The Organisation for Economic Co-operation and Development (OECD) has just released a paper entitled “Aggressive Tax Planning based on After-Tax Hedging.” It describes the features of that type of planning, as well as the strategies tax authorities use to detect and respond to these arrangements. The OECD paper also highlights a number of challenges from a compliance and policy perspective.
After-tax hedging is a difficult area and inevitably the explanations in the OECD paper are fairly complex.
The discussion in the paper notes that a hedge is effective in pre- and post-tax terms when the tax treatment is neutral – e.g., when losses on one position (e.g., an asset) are deductible and gains on the opposite position (e.g., the hedge) are taxable. When tax rules do not operate in such a symmetric way, the hedge will be imperfect on an after-tax basis (e.g., if gains on a hedge are taxable but losses on a corresponding asset are not deductible). The report recognizes that this may create situations in which taxpayers need to factor the effects of taxation into their hedging transactions in order to be fully hedged on an after-tax basis.
The main complaint, however, is when after-tax hedging is deployed as a feature of plans that are designed to allow taxpayers to achieve higher returns, without actually bearing the associated risk, which is in effect passed onto the government through the tax charge.
The report states that some aggressive tax planning involves the tax treatment of the hedge being symmetrical in relation to gains and losses and others feature the situation where the tax treatment of the hedge is not symmetrical (i.e., gains on the hedging instrument are not taxed while losses are deductible). An example of the latter is given in the paper involving gains and losses on the hedged transaction being non-taxable and non deductible, with gains on the hedging instrument being non-taxable, yet losses being tax deductible. Accordingly, on an after-tax basis, tax benefits are obtained in the case of gains on the hedged item, which are not taxed, and losses on the hedging instrument, which are deductible. On the other hand, there are no tax consequences in the case of losses on the hedged item, which are non-deductible, and gains on the hedging instrument, which are not taxed.