The Internal Revenue Service's proposed rules on the taxation of hedging transactions will have more impact on swap providers than on issuers or investors in the municipal market, according to tax lawyers.
The new rules would allow a taxpayer to treat gains or losses from a hedging transaction as ordinary income, even when the hedging uses derivatives. The proposal reverses the five-year-old IRS policy that some gains and losses on hedges, including those with derivatives, could be considered capital income.
Swap providers sometimes use derivatives and swaps to hedge their own portfolios of securities or other derivatives. The more favorable treatment should make hedging less costly, and that could help bring down the costs of using swaps, market observers say.
But since municipal issuers do not pay taxes, the more favorable treatment will be of little direct aid to other sectors of the market. And the new rules may not be of much use to taxexempt investors, either.
"We hold municipal derivatives exclusively as investments, not as inventory," said Jeffrey Sion, director of taxes for Dreyfus Corp. "Therefore, the hedging rules released yesterday should have limited impact on the tax treatment of these securities."
The rules explicitly state that "the rules of this section do not apply to hedges of capital assets."
Hedging transactions by mutual funds would fall into the capital assets category as well.
For tax-paying corporations, the proposal's treatment of hedging gains and losses is considerably more important.
A loss of ordinary income can be used to offset taxable income and lower a company's total tax bill. But capital losses can only be used of offset capital gains.
A hedge is usually designed to help a company offset losses in its day-to-day operations. If a farmer plans to bring grain to market in six months, for example, the farmer may purchase futures contracts to offset a drop in the price of grain until that time.
The amount of money the farmer receives for the grain is ordinary income. But under the old interpretation of the tax laws, the hedge could be considered capital income.
If the price of grain did not fall, the farmer would not lose ordinary income from the grain sold. But the futures contracts would create a loss. If that loss was consideredd a capital loss, it would not provide any tax benefit to the farmer.
The IRS position evolved after the Supreme Court handed down a decision in a 1988 case, Arkansas Best v. Commissioner. In that case, the Supreme Court said some hedging transactions produce ordinary, not capital income. That prompted the IRS to adopt a broad interpretation of what constitutes capital income. But in June, the U.S. Tax Court unanimously rejected the IRS interpretation of that case.
The IRS will accept comments until Dec. 20. on the new rules, which came in response to the Tax Court's June decision. A hearing on the issue is scheduled for Jan. 19, 1994.