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October 21, 2021

US IRS rules gains and losses arising from commodity hedges may be sourced by reference to the underlying hedged inventory property

The United States (US) Internal Revenue Service (IRS) ruled in PLR 202140016 that a taxpayer (Taxpayer) can source gains or losses arising from certain commodity derivative hedging transactions (Commodity Derivatives) by reference to the source of gains or losses derived from the sale of the underlying inventory property being hedged. The IRS made its ruling by analogy to the inventory sourcing rules.


Taxpayer is a manufacturer that sells products for consumption or further processing. Taxpayer also purchases material for manufacturing in its plants when required, as well as finished products to sell to its customers (Inventory Property). Taxpayer executes thousands of sale and exchange transactions of Inventory Property every year. External factors, such as weather and natural disasters, geopolitical events and facility maintenance give rise to price risks with respect to its Inventory Property.

Taxpayer, via two members of its US consolidated group, enters into Commodity Derivatives (including futures contracts and options contracts) in the normal course of its business, primarily to manage this price risk. Taxpayer represented that (1) the Commodity Derivatives qualify as hedging transactions under IRC Section 1221(b)(2)(A) and Treas. Reg. Section 1.1221- 2(b); (2) it satisfied the IRC Section 1221(a)(7) and Treas. Reg. Section 1.1221-2(f) identification requirements for the Commodity Derivatives; and (3) the Commodity Derivatives hedge "inventory property" as defined under IRC Section 865(i)(1). For US federal income tax purposes, Taxpayer reported gain or loss on the Commodity Derivatives by reference to the source of gain or loss derived from the sale of the underlying hedged Inventory Property.


Under IRC Section 865(a), income from the sale of personal property is generally sourced based on the seller's residence. IRC Section 865(b) sources income from the sale of inventory property by reference to IRC Sections 861(a)(6), 862(a)(6) and 863. IRC Sections 861(a)(6) and 862(a)(6) source gain or loss from purchased inventory property to the place of the property's sale or exchange. IRC Section 863 sources gain or loss on produced inventory based on the location of the production activities. Treas. Reg. Section 1.865-1 describes rules for sourcing losses of personal property other than stock. Under Treas. Reg. Section 1.865-1(c)(1), however, this section does not apply to loss recognized on options contracts or certain other derivative financial instruments.

IRC Section 865(i)(1) defines "inventory property" as personal property described in IRC Section 1221(a)(1). Under IRC Section 1221(a)(1), the term "capital asset" does not include:

  • Stock in trade of the taxpayer or other property that the taxpayer would properly include in its inventory if on hand at the close of the tax year, or
  • Property that the taxpayer holds "primarily for sale to customers in the ordinary course of [its] trade or business"

IRC Section 865(j)(2) directs the Treasury Department to prescribe the necessary regulations to carry out IRC Section 865, including rules on income from trading in certain derivatives (including futures and option contracts). The Treasury Department has not yet done so. The source of income from an item for which no specific rule exists may be determined by analogy by looking to the substance of the transaction. Both IRC Section 865(a) and the inventory sourcing rules have been suggested as reasonable analogies for sourcing income arising from futures and options contracts.

No court has addressed the sourcing of gain or loss arising from a hedging transaction described in IRC Section 1221(a)(7). The Supreme Court previously analyzed similar commodity derivatives in a different context, however, and determined those transactions were an integral part of the taxpayer's business. In addition, special character and timing rules apply to IRC Section 1221(a)(7) hedging transactions to characterize any gain or loss from a properly identified hedging transaction as ordinary, and to reasonably match the timing of any items of income, expense, gain or loss on the hedging transaction with the timing of those items on the underlying hedged items.


In ruling that gains and losses from the Commodity Derivatives may be sourced by reference to the underlying hedged Inventory Property, the IRS, relying on Bank of America, focused on the substance of the transactions at issue. In doing so, the IRS highlighted that a residence-based sourcing outcome under IRC Section 865(a) would result in US-sourced gain or loss on the Commodity Derivatives, and either US- or foreign-source gain or loss on the underlying hedged inventory property. The IRS stated this result would be inconsistent with the substance of the Commodity Derivatives as IRC Section 1221(a)(7) hedges of the underlying Inventory Property.

As support for its ruling, the IRS relied on the Supreme Court's characterization of similar commodity derivative transactions as an integral part of that taxpayer's business and concluded they were properly treated as surrogates for the taxpayer's stored inventory.6 Moreover, the IRS stated that Congress "imported" the principles of Corn Products to IRC Section 865 by cross-referencing IRC Section 1221(a)(1) to define "inventory property" in IRC Section 865(i)(1).Noting the similarities between the Taxpayer's Commodity Derivatives and the petitioner's contracts in Corn Products, the IRS concluded that sourcing gains and losses on the Commodity Derivatives by analogy to the inventory sourcing rules for the underlying hedged property more appropriately reflected the substance of the transactions as hedges of the underlying Inventory Property.


Although PLR 202140016 solely addresses hedges of inventory property, the ruling may provide insight on the source of gain or loss from hedges of other types of property. In focusing on the substance of the transaction at issue, the IRS dismissed application of rules that would have created inconsistencies in the sourcing of any items of income or loss from the Commodity Derivatives compared to sourcing those items on the underlying hedged transactions. This is consistent with the general matching rules for character and timing found in IRC Section 1221(a)(7) and Treas. Reg. Section 1.446-4. Because those provisions relate to character and timing, respectively, the IRS did not specifically rely on these authorities as support for its conclusion. Instead, the IRS primarily relied on the Supreme Court's characterization of similar contracts as surrogates for inventory property. While that analysis may not apply to all hedging transactions, sourcing gains and losses from hedging transactions by reference to the rules for the underlying hedged item is a sensible result that is consistent with the matching principles applicable to hedging transactions. 


For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP (United States), International Tax and Transaction Services – Capital Markets Tax Practice

Ernst & Young LLP (United States), International Tax and Transaction Services


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