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STATUTORY EXCEPTION TO DEFINITION OF CAPITAL ASSET SUGGESTED AS REPOSE TO ARKANSAS BEST.

NOV. 21, 1989

STATUTORY EXCEPTION TO DEFINITION OF CAPITAL ASSET SUGGESTED AS REPOSE TO ARKANSAS BEST.

DATED NOV. 21, 1989
DOCUMENT ATTRIBUTES
  • Authors
    Gordon, Richard A.
  • Institutional Authors
    Arthur Andersen & Co.
    Cleary, Gottlieb, Steen & Hamilton
  • Code Sections
  • Index Terms
    capital gain
    mark-to-market
    straddle
    ordinary income
    hedging
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 89-9355
  • Tax Analysts Electronic Citation
    89 TNT 251-23

 

=============== SUMMARY ===============

 

ABSTRACT: The solution to the difficulties created by Arkansas Best is a new statutory exception to the definition of "capital asset" under section 1221, says Cleary, Gottlieb, Steen & Hamilton.

SUMMARY: Richard A. Gordon of Arthur Andersen & Co. has submitted a memorandum prepared by Cleary, Gottlieb, Steen & Hamilton, which contains a statutory solution to a problem that the firm sees with Arkansas Best v. Commissioner, 108 S. Ct. 971 (1988). (See Tax Notes, December 4, 1989, p. 1169, for a summary of an earlier memorandum by Cleary, Gottlieb, Steen & Hamilton.) The firm now says that the solution to the difficulties created by Arkansas Best is a new statutory exception to the definition of "capital asset" under section 1221.

This exception, says the firm, should explicitly state Congress' intent to require ordinary income and loss treatment for business hedges. An amendment to section 1221, says the firm, would have the advantage of clarifying that the ordinary income treatment would apply for section 1256(e) hedges that are otherwise not subject to the rules of the mark-to-market or straddle rules of sections 1256 and 1092. The proposed solution, says the firm, would be applied retroactively to all qualifying hedging transactions under section 1256(e) which were entered into after the original effective date of that section.

 

=============== FULL TEXT ===============

 

November 21, 1989

 

 

Ms. Kathleen Ferrell

 

Attorney Advisor

 

Department of the Treasury

 

Office of the Tax Legislative Counsel

 

1500 Pennsylvania Avenue, N.W.

 

Room 4021

 

Washington, D.C. 20220

 

 

Dear Kathleen:

Enclosed are three copies of a memorandum dated November 17, 1989 which supplements the November 7, 1989 memorandum concerning the Arkansas Best case. This memorandum describes in more detail our proposed legislative solution that would resolve the problems for business hedges while preserving the impact of the Arkansas Best case as applied to its specific facts, the sale of stock of a subsidiary.

I will be calling within the next few days to set up a meeting with you and the appropriate persons from the Treasury to discuss our proposals.

Please call me if you have any questions.

Sincerely,

 

 

Richard A. Gordon

 

Arthur Andersen & Co.

 

Washington, D.C.

 

 

Enclosures

 

 

November 17, 1989

 

 

SUPPLEMENTAL MEMORANDUM REGARDING A

 

PROPOSED TECHNICAL CORRECTION TO THE

 

HEDGING RULES OF THE INTERNAL REVENUE CODE

 

 

I. INTRODUCTION.

In Arkansas Best v. Commissioner, 108 S. Ct. 971 (1988), the Supreme Court held that loss recognized on the sale of stock in a subsidiary was capital lose, regardless of the "business purposes" for which the stock was acquired. In reaching that result, the Court adopted an extraordinarily narrow interpretation of its earlier decision in Corn Products Co. v. Commissioner, 350 U.S. 46 (1955), which interpretation had the collateral, and apparently unintended, effect of overturning thirty years of common understanding by taxpayers and the Internal Revenue Service as to the ordinary income and loss treatment of business hedging transactions.

In a memorandum dated November 7, 1989, we discussed at length the adverse and inappropriate effects of Arkansas Best on common business hedging strategies. That earlier memorandum argued that Arkansas Best produces results that directly contravene Congressional intent, by effectively eviscerating the current hedging rules of section 1256(e) for a wide range of hedging transactions (for example, liability hedges) not involving inventory. 1 As discussed in greater detail in our memorandum of November 7th, Congress, in enacting section 1256(e) in 1981, ASSUMED that the Corn Products doctrine as then understood would enable hedges to satisfy the exclusively ordinary income/loss test of section 1256(e)(2)(B). Now that Arkansas Best has repudiated that common understanding of the scope of Corn Products, section 1256(e) arguably does not apply -- and has NEVER applied -- to a wide range of business hedging transactions expressly understood by Congress to give rise to ordinary income/loss treatment (as well as to exclusion from the section 1256 mark-to-market and section 1092 straddle rules).

This memorandum supplements our November 7th memorandum by describing in detail a proposed legislative solution that would restore business hedging to its former state of ordinary income/loss treatment, while preserving capital gain or loss treatment for transactions involving sales of subsidiary stock or other investment assets. Thus, the results of the Arkansas Best case itself, as applied to its facts, would NOT be affected by our proposal.

II. PROPOSED LEGISLATIVE SOLUTION.

The solution to the difficulties created by the Arkansas Best case is a new statutory exception to the definition of "capital asset" in section 1221 that makes EXPLICIT Congress' intent to require ordinary income and loss treatment for business hedges. As described in more detail in Part III, an approach that achieves mandatory ordinary income or loss treatment for business hedges through an addition to section 1221 (rather than, for example, through a "technical correction" to section 1256) would have the advantage of clarifying that this ordinary treatment would apply for business hedges that are described in section 1256(e) but that otherwise are not subject to the mark-to-market or straddle rules of sections 1256 and 1092 (in particular, certain liability hedges). In order to restore the common understanding that served as the basis for the enactment of the hedging transaction rules of section 1256(e), the proposed solution would be applied retroactively to all qualifying hedging transactions described in section 1256(e) that were entered into after the original effective date of section 1256(e).

Our proposed solution would require three changes to the existing statutory language:

1. Section 1221 would be amended to add a new subsection 1221(6). As amended, section 1221 would read as follows:

"For purposes of this subtitle, the term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include --

(6)(A) property that is, or at any time was, part of a hedging transaction in the hands of the taxpayer, within the meaning of section 1256(e)(2)(A) and (B).

(B) In the case of property disposed of at a loss, subparagraph (A) of this paragraph (6) shall apply only if that property properly was identified by the taxpayer as a hedging transaction under section 1256(e)(2)(C).

(C) SPECIAL RULE FOR CERTAIN POST-1981 ACT HEDGES. Property acquired after December 31, 1981 and before [Effective Date of This Legislation] shall be treated as described in this paragraph (6) if it is described in subparagraph (A) of this paragraph (6), without regard to whether it also meets the identification requirements of subparagraph (B) of this paragraph (6).

2. Section 1256(e)(2)(B) would be amended so that the test for a hedging transaction looks only to the ordinary nature of the EXPOSURE BEING HEDGED. As amended, section 1256(e)(2) would read as follows:

"For purposes of this subtitle, the term "hedging transaction" means any transaction if --

(A) such transaction is entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily --

(i) to reduce risk of price change or currency fluctuations with respect to property which is held or to be held by the taxpayer, or

(ii) to reduce risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred, by the taxpayer,

(B) gain or loss on the property, borrowings or obligations referred to in subsection (A) is treated entirely as ordinary income or loss, and

(C) before the close of the day on which such transaction is entered into (or such earlier time as the Secretary may prescribe by regulations), the taxpayer clearly identifies such transaction as being a hedging transaction."

3. Section 1256(f)(1) would be amended so that its anti-abuse rule explicitly would apply to all hedging transactions for which the taxpayer can claim ordinary loss treatment rather than to hedges for which a section 1256(e) identification has been made for purposes of the mark-to-market or straddle rules. As amended, section 1256(f)(1) would read as follows:

"DENIAL OF CAPITAL GAINS TREATMENT FOR PROPERTY IDENTIFIED AS PART OF A HEDGING TRANSACTION -- For purposes of this title, gain from any property shall in no event be considered as gain from the sale or exchange of a capital asset if such property was at any time identified under subsection (e)(2)(C) by the taxpayer as being part of a hedging transaction."

III. DISCUSSION.

A. RESTRICTION TO BUSINESS HEDGES.

The intent of the proposed solution is to restore ordinary income and loss treatment for bona fide business hedging transactions, without reopening the debate as to the character of gains and losses from investment or other non-hedging transactions. Under new section 1221(6), the substantive ordinary income or loss rule for hedges would be limited to those transactions described in section 1256(e)(2)(A) and (B). The new section therefore would apply only to transactions that function as HEDGES -- that is, transactions entered into in the normal course of the taxpayer's trade or business to reduce the risk of price, interest rate or currency fluctuations with respect to a taxpayer's business assets or liabilities. Sales of stock of a subsidiary or other transactions that do not serve a hedging function would be entirely outside the scope of the new section 1221(6). Moreover, purported "hedges" of investment positions would be excluded from ordinary income or loss treatment by virtue of section 1256(e)(2)(B), because section 1256(e)(2)(B), as amended by the proposal, would require that the asset or liability being hedged itself give rise exclusively to ordinary income or loss.

By tying the definition of qualifying ordinary income or loss hedges to an objective test under section 1256(e) (i.e., a risk- reducing relationship with an underlying ordinary income or loss asset), new section 1221(6) would avoid the "slippery slope" issues raised by the subjective "business purpose" language of the Corn Products decision. The proposed amendment thus would be consistent with the holding of Arkansas Best as applied to its facts, and at the same time would restore consistent ordinary income and loss treatment for business hedges within the "everyday operation of a business" parameters originally envisioned by the Supreme Court in its Corn Products opinion.

B. PREVENTING SELECTIVE ORDINARY INCOME/LOSS REPORTING FOR BUSINESS HEDGES.

1. BACKGROUND. Prior to Arkansas Best, the character rules for business hedges were based on a commonly understood extra-statutory exception to capital asset status, rather than any identifiable Code section. That extra-statutory exception is most commonly associated, of course, with the pre-Arkansas Best understanding of the holding of Corn Products. Accordingly, prior to Arkansas Best the only prerequisite to ordinary treatment for a purported hedging transaction was a demonstration of its nexus to the taxpayer's ordinary business.

The introduction of statutory straddle and mark-to-market requirements as part of the Economic Recovery Tax Act of 1981 (the "1981 Act") for the first time provided an incentive for taxpayers to identify "hedging transactions" at their inception. Section 1256(e), as added by the 1981 Act, applies to transactions entered into "in the normal course of the taxpayer's trade or business" for the "primary purpose" of hedging price, currency or interest rate fluctuations on assets or liabilities held or incurred by the taxpayer, if both the item being hedged and the hedge itself give rise entirely to ordinary income or loss, AND IF the transaction is identified as a hedging transaction on the day it is entered into. If a transaction satisfies all the requirements of section 1256(e), it is excluded from the application of the mark-to-market rules of section 1256 (an exclusion that is relevant only if one or more of the positions comprising the transaction is a section 1256 contract), and also is excluded from the application of the straddle rules of section 1092 (an exclusion that is relevant only if the transaction otherwise would be a straddle -- which, particularly in the case of U.S. dollar liability hedges, is not always the case).

The 1981 Tax also introduced section 1256(f) to prevent taxpayers from using section 1256(e) as a means effectively to elect into ordinary loss treatment for speculative straddles (as contrasted to true hedges). Section 1256(f) achieves this result by requiring that gain from the disposition of any position in personal property that has been identified as a section 1256(e) hedging transaction must always be treated as ordinary income, while loss can be recharacterized as capital loss if the transaction in fact is not within the scope of section 1256(e).

By its terms, section 1256(e) does not produce ordinary income/loss results for hedges. To the contrary, Congress, in enacting section 1256(b), ASSUMED that Corn Products would characterize hedge gains and losses as ordinary in order to satisfy section 1256(e)'s prerequisite that all components of a hedging transaction give rise exclusively to ordinary income or loss. Prior to Arkansas Best, however, the Corn Products doctrine also was assumed to ensure ordinary income or loss treatment for business hedging transactions that, while of the type DESCRIBED in section 1256(e), did not need to be IDENTIFIED as "hedging transactions" under section 1256(e)(2)(C).

For example, the definition of a hedging transaction in section 1256(e)(2) includes a position designed to reduce the risk of interest rate fluctuations in respect of a taxpayer's own borrowings. A taxpayer that hedged its own U.S. dollar-denominated borrowing with an over-the-counter Treasury forward contract, rather than a section 1256 contract, would not have been subject either to the mark-to- market rules of section 1256 (because neither its borrowing nor the Treasury forward were section 1256 contracts), or to the straddle rules of section 1092 (because the taxpayer's borrowing was not a "position in personal property" as to the taxpayer). 2 Accordingly, such a taxpayer would have had no reason to identify that transaction under section 1256(e), even though its liability hedge wss described in section 1256(e). Because such unidentified hedging transactions were not subject to the anti-abuse rules of section 1256(f), the Internal Revenue Service remained at risk that taxpayers might selectively apply the Corn Products doctrine to claim capital gains, but ordinary losses, in a fashion that might be difficult to discover upon audit.

2. PROPOSED SOLUTION. Prospectively, new section 1221(6) effectively would require identification under amended section 1256(e) for ALL post-amendment hedging transactions (rather than just those transactions subject to mark-to-market or straddle concerns). Same-day identification would prevent taxpayers from selectively claiming capital or ordinary treatment for business hedges based on the subsequent market performance of those hedges. Since hedges, by their nature, are equally likely to produce losses or gains, the risk that such losses otherwise would be treated as capital under section 1221(6)(B) would induce taxpayers to identify all those transactions intended to be business hedges. A similar "carrot and stick" method of encouraging taxpayers to identify hedging transactions recently was adopted, for example, in regulation section 1.861-9T(b)(6), relating to the interest allocation effects for foreign tax credit purposes of certain liability hedges.

Even if tax rates change to make capital gains more attractive, taxpayers that might attempt to claim capital gain treatment for appreciated hedge positions previously identified as section 1221(6)/1256(e) hedging transactions would be stymied by the expanded anti-abuse rule under section 1256(f)(1). With an expanded section 1256(f)(1) that covers ALL identified hedges, taxpayers could not argue (as they might under current law) that the anti-abuse provisions do not apply, for example, to the sale of hedging positions that technically do not involve "personal property" as defined by section 1092.

Once all purported hedging transactions are identified under sections 1221(6) and 1256(e), the task of the Internal Revenue Service in distinguishing bona fide business hedges from improperly labeled speculative or investment activities would become much more straightforward. Moreover, because ordinary treatment of hedging GAINS (as opposed to losses) would not require prior identification under new section 1221(6), the Internal Revenue Service would have independent authority to designate any position that satisfies the criteria of section 1256(e)(2)(A) and (B) as an ordinary income "hedge," regardless of a taxpayer's failure to so identify that position. This authority would preclude any residual "gaming" opportunities that might result, for example, from the ability to obtain either ordinary or capital gain or loss for certain hedging positions by altering the method of disposition.

C. SPECIAL RETROACTIVITY CONSIDERATIONS.

For the reasons articulated in our November 7th memorandum, we believe that, ideally, any solution to the problems for business hedges raised by Arkansas Best should apply to the date of the original Corn Products decision in 1955. Nonetheless, we recognize that proposals for retroactive tax legislation are extremely sensitive, given the risks of frustrating taxpayers' legitimate expectations as to the tax treatment applicable to prior transactions. The "foreseeability" concerns that often inhibit retroactive tax legislation would not arise, however, with respect to a rule that would retroactively reinstate ordinary income and loss treatment for business hedges entered into after December 31, 1981 -- the effective date of section 1256(e). Indeed, the fairness concerns that often militate against giving retroactive effect to tax legislation in this case would provide strong arguments FOR retroactivity: if Arkansas Best is corrected on a prospective basis only, the end result will be a retroactive change in the previously settled law concerning business hedges that upsets reasonable expectations and undermines confidence in the U.S. tax system.

When it enacted section 1256(e) as part of the 1981 Act, Congress itself believed that the then-settled interpretation of Corn Products provided ordinary treatment for business hedges. That legislation specifically invited taxpayers to identify business hedges under section 1256(e) -- a procedure that, absent a retroactive solution to Arkansas Best, will place those taxpayers at risk of realizing ordinary income, but capital loss with respect to many such identified transactions under section 1256(f)(1).

The Congressional assumption that ordinary income or loss treatment necessarily would be available under Corn Products for the types of hedging transactions described in section 1256(e) also created rational expectations by taxpayers as to the mandatory ordinary treatment of such hedges when employed in situations DESCRIBED in section 1256(e), but in respect of which identification under section 1256(e) was not required (such as the U.S. dollar liability hedge described above). If Corn Products, for example, ensured ordinary treatment of a futures contract used to hedge a taxpayer's liability so as to allow the futures contract to qualify for exemption from the mark-to-market rules under section 1256(e), why should the result be different when the taxpayer instead hedged its liability with a non-section 1256 contract that did not require an explicit identification under section 1256(e)?

Accordingly, the proposed solution described in Part II offers an approach that would restore settled expectations to both such classes of prior hedging transactions: positions entered into or acquired after the effective date of the 1981 Act (but before the effective date of the proposed solution) that otherwise are DESCRIBED as "hedging transactions" under section 1256(e)(2)(A) and (B) will be treated as within the substantive ordinary income and loss rule of new section 1221(6), regardless of whether those positions also were IDENTIFIED as "hedging transactions" under section 1256(e)(2)(C) at the time they were entered into or acquired. Such a rule would allow special ordinary income and loss treatment under new section 1221(6), for example, for past liability hedges that did not involve section 1256 contracts, but NOT for prior sales of subsidiary stock or hedges of investment assets.

Like the rest of new section 1221(6), this "transition" rule would not be elective. Thus, the Internal Revenue Service, as well as taxpayers, could designate prior hedging transactions as ordinary income or loss assets under new section 1221(6)(C). This flexible approach to retroactivity would protect the Government from a flood of refund claims by taxpayers that, having reported prior hedging gains as ordinary income, on the theory that Corn Products permitted no other result, now might conclude that such gains should have qualified for favorable capital gains tax rates under the Arkansas Best analysis.

Cleary, Gottlieb, Steen & Hamilton

 

FOOTNOTES

 

 

1 In this memorandum, section references are to the Internal Revenue Code of 1986 and the Treasury regulations promulgated thereunder.

2 See, e.g., In re State Tax on Foreign-Held Bonds, 82 U.S. (15 Wall) 300, 320 (1872).

DOCUMENT ATTRIBUTES
  • Authors
    Gordon, Richard A.
  • Institutional Authors
    Arthur Andersen & Co.
    Cleary, Gottlieb, Steen & Hamilton
  • Code Sections
  • Index Terms
    capital gain
    mark-to-market
    straddle
    ordinary income
    hedging
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 89-9355
  • Tax Analysts Electronic Citation
    89 TNT 251-23
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