Tax Hedge Accounting Matching Principles and Revenue Ruling 2002-71

Tax hedge accounting is one area of life insurance tax law that is not well understood. There are several reasons for this, not the least of which is limited Internal Revenue Service (IRS) guidance and the fact that in many companies the investment department and risk managers do not communicate well with the tax department. The purpose of this article is to clear up some common misconceptions about the matching requirement for tax hedge accounting as interpreted by one of the few relevant revenue rulings. In the authors’ experience, the matching principle frequently is misapplied by IRS agents on audit and by life insurance companies themselves.

What Qualifies as a Tax Hedge?

In general, realized gains and losses on financial instruments must be recognized for tax purposes, unless the instrument is part of a hedging transaction as defined in the Internal Revenue Code and regulations. Gain and loss relating to a derivative that is part of a tax hedging transaction must be accounted for as ordinary income or loss in a manner that clearly reflects income. A hedging transaction for tax purposes includes a transaction that a taxpayer enters into in the normal course of its trade or business primarily to manage the risk of (1) price changes or currency fluctuations with respect to ordinary property that is held or to be held by the taxpayer, or (2) interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer. Whether a transaction manages a taxpayer’s risk is determined based on all of the facts and circumstances surrounding the taxpayer’s business and the transaction. A taxpayer’s hedging strategies and policies, as reflected in its business records, are evidence of whether a hedging transaction manages risk. The general test for whether there is risk management is determined at the macro level. Thus, a hedging transaction designed to manage risk with respect to a particular ordinary asset or liability generally is treated as a tax hedging transaction only if it also manages overall risk of the taxpayer’s operations.

Several other observations about the tax hedge qualification rules are worth noting. First, a qualified hedging transaction includes a hedge of an anticipatory acquisition of an ordinary asset or issuance of a liability. Second, tax hedge treatment can apply even if the hedge is for less than all the risk or for less than the entire period of the risk. Third, unless a separate company election is made, the determination of whether a transaction qualifies as a tax hedge is made by treating all members of a consolidated tax return as if they were divisions of the same company. Fourth, there are same-day tax hedge identification requirements that must be satisfied. Finally, and significantly for life insurance companies, it is the IRS’s position that whether a so-called “gap hedge” qualifies as a hedge of ordinary liabilities is a question of fact and depends on whether the hedge is more closely associated with liabilities than with capital assets. This more closely associated standard is not found in the Code or regulations, but only in the preamble to Treas. Reg. § 1.1221-2(b), and has led to much controversy in recent years.

There are several advantages of tax hedge qualification: Regulated futures that are part of a tax hedging transaction are not required to be marked to market under I.R.C. § 1256; the character of gain and loss on the hedging instrument is ordinary rather than capital; and a tax hedging transaction is not subject to the straddle rules of I.R.C. § 1092, under which losses realized on the disposition of a straddle position generally are deferred to the extent of unrecognized gain in positions open at year-end. Most important for purposes of this tidbit, tax hedge qualification requires the adoption of an accounting method that clearly reflects income.