CCA 1024049: Hedge-timing rules generally require matching option results to inventory sales

Plain-English summary

The Office of Chief Counsel analyzed a collar transaction involving puts and calls that was treated as hedging pricing risk for future inventory sales. Assuming the calls were qualifying hedges under IRC § 1221, the advice states that the non-section 1256 transactions should generally follow the hedge-timing rules in Treas. Reg. § 1.446-4. Gains and losses should be reasonably matched to the related inventory sales, with different treatment depending on whether the options were physically delivered or cash settled. The advice also discusses when a simpler realization method might clearly reflect income and whether modifications to the calls could trigger gain or loss under IRC § 1001. It expresses no opinion on matters not addressed, including the straddle rules and IRC § 475(e) or (f).

Ruling snapshot

• Question: How should qualifying call-option hedges for future inventory sales be accounted for?
• Outcome: Advice given
• Key authorities: IRC §§ 1221, 1256, 1001, and 475; Treas. Reg. § 1.446-4; Rev. Rul. 2003-127

Full text (IRS public release)

ID: CCA_2009060915001317 Number: 201024049
Release Date: 6/18/2010
Office: ----------------
UILC: 446.33-00

From: -------------------
Sent: Tuesday, June 09, 2009 3:00:20 PM
To: ---------------------
Cc:
Subject: Hedge Timing Proposed Adjustment

Taxpayer entered into a collar transaction (involving a series of puts and calls) which
you believe was designed to manage pricing risks associated with its inventory sales.
Though not identified as such, Taxpayer later claimed that the puts that it acquired were
hedging transactions under section 1221, but it contends that the calls were not
hedges. You are currently assisting Exam with the audit and evaluation of the call
options, including whether they were hedging transactions. You have also generally
inquired regarding Taxpayer’s tax accounting treatment of the call options. For purposes
of this email, it is assumed that facts will show the calls were qualifying section 1221
hedges but for Taxpayer’s failure to identify them as hedges.

As discussed, the Service position is that non-section 1256 transactions that otherwise
qualify as hedges under section 1221 must be accounted for under the hedge timing
rules of section 1.446-4. Rev. Rul. 2003-127. The hedge timing rules were generally
promulgated to preclude taxpayers from selectively recognizing built-in losses on
hedges, which like straddles economically offset other taxpayer positions. In
addressing loss selectivity concerns in the preamble to the Notice of Proposed
Rulemaking for the hedge timing rules, the Service stated that, “Although flexibility to
control the timing of gain or loss generally is accepted in the tax law, that flexibility is
inappropriate when the transaction is so closely related to the asset or liability being
hedged.” 1993-2 C.B. 615, 616. The hedge timing rules generally require a taxpayer to
reasonably match income, deduction, gain or loss on a hedge to the income, deduction,
gain or loss on the underlying hedged items. Section 1.446-4(b).

Here, Taxpayer hedged its future inventory sales. Taxpayer’s call options were
European-style options with specified exercise and delivery dates extending out several
years or more; thus, gain or loss on the hedge contracts could be readily matched to the
inventory sales in a taxable period for which each hedge was intended to adjust pricing
risk. If physical deliveries were made under the call contracts, then the premium
associated with such deliveries should be included in sales proceeds so as to produce a
reasonable matching. However, if the call options were cash settled, gain or loss on the
options should be spread to and matched with the income generated from inventory
sales in the period that the hedge contracts were designed to manage pricing risk, i.e.,
the taxable period in which delivery was specified in the hedge contract. See generally
section 1.446-4(e)(3). Thus, your proposal to allocate gain or loss from any cash settled

calls consistent with future delivery dates for the European-style options should produce
reasonable matching.

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Even if Taxpayer did not comply with section 1.446-4(d), it may seek to argue that its
use of realization accounting is permitted by section 1.446-4(e)(3). That provision
states that other simpler, less precise methods may be used in appropriate cases where
the clear reflection requirement of section 1.446-4(b) is satisfied. Section 1.446-
4(e)(3)(ii)(A) provides for example that taking into account realized gains and losses on
hedges of inventory sales when they would be taken into account if the gains and
losses were elements of inventory cost in the period realized may clearly reflect income
in some situations, but does not clearly reflect income for a taxpayer that uses the last-
in, first-in, first-out method of accounting for its inventory. Given Taxpayer uses the first-
in, first-out method, it is not expressly precluded from using a simpler realization method.
However, Taxpayer would still have to show that its method clearly reflects income and
produces reasonable matching. Section 1.446-4(e)(3)(ii). Had the calls in question
been of short duration and inventory turned over rapidly, we suspect that Taxpayer
could reasonably argue that realization treatment produces a reasonable match as
minimal would be gained from requiring more precise accounting and Taxpayer’s ability to
gain advantage from selectively recognizing losses would be inherently constrained.
Here, however, the fact that the calls in question generally ran for several years or
longer makes such an argument quite difficult.

Your circumstances are complicated by the fact that Taxpayer modified the call options
prior to their cash settlement. ----------------------------------------------------------------------------

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All facts and circumstances need to be considered in determining whether the other
agreements were materially different so that section 1001 gain or loss was triggered.
The fact that the replacement calls were held by different dealers would normally not be
considered significant. Further, the fact that some or all of the calls were altered so as
to include a fair market value delivery feature (together with the call rights at the
original or slightly varied prices) would not seem to be significant in an of itself given
that the property involved was fungible and actively traded. Moreover, from a practical
standpoint, there should be little or no consequence to determining whether a section
1001 event occurred for those contracts that continued to call for delivery of inventory
during the same taxable period because any gain or loss on the original and
replacement contracts should be spread to the same periods under the section 1.446-4
matching rules.

Also, please feel free to contact us for further assistance on any related matters
including any issues associated with whether the contracts were qualifying hedging
transactions. No opinion is expressed herein on the potential application of the straddle
rules, section 475(e) or (f) or any other matter not expressly addressed. Obviously
much of this advice is being provided without benefit of Taxpayer’s analysis, so we
would be happy to provide further thoughts as this matter develops and insights are
gained on Taxpayer’s views.