Another Uneasy Compromise: The Treatment of Hedging in a Realization Income Tax

Abstract

Tax law distinguishes between holding an asset and disposing of it. Dispositions are "realization" events, occasions for taxing accrued appreciation, while holding is not. An owner of an asset who would like to dispose of it may instead hold the asset and hedge. Hedging, like disposing, changes a taxpayer's exposure to risk, but is, in many cases, not a realization event. A taxpayer may hedge an asset by obtaining a derivative financial instrument whose value varies inversely with the value of the asset. Derivative financial instruments thus enable taxpayers to simulate a disposition without current tax. Because hedging is often a close economic substitute for disposing, hedging should arguably be taxed like a disposition. If taxpayers are indifferent between two methods of accomplishing the same result, tax law can create social costs by taxing the two methods differently. Indeed, on January 12, 1996, the Treasury released a proposal that would treat an owner of an appreciated asset as having sold the asset if the person enters into a transaction that offsets exposure to risk in the appreciated asset. Several authors also favor treating hedging as a realization event, while others believe that this would not be a helpful reform.This article explores the conceptual and practical foundations and limits of the economic substitute argument for taxing hedging like a disposition. Within the context of an income tax, reformations of the realization requirement to apply to hedges might well accomplish little improvement in the efficiency and equity of the tax system because the realization requirement itself is a departure from an ideal income tax. Although treating hedging as a realization event might reduce transaction costs associated with hedges, it would encourage taxpayers to engage in more complicated and expensive transactions to avoid the new realization rule and would increase the extent to which taxpayers are locked into investments that they would prefer to sell. As to equity, the current ability to hedge without tax undermines the tax on capital. But, so too does the ability to hold without tax, and this undermines the equity argument for taxing hedging. By exposing the inevitable formality of the realization requirement, this article supports examination of a broader reform that would apply accrual taxation to marketable securities.