WASHINGTON -- The Internal Revenue Service issued final hedging rules yesterday that dictate how and when hedging transactions should be taxed.

The rules, which generally take effect in October, typically would not affect municipal issuers or investors. Issuers are not subject to taxation because they are governmental entities. Investors would not be taxed because they would receive tax-exempt interest.

But the rules would affect swap, cap, and other hedge providers.

The final rules are similar to the rules the IRS proposed last October because they would require a hedge provider or other taxpayer to treat the gains or losses from a hedging transaction as ordinary income or losses, rather than as capital gains or losses.

This is a reversal in IRS policy and is significant for taxpayers because it means they can no longer take capital losses from hedging transactions to offset capital gains.

The final rules are also similar to the proposed rules since they require the reporting of the gains and losses from the hedge to be matched with the reporting of the gains and losses of the instrument or item being hedged.

There are some differences in the final rules, such as a much broader definition of a hedging transaction, Treasury and IRS officials said.

A Treasury official said the rules' definition of a hedge can be used by municipal market participants to help determine when hedges are "qualified hedges" for arbitrage purposes. Qualified hedges are hedges that meet 19 requirements, including a requirement that they be hedges.

Under the arbitrage rules, issuers with bonds with qualified hedges are allowed to compute the yield on bonds by treating the payments on the hedge as payments on the bonds.

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