and hedges
• Adjustments reflected in earnings or OCI
• Identifies criteria for hedge accounting

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FAS 133 - General Rules

• What is a derivative?

7
FAS 133 - General Rules

• A derivative instrument is a contract with
• One or more underlying (e.g., spot commodity
  price, interest rate or foreign exchange rate)
• One or more notional amounts
• Allows for net settlement
• No initial net investment

8
FAS 133 - General Rules

• Common derivative transactions
• Interest rate swap
• Currency swap
• Purchased/written option
• Net settled commodity contract
• Futures Contract

9
FAS 133 - General Rules

• Items not covered by SFAS 133 include

• Traditional insurance
• Stock compensation
• Equity indexed contracts
• Contingent purchase price

• Regular way trades
• Normal sales/purchases
• Debt and equity
• Financial guarantees

10
FAS 133 - General Rules

• Mark-to-market derivative through earnings
• However, if hedging relationship exists,
  adjustments are made to OCI or reflected in
  earnings

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FAS 133 Book/Tax Hedging Issues

• FAS 133 Hedging Treatment
• Cash flow
• Fair value
• Net investment in foreign subsidiaries

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Cash Flow Hedge
Forecasted Natural Gas Sale
US
Forward

• Cash flow hedge is a hedge of an anticipated
  transaction
• Derivative marked-to-market quarterly
• Mk-to-Mkt gain or loss recorded in OCI
• Reversed into earnings upon realization of
  transaction

13
Fair Value Hedge

Forward
US

CFC

A/R

• A fair value hedge is a hedge of an accrued asset
  or liability
• The derivative and the hedged item are
  marked-to-market
• Mk-to-Mkt gains losses recorded in earnings

14
Net Investment Hedge
US
Currency Contract (Debt)
CFC

• A net investment hedge hedges the FX risk related
  to the investment in a foreign subsidiary
• The derivative (or debt) is marked-to-market
  quarterly
• The Mk-to-Mkt gains losses are recorded in OCI
  until liquidation of the investment

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FAS 133 Book/Tax Hedging Issues

• Book/Tax Mismatches
• Naked derivatives
• No bifurcation for tax
• No net hedging for book
• Fair value and net investment hedges
• Highly effective v. risk management
• Hedging identification

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Taxation of Financial Products

• Characterization
• Timing
• Realization
• Anti-straddle rules
• Hedges
• Mark-to-market
• Character
• Capital
• Ordinary
• Source
• U.S.
• Foreign

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Characterization What is it?

• Types of Instruments
• Forwards, futures and options
• Notional principal contracts (swaps, caps and
  floors)
• Collars
• Structured Transactions
• Short sales
• Repurchase agreements
• Hybrids

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Timing

• Realization
• No gain/loss until event
• Payment
• Sale or exchange
• Termination
• Incremental changes in value ignored

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Section 1256 - Mark-to-Market

• Section 1256 contracts
• Regulated futures
• Foreign currency contracts
• Non-equity options
• Dealer equity options
• Year-end mark-to-market
• 60/40 capital treatment (except for foreign
  currency contracts)
• Sec. 1221/Reg. Sec. 1.1221-2 hedging exception

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Straddles
Sept. 1
Dec. 31
Jan. 2
close out short at loss
short Mar. 31 futures
C
C
C
close out long at gain

long Mar. 31 futures
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Section 1092 - Taxation of Straddles

• Definition of a Straddle
• Offsetting positions with respect to actively
  traded personal property
• Loss Deferral
• Realized losses deductible only to the extent the
  loss exceeds unrecognized gain on the offsetting
  position

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Section 1092 Taxation of Straddles
short
C
long
7,000 unrecognized gain
10,000 realized loss
Recognized loss 10,000 - 7,000
3,000 Unrecognized loss 7,000
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Section 1092 - Taxation of Straddles

• Exceptions
• Sec. 1221/Reg. Sec. 1.1221-2 hedging exception
• Sec. 475 mark-to-market

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Section 475 - Mark-to-Market

• Dealers in securities
• Generally ordinary character
• Applies to broad range of instruments
• Customers can include related persons
• Elective for dealers/traders in commodities and
  traders in securities
• Ordinary character
• Only applies to actively traded commodities

25
Section 475 Mark-to-Market
short
C
long
7,000 FMV
(10,000) FMV
Realized and recognized net loss 3,000
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Sec. 1221/Reg. Sec. 1.1221-2 Hedging Transactions

• Entered in normal course of business
• Primarily to
• Manage risk of price changes or currency
  fluctuations with respect to ordinary property
  held or to be held
• or
• Manage risk of interest rate, price changes or
  currency fluctuations on borrowings or ordinary
  obligations incurred or to be incurred
• Same-day identification

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Hedging Transactions - Defined

• Applies only to hedges of ordinary property,
  ordinary liabilities or borrowings
• Not available for hedges of ordinary income
  streams from capital assets
• Noninventory supplies and commodities derivatives
  held by a dealer are now ordinary assets

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Hedging Transactions -Risk Management

• Hedge must manage overall risk (enterprise or
  macro risk)
• Hedge of single asset/liability or group of
  assets/liabilities respected if
• Manages transaction risk and reasonably
  calculated to manage overall risk
• or
• Entered as part of program to manage overall risk

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Hedging Transactions - Identification
Requirements

• Unambiguous tax identification required
• Same day identification of hedge
• Contemporaneous (35 day) identification of
  hedged risk and accounting methods
• Identification for financial accounting purposes
  not sufficient -- post-FAS 133?
• Whipsaws
• Improper identification
• Failure to identify (hedging treatment not
  elective)

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Consolidated Hedging Regulations

• US consolidated tax group
• Consolidated group treated as single entity
• Separate entity election available
• Non-consolidated entities and controlled foreign
  corporations
• Separate company risk assessment

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Hedging Transactions - Timing Rule

• Income, deduction, gain or loss on hedge must be
  reasonably matched to hedged item

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Sept. 1
Nov. 30
Jan. 15
floating buy of jet fuel
floating buy of jet fuel
jet fuel
100,000
20,000 reduction in cost of fuel
Fixed cash settled buy of jet fuel
20,000