SCOTUS Reports

Tag: Hedging

  • Federal National Mortgage Ass’n v. Commissioner, 100 T.C. 541 (1993): When Hedging Transactions Generate Ordinary Gains and Losses

    Federal National Mortgage Association v. Commissioner, 100 T. C. 541 (1993)

    Hedging transactions that are integrally related to a taxpayer’s business can generate ordinary gains and losses if they offset risks associated with assets that are not capital assets.

    Summary

    The Federal National Mortgage Association (FNMA) engaged in hedging transactions to mitigate interest rate risk associated with its mortgage portfolio and debt issuance. These transactions involved futures contracts, short sales of Treasury securities, and options. The Tax Court ruled that FNMA’s hedging activities produced ordinary gains and losses because they were integral to managing its mortgage commitments and debt, which were treated as ordinary assets. However, the court disallowed losses claimed from currency swap transactions related to yen-denominated debt, as the basis of the yen was determined by the swap agreements, resulting in no realized gains or losses in the year in question.

    Facts

    FNMA, a government-sponsored enterprise, purchased residential mortgages and financed these through issuing debentures. To manage the risk of rising interest rates, FNMA implemented a hedging program in 1984 and 1985. This program included: short positions in futures contracts, short sales of Treasury securities, and options on futures contracts. FNMA hedged certain debenture issuances and mortgage commitments, including commitments to purchase notes from the Alaska Housing Finance Corporation and convertible mortgage commitments. Additionally, FNMA issued yen-denominated debt and engaged in related currency swap agreements to manage foreign exchange risk.

    Procedural History

    The IRS issued a notice of deficiency to FNMA for the tax years 1974 and 1975, disallowing net operating loss carrybacks from 1984 and 1985. FNMA filed a petition with the U. S. Tax Court, contesting the disallowance. The Tax Court considered the character of FNMA’s hedging gains and losses and the treatment of its foreign currency transactions.

    Issue(s)

    1. Whether the gains and losses from FNMA’s hedging transactions should be treated as ordinary income or loss.
    2. Whether FNMA’s methodology for calculating gains and losses from short sales of Treasury securities and options was correct.
    3. Whether FNMA recognized ordinary gains or losses from its disposition of yen pursuant to currency swap agreements in 1985.

    Holding

    1. Yes, because the hedging transactions were an integral part of FNMA’s system of purchasing and holding mortgages, which were treated as ordinary assets under section 1221(4).
    2. No, because the interest expense from a short sale closed out in 1986 should not have been included in 1985’s loss calculation.
    3. No, because the basis of the yen was determined by the currency swap agreements, resulting in no realized gains or losses in 1985.

    Court’s Reasoning

    The court applied the principles from Arkansas Best Corp. v. Commissioner, concluding that hedging transactions related to ordinary assets could be treated as ordinary. FNMA’s mortgages were considered ordinary assets under section 1221(4) as they were acquired for services rendered in enhancing the secondary mortgage market. The hedging transactions were deemed integral to FNMA’s business operations, thus qualifying for ordinary treatment. Regarding the currency swaps, the court rejected FNMA’s method of calculating gains and losses, determining that the swap agreements fixed the yen’s basis, resulting in no gain or loss in 1985. The court also found no basis for integrating the yen debt obligations and their related swap agreements under the step transaction doctrine, as each step had economic substance.

    Practical Implications

    This decision clarifies that hedging transactions can generate ordinary income or loss when they are integrally related to the taxpayer’s business and offset risks associated with ordinary assets. Legal practitioners should analyze hedging strategies in light of this ruling, ensuring that such transactions are closely tied to the business’s core operations. The case also underscores the importance of properly calculating the basis in foreign currency transactions, particularly when swap agreements are involved. Subsequent cases, such as Azar Nut Co. v. Commissioner, have followed this reasoning, emphasizing the need for a close business connection between the hedge and the underlying asset or liability. Businesses engaging in hedging should ensure their documentation and strategy align with this case’s principles to secure favorable tax treatment.

  • Hoover Co. v. Commissioner, 72 T.C. 206 (1979): When Currency Hedging Transactions Result in Capital Gains and Losses

    Hoover Co. v. Commissioner, 72 T. C. 206 (1979)

    Forward currency transactions intended to hedge against potential declines in stock value due to currency devaluation result in capital gains and losses, not ordinary income or loss.

    Summary

    Hoover Co. engaged in forward currency sales to hedge against potential declines in its stock investments in foreign subsidiaries due to currency devaluation. The court held that these transactions did not qualify as hedges under tax law, as they were not tied to the company’s day-to-day business operations but rather to its investment in stock, which is a capital asset. Consequently, gains and losses from these transactions were treated as capital gains and losses, not ordinary income or loss. The court’s rationale emphasized the distinction between protecting business operations and protecting stock investments, determining that Hoover’s transactions did not meet the criteria for a bona fide hedge under Section 1233(g).

    Facts

    Hoover Co. , a Delaware corporation, owned significant shares in foreign subsidiaries, particularly Hoover Ltd. in the UK. Concerned about currency devaluations affecting the value of these investments, Hoover entered into forward sale agreements for foreign currencies. These transactions were not linked to specific business operations but aimed to offset potential financial reporting losses due to currency fluctuations. The company did not physically deliver currency but often offset forward sales with purchase contracts from the same bank. Hoover reported the gains and losses from these transactions as ordinary income and loss, which the IRS challenged.

    Procedural History

    The IRS determined deficiencies in Hoover’s federal income taxes for 1968-1970, asserting that the gains and losses from the currency transactions should be treated as capital. Hoover contested this, arguing for ordinary treatment. The Tax Court reviewed the case and ultimately agreed with the IRS, holding that the gains and losses were capital in nature.

    Issue(s)

    1. Whether gains and losses from Hoover’s forward currency transactions constitute ordinary gains and losses or capital gains and losses?
    2. If capital, whether these gains and losses are short-term or long-term?

    Holding

    1. No, because the transactions were not bona fide hedges under tax law but were related to protecting stock investments, which are capital assets.
    2. The gains and losses were short-term, except for one transaction which resulted in long-term capital gain due to the holding period.

    Court’s Reasoning

    The court applied a narrow definition of a hedge, requiring a direct link to day-to-day business operations, which was not present in Hoover’s transactions. The court distinguished between protecting business operations and stock investments, stating that Hoover’s transactions were designed to offset financial reporting losses and protect stock value, not business income. The court cited Corn Products Refining Co. v. Commissioner, explaining that transactions must be integral to business operations to warrant ordinary treatment. Since Hoover’s transactions were not tied to its business operations but rather to its investment in foreign subsidiaries, they did not qualify as hedges. The court also rejected Hoover’s arguments that the transactions were insurance expenses or that the currency was not a capital asset. Finally, the court determined that the transactions met the requirements for capital treatment under Section 1233, with most resulting in short-term gains or losses due to the holding period.

    Practical Implications

    This decision clarifies that forward currency transactions aimed at protecting the value of stock investments due to currency fluctuations will be treated as capital transactions. Companies engaging in similar hedging activities must carefully consider the tax implications, as such transactions will not be deductible as ordinary business expenses. This ruling impacts multinational corporations’ financial planning, as they must account for potential capital gains or losses when hedging against currency risks. Future cases involving currency hedging may reference Hoover to determine the tax treatment of such transactions. Additionally, this decision underscores the importance of distinguishing between hedging for operational purposes versus investment protection in tax law.

  • Commissioner v. Bagley & Sewall Co., T.C. Memo. 1959-189: Payments from Newsprint Contract Assignments as Ordinary Income

    Commissioner v. Bagley & Sewall Co., T.C. Memo. 1959-189

    Gains from transactions involving assets that are an integral part of a taxpayer’s business operations, such as a newsprint supply contract for a newspaper publisher, are considered ordinary income, not capital gains, even if the asset might otherwise fit the definition of a capital asset.

    Summary

    Bagley & Sewall Co., a newspaper publisher, entered into a long-term newsprint contract to ensure a stable supply of paper. It later allowed other publishers to purchase newsprint under its contract, receiving payments for this arrangement. The Tax Court held that these payments constituted ordinary income, not capital gains. The court reasoned that the newsprint contract was integral to Bagley & Sewall’s business of publishing newspapers, serving as a form of inventory and hedge against price fluctuations. Therefore, gains from allowing others to use this contract were ordinary income generated from the regular course of business operations, aligning with the precedent set in Corn Products Refining Co. v. Commissioner.

    Facts

    Petitioner, Bagley & Sewall Co., was engaged in the newspaper publishing business and relied on a consistent supply of newsprint paper. To secure this supply, Petitioner entered into a 10-year newsprint contract with Coosa River providing a stable price. In 1951 and 1952, Petitioner entered into agreements with three other publishers (Brush-Moore, Beacon, and Lorain County Printing Company). Under these agreements, the other publishers could purchase newsprint directly from Coosa River under Petitioner’s contract quota. In return, these publishers paid Coosa River the contract price for the newsprint and an additional sum to Petitioner.

    Procedural History

    The Commissioner of Internal Revenue determined that the payments received by Petitioner were ordinary income, not capital gains. Petitioner contested this determination in the Tax Court.

    Issue(s)

    1. Whether payments received by Petitioner from other publishers, for allowing them to purchase newsprint under Petitioner’s contract with Coosa River, constitute ordinary income or capital gain?

    Holding

    1. No, the payments constitute ordinary income because the newsprint contract was an integral part of Petitioner’s business operations, and the transactions were essentially dealings in its newsprint inventory.

    Court’s Reasoning

    The court reasoned that the newsprint contract was not a capital asset in the context of Petitioner’s business. Obtaining and maintaining long-term newsprint contracts was a customary and essential part of the publishing business, ensuring a continuous supply of paper at stable prices. The court emphasized that “Obtaining and having such contracts is an integral part of the conduct of petitioner’s ordinary trade and business.” The transactions were viewed as “anticipatory arrangements under which petitioner had deliveries made to others” of its contracted newsprint. Relying on Corn Products Refining Co. v. Commissioner, the court held that transactions related to inventory, integral to the taxpayer’s business, result in ordinary income, even if the asset appears to fit the literal definition of a capital asset. The court likened the arrangement to a hedge, as the stable pricing in the Coosa River contract allowed Petitioner to profit from market fluctuations. The court distinguished cases cited by Petitioner, noting that the doctrine of cases like Commissioner v. Covington had been overruled by Corn Products.

    Practical Implications

    This case reinforces the principle established in Corn Products that the definition of a capital asset should be interpreted in light of the asset’s role in the taxpayer’s business. It demonstrates that even if an asset appears to be a contract right, if it is fundamentally tied to the company’s inventory management or operational necessities, gains from its disposition in the ordinary course of business will likely be treated as ordinary income. For businesses, this means that long-term supply contracts, especially those designed to stabilize inventory and prices, are likely to be considered integral to business operations. Therefore, any income derived from assigning or altering these contracts may be taxed as ordinary income, not capital gains. This case highlights the importance of analyzing the business context and purpose of an asset when determining its capital or ordinary nature for tax purposes. Later cases applying Corn Products and its progeny continue to emphasize the “integral part of the business” test.

  • Estate of Dorothy Makransky, 5 T.C. 397 (1945): Defining Hedges and Capital vs. Ordinary Losses

    5 T.C. 397 (1945)

    A loss from commodity futures transactions is considered an ordinary loss if the transactions constitute a hedge against business risks, but is a capital loss if the transactions are speculative.

    Summary

    The Tax Court addressed whether losses incurred by a textile manufacturer from commodity futures transactions constituted ordinary losses from hedging or capital losses from speculation. The court ruled that the transactions were speculative because the taxpayer had not made any forward commitments for sales of its manufactured product, and therefore, there was no fixed risk for the purchase of raw material futures to offset. Without forward sales commitments, the futures contracts were not balancing transactions and did not qualify as hedges, resulting in a capital loss, subject to limitations.

    Facts

    Dorothy Makransky’s estate sought to deduct losses from futures transactions. The taxpayer, a textile manufacturer, bought raw material futures. However, the taxpayer had not entered into any forward sales commitments for its manufactured products. The taxpayer argued these futures purchases were hedges to protect against price fluctuations in raw materials.

    Procedural History

    The Commissioner determined that the losses were capital losses and limited the deduction. The Tax Court reviewed the Commissioner’s determination.

    Issue(s)

    Whether losses from commodity futures transactions are deductible as ordinary losses because they constitute a hedge against business risks, or whether they are capital losses because they are speculative in nature.

    Holding

    No, because the taxpayer did not have any forward sales commitments to offset with the futures transactions, rendering the transactions speculative and not hedges.

    Court’s Reasoning

    The court reasoned that hedging involves maintaining a balanced market position, essentially acting as price insurance. To qualify as a hedge, the futures transactions must offset a specific business risk, such as forward sales commitments. The court emphasized that “if a manufacturer or processor of raw materials is short on inventory and makes sales of his finished product for forward delivery, the appropriate hedging transaction in that instance would be the purchase of raw material futures at or about the time he makes the sale.” In Makransky’s case, the absence of forward sales meant there was no fixed risk to offset with the futures, making the transactions speculative. The court distinguished true hedging from speculation, stating that, unlike hedging, speculative transactions do not offset any existing business risk. Because Makransky had no forward sales commitments, the court concluded that the futures transactions were speculative and, therefore, subject to capital loss treatment.

    Practical Implications

    This case clarifies the definition of a hedge for tax purposes, emphasizing the requirement of an offsetting business risk. It highlights that simply buying or selling futures in relation to inventory or raw materials is not enough; there must be a direct link to forward sales commitments. Legal practitioners must carefully analyze the taxpayer’s business operations to determine whether futures transactions are genuinely hedging existing risks or are merely speculative ventures. The absence of forward contracts or other demonstrable commitments significantly weakens the argument for hedge treatment. Later cases cite this case to differentiate between hedging and speculation, showing the lasting impact of this ruling on tax law.

  • Stewart Silk Corp. v. Commissioner, 9 T.C. 174 (1947): Defining Hedging Transactions for Tax Purposes

    9 T.C. 174 (1947)

    Losses from commodity futures transactions are deductible as ordinary business losses if the transactions constitute hedges entered into for business risk protection, rather than speculation, and are directly related to the taxpayer’s dealings in the actual commodity.

    Summary

    Stewart Silk Corporation, a silk cloth manufacturer, sought to deduct losses from silk futures transactions. The Tax Court addressed whether these transactions were hedges, intended to mitigate business risk, or speculative investments. The court held that the futures transactions were legitimate hedges designed to protect the company’s inventory from market fluctuations, and thus the losses were fully deductible as ordinary business losses. The court emphasized the company’s purpose in maintaining a balanced market position and mitigating risk associated with its inventory.

    Facts

    Stewart Silk Corporation faced increasing competition from synthetic fabrics. In 1939, it had a large raw silk inventory. Concerned about potential price declines, and at the insistence of its financier, Stern & Stern Textile Importers, Inc., the company sold silk futures on the Commodity Exchange covering about one-third of its silk holdings. After war broke out in Europe, silk prices rose dramatically. The company closed out its futures contracts, largely through offsetting purchases, incurring a substantial loss.

    Procedural History

    The Commissioner of Internal Revenue determined deficiencies in Stewart Silk Corporation’s income, declared value excess profits, and excess profits taxes for 1941, disallowing most of a net operating loss carry-over from 1939. The Tax Court reviewed the Commissioner’s determination regarding the characterization of the silk futures transactions.

    Issue(s)

    Whether the silk futures transactions entered into by Stewart Silk Corporation in 1939 constituted hedges for business risk protection or speculative investments.

    Holding

    Yes, because the transactions were hedges entered into for the purpose of protecting against a business risk rather than for speculation, and the resulting loss is deductible in full.

    Court’s Reasoning

    The court emphasized that the essence of hedging is maintaining a balanced market position as a form of price insurance. Unlike speculative transactions, hedging aims to mitigate the risk of price changes in a commodity the taxpayer deals with. The court found that Stewart Silk’s futures sales were intended to “freeze” the value of a portion of its silk holdings and eliminate the risk of market fluctuations. The court noted that selling futures against inventory serves to fix the value of the raw materials. The court stated that “[a] sale of any commodity for future delivery on Commodity Exchange, Inc., to the extent that such sale is offset in approximate quantity by the ownership or purchase of the same cash commodity or related commodity” constitutes a hedging transaction. Because Stewart Silk held enough raw silk to cover its futures commitments, the transactions qualified as hedges. The court distinguished this case from those where futures transactions were not concurrent with the risk sought to be protected against.

    Practical Implications

    This case clarifies the distinction between hedging and speculation for tax purposes. It emphasizes that hedging transactions must be directly related to the taxpayer’s business and intended to mitigate the risk of price fluctuations in commodities the taxpayer deals with. To qualify as a hedge, the taxpayer must demonstrate a balanced market position, with the futures transactions offsetting the risk associated with their actual holdings or forward sales. This case is significant for businesses that use commodity futures to manage price risk, providing guidance on how to structure these transactions to ensure favorable tax treatment. Later cases have relied on this decision to determine whether specific futures transactions constitute hedging or speculation based on the taxpayer’s intent and the relationship between the futures and the underlying business.

  • Ben Grote v. Commissioner, 41 B.T.A. 247 (1940): Futures Contracts as Capital Assets vs. Ordinary Business Expenses in Hedging

    Ben Grote v. Commissioner, 41 B.T.A. 247 (1940)

    Losses from transactions in commodity futures contracts are considered capital losses unless they constitute a true hedge against business risks, in which case they may be treated as ordinary business expenses.

    Summary

    Ben Grote, a suit manufacturer, sought to deduct a partnership loss from futures contracts in wool tops as an ordinary business expense carry-over. The partnership purchased these contracts after the outbreak of WWII, anticipating wool supply issues, but later sold them at a loss. The Board of Tax Appeals determined that these futures contracts were capital assets and the transactions were not true hedges. Therefore, the loss was classified as a short-term capital loss, which, due to lack of capital gains, could not generate a net operating loss carry-over for the partners’ individual income tax in 1941. The Board emphasized that hedging must be directly linked to protecting against price fluctuations in actual business operations, not speculative or isolated transactions.

    Facts

    1. Petitioner Ben Grote was a partner in a business manufacturing men’s suits from purchased piece goods.
    2. The partnership sold finished suits to retailers through salesmen.
    3. In September 1939, after the outbreak of World War II, the partnership purchased 100 wool top futures contracts.
    4. This purchase was made due to concerns about future wool supply, not as a hedge against existing sales contracts.
    5. In February 1940, the partnership sold these futures contracts at a loss of $95,750.
    6. The partnership treated this loss as a cost of hedging to protect wool purchases and charged it to “Woolens Purchases” on their books.
    7. The partnership did not take delivery of the wool tops and did not include the futures contracts in inventory.

    Procedural History

    The Commissioner of Internal Revenue determined that the loss from the futures contracts was a short-term capital loss and disallowed the partnership’s attempt to carry it over as a net operating loss. The petitioners appealed to the Board of Tax Appeals.

    Issue(s)

    1. Whether the loss of $95,750 from the sale of wool top futures contracts was a short-term capital loss as defined in Code Section 117.
    2. Alternatively, whether the loss was deductible as an ordinary and necessary business expense under Code Section 23(a) because it arose from hedging operations.

    Holding

    1. No, the loss was a short-term capital loss because the futures contracts were capital assets as defined in Code Section 117 and did not fall under any exceptions.
    2. No, the loss was not an ordinary and necessary business expense because the transactions were not true hedging operations in the context of the partnership’s business.

    Court’s Reasoning

    The court reasoned as follows:
    – Futures contracts are generally considered capital assets unless they fall under specific exceptions in Code Section 117, such as inventory, stock in trade, or property held primarily for sale to customers.
    – The partnership’s futures contracts were not inventory because futures contracts are not included in inventory according to Treasury Regulations and prior rulings (Regs. 103, Sec. 19.22(c)-1; A.R.R. 100; A.R.M. 135; Commissioner v. Covington; Tennessee Egg Co.).
    – The contracts were not stock in trade or property held primarily for sale to customers in the ordinary course of business (Commissioner v. Covington).
    – The contracts were not subject to depreciation.
    – Since the contracts were held for less than 18 months, any loss would be a short-term capital loss unless it resulted from a true hedge.
    – True hedging transactions are treated as a form of business insurance, resulting in ordinary business expense deductions (G.C.M. 17322; Ben Grote; Commissioner v. Farmers & Ginners Cotton Oil Co.; Kenneth S. Battelle).
    – A hedge is meant to reduce risk from price changes in commodities related to the business’s operations, maintaining a balanced market position (Commissioner v. Farmers & Ginners Cotton Oil Co.).
    – The partnership’s futures contracts were not a hedge because they were not connected to present sales of clothing or a method of insuring against price changes in their ordinary course of business. Instead, it was an “isolated transaction” based on a “panicky condition” after the war outbreak, making it speculative, not a hedge.
    – The court distinguished this case from Kenneth S. Battelle, where hedging was found to be present. Even in Commissioner v. Farmers & Ginners Cotton Oil Co., where the taxpayer’s transactions more closely resembled a hedge, the court still ruled against the taxpayer.
    – The court quoted Anna M. Harkness, stating, “It seems to us to be fundamentally unsound to determine income tax liability by what might have taken place rather than by what actually occurred.”

    Practical Implications

    – This case clarifies the distinction between capital asset transactions and ordinary business hedging in the context of commodity futures.
    – It emphasizes that for futures transactions to be considered hedges and generate ordinary business losses, they must be integral to the taxpayer’s business operations and serve as a direct form of price insurance against risks inherent in the business.
    – Isolated or speculative purchases of futures contracts, even if related to business inputs, are unlikely to qualify as hedges, especially if not linked to existing business commitments or sales.
    – Taxpayers must demonstrate a clear and direct relationship between their futures trading and the reduction of risks in their core business activities to claim ordinary loss treatment. Bookkeeping treatment alone (like charging to “Woolens Purchases”) is not determinative.
    – This case reinforces the principle that tax liability is based on what actually occurred (futures contract trading) rather than what might have occurred (taking delivery of wool tops).