Tax Aspects of Energy Derivatives

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Tax Aspects of Energy Derivatives
Doug Chestnut, Partner Ernst Young LLP
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Taxation of Energy Trading

• Characterization
• Timing
• Character
• Source

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Characterization

• Types of Financial Instruments
• Forwards, futures and options
• Notional principal contracts (swaps, caps and
  floors)
• Collars
• Structured Transactions
• Physical Contracts
• Power plant, utility company, trading company,
  etc.

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Characterization
Example Forward Contract
5.50/ MMBTU
In 6 Mos.
1,000,000 MMBTUs
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Timing

• Realization
• Anti-straddle rules
• Mandatory mark-to-market
• Loss deferral
• Elective mark-to-market
• Hedges

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Anti-Straddle RulesSection 1256 Mark-to-Market

• Section 1256 contracts
• Regulated futures
• Foreign currency contracts
• Non-equity options
• Dealer equity options

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Section 1256 (continued)

• Year-end mark-to-market
• 60/40 capital treatment (except for foreign
  currency contracts)
• Section 1221/Treas. Reg. Sec. 1.1221-2 hedging
  exception

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Section 1256 (continued)
Example
100,000 MMBtus
Trading Co.
Natural gas Futures contract 12 mos

12 mos
100,000 MMBtus

• Gain on futures accelerated at year end
• Loss on physicals contract not accelerated

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Anti-Straddle RulesSection 1092 Loss Referral

• Definition of a Straddle
• Offsetting positions with respect to personal
  property which is actively traded
• Loss Deferral
• Realized losses not deductible to the extent they
  exceed realized gains on the offsetting position
• Exceptions
• Section 1221/Treas. Reg. Sec. 1.1221-2 hedging
  exception
• Section 475 mark-to-market

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Section 1092 (continued)
Example
100,000 MMBtus
Trading Co.
Natural gas Futures contract 12 mos

12 mos
100,000 MMBtus

• Loss on futures contract deferred
• Gain not deferred

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Section 475 Mark-to-Market

• Dealers in securities
• Elective for dealers/traders in commodities
• Ordinary character
• Only applies to actively traded commodities

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Section 475 (contd)
Example
100,000 MMBtus
Trading Co.
Natural gas Futures contract 12 mos

12 mos
100,000 MMBtus

• Gain/loss on futures contract recognized at same
  time as loss/gain on internal contract

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Character

• Derivatives are generally capital assets
• Exceptions
• Dealers/traders
• Hedging transactions
• Physicals character depends upon who you are
• Producer/consumer likely ordinary
• Trader likely capital

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Section 1221/Treas. 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

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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

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Hedging Price Risk on an Ordinary Obligation
Contract to supply electricity
for a fixed price
Futures contract to buy electricity
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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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Macro Hedging
Contract to supply 736 mwh
Trading Mktg.
Futures contract to buy 736 mwh
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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

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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
• Specific rules for aggregate and other special
  types of hedges

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Fixed Price Hedging

• On 11/ 1, Utility enters into contract to buy
  100,000 MMBtus of natural gas for 550,000 on 1/
  31
• If market price drops, Utility overpays for gas
• Utility hedges risk by entering into futures
  contract to sell natural gas for 550,000 on 1/ 31

short futures contract
contract for 100,000 MMBtus of natural gas
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Fixed Price Hedging

• Book (FAS 133)
• Fair value hedge
• Fair value purchase contract
• Fair value futures contract
• Tax
• Futures contract 1256
• Qualifies as hedging transaction
• Manages risk
• Ordinary contract
• Contemporaneous identification
• Ordinary character
• Reasonable matching

short futures contract
contract for 100,000 MMBtus of natural gas
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Fixed Price Hedging
Dec. 31
futures contract
Book Natural Gas Contract (50,000) Futures
Contract 50,000 Tax Natural Gas
Contract 0 Futures Contract
0
550,000
500,000 fmv
100,000 MMBtus of natural gas
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Fixed Price Hedging
Jan. 31
futures contract
Book Cash (500,000) Natural Gas
500,000 Tax Natural Gas 550,000 Adjustment
to Cost (50,000)
550,000
500,000 fmv
100,000 MMBtus
550,000