Impact of Cash Flow Hedges on Taxes

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Companies can anticipate future cash flow based on hedging contracts they enter into.
Companies can anticipate future cash flow based on hedging contracts they enter into. (Image: Dynamic Graphics/Dynamic Graphics Group/Getty Images)

Cash flow hedges allow businesses to offset rising prices of supplies and other commodities by entering into a contract that secures the purchase price for the product at the present-day price. These hedges allow businesses to secure cash flow for their operations by anticipating and avoiding higher prices in the future. Although the process is somewhat complicated, assessing the impact of these cash flow hedges on taxes is rather straightforward.

Gains and Losses

Gains and losses on a cash flow hedge are deferred and reported as a portion of other income that is later reported for tax purposes. What this means is that the losses or gains that are made do not necessarily have immediate tax consequences. When a company uses a hedge to offset future gains in price, the difference that is either saved or lost is accounted for separately in the company's cash flow statement.

Contracts

Companies enter into futures contracts to hedge against future cash flow shortages by securing the product at a lower present price. For instance, if a company attempts to secure 1,000 units of a certain product in May of 2010 at a price of $10 per unit while anticipating a rise in price, it can enter into a future contract to secure the item at $10,000 on a future specified date. For example, the contract may specify a purchase in May of 2011. If the price of the item has risen to $11 per unit during that time frame, the company secures the product for $10,000 in May 2010, even though the true value of the product is $11,000 the following year in May 2011.

Reporting

Reporting on the gains or losses made in such a cash flow hedging investment involves reporting the current price at which the goods were secured as part of the inventory, while reporting the difference in price as cash. In our example, the transaction is entered into the company ledger at the price of the product on the day it was purchased, but not what it was purchased for. Here it would be reported as $11,000 added to inventory on the contract date in May 2011. The difference in price secured by the contract would require a separate entry of $1,000 as cash, on that same day. This $1,000 would later be included when the inventory was sold.

Taxation

The way in which the income from cash flow hedges is reported on a business's taxes is somewhat complicated. The fact that these investments result in deferred reporting of income means that there is a specific method for determining how and when these gains are reported. Internal Revenue Code IRC § 1256(a)(1) requires that the income gains be reported on tax forms as if the inventory were sold on the last day of the tax year at the inventory's fair market value. Of the income reported, 40 percent must be reported as a short-term gain, while 60 percent is treated as a long-term gain. Therefore, the $1,000 in our example would be reported as a $400 short-term gain and a $600 long-term gain, assuming the market value did not change by December 31, 2011.

Short-term gains can be taxed at rates of anywhere from 10 to 35 percent, depending upon which tax bracket the company falls in. This means that the company would owe between $40 and $140 tax on the $400. Long-term gains are taxed at either zero percent or 15 percent. This also depends upon the company's corresponding tax bracket. Those falling into the 25 percent bracket or higher would have to pay $90 tax on the $600, while those in the 15 percent bracket would not pay anything.

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