How Transportation Hedgers Cope with Overtaxing Rules

Article excerpt

How transportation hedgers cope with overtaxing rules

"Without careful tax planning, Uncle Sam could make more on a fuel hedge than the taxpayer," says Ed Paules, a tax and accounting arbitrage specialist with Continental Bank's risk management group.

That caution has been especially important since August, when the Iraqi incursion into Kuwait motivated "thoughtful consideration of fuel hedging"--as one airline official redundantly put it -- by numerous transportation company executives who had previously disdained it.

"Typically, such a shift in view is a response to a negative event," says Todd E. Petzel, vice president of research at the Chicago Mercantile Exchange. It also is "one of the worst possible reasons to think about hedging," he adds. Experienced hedgers, he continues, "all share a common characteristic: They look forward."

Thus it is that financial engineers urge clients to consider the tactics that might serve their needs -- forward contracts, hedges using futures, hedges using exchange-traded options and various over-the-counter products such as swaps, caps or collars. They then urge them to choose the most cost-effective method to protect against price risk, given their long-term business goals.

But, along with everything else that fuel hedgers must consider, Paules says, is the fact that "forwards, futures, options and swaps all have different tax and accounting impacts, which can be as important when designing hedging strategies as the markets themselves."

As a result, hedgers must deal with a tax arbitrage. In addition to choosing tactics that make business sense in the ordinary way, they must decide which will produce the most favorable tax treatment. This is especially true operating in what can be called the "hidden" transportation sector.

Reflecting the ordinary view of the transportation sector, the Dow Jones Transportation Index includes 19 "common carriers": nine airlines, six railroads, three trucking companies and one shipping line.

But any highway traveler is also aware that numerous manufacturing companies, especially in chemicals and food products, manage vast fleets of trucks dedicated to their special cargoes. Those transporters face the same fuel price risk as the common carriers, but for them, the hedging decision process can be trickier.

"There's more tax planning room in commodities but also more traps," Paules warns.

According to Robert R. Baer, a senior tax officer with the Continental Bank risk management group, tax law derives from three sources: Congress, the Internal Revenue Service (IRS) and the courts.

Three branches

Congress passes laws. Then, to define how a law applies, the IRS may issue a regulation that has the power of law. Should a dispute arise over an application, the parties may take the issue to court. The eventual decision becomes another part of the law.

Just such a process led to the arbitrage to which Paules refers.

The actual laws and regulations say little about commodities. The elements that do apply to hedging for the most part address interest rates with regard to financing and foreign tax credits. Also, some pretty detailed rules limit U.S. companies' ability to take foreign tax credits.

But Regulation 1256, which deals with hedging concerns, insofar as they are dealt with, contains little to help fuel hedgers -- or really anyone hedging commodity price risk.

The basic problem for manufacturing companies wishing to hedge any of their commodity price risk is that the tax law, more by omission than design, treats cash forwards and futures positions as capital assets.

A typical manufacturing company usually wants to avoid capital losses because it can only offset capital losses against capital gains and because it generates almost no capital gains or losses in the ordinary course of business.

Therefore, capital losses warrant no tax deduction even though the tax law allows a three-year carry back and a five-year carry forward -- that is, if a company has a capital gain any time in the last three or the next five years, it can offset a capital loss. …