CCA 1034018: Failed hedge identifications do not support ordinary treatment of commodity contracts

Plain-English summary

Chief Counsel Advice considered a commodity business's request to recharacterize gains and losses from price-to-be-fixed supply contracts and section 1256 contracts as ordinary rather than capital. The advice concluded that the taxpayer had not made timely and valid tax hedge identifications under sections 1221(a)(7) and 1256(e)(2). It stated that the section 1256 rules do not incorporate the section 1221 inadvertent-error exception for failed identifications. The advice also concluded that the taxpayer had not shown that its failures to identify the contracts were inadvertent errors, because the taxpayer deliberately chose not to investigate or apply the rules after becoming aware that ordinary treatment might be available. It noted that section 1256 contracts generally remain subject to mark-to-market accounting unless timely identified as hedging transactions.

Ruling snapshot

• Question: Could the taxpayer treat gains and losses from its commodity contracts as ordinary through hedge identifications or the inadvertent-error rule?
• Outcome: Advice given
• Key authorities: IRC §§ 1221(a)(1), 1221(a)(7), 1256(a)(1), 1256(e)(2), and 446; Treas. Reg. §§ 1.1221-2 and 1.1256(e)-1

Full text (IRS public release)

ID: CCA_2010042010340317 Number: 201034018
Release Date: 8/27/2010
Office: ----------------
UILC: 1221.12-02, 1256.01-00, 1256.05-
02, 446.33-00

From: -------------------
Sent: Tuesday, April 20, 2010 10:34:09 AM
To: --------------------
Cc: ------------------------
Subject: Failed Section 1221(a)(7) and Section 1256(e)(2) Hedge Identifications

Taxpayer is in the commodity X business, buying inventory, processing it and then
selling such to customers. Taxpayer filed a refund claim for several back years in which
it claims to have erroneously treated as capital the gains and losses originally reported
from certain asserted hedging transactions.

The gains and losses arose from “price-to-be-fixed” (PTBF) supply contracts for
commodity X and certain section 1256 contracts, exchange-traded options and futures
with respect to commodity X. The PTBF supply contracts were agreements in which
Taxpayer separately took delivery of commodity X that it recorded as inventory on its
books at the current spot price. The final price, however, was not locked-in till later.
Rather than report the difference between the spot price and the final locked-in price as
an adjustment of its inventory accounting, Taxpayer accounted for any difference as
capital gain or loss. Gains and losses on the PTBF supply contracts and the exchange-
traded option and future contracts were recognized on a realization basis.

Faced with expiring capital losses, Taxpayer filed amended returns for back years
seeking to recharacterize the gains and losses from the above transactions as ordinary.
Taxpayer’s position is that the gains and losses on the PTFB contracts are ordinary
because those amounts arose from inventory purchases covered under section
1221(a)(1). Taxpayer further contends that it made a valid section 1221(a)(7) hedge
identification of all of the above contracts and that it also validly identified the exchange-
traded contracts as hedges under section 1256(e)(2). Finally, Taxpayer alternatively
contends that its failure to timely identify the transactions as hedges under section
1221(a)(7) and section 1256(e)(2) is excusable under the inadvertent error rule of
section 1.1221-2(g)(2)(ii).

Two years ago, during a separate audit partly covering the refund claim period, the
Service issued an information document request that questioned the nature of
Taxpayer’s commodity X hedging. The auditor had highlighted that Taxpayer board of
director minutes seemed to conflict with an initial audit interview in which Taxpayer
claimed that the company did not hedge its commodity X inventory. The information
document request also stated that the company had indicated that it had entered into
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speculative transactions. In response to the detailed tax hedging related inquiries,
Taxpayer generally provided the blanket response -- “No hedge accounting.”

For now, we are only commenting on Taxpayer’s hedging transaction contentions as we
have just begun to coordinate the section 1221(a)(1) and associated accounting issues
with ----------. Consistent with your preliminary views, we find Taxpayer’s claim for
ordinary treatment based on the hedging rules to be without merit. Taxpayer’s various
hedge-related contentions are discussed below; additional facts are highlighted where
relevant.

Claimed Hedge Identifications Under Sections 1221(a)(7) and 1256(e)(2)

Consistent with its ongoing treatment of gains and losses on the PTFB and exchange-
traded contracts as capital, Taxpayer apparently concedes that there is nothing in its
books and records specifically identifying the transactions as hedges for Federal income
tax purposes. Rather, Taxpayer argues that certain non-tax specific public records are
section 1221(a)(7) and section 1256(e)(2) identifications. In particular, Taxpayer argues
that it clearly identified the transactions and claims that all of its PTBF and exchange-
traded futures contracts were economically managing commodity X pricing risk.

Section 1221(a)(7) provides ordinary asset treatment for any hedging transaction which
is clearly identified as such before the close of the day on which it is acquired,
originated, or entered into (or such other time as the Secretary may by regulations
prescribe). See also section 1.1221-2(f)(1) (containing hedge identification language
that mirrors section 1221(a)(7)). Section 1.1221-2(f)(4)(i) requires that the identification
be retained as part of the taxpayer’s books and records. Further, the presence of the
identification must be unambiguous. Section 1.1221-2(f)(4)(ii). The regulation further
states that the identification of a hedging transaction for financial accounting or
regulatory purposes is not unambiguous unless the books and records indicate the
identification is also being made for tax purposes.

Nothing in the facts reviewed suggests Taxpayer satisfied the same day identification
requirement or that hedge identifications were made for tax or any other purpose. The
public statement that Taxpayer relies on does not mention tax or an identification of any
type. It simply reports that Taxpayer will often hold a mix of exchange-traded contracts
(options and futures) to hedge commodity X prices. By contrast, an annual report
issued during the same time period states that Taxpayer acquired various derivatives as
investments or as economic hedges but that the derivatives were not designated as
accounting hedges. Taken together, the public documents establish that some but not
all of Taxpayer’s exchange-traded derivatives were entered into to economically hedge
commodity X inventory, the PTFB contracts were not considered hedges, and Taxpayer
did not even designate the exchange-traded derivatives as hedges for financial
accounting purposes. Notably, there is nothing in the information reviewed that
suggests that tax hedging identifications were intended or made – consistent with the
treatment of the transactions in Taxpayer’s originally filed returns and consistent with
the fact that only some were regarded as economic hedges. Moreover, Taxpayer’s
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contention that it made valid identifications is further undermined by its claim, discussed
below, that it was unaware of the tax hedge identification requirements and that it did
not develop an identification practice.

Given that it is undisputed that the exchange-traded commodity X contracts were
section 1256 contracts and capital assets in Taxpayer’s hands, they were subject to
section 1256 character treatment (60% long-term capital gain or loss and 40% short-
term capital gain or loss) unless they were properly identified under section 1256(e)(2)
as hedging transactions. Section 1256(e)(2) provides that the hedging identification
must be clearly made before the close of the day on which the transaction was entered
into (or such earlier time as the Secretary may prescribe by regulations). Under section
1.1256(e)-1(b), the hedging identification requirements of section 1.1221-2(f)(1) must be
satisfied to be a valid section 1256(e)(2) identification. Given Taxpayer did not make
timely and valid identifications under section 1.1221-2(f)(1), section 1256(e)(2)
identifications were also not made.

Claimed Inadvertent Error

Generally, the absence of an identification that satisfies the requirements of section
1.1221-2(f)(1) will be binding to establish the transaction is not a hedging transaction.
However, ordinary treatment of hedging transactions under section 1221(a)(7) is
permitted under an inadvertent error exception. Under section 1.1221-2(g)(2)(ii), a
taxpayer may treat as ordinary the gain or loss from a transaction that would otherwise
qualify as a hedging transaction if generally the failure to identify the transaction was
due to “inadvertent error” and all of the taxpayer’s hedging transactions in all open years
are being treated as ordinary. Notwithstanding Taxpayer’s consistent and ongoing
treatment of the PTFB and exchange-traded contracts as capital, it contends that its
failure to timely identify the contracts was attributable to inadvertent error.

Not Applicable Under Section 1256

The bulk of the capital losses at issue arose from section 1256 exchange-traded
contracts. Although the section 1256 regulations do not contain an inadvertent error
exception, Taxpayer maintains that the section 1221 inadvertent error exception is
incorporated into section 1256 so as to also excuse failed section 1256(e)(2)
identifications. To make its argument, Taxpayer’s simply misstates the language in the
regulations.

The section 1256 regulations do not incorporate the section 1.1221-2(g)(2)(ii)
inadvertent error exception for failed identifications, though they do pick up the separate
inadvertent identification rule in section 1.1221-2(g)(1)(ii) so that inadvertently identified
transactions are treated as not identified under section 1256(e)(2). See section
1.1256(e)-1(c).

Section 1.1256(e)-1(b) states that an identification of a hedging transaction for purposes
of section 1256(e)(2) must satisfy the requirements of section 1.1221-2(f)(1). As
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discussed above, section 1.1221-2(f)(1) requires timely and clear (unambiguous)
identification. The section 1256 regulations go on to say that an identification under
section 1.1221-2(f)(1) is considered an identification under section 1256(e)(2), but
notably does not state that the inadvertent error exception of section 1221 excuses a
failed identification under section 1256(e)(2). Further, section 1.1256(e)-1(b) provides
that an identification that does not satisfy all of the requirements of section 1.1221-
2(f)(1) is treated as identified under section 1256(e)(2) but only for the narrow purpose
of applying section 1256(f)(1). (Taxpayer misstated this rule to apply much more
broadly than to deny capital gains treatment as provided by section 1256(f)(1).)

There may be at least a couple reasons the section 1256 regulations do not pick up the
section 1.1221-2(g)(2)(ii) inadvertent error rule. First, section 1221(b)(2)(B) instructs
that the Secretary shall prescribe regulations to address the treatment of non-identified
hedging transactions, whereas section 1256(e)(2) states that a hedging transaction
must be clearly identified before the close of the day on which such transaction was
entered into or such earlier time as the Secretary may prescribe by regulations. Apart
from the narrower statutory language in section 1256, inadvertent error relief for failed
section 1256(e)(2) identifications may have been thought undesirable because hedging
transaction identification also determines whether a section 1256 contract is subject to
section 1256(a)(1) mark-to-market accounting. Given the special hindsight concerns
that exist with mark-to-market accounting, stricter identification procedures are
especially warranted. Whatever the reason(s), however, Taxpayer has no legal basis
for claiming that its failure to timely identify the section 1256 contracts as hedging
transactions is cured by a claim of inadvertent error.

Factual Burden Not Satisfied

Since the PTFB contracts were not section 1256 contracts, Taxpayer’s satisfaction of
the inadvertent error exception could potentially excuse its failure to timely identify those
transactions as hedges under section 1221. Taxpayer’s argument is relatively
straightforward – it argues that it was inadvertent error not to have identified the PTFB
(and exchange-traded contracts) because it was unaware of the need to identify the
transactions as hedges for Federal income tax purposes. Relying on Service letter
rulings that suggest that the term “inadvertent” means “an accidental oversight or a
result of carelessness,” Taxpayer claims that it was accidental oversight not to apprize
itself of the hedge identification rules. Taxpayer contends “no practice to identify or not
identify was developed at all” but that if it had researched the law, the gains and losses
would have been treated as ordinary. Though Taxpayer does not couch it as such, it
argues, in essence, that “ignorance of the law” is excusable inadvertent error under
section 1.1221-2(g)(2)(ii).

Even if the inadvertent error can legally excuse “ignorance of the law,” we are not
factually persuaded by Taxpayer’s argument. In particular, we are not convinced that
Taxpayer’s non-identification was either “error” or “inadvertent.”
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As for being “error,” the public statement relied upon by Taxpayer indicates that it only
considered the exchange-traded contracts to be economic hedges, but did not consider
the PTFB contracts as such. Further, Taxpayer’s prior audit response that there was
“No hedge accounting” is consistent with the information document request that repeats
Taxpayer’s statement in an initial interview that it did not hedge commodity X. Given
that some of the contracts in question were for the purchase of inventory and others
were made speculatively or as investments, it is difficult to accept Taxpayer’s blanket
contention that the arrangements would have qualified as hedging transactions for
Federal income tax purposes. Stated otherwise, it seems fairly clear that Taxpayer did
not make an error in not identifying many of the transactions as hedges as they were
not primarily entered into to manage pricing risks. Section 1.1221-2(b)(1).

We also are not factually persuaded by Taxpayer’s claim of “inadvertence.” Taxpayer’s
more recent responses to information document requests state that it was aware of the
ability to treat hedges as ordinary under the tax rules, but it made the decision not to
further research such. In one response, it advised that it made the decision not to
amend tax returns several years earlier (when it first became aware of the opportunity to
treat hedges as ordinary) because of the cost and work involved. Though glossed over,
Taxpayer continued to not identify the transactions as hedges even after the large
losses several years ago and continued to treat gains and losses as capital. This
neglect of the rules continued even after the Service raised detailed questions on audit
regarding Taxpayer’s hedging.

We are not in a position to challenge Taxpayer’s assertion that it did not bother looking
into the tax rules even after the large capital losses or after and as part of responding to
the Service audit inquiry regarding hedging. However, we can confidently state that, at
best, Taxpayer made the decision not to investigate further even after having at least a
general appreciation that ordinary treatment might be available for tax hedges. As a
factual matter, such a decision is not inadvertence. It is deliberate and conscious.

Based on the above, we do not see factual grounds for concluding that Taxpayer has
satisfied its burden of proving either “error” or that it “inadvertently” failed to identify the
PTFB or exchange-traded contracts as hedges.

Given the above should dispense with the Taxpayer’s hedge arguments, it is not
necessary to address as a legal matter at this time the question of whether and/or when
“ignorance of the law” excuses a failure to identify under the section 1.1221-2(g)(2)(ii)
“inadvertent error” rule.

Additional Comments and Caveats

As discussed, we will continue to coordinate with ----------on the section 1221(a)(1)
issue, particularly given the potential inventory accounting and change in accounting
method implications of Taxpayer’s section 1221(a)(1) argument.
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Based on facts provided to date, we would not assume or concede that: (a) Taxpayer
entered into PTFB contracts or each exchange-traded commodity X contract primarily to
manage pricing risks of inventory (i.e., as hedging transactions) or (b) Taxpayer was
unaware of the tax hedging requirements -- particularly without at least examining
relevant source documents (including public accounting firm and internal audit
checklists).

Though presumably not at issue in examination of the refund claim, please be aware
that section 1256(a)(1) requires mark-to-market accounting of the section 1256
contracts absent timely identification of those contracts as hedging transactions under
section 1256(e)(2). Also, if evidence is produced to enable you to determine that any of
the non-section 1256 contracts are section 1.1221-2(b) hedging transactions (even if not
identified as such) or that some of the section 1256 contracts were timely and properly
identified as hedging transactions, you may wish to touch base to discuss the section
1.446-4 hedge accounting rules which generally require a taxpayer to clearly reflect
income by reasonably matching the timing of income, deduction, gain or loss from a
hedging transaction with the timing of the income, deduction, gain or loss from the item
or items hedged. Consistent with the carve out of section 1256 contracts from Rev. Rul.
2003-127 and the plain reading of the statutory language of section 1256, the section
1256(a)(1) mark-to-market accounting regime (and not the section 1.446-4 hedge
accounting rules) applies to section 1256 contracts that are not timely and clearly
identified under section 1256(e)(2) even if the contracts would have otherwise
constituted qualifying hedging transactions if timely and properly identified.

Thanks for contacting us on this and hope this helps with your disposition of this
matter.