Association Suggests Changes to Proposed Regs on Hedging Transactions

[1] This letter sets forth the comments of the International Swaps and Derivatives Association, Inc. ("ISDA") on proposed regulations concerning hedging transactions (the "Proposed Regulations"), as published by the Internal Revenue Service (the "Service") in the Federal Register on January 17, 2001. ISDA has separately filed a request to testify at the May 16, 2001 public hearing on the Proposed Regulations, together with an outline of its proposed oral testimony.

[2] ISDA is an international organization and its more than 500 members include most of the world's leading dealers in swaps and other off-exchange derivatives transactions (collectively "OTC derivatives"). The membership of ISDA also includes many of the businesses, financial institutions, governmental entities and other end users that (like ISDA's dealer-members) rely on OTC derivatives to manage the financial, commodity and other risks inherent in their core economic activities with a degree of efficiency and effectiveness that would not otherwise be possible. A list of ISDA's members is attached to this letter. Additional information with respect to ISDA and its programs is available on the ISDA website at www.isda.org.

I.

Overview of ISDA's Comments

[3] In 1999, Congress amended section 1221 of the Internal Revenue Code of 1986 (the "Code") to provide statutory authority for ordinary gain or loss treatment for "hedging transactions". In doing so, Congress did not simply provide specific statutory authority for the then outstanding hedging regulations (the "1994 Regulations"). Congress also explicitly "broadened" the standard for qualification as a hedging transaction from risk REDUCTION to risk MANAGEMENT. H. Rep. 106-478, 158 (1999) (the "Conference Report"). Since the hedging rules of section 1221 were intended by Congress as the exclusive means for taxpayers to attain ordinary treatment for hedging transactions, ISDA welcomes the decision of the Service to propose regulations to implement the broadened standard of risk management. As the Senate Committee on Finance explained, the concept of risk management ". . . better describes modern business hedging practices that should be accorded ordinary character treatment." S. Rep. 106- 201, 24 (1999) (the "Senate Report").

[4] In ISDA's view, the Proposed Regulations do not properly implement Congressional intent with respect to the risk management standard. While the Proposed Regulations do use the words "risk management", the principal operative provisions of the Proposed Regulations (section 1.1221-2(c)) appear to be substantively unchanged in many respects from the 1994 Regulations. As a result, the Proposed Regulations seem in fact to be based largely on the more restrictive concept of risk REDUCTION. For example, the 1994 Regulations stated: "[a] transaction that is not entered into to reduce a taxpayer's risk is not a hedging transaction." Section 1.1221-2(c)(vii) of the 1994 Regulations. The comparable provision of the Proposed Regulations states: "[a] transaction that is not entered into to reduce a taxpayer's risk does not manage risk." Section 1.1221-2(c)(vii) of the Proposed Regulations.

[5] Continued de facto adherence by the Service to risk REDUCTION as the operative principle will call into question the "hedging transaction" status of many of the transactions that businesses and others now undertake daily in the ordinary course of business as an integral part of their risk managment programs. The risk of adverse tax consequences created by character mismatches resulting from continued application of the risk reduction standard will also discourage continued financial innovation in risk management. This is contrary to the intent of Congress and key financial regulators, and may increase business volatility and systemic risk.

[6] In ISDA's view, Congressional intent in replacing risk REDUCTION with risk MANAGEMENT as the standard for hedging transaction status can be implemented properly only if the Proposed Regulations are revised to incorporate the principle that risk MANAGEMENT generally includes any transaction under taken in the ordinary course of business that alters a taxpayer's exposure to one or more of the risks that are inherent in its core economic activities. This definition of risk management will not expose the Service to so-called "whipsaw" situations and, as Congress wished, will not extend hedging transaction status to "speculative transactions". Moreover, because a broad definition of "hedging transaction" will reduce the potential for character mismatches, the proposed definition of risk management is consistent with sound principles of tax policy.

[7] Part II of this letter demonstrates that the enactment of the risk management standard in 1999 was intended by Congress as a substantive expansion of the definition of "hedging transaction". Part III sets forth ISDA's views with respect to the proper definition of risk management. Part IV contains ISDA's comments on specific types of hedging transactions, including many of the transactions identified in the Proposed Regulations. Part IV also sets forth ISDA's views with respect to the scope of the regulatory authority granted by Congress in section 1221(b)(2)(A)(iii). In ISDA's view, this regulatory authority can and should be promptly and broadly exercised, particularly in light of the intent of Congress that section 1221 is to be the exclusive means for attaining "hedging transaction" status.

II.

Congress Recognized that "Risk Management" is a Substantively Different Standard than "Risk Reduction"

[8] The 1994 Regulations were issued by the Service at the urging of Congress to resolve the uncertainties created by Arkansas Best Corp. v. Comm'r, 485 U.S. 212 (1988), and subsequent court decisions, with respect to the proper tax treatment of hedging transactions. Under the 1994 Regulations, a hedging transaction was defined as one entered into by a taxpayer in the ordinary course of business primarily to REDUCE certain enumerated risks (price changes, currency fluctuations, and interest rate changes) with respect to ordinary income property, borrowings or ordinary obligations.

[9] When the 1994 Regulations were issued, section 1221 did not contain a specific provision providing for ordinary gain or loss treatment for hedging transactions, but section 1256(e) contained an exception from the mark-to-market rules of section 1256(a) for "hedging transactions" (and section 1092(e) excluded "hedging transactions", as defined in section 1256(e), from the straddle rules). At that time, section 1256(e)(2) limited the definition of "hedging transaction" to one entered into to "reduce risk". As a result, the Service concluded that it was required to model the 1994 Regulations on the risk REDUCTION standard.

[10] In 1999, Congress amended section 1221 to provide specific statutory authority for ordinary gain or loss treatment for hedging transactions. ¹ The legislative history makes it abundantly clear that Congress had two goals in so amending section 1221. First, as noted by the Service in the Preamble to the Proposed Regulations, Congress believed that the approach taken in the 1994 Regulations generally should be codified as an appropriate interpretation of the THEN present law. Thus, Congress believed that "the approach taken in the Treasury regulations under PRIOR law with respect to the character of hedging transactions generally should be codified as an appropriate interpretation of PRIOR law." Staff of Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 106th Congress (the "Blue Book") 46 (Joint Comm. Print 2001) (Emphasis added); See Senate Report at 24. Second, and of fundamental importance, Congress concluded that the broader standard of risk MANAGEMENT was the more appropriate standard.

[11] The adoption of the risk management standard was recommended by the Department of the Treasury and was recognized as a proposal of a substantive nature. In its analysis of the Treasury proposal, the staff of the Joint Committee on Taxation stated:

The principal change that the proposal would make in the

[12] There is no question but that Congress itself recognized that risk MANAGEMENT is a broader standard than risk REDUCTION. In part, the Report of the Senate Committee on Finance states:

. . . The [1994] Treasury regulations, however, model the

[13] In a footnote to the portion of its Report just quoted, the Committee noted that the treatment by the 1994 Regulations of certain transactions as hedging transactions ". . . is appropriate AND . . . it is also appropriate to modersize the DEFINITION of a hedging transaction by providing risk management as the standard." Senate Report at 24, n.12. (Emphasis added.)

[14] The Finance Committee clearly believed that substitution of risk MANAGEMENT for risk REDUCTION was more than a simple a change in labels. The Committee's Report states that . . . the 'risk reduction' standard of the regulations is BROADENED to 'risk management'. . . ." Senate Report at 25. (Emphasis added.)

[15] In its report, the House-Senate Conference Committee was equally clear in its understanding that, in adopting the risk management standard, the Senate had made a substantive change in the standard for "hedging transaction" status:

. . . In defining a hedging transaction, [the legislation]

[16] In these circumstances, it is readily apparent that Congress did more than codify the 1994 Regulations and adopt a mere "change of labels" having no substantive effect. To the contrary, the reference to a "broadened" standard indicates that Congress was well aware that the risk MANAGEMENT standard would encompass transactions that were not covered by the risk REDUCTION standard. Moreover, in framing the specific language of its amendment to section 1221, Congress acted broadly by directing that "any transaction" entered into in the ordinary course of business primarily "to manage risks" enumerated in the statute or regulations be treated as a hedging transaction. Thus, the Proposed Regulations must be substantially modified to give meaningful effect to the substantive change in law enacted by Congress in 1999.

III.

Defining "Risk Management"

[17] Both Congress and key financial regulators have repeatedly emphasized the importance of risk management to individual businesses and to the stability of the nation's economy as a whole. For example, in its Report on the Commodity Futures Modernization Act of 2000, the Senate Agriculture Committee stated:

Derivative instruments, both exchange-traded and those

[18] In its report on the same legislation, the House Banking Committee emphasized the importance of OTC derivatives and risk management to banks:

OTC derivatives have become essential to banks' risk

[19] In addition to these compelling reasons of economic policy to encourage hedging transactions by businesses, ISDA notes that the Service has historically viewed hedging as a form of business insurance and, when so viewed, the Service should likewise not discourage business hedging. See Kramer, Financial Products 35-45 (Aspen Publishers (2000)). Continued de facto reliance by the Service on the risk reduction standard to define what will and what will not be classified as a hedging transaction for tax purposes is at odds with these broader policy considerations as well as with the specific statutory changes to section 1221 enacted by Congress in 1999.

[20] One of the ways in which risk management is a "broader" standard than risk reduction is that risk management is a dynamic and evolving concept with new tools emerging almost daily. For example, OTC derivatives as a class were just emerging in the mid-1980s as the Arkansas Best case was making its way through the federal court system. Today, OTC derivatives comprise the core of many risk management programs and the volume of OTC derivatives transactions in many instances exceeds the volume of comparable exchange-traded derivatives. OTC derivatives have not simply grown in volume. They have also become more diverse. For example, credit derivatives were virtually non-existent only a few years ago, but they are today key components of the risk management programs of many financial institutions. Similarly, OTC derivatives products designed to enable businesses to manage risks related to energy, weather and other non- financial contingencies have recently emerged. Continued financial innovation in risk management techniques will enable end users to manage a broader range of the risks inherent in their core economic activities more effectively.

[21] It is important therefore that the final hedging transaction regulations define the controlling standard of risk management in a manner that recognizes these dynamics and is sufficiently flexible to encompass new risk management products as they become available in the future. For example, it is common knowledge that credit card issuers experience greater levels of default in periods of economic downturn and there is increasing evidence that movements in consumer sentiment may be indicators of future economic downturns or upswings. If an OTC derivative based on changes in consumer sentiment can be developed, it could be an important risk management tool for credit card issuers and its use should qualify as a hedging transaction for tax purposes.

[22] Consistent with the foregoing, ISDA recommends that the Proposed Regulations be amended to include in section 1.1221-2(b), or elsewhere as appropriate, a definition of the "risk management" standard substantially as follows:

"The term 'risk management' includes any transaction

[24] ISDA's suggested definition of "risk management" is consistent with Congress' view that that standard is "broader" than risk reduction. As discussed in the next section of this letter, there are numerous instances where application of the risk management standard would, and should as a matter of policy, produce results with respect to specific transactions that differ from the results contemplated by the Proposed Regulations.

IV.

The Risk Management Standard in Practice

"Investments" as Hedging Transactions.

[25] Section 1.1221-2(c)(3) of the Proposed Regulations provides that the acquisition of an asset (such as an investment) generally will not qualify as a hedging transaction, because the primary purpose of such acquisition generally is not to manage risk. Similarly, borrowings generally will not qualify as hedging transactions. To illustrate this limitation, the Proposed Regulations indicate that a taxpayer acquiring debt instruments to reduce interest rate risk from a borrowing cannot treat that acquisition as a hedging transaction and thus cannot treat the gain or loss from the sale of those debt instruments as ordinary. The Proposed Regulations justify this result with the statement that the transaction ". . . is not entered into to reduce the taxpayer's risk".

[26] This provision might be interpreted to imply that the acquisition of an asset, or a borrowing, will rarely, if ever qualify as a hedging transaction even if the asset or borrowing reduces the taxpayer's risk with respect to other assets or liabilities. A simple example illustrates that such an approach would be too broad. Transactions that might be termed "investments" frequently are hedges. If a corporation issues debt with a maturity of 10 years at a time when the interest rate spread between government bonds and corporate bonds is low, but when long term risk-free interest rates are expected to decline in the future, the corporation could hedge its interest rate risk through the purchase of a government bond with a 10-year maturity and finance that purchase in the repurchase ("repo") market. The government bond would be sold and the repo "unwound" when the corporation decided to lock in the risk-free interest rate component of its debt issuance. In these circumstances, the purchase of the government bond is in fact a hedging transaction, and it should be so treated for tax purposes, since the acquisition of the bond altered the taxpayer's exposure to a risk inherent in its business.

[27] Failure of the Proposed Regulations to treat the gain or loss on the disposition of the government bond as ordinary gain or loss would produce a character mismatch: gain or loss from the sale of the government bond is treated as capital while the corresponding income or loss from the borrowing is treated as ordinary. A rule that creates such as mismatch, which in any particular case could work to the taxpayer's benefit or detriment, is indefensible as a tax policy matter. It produces exactly the kind of mismatch that the hedging rules are designed to prevent.

[28] As a further example, if a taxpayer is a party to one or more structured notes under which future payments are determined by reference to price movements of certain securities, the taxpayer may subsequently purchase those securities in order to manage its risk under the structured notes. In these circumstances, the purchase and sale of the securities is in fact a hedging transaction and it should be so treated for tax purposes since the acquisition of the stock altered the taxpayer's exposure to a risk inherent in its business. Otherwise, assuming the notes are treated as debt for tax purposes, a character mismatch will occur.

[29] In both of the preceding examples, were ISDA's recommendations to be accepted, the taxpayer would have to satisfy the "same day" identification and record-keeping requirements of section 1.1221-1(e) of the Proposed Regulations. This would of course eliminate the exposure to the Service to a "whipsaw" situation and it will also deter those who purchase securities or other assets with a profit motivation from classifying those purchases as hedging transactions. If an ordinary course of business transaction is entered into primarily to alter a risk to which the business subject, and if the same-day identification requirements are satisfied, there is little reason for the Service to classify such transactions as "investments" and thus as ineligible for hedging transaction status.

[30] The only possible policy reason ISDA can discern for the Service's unwillingness to treat transactions such as those described above as hedging transactions under section 1221 is that such treatment may result in deferral of gain or loss under the hedge timing rules of Section 1.446-4 of the Regulations. Specifically, the Service may be concerned that taxpayers might inappropriately take advantage of hedging transaction treatment for an investment to defer recognition of gain that is economically equivalent to interest income (or perhaps also to manipulate timing of a loss that is economically equivalent to an interest expense). Without commenting on whether such abuse is possible, ISDA believes it is clear that the remedy for any such abuse lies in changes to Section 1.446-4 of the Regulations, and not in denying ordinary treatment to certain otherwise-qualifying hedging transactions merely because they take the form of "investments" or "borrowings". If the Service believes that such abuse would be possible if investments and borrowings were treated as hedging transactions, the Service should consider revising Section 1.446-4 of the Regulations to exclude from its scope gains and losses derived from investments and borrowings to the extent those gains and losses are economically equivalent to interest.

[31] Implementation of ISDA's recommendations would not, of course, enable taxpayers to treat a broad range of speculative investments as hedging transactions. In many situations, taxpayers acquire assets with the expectation of gain and, as noted above, there is little incentive for them identify those assets as hedges and thus ensure ordinary income treatment of the expected gains. Indeed, taxpayers have a strong incentive NOT to identify in such cases. Thus, the identification rules themselves provide protection against the inappropriate classification of asset acquisitions as hedges. Moreover, ISDA's proposed definition of risk management is not so broad as to encompass all asset acquisitions. For example, if a taxpayer owns stock, it cannot convert that stock into a hedge by subsequently issuing a note with payments determined in part by reference to movements in the price of the stock.

Borrowings to Manage Risk

[32] Under section 1.1221-2(c)(3) of the Proposed Regulations, borrowings are described as "generally . . . not made primarily to manage risk" and thus cannot qualify as hedging transactions. ISDA believes that hedge transaction status should not be denied in the case of all borrowings. For example, if a gold producer issues a gold-linked note, the transaction is no less a hedge merely because it is combined with raising funds needed by the business. (In this particular case, of course, the gain or loss would be ordinary in character if the instrument is treated as debt for tax purposes.)

Gap Hedges

[33] The Preamble to the Proposed Regulations creates uncertainty concerning the status of so-called "gap hedges" used by insurance companies, and others, to hedge the gap between their liabilities and the assets acquired to fund those liabilities. Specifically, the Preamble suggests that the Service will deny hedge treatment unless the taxpayer can demonstrate that the transaction is more closely associated with the liabilities of the taxpayer than with the assets and thus can qualify as a "liability hedge". ISDA believes that this distinction is not meaningful and cannot be applied in practice. As a general principle, ISDA believes that gap hedges should be treated as hedging transactions for tax purposes where they in fact alter a risk to which the taxpayer is subject, are entered into in the ordinary course of business and the same day identification requirement is satisfied.

Hedges of Other Risks

[34] In 1999, Congress granted hedge transaction treatment to transactions entered into to manage risks of interest rate or price changes or currency fluctuations and "to manage such other risks as the Secretary may prescribe in regulations." Section 1221(b)(2)(A)(iii). Section 1.1221-2(c)(8) of the Proposed Regulations provides that "[e]xcept as otherwise determined in a regulation, revenue ruling, or revenue procedure, a hedging transaction does not include a transaction entered into to manage risks other than interest rate or price changes, or currency fluctuations, but the Preamble to the Proposed Regulations indicates that the Service wishes to receive comments on the types of additional risks that should be covered.

[35] As discussed more fully below, ISDA believes that the final regulations should extend hedge transaction treatment to transactions undertaken to manage a broad range of risks other than interest rate or price changes or currency fluctuations. Although section 1221(b)(2)(A)(i) and (ii) are cast in terms of management of specific types of risk, the Service clearly has regulatory authority under section 1221(b)(2)(A)(iii) to address other types of risks, including weather derivatives, energy supply derivatives and hedges of profitability. In ISDA's view, hedges that alter risks inherent in the taxpayer's core economic activities generally should be treated as hedges for tax purposes.

[36] Weather Derivatives. The Preamble to the Proposed Regulations indicates that a weather derivative used by an energy producer to hedge against the risk of decreases in the volume of sales resulting from variations in weather patterns will not qualify as a hedge transaction until the Service exercises its regulatory authority. The Service should do so now.

[37] Weather derivatives are increasingly used by businesses of all kinds, including energy producers, utilities, municipalities, ski resorts and outdoor restaurants. Weather derivatives may also be used in agribusiness as an alternative to crop insurance. In each case, the taxpayer is exposed to a specific risk ("bad" weather) that, by definition, will have a demonstrable and adverse effect on its business. In these cases, weather derivatives alter the taxpayers' exposure to risks that are inherent in their core economic activities.

[38] For example, a gas supplier (X) experiences decreased demand for gas during warmer than normal winters in its service territory. Specifically, X determines that it will lose approximately $10,000 in earnings for each heating degree day ("HDD") below normal. X enters into an off-exchange derivatives contract intended to provide earnings protection during a warmer than normal winter. Under the contract, X will receive payments of $10,000 (up to a maximum of $2 million) for each HDD during the contract period (November 1-March 31) below a specified strike level of HDDs. (The strike level of HDDs is determined by reference to a 10-year weather average.)

[39] As a second example, a ski resort (Y) experiences decreased lift ticket sales in winters having a below normal snowfall. Specifically, Y determines that for each day that snow depth falls below 10 centimeters, it will lose $10,000 in earnings. Y enters into a weather swap calling for payments from one party to the other depending on the number of skiing days over a specified period that are greater than or less than a specified strike level of skiing days. A "skiing day" is defined in the swap agreement as a day on which snow depth exceeds 10 centimeters. If the swap has a strike level of 15 skiing days over the two month period December 1-January 31, then for every skiing day below 15 days, Y receives a payment of $10,000 from its counterparty (up to a maximum of $100,000). For every skiing day above 15 days, Y makes a payment of $10,000 to its counterparty (but that cost would be offset by a rise in sales due to increased skiing potential).

[40] Weather derivatives such as those in the two preceding examples should qualify as hedging transactions as they manage risks specifically weather -- that are inherent in the taxpayer's business. There is no discemable policy rationale for delay in extending hedge transaction treatment to weather derivatives, particularly in light of the exclusivity provisions of the Proposed Regulations.

[41] ENERGY DERIVATIVES. Under the Proposed Regulations, if a business that is an intensive user of energy (e.g., an aluminum producer) enters into a transaction to manage the risk of increased energy prices, that transaction apparently can qualify as a hedging transaction. If, however, the transaction is intended to manage the risk of an energy supply interruption, it apparently will not qualify as a hedge transaction unless and until the Service exercises its regulatory authority under section 1221(b)(2)(A)(iii). Energy supply derivatives have particular importance in circumstances where business users may be subject to utility supply curtailments so higher priority residential and health care services can be maintained. Moreover, it is possible that both price risks and curtailment risks may be addressed in a single transaction.

[42] As in the case of weather derivatives, energy supply derivatives enable a taxpayer to manage a specific risk (loss of energy supply) that will have a demonstrable and adverse effect on its business. The energy supply derivative, like the weather derivative, alters the taxpayer's exposure to risks that are inherent in its core economic activities and there is no discernable policy rationale for delay in extending hedge transaction treatment to energy supply derivatives, particularly in light of the exclusivity provisions of the Proposed Regulations.

[43] HEDGES OF PROFITABILITY, ETC. The Preamble to the Proposed Regulations states that "not all business hedges are intended to be covered" by the Proposed Regulations and, more specifically, that the Service does not propose to extend hedge transaction treatment to cases where ". . . a taxpayer hedges a dividend stream, the overall profitability of a business unit, or other business risks that do not relate directly to interest rate or price changes or currency fluctuations with respect to ordinary property, ordinary obligations, or borrowings".

[44] ISDA believes that such a broad limitation is not appropriate and that many transactions falling within the category of transactions cited in the Preamble, as well as portfolio hedges, should be treated as hedging transactions in the final regulations in accordance with the authority of the Service under section 1221(b)(2)(A)(iii). As a matter of policy, there is no discernable reason why any business risk for which a hedging transaction exists should be excluded from the TAX definition of a "hedging transaction". Denying hedge treatment may in many cases create a character mismatch. Moreover, as discussed above, the same-day identification requirements will discourage speculators from seeking hedge treatment in cases where profit, rather than risk management, is the motivation for their transactions.

[45] Moreover, the requirement inherent in ISDA's proposed risk management standard that the transaction alter one or more of the risks inherent in the taxpayer's core economic activities will, when coupled with the ordinary course of business requirement and the same day identification rule, make it difficult for a taxpayer to circumvent the rules. For example, if a taxpayer purchases a derivative based on a basket of foreign currencies whose movements historically have affected the profits of its international operations (and thus hedges the overall profitability of those operations), there is no reason to deny hedge transaction status to the derivative merely because it is not a hedge of specific ordinary property or obligations. (In this case, of course, the gain or loss would be ordinary in character under section 988.)

Sincerely,

² In 1999, Congress also amended section 1256(e)(2) to substitute "risk management" for "risk reduction" as the statutory standard for the straddle rules of section 1092 and the mark-to- market rules of section 1256(a).

[46] The Internal Swaps and Derivatives Association, Inc. ("ISDA-) hereby requests an opportunity to testify at the May 16, 2001 hearings on proposed regulations concerning hedging transactions, as published in the Federal Register for January 18, 2001. Mr. Mark S. Perwien, Chair of ISDA's North American Tax Committee and Tax Director of Salomon Smith Barney, will present ISDA's oral testimony. An outline of Mr. Perwien's testimony is enclosed.

[47] ISDA has separately filed written comments on these proposed regulations.

Sincerely,