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.