65 Tax L. Rev. 241 2011-2012

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YARON Z. REICH*

I. Introduction ...... 242 II. Overview of Matching and Mismatches ...... 245 III. The Matching Concept and Mismatches in Various A reas ...... 248 A. Character: Capital vs. Ordinary ...... 248 B . T im ing ...... 251 C. Hedging, Straddles, and Other Approaches to Matching Character and Timing ...... 254 1. Hedging Transactions ...... 254 2. Section 475 ...... 260 3. Straddles ...... 263 4. Foreign Currency Hedging Transactions ...... 265 D. International Tax Provisions ...... 268 1. Source ...... 269 a. In G eneral ...... 269 b. Interest Expense ...... 270 c. Interest Equivalents ...... 274 d. Foreign Currency Sourcing Rules ...... 274 e. Personal Property Sales ...... 275 2. Global D ealing ...... 275 3. Subpart F ...... 277 4. Foreign Tax Credit ...... 279 E. Related Party Transactions ...... 281 1. Consolidated Tax Groups ...... 281 2. Section 267 ...... 284 3. Partners and Partnerships ...... 286 F. Limitations on Individual Deductions ...... 288 G. Financial Transactions and Products ...... 289 H . Tax Shelters ...... 291 IV. Observations and Specific Recommendations Regarding Matching and Mismatches ...... 292 A . O bservations ...... 292

* Partner, Cleary Gottlieb Steen & Hamilton, LLP. I am grateful to Victoria Belyavsky, Matthew B. McFeely, and Andrew P. Meisner for their assistance in the preparation of this article, and to James M. Peaslee, Julie A. Roin, Leslie B. Samuels, and David Schulder for their helpful comments. An earlier version of this Article was presented at the Tax Club in New York on September 15, 2011. 241

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: B. Specific Recommendations ...... 294 V. Policy Considerations in Formulating a Super-Matching R ule ...... 296 A. The Benefits of a Super-Matching Rule Compared to the Status Quo and to Alternative Approaches to M ism atches ...... 296 B. Rules vs. Principles, Certainty vs. Flexibility ...... 298 C. The Substance of Matching: When, What, and How to M atch ...... 300 D. Relevance of Accounting or Business Treatment ... 301 E. Elective or Mandatory, and by Whom ...... 302 F. Legislative or Regulatory Guidance, General or T ailored ...... 303 VI. A Proposed Super-Matching Rule ...... 304 A. Description of Proposal ...... 304 B. D iscussion ...... 306 V II. Conclusion ...... 310

I. INTRODUCTION Many of the challenges, frustrations, and opportunities faced by taxpayers and tax practitioners arise because of tax rules that result in a "mismatch" of one sort or another in the treatment of offsetting or other related items, including with respect to the character, timing, source, or (non)recognition of items of income or expense. These mismatches can arise in a variety of situations. Some can be managed (or abused) through tax planning or by making appropriate timely elections, while others are difficult or impossible to avoid. Some of these mismatches may be reflections of thoughtful tax policy decisions, while others are simply the (unanticipated) result of the interface between rules that evolved to address different issues. Taxpayers and their advisers expend an enormous amount of effort dealing with mismatch problems. Mismatches also are problematic for the government because they can facilitate tax arbitrage and other tax minimization transactions that arguably are not consonant with good tax policy. The tax law contains an increasing number of targeted rules intended to ameliorate specific mismatch problems that may adversely affect the taxpayer or the government. Obvious examples include the hedging and straddle rules. In addition, there are some general rules that to one extent or another can be read as overriding other technical provisions to require the matching of related items. The promulgation of statutory or regulatory rules addressing problematic mismatches has been a painstakingly slow process. Many seri-

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE ous mismatch problems have taken years to resolve, and relief remains elusive for many others. Even where a fix is promulgated, it often fails to address all situations covered by the problematic mismatch. To date, the tax law has not explicitly articulated an overarch- ing "matching" rule or principle that would provide guidance to taxpayers and the IRS as to when and how mismatch problems might be resolved and, on the other hand, when they must be accepted as manifestations of considered policy judgments. Current proposals for tax reform generally tend to focus-as they should-on important considerations such as tax rates, equity, simplification, international competitiveness, and deficit reduction.1 Most tax reform proposals seek to simplify the tax law by expanding the tax base and eliminating tax expenditures 2 and other special rules that add complexity. The tax law, however, necessarily will continue to have numerous, detailed rules, which will be a source of continuing

1 See, e.g., Tax Reduction and Reform Act of 2007, H.R. 3970, 110th Cong. § 3001, available at http://www.opencongress.org/bill/l10-h3970/text (proposing, along with many other suggestions, to lower the top corporate marginal tax rates); Staff of H. Comm. on Ways & Means, 112th Cong., Summary of Ways and Means Discussion Draft: Participa- tion Exemption (Territorial) System 1-3 (2011), available at http://www.waysandmeans. house.gov/UploadedFiles/Summary-of Ways-andMeansDraftOption.pdf (proposing revenue-neutral tax reform with reduced tax rates, a broader tax base, and a territorial system to increase international competitiveness of U.S. corporations); The White House & Treasury Dep't, The President's Framework for Business Tax Reform (2012), available at http://www.treasury.gov/resource-center/tax-policy/Documents/The-Presidents-Frame work-for-Business-Tax-Reform-02-22-2012.pdf (proposing, along with other suggestions, to simplify and cut taxes for small businesses, establish a new minimum tax on foreign earnings to encourage domestic investment, and to restore fiscal responsibility by "not add[ing] a dime to the deficit"); Treasury Dep't, General Explanations of the Administration's Fis- cal Year 2013 Revenue Proposals (2012), available at http://www.treasury.gov/resource- center/tax-policy/Documents/General-Explanations-FY2013.pdf (proposing, among other measures, reform of the international tax system, and reduction of the tax gap and simplification of the tax system); Nat'l Comm'n on Fiscal Responsibility & Reform, The Moment of Truth 28-29 (2010), available at http://www.fiscalcommission.gov/sites/fiscalcommission. gov/files/documents/TheMomentofrruthl2 1 2010.pdf (proposing tax reform to achieve lower rates, a broader tax base, simplification, progressivity, and international competitiveness); The President's Econ. Recovery Advisory Bd., The Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation 3-4, 53-56, 65-69, 81-94 (2010), available at http://www.whitehouse.gov/sites/default/files/microsites/PERABTaxReform_ Report.pdf (offering a range of options for simplifying the tax code, improving taxpayer compliance, and reforming corporate taxation in the interest of maintaining international competitiveness, including through a reduction of the corporate tax rate, while maintaining overall revenue neutrality); Bipartisan Pol'y Ctr., Restoring America's Future: Reviving the Economy, Cutting Spending and Debt, and Creating a Simple, Pro-growth Tax System 16-21 (2010), available at http://www.bipartisanpolicy.org/sites/default/files/BPC%20FI NAL%20REPORT%20FOR%20PRINTER%2002%2028%2011.pdf (proposing a cut in tax rates and broadening the tax base by eliminating most tax expenditures). 2 See John L. Buckley, Tax Expenditure Reform: Some Common Misconceptions, 132 Tax Notes 255, 257 (July 18, 2011) (noting that "[t]he current tax reform debate ...seems to be almost completely focused on tax expenditures," and discussing the complexity of reforming tax expenditures).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: complexity.3 Moreover, as illustrated in this Article, beyond the complexity that arises from the need to understand and apply numerous detailed rules, a substantial amount of complexity (and unfairness) in the administration of the tax law is attributable to the mismatches that arise from the interface between these rules, many of which were promulgated to address specific concerns without any consideration of how the interface between these rules should be navigated. Thus, as part of any tax reform or simplification effort, it would appear to be highly desirable to consider whether it is feasible for Congress or Treasury to enunciate a "super-matching" rule-or a series of such rules tailored for different contexts-that would provide general guidance to taxpayers and the Service as to when and how to address the gaps and conflicts in existing law that give rise to mismatch problems and how to interpret the interplay between different substantive rules. In addition, consideration might be given as to whether and how the matching principle should be taken into account more prominently and consciously in crafting legislative and regulatory rules. Preliminary to considering the feasibility and possible terms of a super-matching rule (or rules), this Article first provides, in Part II, a more precise definition of "matching" and "mismatches," as well as an overview of the matching concept, and explores the degree to which this concept is already reflected in the tax law. Part III describes in greater detail how the matching concept is reflected in a variety of areas, as well as mismatch problems that arise. Apart from identifying cases that merit relief, an objective of this review is to endeavor, in Part IV, to derive lessons as to the sources of mismatch problems and the efficacy of approaches that have been adopted to achieve matching. Part IV also recommends specific changes in several areas that would likely have a significant beneficial impact on mitigating mismatches. Finally, this Article discusses in Part V considerations that are relevant to evaluating the feasibility and possible terms of a super- matching rule, makes recommendations in Part VI as to the possible scope and terms of such a rule, and provides some concluding comments in Part VII.

3 See Deborah L. Paul, The Sources of Tax Complexity: How Much Simplicity Can Fundamental Tax Reform Achieve?, 76 N.C. L. Rev. 151, 163 (1997) (arguing that tax complexity inevitably arises from any regime that is committed to raising a large amount of revenue equitably); cf. Steven A. Dean, Attractive Complexity: Tax Deregulation, the Check-the-Box Election, and the Future of Tax Simplification, 34 Hofstra L. Rev. 405, 413 (2006) (arguing that rational taxpayers will favor "attractive complexity" from tax rules that benefit them more than they cost them).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE

1I. OVERVIEW OF MATCHING AND MISMATCHES This Article focuses on the treatment of related or offsetting items by a taxpayer or related persons. In particular, it examines situations in which the tax law achieves consistent or symmetrical treatment (matching) of offsetting or other related items by a taxpayer or related persons. 4 Typically, where matching occurs, a taxpayer and related persons are taxed in respect of those items on a basis that is consistent with the economic income generated by those items. This Article is particularly interested in those situations in which there are "mismatches"-that is, where the tax law requires or permits offsetting or other related items to be treated inconsistently or asymmetrically by a taxpayer or related persons. The matching concept is prevalent throughout the tax law. As Reed Shuldiner has observed, "The basic approach of the Internal Revenue Code is one of consistency [that is, matching]."' 5 Thus, to cite just a few examples: 0 The fundamental tax accounting methods under § 446(a)-the cash and accrual methods-are each an attempt to provide a coherent and appropriate framework for determining a taxpayer's income and deductions, and, by virtue of the application of coherent and consistent rules for the reporting of items of income and deduction, achieve some degree of matching of offsetting or other related items by a taxpayer.

4 The concepts of consistency and symmetry in the tax law have been explored by others, using somewhat different terminology. See, e.g., Randall K.C. Kau, Carving Up Assets and Liabilities-Integration or Bifurcation of Financial Products, 68 Taxes 1003, 1007 (1990) ("I would propose that in analyzing various financial products and transactions, we follow the simple rule of adopting principles that minimize mismatching of timing, source and character wherever possible. In practice this involves adoption of what I will call 'integration' or the 'matching principle' wherever possible, many examples of which already exist in the law .... They all operate, however, by determining the consequences of a transaction by reference to all its parts and applying rules based on the pre- dominant characteristic of the transaction."); Julie A. Roin, Unmasking The "Matching Principle" in Tax Law, 79 Va. L. Rev. 813, 814 (1993) (using the term "systemic matching" or just "matching" to mean "relating the tax treatment of various parties in a given transaction to each other's tax treatment"); David M. Schizer, Balance in the Taxation of Deriva- tive Securities: An Agenda for Reform, 104 Colum. L. Rev. 1886, 1890 (2004) (advocating "balance" in taxing derivatives, "mean[ing] that for each risky position, the treatment of gains should match the treatment of losses"); Reed H. Shuldiner, Consistency and the Tax- ation of Financial Products, 70 Taxes 781, 782 (1992) (using "the term 'symmetry' to refer to equivalent treatment of the two sides to a single transaction [by the parties thereto] and the term 'consistency' to refer to equivalent treatment by a single taxpayer of two or more individual transactions making up parts of a larger overall transaction"). 5 Shuldiner, note 4, at 782. Shuldiner catalogues various manifestations of the matching principle, most of which are discussed herein. Id. at 782-90 (describing the matching principle in the context of tax accounting, investment expense deductions, timing option limitations, and financial product taxation).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: * The tax benefit rule-a judicially created doctrine endorsed by Congress in § 1116-is, at its core, a manifestation of the matching principle, by requiring that a taxpayer include a previously deducted amount in income whenever a "later event is... fundamentally inconsistent with the premise on which [a] deduction was initially based."'7 * Another judicially created principle, the Arrowsmith rule that relates the character of subsequent payments to that of the initial transaction, 8 is another manifestation of the matching principle. * Depreciation recapture 9 reflects a policy determination that to the extent that depreciation was available to offset ordinary income, subsequent gain should not be eligible for the more favorable capital gains rate.10 As is the case in other contexts as well, here the matching principle is tempered by other policies, so that, for example, in the case of depreciable real property, only the excess of accelerated over straight line depreciation is subject to depreciation recapture under § 1250.11 * The capitalization requirements of §§ 263 and 263A seek to better match the costs of capital assets and inventory, respectively, to the 2 income generated therefrom.' * Various limitations on the deductibility of interest are intended to conform-to one extent or another-the tax treatment of interest 13 to that of the associated income or activity.

6 There are two components to the tax benefit rule-the inclusionary aspect and the exclusionary aspect. The inclusionary aspect of the rule requires inclusion in income of any recovery of "an item that would not be includible in income except for the fact that that it was previously deducted or credited in . . . a prior year" and the like. Boris I. Bittker & Stephen B. Kanner, The Tax Benefit Rule, 26 UCLA L. Rev. 265, 272 (1978) (footnote omitted). "The exclusionary aspect... qualifies the rule's inclusionary principle by exclud- ing the recovery from income if, and to the extent that, the earlier deductions or credits were of no tax benefit." Id. at 276. 7 Hillsboro Nat'l Bank v. Commissioner, 460 U.S. 370, 383 (1983). 8 See Arrowsmith v. Commissioner, 344 U.S. 6, 8-9 (1952) (holding that the payment of a judgment rendered against a liquidated corporation should be treated as a capital loss because the liquidating distributions were treated as capital gains in prior years). 9 IRC §§ 1245, 1250. 10 S.Rep. No. 87-1881, at 92-93 (1962). 11 IRC § 1250(b)(1); cf. IRC § 1(h)(1)(D) (imposing a higher-than-usual capital gains rate to the extent of unrecaptured depreciation taken). Despite the recapture rules, however, the taxpayer benefits from the time value of money since the advantage of depreciation is recaptured in the year of sale, while depreciation deductions occur over the life of the asset. See Boris I. Bittker & Lawrence Lokken, Federal Taxation of Income, Estates & Gifts 1 51.1 (3d ed. 1999). 12 See IRC § 263(a) (capital assets), § 263A(a)-(b) (inventory and certain other property). 13 E.g., IRC § 163(d) (limiting deduction for interest attributable to investment income), § 163(h) (limiting deduction for interest attributable to personal expenditures), § 263(g) (limiting deduction for interest attributable to straddle positions), § 265 (limiting deduction for interest and other expenses attributable to tax-exempt income), § 469 (limiting deduc-

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE * The straddle rules,14 hedging rules,1 5 and mark-to-market rules for securities dealers16 represent different approaches to achieving matched treatment, for timing and character purposes, of offsetting positions. * In the related party context, the arm's length principle of § 482 can be viewed as a general, location-focused matching rule to ensure that items of income and expense are properly allocated between related persons. In addition certain deductions and losses are deferred or disallowed to better (but imperfectly) match the results of treating the related parties as a single economic unit,17 while the affiliated group intercompany transaction rules are infused with the matching principle,' 8 as are the rules for determining substantial economic effect of special allocations among partners.1 9 The rules prescribing a taxable year for different types of taxpayers 20 are intended to limit the opportunity for deferral of income inclusions (that is, a timing mismatch) between related parties. * In the international context, the matching concept underlies various source,2a subpart F,22 and foreign tax credit provisions, 23 but as discussed below, there are also significant mismatches. 24 * The provisions for mitigation of errors that would otherwise result in double inclusions or exclusions of income, deductions, or cred- 5 its2 achieve matching in a discrete set of circumstances. * The taxpayer's "duty of consistency" to report items consistently in subsequent periods regardless of whether the position taken in a prior period was correct is animated by a matching objective. 26 tion for interest and other expenses attributable to passive activities), § 1277 (limiting deduction for interest attributable to market discount). 14 IRC §§ 1092, 263(g). 15 IRC § 1221(a)(7); Reg. § 1.446-4. 16 IRC § 475. 17 IRC §§ 267(a), 707(b). 18 IRC § 267(f); Reg. § 1.1502-13. 19 IRC § 704(b)(2); Reg. § 1.704-1(b)(2). 20 E.g., IRC § 441(i) (personal service corporations), § 444(b) (limitations on taxable year other than required taxable year of a partnership, personal services corporation, or S corporation), § 706(b) (partnerships), § 898 (certain controlled foreign corporations), § 1378 (S corporations). 21 IRC §§ 861-865. 22 IRC §§ 951-965; see Joint Comm. on Tax'n, 111th Cong., Present Law and Back- ground Related to Possible Income Shifting and Transfer Pricing 36-47 (Comm. Print 2010). 23 IRC §§ 901-909. 24 See Section III.D. 25 IRC §§ 1311-1314. 26 See generally Steve R. Johnson, The Taxpayer's Duty of Consistency, 46 Tax L. Rev. 537, 537 (1991).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: Part III discusses in greater detail several of the foregoing examples of matching, as well as other cases, with a particular focus on the gaps, conflicts, and other circumstances that give rise to mismatches. At this juncture, it is worth noting that while the matching principle is a prevalent and longstanding policy consideration that operates in many areas of the tax law, it competes with and is sometimes overridden to one extent or another by other tax policy, structural, or practical considerations. Moreover, the matching principle is often downplayed, and thus it appears that in many instances in which different rules intersect so as to produce a mismatch, the mismatch is attributable more to oversight than forethought. Finally, it should be noted that the examples of mismatches discussed in the next Part are a small fraction of the mismatches that arise in the tax law.

III. THE MATCHING CONCEPT AND MISMATCHES IN VARIOUS AREAS A. Character: Capital vs. Ordinary When Congress first enacted a preferential flat tax rate for capital gains in 1924, it also introduced a flat rate deduction for capital losses, 27 on the grounds that such treatment is justified under a matching concept: "If the amount by which the tax is to be increased on account of capital gains is limited to 12-1/2[%] of the capital gain, it follows logically that the amount by which the tax is reduced on ac- ' count of capital losses shall be limited to 12-1/2[%] of the loss. 28 The manner in which capital gains and losses of individuals and corporations are treated has varied significantly over time.29 Today, individuals enjoy a preferential tax rate on net (long-term) capital gains,30 while capital losses can offset only capital gains plus $3000 of ordinary income in any taxable year.31 Capital gains of corporations are subject to tax at the same rates as ordinary income, 32 while capital losses can offset only capital gains.33 In a manifestation of the matching concept, short-term capital gains and losses, and long-term capital gains and losses, respectively, are first netted against each other and then against one another to arrive at net capital gain or loss. 34

27 Revenue Act of 1924, ch. 234, § 208(c), 43 Stat. 253, 263. 28 H.R. Rep. No. 68-179, at 20 (1924), reprinted in 1939-1 C.B. 255. 29 See generally Boris I. Bittker, Martin J. McMahon, Jr. & Lawrence A. Zelenak, Fed- eral Income Taxation Of Individuals 1 31.01 (3d ed. 2002) (noting that the "statutory details" governing capital gains and losses "have varied widely from time to time"). 30 IRC § 1(h). 31 IRC § 1211(b). 32 IRC §§ 11, 1201(a). 33 IRC § 1211(a). 34 IRC § 1222.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE While, as noted above, the capital loss limitation was initially based on the matching principle, this justification has been challenged by commentators as weak and imperfect,35 and of course this rationale does not explain the continued existence of that limitation where, as in the case of corporations, capital gains are not taxed at a preferential rate. The principal justification for maintaining the capital loss limitation is that otherwise taxpayers would be able to time their loss real- izations to offset ordinary income while deferring unrealized capital 6 gains. 3 Accepting the general need for a capital loss limitation and the at- tendant mismatches that arise therefrom to the extent the limitation prevents a taxpayer from benefiting from an economic loss that it suf- fered, 37 the limitation nonetheless gives rise to particularly unfair and inappropriate results where a single or integrated transaction produces both ordinary income and capital loss, especially where such a result is expected due to the nature of the transaction. In such a situation, the argument that a capital loss limitation is appropriate to prevent taxpayers from selectively selling loss assets to accelerate losses while deferring gains on other assets loses its force since the character mismatch is inherent in the single investment.

Example 1: In order to partially hedge its exposure to a portfolio of commercial real estate properties, a diversified real estate company enters into a derivative contract that is based on a broad market index. Depending on the nature of the

35 See, e.g., Alvin C. Warren, Jr., The Deductibility by Individuals of Capital Losses Under the Federal Income Tax, 40 U. Chi. L. Rev. 291, 309 (1973) ("[T]he argument for limiting the deductibility of capital losses as a parallel concomitant of preferential treatment of capital gains ... fails to overcome the case for full deductibility."). 36Staff of the Joint Comm. on Tax'n, 98th Cong., Taxation of Capital Gains and Losses 11-12 (Comm. Print 1983) ("The present limits on the deductibility of capital losses against ordinary income are made necessary by the fact that taxpayers have discretion over when to sell assets. Thus, if capital losses were fully deductible against ordinary income, as was the case between 1921 and 1934, a taxpayer owning many assets could selectively sell only those assets with losses and thereby eliminate the tax on ordinary income even though those losses were offset by unrealized capital gains in the taxpayer's portfolio."). Two other justifications have been provided for the capital loss limitation-namely, protecting the fisc and matching the treatment of capital gains and losses, mentioned above. Warren, note 35, at 309. 37Whether the capital loss limitation should exist and what the scope of the limitation should be is a matter of serious debate. See, e.g., Robert H. Scarborough, Risk, Diversifi- cation and the Design of Loss Limitations Under a Realization-Based Income Tax, 84 Tax L. Rev. 677, 707-16 (1993) (proposing reforms of the capital loss limitation with the aim of neutrality towards risk that can be eliminated by offsetting positions); Warren, note 35, at 314-16 (arguing that the limitation as then enacted fails to meet five criteria for acceptable treatment of capital losses); W. Kirk Baker, Note, Capital Loss Deduction Limits After the Tax Reform Act of 1986, 66 Tex. L. Rev. 159, 183-84 (1987) (advocating full deduction of capital losses generally with limits on deductions of certain "restricted assets").

Imaged with the permission of Tax Law Review of New York University School of Law 250 TAX LAW REVIEW [Vol. 65: derivative contract (for example, whether it is a swap, forward, or futures contract), gain or loss on the derivative contract may be ordinary, capital, or subject to § 1256 (60% long-term and 40% short-term capital gain or loss). On the other hand, under § 1231, any real estate gain could be capital (except to the extent of depreciation recapture) and any real estate loss could be ordinary. Example 2: An investor who has in effect an election to ac- 38 crue market discount each year as ordinary interest income purchases for $500 a distressed bond, issued with a face amount of $1000, representing a market discount of 50%. The accrued market discount increases the basis of the bond,39 so if the investor eventually sells the bond for the same price he purchased it (for example, because the financial prospects of the issuer and prevailing interest rates do not change materially during the period the investor holds the bond), he will suffer a capital loss. Similarly, the investor generally will be required to accrue the interest coupon on the bond on a current basis, as ordinary income, and would have a capital loss if eventually he does not receive payment.40

38 This election may be made under § 1278(b)(1), and once made is generally binding on the taxpayer for subsequent years. IRC § 1278(b)(3). See also Reg. § 1.1272-3 (election to accrue all income on debt instruments as it accrues, based on a single yield to maturity). If neither election is in effect, accrued market discount would not be includible in income on an annual basis, but upon a disposition of the market discount bond at a gain, a dispropor- tionately large share of the gain would be ordinary interest income due to the noneconomic assumptions of the market discount rules. See discussion and sources cited in note 40. 39 IRC § 1278(b)(4). 40 The character and timing mismatches arising from investments in distressed debt have emerged as serious problems in the recent financial crisis, and have prompted several thoughtful proposals for reform. See, e.g., N.Y. St. Bar Ass'n Tax Sec., Report on the Taxation of Distressed Debt, reprinted in 2012 TNT 15-21 (Jan. 23, 2012), available in LEXIS, Tax Analysts File ("NYSBA Distressed Debt Report") (discussing certain anoma- lies that occur when the current federal income tax rules applicable to debt instruments are applied to distressed debt instruments, and making regulatory recommendations); Ass'n of the Bar of the City of New York, Report Regarding Proposals for Accounting Treatment of Interest on Non-Performing Loans 16, reprinted in 120 Tax Notes 769 (Aug. 25, 2008) (discussing character and timing mismatches from the application of the general interest accrual, original issue discount (OLD), and market discount rules to nonperforming loans and making recommendations); David C. Garlock, How to Account for Distressed Debt, 127 Tax Notes 999, 1006-07 (May 31, 2010) (discussing impact of the tax law standard that requires accrual unless there is no reasonable expectation of collection, as well as the payment ordering rule of Reg. § 1.446-2(e), which treats any payment under a debt instrument as first attributable to interest to the extent accrued, and offering a variety of options for addressing the problem of "holders of distressed debt [required] to overaccrue ordinary taxable income"); see also Andrew W. Needham, Do the Market Discount Rules Apply to Distressed Debt? Probably Not, 8 J. Tax'n Fin. Products 19, 30 (2009) (arguing that the

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE Under a matching concept, an appropriate approach to the character mismatch arising from a single or integrated transaction would be to permit the taxpayer to recharacterize a capital loss as an ordinary loss to the extent of previously (or currently) included offsetting income from the position or a hedge position. Conversely, in a single or integrated transaction that first produces capital losses and later produces ordinary income, the subsequently included ordinary income should be permitted to be treated as capital gain to the extent of the previously (or currently) claimed capital losses. Indeed, Treasury and the IRS have crafted such a "character rever- sal matching rule" in the context of contingent payment debt instruments, where loss on a sale, exchange, or retirement that otherwise would be a capital loss is recharacterized as ordinary loss to the extent of the net amount of previous interest inclusions. 41 Issues related to character matching and mismatches are discussed further below, in the context of the hedging and straddle rules.42

B. Timing As noted in the previous Part, the cash and accrual methods of tax accounting achieve some degree of matching of offsetting or other related items by virtue of their application of coherent and consistent rules for the reporting of items of income and deduction. Under a realization-based tax system, however, timing mismatches are inevita- ble since by design or circumstances the cash- or accrual-basis realization event for various offsetting or other related items may fall in different time periods. Ordinarily, these timing mismatches are market discount rules do not pre-empt the common law "doubtful collectability" exception to the accrual of interest on distressed debt and that Congress did not intend to tax gains on distressed debt, as opposed to creditworthy debt, purchased at a market discount as interest income). The proposals relating to accrual of regular interest, OID, and market discount have largely sought to "turn off" the regular rules from applying to distressed debt (at least to the extent the income accrual exceeds some reasonable benchmark interest rate), but they present the challenge of determining precisely under what circumstances the general rules should be modified due to the distressed nature of the debt and what rules should apply to those circumstances. It has been reported that tax practitioners have accepted the nonac- crual of interest, OID, and market discount in excess of a benchmark market rate where the debt instrument's fair market value is below 50% of its principal amount. See NYSBA Distressed Debt Report, supra, at 16 (proposing a 50% valuation safe harbor, based in part on market practice, as well as a yield-based safe harbor and a presumption, in addition to a general rule for determining when debt is distressed); Garlock, supra, at 1002 ("[Tjests have emerged as practical ways of drawing a line between mildly and severely distressed debt.., the 50 percent line is purely arbitrary, but consensus seems to have arisen that this is a reasonable and conservative place to differentiate between mildly and severely distressed debt, at least in the current low-interest rate environment."). 41 Reg. § 1.1275-4(b)(8). 42 See Section III.C.

Imaged with the permission of Tax Law Review of New York University School of Law 252 TAX LAW REVIEW [Vol. 65: viewed as acceptable imperfections of annual accounting periods, especially where they are recurring ordinary-course-of-business items. Similarly, the allowance in general of a current deduction for investment interest relating to long-term capital investments-such as an investment in stock where the offsetting gains, if any, will be realized only upon a sale or taxable exchange of the investment-seems to reflect the judgment that such a mismatch (when viewed from the perspective of a direct tracing of the interest expense to the discrete leveraged investment) is an acceptable feature of a realization-based tax system so long as an overall matching is achieved by limiting the amount of aggregate investment interest deductions in any taxable year to the net investment income in that taxable year.43 On the other hand, certain mismatches-such as LIFO (last-in, first-out) inventory accounting and accelerated depreciation-reflect policy or political 44 decisions to benefit certain groups of taxpayers or activities. Among the situations where timing mismatches have been considered potentially abusive are those where tax losses and deductions are accelerated while related taxable income or gains are deferred, in particular where there is no overall economic loss. The tax law has sought to address these mismatches through the straddle rules of §§ 1092 and 263(g). 45 It has also been important to address timing mismatches in the context of hedging transactions, financial instru- 46 ments, and other integrated transactions. A very effective solution to timing mismatches is a mark-to-market method of tax accounting, as employed for securities dealers (and electively for securities and commodities traders) in § 475,47 and for

43 See IRC § 163(d) (investment interest deduction of a noncorporate taxpayer limited to net investment income for the taxable year); see also IRC § 263(g) (capitalization of interest and carrying charges that are properly allocable to a straddle position). 44 The stated purpose given for allowing LIFO accounting is that it "properly im- muniz[es] taxpayers from paying tax on 'phantom' inventory gains attributable to infla- tion." Edward D. Kleinbard, George A. Plesko & Corey M. Goodman, Is It Time to Liquidate LIFO?, 113 Tax Notes 237, 243 (Oct. 16, 2006); see also Amity Leather Products Co. v. Commissioner, 82 T.C. 726, 732 (1984) (citing Fox Chevrolet, Inc. v. Commissioner, 76 T.C. 708, 722 (1981)) (finding that LIFO "eliminat[es] from earnings any artificial profits resulting from inflationary increases in inventory costs"). It has been argued, however, that LIFO fails to achieve that purpose because it is "overinclusive in the gains that it permits taxpayers to defer." Kleinbard et al., supra, at 243. Under the accelerated depreciation regime, a deduction is allowed to precede the economic depreciation it corresponds to, reflecting a political decision to stimulate economic growth. William A. Klein, Joseph Bankman, Daniel N. Shaviro & Kirk J. Stark, Federal Income Taxation 568-69 (15th ed. 2009) ("Congress has deliberately provided taxpayers with a deduction that is generally in excess of the anticipated decline in value of the asset, in the hope of thereby stimulating investment."). 45 See Subsection III.C.3. 46 See Subsection III.C.1. 47 See Subsection III.C.2 (discussing § 475 and continuing mismatch issues thereunder).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE certain financial contracts in § 1256.48 Some commentators have advocated a wider application of mark-to-market accounting, while others have noted the difficult valuation, liquidity, and other issues 49 that it would present. The mismatches that can occur under a realization-based tax system can be mitigated or exacerbated through the presence or absence of special rules.

Example 3: Corporation A issues ten-year bonds to investors, in $1000 denominations. Three years after issuance, when Corporation A is experiencing financial distress and the bonds are worth $750, CorporationA and the investors exchange the bonds for new bonds with a $1000 denomination, but a reduced interest rate and lengthier maturity.

Since the repeal of § 1275(a)(4) and the enactment of § 108(e)(10) in 1990,50 CorporationA recognizes cancellation of debt (COD) income of $250 per each $1000 denomination, which would be offset in

48 A mark-to-market accounting method combined with a comprehensive set of hedging rules (as in § 475) can also be an effective tool for addressing character mismatches, but this would not be the case where the mark-to-market rule incorporates a split character rule such as the 60/40 rule of § 1256. See Subsection III.C.2. 49 It is widely agreed "that a mark-to-market (or accrual) system of taxation best measures Haig-Simons accretion to wealth and therefore is the optimal method to tax income." David A. Miller, A Progressive System of Mark-To-Market Taxation, 109 Tax Notes 1047, 1053 (Nov. 21, 2005) (advocating a "progressive" system requiring wealthier companies and individuals to mark certain assets to market). It is also widely agreed, however, that serious obstacles impede the implementation of a mark-to-market system, especially "its twin problems of valuations (How can all assets be valued every year?) and liquidity (How can taxpayers pay taxes if they do not sell their assets?)." David J. Shakow, Taxation Without Realization: A Proposal for Accrual Taxation, 134 U. Pa. L. Rev. 1111, 1113 (1986) (footnotes omitted) (giving those problems particular attention in a proposal for general adoption of mark-to-market taxation); see also Shuldiner, note 4, at 781 (noting increased use of mark-to-market taxation, but "no willingness to adopt mark-to-market taxation generally"). In addition to the valuation and liquidity problems, it has been argued that other problems associated with a mark-to-market system include "unpredictable and counterintuitive" tax results and a failure to "address the fundamental normative ten- sion ... between debt and equity." Edward D. Kleinbard, Beyond Good and Evil Debt (And Debt Hedges): A Cost Of Capital Allowance System, 67 Taxes 943, 956 (1989). 50 Revenue Reconciliation Act of 1990, Pub. L. No. 101-508, § 11325(a), 104 Stat. 1388, 1388-466 (enacting § 108(e)(11), currently designated as § 108(e)(10), Revenue Reconcilia- tion Act of 1993, Pub. L. No. 103-66, § 13226(a)(1)(A), 107 Stat. 312, 487). Section 108(e)(10) provides that a debt-for-debt exchange should be treated as if the debtor had satisfied the old debt with an amount of money equal to the issue price of the new debt, for purposes of determining COD income. Prior to its repeal, § 1275(a)(4) provided that the issue price of new debt issued in a debt-for-debt exchange that qualified as a corporate reorganization under § 368 is equal to the "adjusted issue price" of the old debt instrument if the issue price, as determined under §§ 1273 and 1274, would otherwise have been less than such adjusted issue price, thereby preventing the creation of OID upon a debt-for- debt exchange that qualified as a reorganization.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: amount-but clearly not in timing or in utilization ability-through deductions of OID over the remaining life of the new bonds. This result was criticized on practical and policy grounds when Congress repealed § 1275(a)(4) and created this timing mismatch, 51 and the wisdom of this decision has continued to be questioned.52 From the perspective of this Article, it might be questioned whether the calculus of balancing between the conflicting policy objectives would have produced a different result-either across the board or in the case of fi- nancially distressed borrowers-had the matching concept been given greater explicit prominence in tax policy deliberations. The iriterjec- tion of a mark-to-market realization event that creates a timing mismatch does not seem very sensible where mark-to-market tax accounting is not generally applicable to the overall transaction.

C. Hedging, Straddles, and Other Approaches to Matching Characterand Timing 1. Hedging Transactions The history of the treatment of hedging transactions provides an instructive illustration of the tax law's successes and failures in addressing matching concerns. 53 Moreover, the current state of affairs illustrates that despite the promulgation of a well-crafted set of rules that effectively implements the matching principle, mismatches can still arise. When the Revenue Act of 1934 eliminated the previous two-year holding period requirement that applied to capital assets (other than stocks and securities),5 4 taxpayers suddenly became exposed to the whipsaw of realizing capital gains and losses on forward or futures

51 See, e.g., N.Y. St. Bar Ass'n Tax Sec., Report of Ad Hoc Committee on Provisions of the Revenue Reconciliation Act of 1990 Affecting Debt-for-Debt Exchanges 7-9, reprinted in 51 Tax Notes 79, 86-88 (Apr. 8, 1991) (criticizing the repeal of § 1275(a)(4) because it causes the recognition of COD, and the "repeal appears to have been guided by the hypo- thetical cash exchange theory" which "is unrealistic"). 52 See, e.g., N.Y. St. Bar Ass'n Tax Sec., Report on the Definition of "Traded on an Established Market" Within the Meaning of Section 1273 and Related Issues 4-5 (Mar. 30, 2010), reprinted in 2010 TNT 61-24, Mar. 30, 2010, available in LEXIS, Tax Analyst File (recommending that Treasury exercise its regulatory authority to provide either that (1) issuers in a debt-for-debt exchange may amortize COD income or retirement premium over the new instrument's term, or (2) the issue price of new debt in a debt-for-debt exchange would be equal to the lesser of the issue price determined under § 1274 and the adjusted issue price of the old debt instrument). 53 For a comprehensive history of the hedging rules, upon which this discussion draws, see generally Edward D. Kleinbard & Suzanne F. Greenberg, Business Hedges After Ar- kansas Best, 43 Tax L. Rev. 393, 393-97 (1988); see also T.D. 8493, 1993-2 C.B. 255, 259 (describing the Arkansas Best case and how the uncertainty it caused necessitated the need for regulations addressing this issue). 54 Revenue Act of 1934, Pub. L. No. 72-216, § 117, 48 Stat. 680, 714.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE contracts that they entered into to hedge inventory or other business exposures that produced ordinary income or loss. Although neither the Revenue Act of 1934 nor its legislative history considered the application of the new definition of "capital asset" to hedging transactions, the Service understood the exposures faced by commercial hedgers, and in 1936, General Counsel Memorandum 17322 held that "true" hedges:

are common trade practices and are generally regarded as a form of insurance ... necessary to conservative business operation. Where futures contracts are entered into only to in- sure against the . . . risks [of price fluctuation in a cash position] inherent in the taxpayer's business, the hedging operations should be recognized as a legitimate form of business insurance. As such, the cost thereof (which includes losses sustained therein) is an ordinary and necessary expense .... Similarly, the proceeds therefrom in the form of gains realized upon hedging transactions are reflected in net income . . .55

The ensuing case law accepted the basic proposition of a hedging exception from the definition of capital asset, but struggled to formulate the contours of the exception until the Supreme Court, in the Corn Products case, expanded the exception to treat "profits and losses arising from the everyday operation of a business . . . as ordinary income or loss ...."56 Thereafter, some unwarranted expansions of the hedging exception to encompass investments in stock5 7 led to the Supreme Court's 1988 decision in Arkansas Best, which narrowly re-interpreted the hedging exception to cover only hedges of inventory.58 The severe mismatch problems created by the Arkansas Best decision for ordinary-course-of-business hedges other than inven-

55 G.C.M. 17,322 (1936), restated in part and superseded by Rev. Rul. 72-179, 1972-1 C.B. 57. 56 Corn Products Ref. Co. v. Commissioner, 350 U.S. 46, 52 (1955). 57 See, e.g., Campbell Taggart, Inc. v. United States, 744 F.2d 442, 460 (5th Cir. 1984) (holding that investment company's loss on stock purchased to protect its goodwill was an ordinary loss because the purchase was made with a business purpose), overruled by Ar- kansas Best Corp. v. Commissioner, 485 U.S. 212 (1988); Schlumberger Tech. Corp. v. United States, 443 F.2d 1115, 1120-22 (5th Cir. 1971) (holding that losses from stock investments that were necessary and integral to a taxpayer's business were ordinary losses). 58 Arkansas Best, 485 U.S. at 222-23 (holding that taxpayer's reading of Corn Products is "too expansive" because "Corn Products is properly interpreted as standing for the narrow proposition that hedging transactions that are an integral part of a business' inventory- purchase system fall within the inventory exclusion of § 1221," and thus taxpayer's "loss arising from the sale of the stock is a capital loss").

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: tory59 eventually led Congress and the IRS to promulgate a hedging 60 transaction rule. Under the "hedging transaction" exception, a "capital asset" does not include a transaction entered into in the normal course of the taxpayer's trade or business primarily to manage risk with respect to (1) price changes or currency fluctuations with respect to ordinary property held by the taxpayer, (2) interest rate or price changes or currency fluctuations with respect to borrowings, or (3) other risks covered in regulations.61 To qualify as a hedging transaction, the taxpayer must properly identify each such transaction. 62 If a taxpayer fails to make a timely and proper identification, the transaction will give rise to capital gain or loss notwithstanding that the underlying hedged transaction gives rise to ordinary income or loss. 63 Since a properly identified hedging transaction gives rise to ordinary gain or loss, 6 4 character mismatches are avoided between the underlying transaction and its hedge. Hedging transactions also avoid timing mismatches because they are subject to the matched timing rules of the regulations, which provide that "hedging transactions" must be accounted for using a method that clearly reflects income. 65 The regulations provide specific guidance on which method of accounting is appropriate for certain transactions. 66 However, the requirement that the taxpayer's

59 For example, the Arkansas Best decision cast doubt on the tax treatment of liability hedges, such as a short sale of Treasury securities to hedge against an increase in interest rates in anticipation of a planned future borrowing. The decision also unsettled the operation of § 1256(e), which excluded an ordinary-course-of-business "hedging transaction," in which all gain or loss was ordinary, from the § 1092 straddle rules and the § 1256 mark-to- market rules that apply to certain futures and currency contracts, since under Arkansas Best many such hedges gave rise to capital gain or loss. These and other mismatches arising from the Arkansas Best decision are discussed in Kleinbard & Greenberg, note 53, at 419-40. 60 IRC § 1221(a)(7), (b)(2); Reg. § 1.1221-2. These Code provisions were enacted in 1999. The Ticket to Work and Work Incentives Improvement Act of 1999, P.L. 106-170, § 532(a)(3), 113 Stat. 1860, 1928. In 2001 the IRS issued proposed regulations under §§ 1221(a)(7) and 1221(b)(2), which were finalized in March 2002. T.D. 8985, 2002-1 C.B. 707. 61 IRC § 1221(b)(2). 62 The regulations require same-day identification of the hedging transaction, Reg. § 1.1221-2(f)(1), and substantially contemporaneous identification of the hedged item, Reg. § 1.1221-2(f)(2). 63 Reg. § 1.1221-2(g)(2). There are limited exceptions to this rule. Id. 64 Reg. § 1.1221-2(g)(1). 65 Reg. § 1.446-4(b) ("To clearly reflect income, the method used must reasonably match the timing of income, deduction, gain, or loss from the hedging transaction with the timing of income, deduction, gain, or loss from the item or items being hedged.") 66 For example, the mark-and-spread method is an appropriate method of accounting for hedges of aggregate risk. Reg. § 1.446-4(e)(1)(ii). Moreover, marking the hedge to market for hedges of items marked to market is appropriate. Reg. § 1.446-4(e)(2). Fur-

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE method must clearly reflect income overrides the specific technical rules of the regulations where the application of those rules to a taxpayer's particular situation does not clearly reflect income. 67 In Revenue Ruling 2003-127 the IRS held that the matched timing rules of § 1.446-4 mandatorily apply to every hedging transaction, even if the taxpayer does not satisfy the identification and recordkeeping requirements.68 The ruling is also noteworthy in that it suggests that the "clear reflection of income" standard might be regarded as a "super-matching" rule for timing of income, at least in certain circumstances, that mandatorily applies notwithstanding the failure to satisfy ministerial identification or recordkeeping requirements. Fur- thermore, the ruling suggests that the matching principle might be a stronger force in the context of timing issues than in the context of character issues. In any event, the hedging character rules of § 1221(a)(7) and timing rules of § 1.446-4 represent a comprehensive and coherent response to the character and timing matching issues presented by hedging transactions. Mismatches can nonetheless arise in several circumstances. The most important gap arises with respect to transactions that are intended to constitute, and in fact are, economic hedges or are otherwise offsetting positions but that fail to satisfy the requirements for constituting a hedging transaction for purposes of § 1221(a)(7) and § 1.446-4. A common situation is a transaction that involves an economic hedge of an asset that is not ordinary property, such as a capital asset.

Example 4: A bank invests in mortgage backed securities (MBS) through a wholly owned LLC (treated as a disregarded entity) for valid business reasons. Two years after the LLC acquires the MBS, it enters into a total return swap (TRS) transaction with a counterparty to hedge a portion of its risk with respect to the MBS portfolio that it holds. thermore, for hedges of inventory, accounting for them in the same period as inventory costs or sales proceeds may be appropriate. Reg. § 1.446-4(e)(3)(i). 67 Reg. § 1.446-4(e). 68 Rev. Rul. 2003-127, 2003-2, C.B. 1245. The Service used the following reasoning: [T]he purpose of §§ 1221(a)(7) and 1221(b) is to address the character of income or loss. Specifically, these sections match the character of the hedge to that of the hedged item in a manner that is generally advantageous to taxpayers. The purpose of § 1.446-4 is to clearly reflect income by matching the timing of income, gain, loss, and deductions of a hedging transaction to income, gain, loss and deductions of a hedged item. This purpose is independent of character of income and loss. The ruling also justifies its conclusion on the ground that regulation § 1.446-4(a) refers only to the definition of "hedging transaction" in regulation § 1.1221-2(b) and not to the identification requirements of § 1.1221-2(f). See id.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: Under the TRS, changes in the value of the referenced securities are taken into account annually in determining the payments owed between the bank and the counterparty. Because the gain or loss on the MBS is capital gain or loss to the bank, 69 the transaction does not manage risk with respect to "ordinary property," and therefore, the swap transaction cannot qualify as a hedging transaction under either § 1221(a)(7) with respect to character or under § 1.446-4 with respect to timing. Thus, gain or loss on the MBS portfolio would be capital gain or loss and would be recognized upon a sale or taxable exchange of the MBS, whereas change-of-value payments under the TRS would be ordinary70 and would be accrued based on the ratable daily portion of the payments for the taxable year.71

Example 5: Same as Example 4 except that the bank holds the MBS directly, enters into the TRS, and identifies the positions as a hedging transaction.

In contrast to Example 4, the transaction in Example 5 qualifies as a hedging transaction because under § 582(c) all gain or loss on the MBS will be ordinary.72 Thus, the bank will take into account gain or loss on the TRS and on the MBS that are hedged by the TRS, on a consistent matched basis, as ordinary gain or loss recognized in the same period(s). 73

69 While § 582(c) provides for ordinary gain or loss on debt instruments held by a bank, "[i]f the single owner of a business entity is a bank .... then the special rules applicable to banks under the Internal Revenue Code will continue to apply to the single owner as if the wholly owned entity were a separate entity." Reg. § 301.7701-2(c)(2)(ii). Thus, § 582(c) is inapplicable to the bank in Example 4 in respect of its ownership of the MBS through the LLC. Regulation § 301.7701-2(c)(2)(ii) certainly merits reconsideration, but for purposes of this discussion, it should be recognized that a similar mismatch would arise if the LLC were a bona fide partnership owned, say, 99% by the bank and 1% by an affiliate. Although the MBS and the TRS are a straddle under § 1092 (since the MBS are "actively traded personal property" pursuant to § 1.1092(d)-l(a)), the gain or loss would still be capital. Because the example assumes that the LLC held the MBS for two years before entering into the straddle, the gain or loss on the MBS should be long-term. See Temp. Reg. § 1.1092(b)-2T(a)(2). 70 Prop. Reg. § 1.1234A-1(b); T.A.M. 9730007 (Apr. 10, 1997). 71 Reg. § 1.446-3(e)(2)(i) (providing for recognition of the ratable daily portion of a periodic payment for the taxable year to which that portion relates). In this example the change-of-value payments are periodic because they are paid annually. See also Prop. Reg. § 1.446-3(f)(2), (g)(6) (providing for recognition of the change-of-value payments over the term of the swap even if they are nonperiodic payments). Because the MBS and the TRS are offsetting positions in a straddle, loss may be deferred under § 1092. See Subsection III.C.3. 72 See note 69. 73 See Reg. § 1.446-4.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE 259 It is difficult to rationalize the mismatches in Example 4 compared to the matched treatment in Example 5. Similar mismatches can arise in other situations in which the hedged position is not ordinary property (for example, Example I above, involving an economic hedge of real estate). A matching of the character and timing of gains and losses on hedges and their offsetting positions is desirable even where the hedged positions are not ordinary property. Presumably, the character of the gain and loss on the hedged and hedging positions should be capital in such cases to the extent consistent with the holding period principles of the straddle regulations under § 1092.74 Another type of mismatch concern for taxpayers in the area of hedging transactions arises from the Service's narrow interpretation of the situations in which failures to properly identify hedging transactions-in particular, inadvertent failures-will be forgiven. Recogniz- ing that the identification requirement is critical to protect the government against late elections that with the benefit of hindsight could whipsaw the government, 75 the regulations nonetheless contain an exception to the identification requirement for a taxpayer that failed to identify a transaction as a hedging transaction "due to inadvertent error" if the transaction otherwise would have qualified as a hedging transaction and the taxpayer so treats all hedging transactions in all taxable years not barred by the statute of limitations.76 In prac- 77 tice, however, the IRS has interpreted this exception narrowly, which unfortunately undercuts the matching principle even in situations in which there are no material whipsaw concerns. 78

74 See Subsection III.C.3. 75 See S. Rep. No. 106-201, at 20 (1999), reprinted in 1999-3 C.B. 115 ("[T]o minimize whipsaw potential, the Committee believes that it is essential for hedging transactions to be properly identified by the taxpayer when the hedging transaction is entered into."). 76 Reg. § 1.1221-2(g)(2)(ii). 77 For example, the IRS has held that even if the taxpayer establishes that the inadvertent error exception applies, it would only convert gain or loss on the hedge into ordinary income or loss, but would not avoid the mark-to-market timing rules of § 1256(a)(1) if they were otherwise applicable. See C.C.A. 201046015 (Nov. 19, 2010) (holding that "[t]axpayer is not precluded, as a legal matter, from establishing that gains and losses on its [§] 1256 contracts were ordinary under [§] 1221(a)(7)," thereby potentially avoiding the character rules in § 1256(a)(3), but the mark-to-market timing rules of § 1256(a)(1) still applied), modifying C.C.A. 201034018 (Aug. 27, 2010) (holding that the § 1256 rules do not incorporate the inadvertent error exception of regulation § 1.1221-2(g)(2)(ii)); see also John D. McDonald, Ira G. Kawaller, L.G. "Chip" Harter & Jeffrey P. Maydew, The Devil Is in the Details: Problems, Solutions and Policy Recommendations with Respect to Cur- rency Translation, Transactions and Hedging, 89 Taxes 199, 240 (2011) ("A logical corollary would be that the IRS believes that the taxpayer could not rely on the inadvertent error exception to escape the [§] 1092 straddle rules, either."). 78 As in other areas, tax administration would be better served here if the IRS were willing to give weight to cases in which the taxpayer has identified a hedging transaction as

Imaged with the permission of Tax Law Review of New York University School of Law 260 TAX LAW REVIEW [Vol. 65: 2. Section 475 In the case of dealers in securities, 79 the importance of the hedging transaction rules for achieving matched character and timing results is eclipsed by § 475's requirement that dealers in securities mark to market their positions in securities (whether or not they are hedging transactions) and treat the gain or loss as ordinary,80 unless those positions are properly identified as held for investment or as hedges of investment positions.81 Matching will necessarily be achieved with respect to all securities that give rise to ordinary marked-to-market gain or loss under § 475. It is also noteworthy from a matching perspective that § 475 permits a taxpayer (1) to identify a position that is not a security, but that hedges a security, as being subject to the ordinary, mark-to-market rules,82 and (2) to identify a security that hedges a position that is not subject to the ordinary, mark-to-market rules as excluded from those rules,8 3 in each case so long as the taxpayer identifies the position by the end of the business day on which the security was acquired, originated, or entered into.8 4 Notwithstanding the comprehensiveness of the matching rules under § 475, that provision is not immune from potentially significant mismatches. A leading cause of these mismatches is uncertainty as to the scope of certain aspects of the provision, including in particular whether certain positions are eligible to be marked to market. Thus, for example, the regulations provide that a taxpayer's own debt is not

such for financial reporting purposes and is treating all similar positions consistently for tax purposes. 79 For purposes of § 475, a "dealer in securities" is a taxpayer that "regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business," or a taxpayer that "regularly offers to enter into, assume, offset, assign or otherwise terminate positions in securities with customers in the ordinary course of a trade or business." IRC § 475(c)(1). A "security" includes any "share of stock in a corporation;" any "partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust;" any "note, bond, debenture or other evidence of indebtedness;" any "interest rate, currency or equity notional principal contract;" any "evidence of an interest in, or a derivative financial instrument in," any of the foregoing; and identified hedges of the foregoing. IRC § 475(c)(2). 80 IRC § 475(a). 81 IRC § 475(b). 82 IRC § 475(c)(2)(F). 83 IRC § 475(b)(1)(C). If and to the extent applicable, these positions may be subject to § 1256, the hedging transaction rules, see Subsection III.C.1, or the straddle rules, see Sub- section III.C.3. 84 IRC § 475(b)(2), (c)(2)(F)(iii). There is no explanation in the legislative history of § 475 for the same-day identification requirement. The preamble to the temporary regulations under § 1.1221-2, however, notes that the same-day identification and record-keeping requirements are designed to help the IRS in "administering the law and ... prevent[ing] manipulation, such as recharacterization of transactions in view of later developments." T.D. 8493, 1993-2 C.B. 255, 258; see also note 75.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE considered a security and therefore cannot be marked to market.85 If interpreted literally and expansively, this would preclude certain dealer-issuers of structured notes from achieving matched character and timing results between the notes (or the embedded derivatives) and the offsetting hedges maintained by the dealer-issuers.

Example 6: A bank that is a derivatives dealer, and therefore, a dealer in securities for purposes of § 475, issues a principal-protected certificate of deposit (CD) that provides investors with an opportunity to partially share in the appre- ciation of a specified underlying stock or commodities index (up to a capped maximum return), while fully protecting them against depreciation in that index. These instruments are treated as debt for tax purposes (and are subject to the contingent payment debt instrument rules 86) because the bank is obligated to at least return the principal. The bank then hedges the economic risk attributable to the CD in the market. Its economic profit is the difference between the price at which the CD is sold to a customer and the price at which it can acquire a hedge that will offset the risk inherent in the derivative component of the CD.

If the regulation is applied literally and expansively, the bank would not be able to mark to market its exposure under the CD and must instead report it on an accrual basis. On the other hand, it would be required to report the economically offsetting gain or loss on the hedge on a marked-to-market basis under § 475. There are persuasive policy and technical reasons for concluding that the regulation should not be applied in this fashion and that the bank should be eligible (and, indeed, required) either to identify the offsetting positions as being subject to mark-to-market treatment under § 475 or, in the alternative, to treat them consistently on a matched accrual basis. 87 It

85 Reg. § 1.475(c)-2(a)(2). This regulation implements a statement in the legislative history of § 475: "[F]or purposes of the mark-to-market rules, debt issued by a taxpayer is not considered to be a security in the hands of such taxpayer." Staff of S. Fin. Comm., 106th Cong., Technical Explanation of the Senate Finance Committee Amendment to H.R. 4210, with Minority Views 91 n.55 (Comm. Print 1992). The preamble to the proposed regulation indicates that the rationale for this exception is that "[m]arking these items to market would not carry out the purposes of [§] 475.... " T.D. 8505, 1994-1 C.B. 152, 154. 86 Reg. § 1.1275-4. 87 Among these reasons are that, first, § 475 is a method of accounting, and thus its application to any particular situation is subject to the clear-reflection-of-income standard of § 446(b). See Bank One Corp. v. Commissioner, 120 T.C. 174, 283-88, 292 (2003), aff'd in part, vac'd in part & rem'd sub nom. JPMorgan Chase & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006). While marking to market the equity-linked CD and the hedge clearly reflects income (and accruing both positions on a consistent basis generally clearly reflects

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: has been reported, however, that IRS agents have been challenging such matched treatment. It is worth pausing to consider whether a clearly enunciated matching principle would obviate the need for Treasury and the IRS to clarify every single ambiguous provision that could lead to a mismatch in certain circumstances such as Example 6. Unlike the hedging transaction rules,88 § 475 and the regulations thereunder do not provide flexibility for taxpayers that inadvertently fail to make timely and proper identifications to rectify those errors.8 9 The Service's harsh and unyielding approach to such inadvertent failures has resulted in severe mismatches in some very sympathetic cases (including structured transactions in which the positions were inextri- cably, and clearly identified as, hedges for business and financial reporting purposes). It appears that the interests of fair tax administration would be better served by applying an inadvertent error rule that is patterned after the hedging transaction provision.

income as well), marking to market the hedge under §-475 but reporting the changes of value on the derivative that is embedded in the CD on a realization/accrual basis does not clearly reflect income. Cf. Rev. Rul. 2003-127, 2003-2 C.B. 1245 (supporting the application of the matched timing rules of § 1.446-4 since the equity-linked CD and the hedge constitute a hedging transaction within the meaning of § 1221(b)(2), notwithstanding that the taxpayer cannot satisfy the identification requirements of § 1.1221-2(f) and § 1.446-4(d) and that one leg is subject to § 475). Second, three factors point to limiting the statement in the § 475 regulations about an issuer's debt: (1) the clear reflection of income dictates of § 446, (2) the equity-linked derivative (viewed separately from the CD, as under analogous rules such as § 1092(d)(7), regulations § 1.1275-4(b)(9)(vi), § 1.246-5(b)(3), and § 1.246-5(c)(7)) and the hedge are both "securities" for purposes of § 475, and (3) § 475 mandates mark-to-market treatment of dealers' securities positions as the "only practical way to eliminate [the] large and unpredictable timing distortions" arising from their dealer activity, Bank One, 120 T.C. at 293, and § 475 contains comprehensive matching rules to match hedged positions. Thus, the statement that an issuer's own debt is not a "security" for purposes of § 475 should properly be construed as limited to its apparent and sensible purpose of not subjecting the funded debt portion of an issuer's balance sheet (that is, debt instruments, which are by definition "securities" absent this regulation) to the mark-to-market rules of § 475. This narrow reading of that statement prevents overturning the application of § 475 to a quin- tessential segment of a derivative dealer's business, particularly where, from the perspective of § 475, there is no discernible difference between equity-linked notes that are principal-protected, and thus treated as debt for tax purposes, and those that are treated as prepaid forward contracts or other nondebt derivatives. 88 See text accompanying notes 75-78. 89 Indeed, the IRS interprets the same-day identification requirement so strictly that a taxpayer that becomes subject to § 475 after it commences operations (whether as a result of a change of circumstances or, for example, as a result of electing out of the customer paper exemption or the negligible sales exemption) cannot make any identifications with respect to positions entered into prior to its becoming a dealer subject to § 475. See Rev. Rul. 97-39, 1997-2 C.B. 62 (Issues 14 and 15).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE 3. Straddles By contrast to the hedging rules and § 475, which contain a comprehensive and neutral set of matching rules (albeit with some gaps that can give rise to mismatches) for offsetting positions that are within the scope of those provisions, the straddle rules of § 1092 are targeted anti-abuse rules designed to counteract the acceleration of tax losses from positions in which there is unrealized gain on offsetting positions.90 Section 1092 also prevents a taxpayer from achieving long- term capital gains on a straddle position that was not held for the long-term holding period prior to establishment of the straddle91 or short-term capital losses where the taxpayer held a long-term capital asset as an offsetting position. 92 In addition, § 263(g) requires a taxpayer to capitalize interest and carrying charges properly allocable to personal property that is part of a straddle.93 Perhaps because they were developed as anti-abuse rules, the straddle rules are less refined than the hedging rules and are prone to over- or under-inclusiveness. For example, they only defer losses, not gains.94 The asymmetrical treatment of gains and losses may be justified on the grounds that, absent an acceleration of losses where there is unrealized gain on an offsetting position, there generally is no reason to interfere with the realization principle. On the other hand, if positions are sufficiently offsetting to be treated as a straddle, it may be argued that the treatment should be symmetrical, as would be the case under the hedging rules. While a matching of gains on straddle positions generally would benefit taxpayers, it would also foreclose strategies that are employed to refresh losses or other tax attributes. 95

90 See S. Rep. No. 97-144, at 8 (1981). 91 Temp. Reg. § 1.1092(b)-2T(a)(2). 92 Temp. Reg. § 1.1092(b)-2T(b)(1). 93 See Prop. Reg. § 1.263(g)-l(a) ("The purpose of [§] 263(g) is to coordinate the character and the timing of items of income and loss attributable to a taxpayer's positions that are part of a straddle. In order to prevent payments or accruals related to a straddle transaction from giving rise to recognition of deductions or losses before related income is recognized and to prevent the items of loss and income from having different character, no deduction is allowed for interest and carrying charges properly allocable to personal property that is part of a straddle. Rather, such amounts are chargeable to the capital account of the personal property to which the interest and carrying charges are properly allocable."). 94 IRC § 1092(a)(1). 95 Other strategies that are based on realizing the gain leg of a straddle in advance of the loss leg have been treated as listed transactions. See, e.g., Notice 2007-57, 2007-2 C.B. 87 (loss importation through use of a foreign currency straddle); Notice 2003-54, 2003-2 C.B. 363 (common trust fund investing in offsetting positions in foreign currencies to shift loss to a different taxpayer); Notice 2002-65, 2002-2 C.B. 690 (S corporation or partnership that enters into a foreign currency straddle, terminates gain leg, and then redeems stock of all shareholders but taxpayer); Notice 2002-50, 2002-2 C.B. 98 (use of tiered partnerships

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: Example 7: Taxpayer with an expiring net operating loss (NOL) carryover enters into a straddle transaction with generally offsetting positions in a volatile foreign currency. When the positions have moved sufficiently, taxpayer sells the gain position. Sometime thereafter it enters into a new offsetting position to limit its further exposure, and in the next taxable year it sells its positions, triggering the offsetting loss and "refreshing" its NOLs. 96

The straddle rules apply only to offsetting positions in "personal property" that is "actively traded. '97 Thus, the straddle rules do not apply to hedges of real estate such as the transaction described in Ex- ample 1, where timing and character mismatches continue to arise. Some taxpayers have attempted to exploit this limitation to structure economic straddles using property that is not actively traded, such as privately placed debt or foreign currencies that are not traded through regulated futures contracts, which the IRS has treated as listed transactions.9" The most troublesome potential mismatch arose under § 1092(a)(1) prior to 2004, where a taxpayer that had a loss on an "unbalanced" straddle position might have been required to defer the loss until it recognized all of its unrecognized gain on all potentially offsetting positions.

Example 8: A taxpayer has a $5 loss on a put option for one share of X Co. stock where the taxpayer holds 100 shares of X Co. stock with unrecognized gain of $8 per share, or $800 in the aggregate. Prior to 2004, it was unclear whether the taxpayer must defer its $5 loss until it recognized at least $5 of gain on each of the 100 shares of X Co. stock because of an uncertainty as to whether the taxpayer could treat the put option as offsetting only one share or instead must treat it as offsetting to some degree each of the 100 shares that it held. 99 without a § 754 election that first terminate gain leg of a straddle, to shift loss to a different taxpayer). 96 Assume the taxpayer also has a business purpose and sufficient opportunity for profit to overcome an attack on economic substance or similar grounds. 97 IRC § 1092(c)(1), (d)(1). 98 See, e.g., Rev. Rul. 2000-12, 2000-1 C.B. 744 (offsetting privately placed notes); No- tice 2003-81, 2003-2 C.B. 1223 (a gift to a charity of call and put options on both foreign currencies that are § 1256 contracts and those that are not). 99 See H.R. Rep. No. 108-548, at 1-363 (2004) ("While the present-law rules provide authority for the Secretary to issue guidance concerning unbalanced straddles, the Com- mittee is of the view that such guidance is not forthcoming. Therefore, the Committee believes that it is necessary at this time to provide such guidance by statute."); see also Ltr.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE This mismatch problem was ameliorated by the 2004 amendment of § 1092(a)(2), which now provides that if the taxpayer identifies the specific positions comprising a straddle (for example, the put option and one share of X Co. stock), the loss is added to the tax basis of the offsetting position(s) of the identified straddle (generally in proportion to their respective shares of the unrecognized gain) and is recov- ered as those offsetting positions are sold.100

4. Foreign Currency Hedging Transactions Not surprisingly in view of the central role that foreign currency hedges play in commercial activities, § 988(d) has its own hedging rule for foreign currency, and authorizes the IRS to issue regulations under which a § 988 transaction 0 1 that is part of a "988 hedging transaction" "shall be integrated and treated as a single transaction or otherwise treated consistently. . .. ,102 Section 988(d)(2) defines a "988 hedging transaction" more broadly than the parallel § 1221(b) hedging trans-

Rul. 199925044 (Feb. 3, 1999) (reviewing the applicable law and ruling that in the absence of regulations under § 1092(c)(2)(B) "it is permissible for Taxpayer to identify which shares of Corporation stock are part of the straddles"). 100 The matching principle is also reflected in the various rules relating to mixed straddles (that is, straddles where at least one, but not all, of the positions are § 1256 contracts and that are timely and properly identified), which are intended to facilitate a better matching of the timing and character of the income, gain, loss, and deductions relating to the positions in the mixed straddle. See IRC § 1256(d) (providing election to have § 1256 not apply to § 1256 contracts that are part of a mixed straddle), § 1092(b)(2); Temp. Reg. §§ 1.1092(b)-3T, 1.1092(b)-4T (providing rules for identified mixed straddles and mixed straddle accounts). 101 A § 988 transaction is any transaction described in § 988(c)(1)(B) "if the amount the taxpayer is entitled to receive (or is required to pay) by reason of such transaction is (i) denominated in terms of a nonfunctional currency, or (ii) is determined by reference to the value of [one] or more nonfunctional currencies." IRC § 988(c)(1)(A). Transactions described in § 988(c)(1)(B) include the following: "(i) The acquisition of a debt instrument or becoming an obligor under a debt instrument[;] (ii) accruing ... any item of expense or gross income or receipts which is to be paid or received after the date on which so accrued .. [; and] (iii) entering into or acquiring any forward contract, futures contract, option, or similar financial instrument." IRC § 988(c)(1)(B). 102 IRC § 988(d)(1). The legislative history indicates that Congress intended a broad exercise of regulatory authority to provide for both complete integration and other approaches to achieve matching of foreign currency hedges with the related positions: The second category of hedging transactions involves transactions that are not entered into as an integrated financial package but are designed to limit a taxpayer's exposure in a particular currency (e.g., the acquisition of a foreign currency denominated liability to offset exposure with regard to a foreign currency denominated asset). These regulations need not provide for complete integration (e.g., the form of currency borrowing may be respected and the interest deduction determined by reference to the spot rate on the date of payment). Where appropriate, these regulations should provide for consistent treatment with respect to character, source and timing. H.R. Conf. Rep. No. 99-841, at 11-548 (1986), reprinted in 1986-3 C.B. (vol. 4) 356.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: action definition, so as to cover managing "risk of currency fluctuations with respect to property which is held or to be held by the taxpayer," regardless of whether the property gives rise to ordinary income or capital gain or loss. 10 3 Pursuant to this grant of regulatory authority, § 1.988-5 provides for fully integrated treatment of § 988 hedging transactions involving (1) certain foreign currency debt instruments,'10 4 and (2) certain hedged executory contracts. 10 5 These rules enable taxpayers to achieve complete matching (for character, timing, and source purposes) of those foreign currency hedging transactions that are eligible for the integrated treatment, if they are timely identified. 10 6 To date the IRS has not promulgated regulations regarding the availability of § 988 hedging transaction treatment to hedged positions in foreign currency debt instruments that do not meet the requirements for full integration under the regulations. Consequently, while many foreign currency hedging activities can be conducted on an appropriately matched basis, taxpayers continue to face several significant mismatch concerns. Several such areas of concern are described herein. 07 First, § 1.988-5(a) permits integration of a nonfunctional currency debt instrument and currency hedge only if "[a]ll payments to be made or received under the qualifying debt instrument (or amounts determined by reference to a nonfunctional currency) are fully hedged on the date the taxpayer identifies the transaction ... as a qualified hedging transaction such that a yield to maturity. .. in the currency in which the synthetic debt instrument [resulting from the hedge] can be calculated."' 08 As a practical matter, this means that a taxpayer must hedge its foreign currency loans receivable through a full-term currency swap, notwithstanding that it may prefer for commercial reasons to enter into a series of rolling shorter-term forward contracts, one after the other. 10 9

103 IRC § 988(d)(2)(A)(ii). 104 Reg. § 1.988-5(a). 105 Reg. § 1.988-5(b). 106 The IRS can integrate a qualifying debt instrument (or executory contract) and its hedge even if they are held by different taxpayers and even if the transaction fails to com- ply with one or more of the technical requirements if the IRS determines that the transaction is, in substance, a qualified hedging transaction (or hedged executory contract). Reg. § 1.988-5(a)(8)(iii), (b)(3)(ii). 107 These and other mismatch problems are discussed in detail in McDonald et al., note 77, at 236-44. 108Reg. § 1.988-5(a)(5)(i). 109In general, entering into a series of short-term forward contracts is usually less ex- pensive than full-term currency swaps that are tailored to match the particular debt instrument (due to such forward contracts' commoditization, standardization, and depth of the market, as well as credit rating and collateral posting considerations), and they provide

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE Second, because § 1.988-5(a) requires that none of the parties to the hedge be related,110 taxpayers cannot use a centralized entity to enter into derivatives transactions with counterparties with respect to the foreign currency loans receivable of various foreign affiliates and enter into back-to-back hedges of those third-party derivatives with the affiliates whose receivables are being hedged. Taxpayers typically seek (or are required by their counterparties) to use a centralized entity to enter into derivatives contracts with the market because of net- ting agreements, creditworthiness considerations, ease of execution under a single ISDA master agreement, and other commercial reasons.11 Third, unlike the § 1221 hedging rules, 112 the regulations under § 988(d) do not have an inadvertent error exception to the identification requirement,11 3 thereby increasing the risk of mismatches 4 arising." Finally, another common mismatch situation involves so-called "Hoover hedges,"11 5 in which a U.S. corporation enters into foreign

greater flexibility in dealing with changes in circumstances. See McDonald et al., note 77, at 238-39. A hedge of foreign currency loans receivables through a series of forward contracts, which does not qualify for integration under § 1.988-5(a), may not be eligible for hedging under §§ 1.1221-2 and 1.446-4 because the receivables would not be ordinary property, and therefore would give rise to timing and character mismatches because §§ 1256 and 1092, rather than § 1.446-4, would be applicable. Id. at 240. It has been suggested, however, that taxpayers may be able to qualify under the § 1221(b) and § 1.446-4 hedging rules by docu- menting the hedge as a hedge of the foreign currency to be received under the loan receivables (which is ordinary property), rather than as a hedge of the loan receivables themselves. Id. In contrast to hedging foreign currency loans receivables, where the hedge relates to foreign currency borrowings of the taxpayer, the transaction will meet the conditions for a hedging transaction under regulation § 1.1221-2. Reg. § 1.1221-2(b)(2). Thus, although the foreign currency gain or loss will be ordinary under § 988, hedged timing treatment will be available under regulation § 1.446-4, and §§ 1256 and 1092 will not apply. 110 Reg. § 1.988-5(a)(5)(iii). M1See McDonald et al., note 77, at 237-38. In contrast to the very restrictive related party rule in the foreign currency debt integration regulation, Reg. § 1.988-5(a)(5)(iii), the OlD debt integration rules, which are patterned after the § 1.988-5(a) regulations but were issued four years later, sensibly provide that the parties may be related if the party providing the hedge uses a mark-to-market method of accounting for the hedge and all similar or related transactions. Reg. § 1.1275-6(c)(1)(ii). If the § 988 regulation were updated to reflect this evolution in thinking, the mismatch problem discussed in the text relating to the use of a centralized hedging entity would be solved. 112 Reg. § 1.1221-2(g)(1)(ii); see text accompanying notes 75-78. 113 See § 1.988-5(a)(8), (b)(3). 114 See McDonald et al., note 77, at 237 (suggesting that taxpayers may be able to rely on the common law "substantial compliance" doctrine under appropriate facts). 115 See Hoover Co. v. Commissioner, 72 T.C. 206, 238-50 (1979) (holding that gain or loss on foreign currency transactions entered into to hedge foreign currency exposures in respect of investments in foreign subsidiaries and their financial statement reporting of those investments were capital gain or loss).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: currency transactions to hedge its foreign currency exposure with respect to investments in its foreign subsidiaries. Because the regulations under § 988(d) do not apply to Hoover hedges, the U.S. corporation is required to recognize the foreign currency gain or loss on these hedges in advance of recognizing the gain or loss on the hedged investment. 16 In sum, notwithstanding a favorable statutory framework and reasonably developed regulations, taxpayers face potentially serious character and timing mismatches on hedged foreign currency transactions. 117

D. InternationalTax Provisions The matching concept is a prominent feature in many international tax provisions, but the potential for mismatches is very high as well. This Section briefly highlights some key examples of matching and mismatches, focusing on the source, global dealing, subpart F, and foreign tax credit rules.'1 8

116 See T.D. 8400, 1992-1 C.B. 101, 105 (Mar. 17, 1992). The IRS declined to adopt special timing rules that either parallel the financial accounting rules for Hoover hedges or that defer gains and losses on the Hoover hedges until dividends are paid to the U.S. corporation on the grounds that these deferral regimes are too complicated and "the general timing rules of the Code as applied to Hoover hedges provide a reasonable result." It noted that character mismatches in respect of Hoover hedges "are resolved under [§] 988(a)(1)(A) which characterizes such gains and losses as ordinary gains and losses (with a taxpayer election for capital gain or loss characterization)." 117Source and subpart F mismatches also occur, as noted in Subsections III.D.l.d and III.D.3. 118 An undeveloped area that is infused with matching issues is the scope of the so-called "consistency rule" that applies to a foreign person that has income that is effectively connected with the conduct of a U.S. trade or business (ECI) and is eligible to claim the benefits of an income tax treaty. Under the consistency rule, such a taxpayer may not take an inconsistent position in claiming benefits under the treaty and U.S. domestic law. For example, the Service held that a Polish resident that sells product A through a U.S. permanent establishment and products B and C through independent contractors cannot invoke the U.S.-Poland treaty to exclude from tax the profits from the sale of product B on the ground that such profits are not attributable to a permanent establishment, while offsetting the loss from the sale of product C against the profits from the sale of product A, on the ground that the loss is effectively connected to a U.S. trade or business and is deductible under the Code. Rev. Rul. 84-17, 1984-1 C.B. 308 (1984). For an extensive discussion of the consistency rule, see Letter from Lawrence R. Uhlick, CEO, Inst. of Int'l Bankers, to Eric Solomon, Assistant Sec'y (Tax Pol'y), Treasury Dep't (Oct. 1, 2007), 2007 TNT 194-29, Oct. 5, 2007, available in LEXIS, Tax Analysts File (criticizing expansion of the consistency rule in the U.S. Treasury Technical Explanations to the new Belgian treaty and German treaty protocol). The technical explanations to subsequent treaties appear to have re- verted to the position that was reflected in earlier technical explanations. See, e.g., Trea- sury Dep't, Technical Explanation of the Convention Between the Government of the United States of America and the Government of Iceland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, arts. 1(2) & 7(2) (Oct. 23, 2007), U.S. Tax Treaties (CCH) 4041 (omitting troublesome language

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE 1. Source a. In General For U.S. persons, the source rules' principal importance is in calculating the foreign tax credit and various discrete provisions that turn on the source of income. For non-U.S. persons, source plays a prominent role in determining whether an item is taken into account for U.S. tax purposes and, if so, on what basis. The matching concept is relevant for determining how items of expense, loss, or other deductions should be allocated or apportioned to related items of income that are sourced either in or outside the United States (or in a particular category of income). In general, the rules of the regulations for allocating and apportioning deductions seek to match the deductions to the classes of gross income to which they relate, either directly or based on a proportionate allocation formula (using appropriate factors), and then on the same basis to apportion those deductions between the statutory grouping (for example, foreign source income) and residual grouping.1 19 Political and other policy considerations, however, can affect those rules. For example, the allocation method for research and de- that appeared in the parallel discussion in the technical explanations to the Belgian and German treaty protocols, see Treasury Dep't, Technical Explanation of the Protocol Signed at Berlin on June 1, 2006 Amending the Convention Between the United States of America and the Federal Republic of Germany for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital and Certain Other Taxes, arts. 1(2) & 7(2), U.S. Tax Treaties (CCH) 1 3229B; Treasury Dep't, Technical Explanation of the Tax Convention for the Avoidance of Double Taxation and the Preven- tion of Fiscal Evasion with Respect to Taxes on Income and Capital and to Certain Other Taxes Signed on 29th August 1989, arts. 1(2) & 7(2) (Nov. 27, 2006), U.S. Tax Treaties (CCH) 1352). The withholding tax on U.S. source rent, dividends, and similar fixed or determinable, annual, or periodical income of non-U.S. persons can give rise to a mismatch to the extent that the non-U.S. person incurs expenses in generating the income, which would not offset the tax base on which the gross withholding tax is imposed. See IRC § 871(a)(1)(individuals), § 881(a)(corporations). In the case of rent from real property, the foreign taxpayer may elect to treat the rental activity as giving rise to ECI, IRC § 871(d)(individuals), § 882(d)(corporations), which is subject to tax on a net basis, IRC § 871(b)(individuals), § 882(a)(corporations). Dividends are not eligible for a net income election, see IRC § 873(a) (limiting deductions to costs connected with individual's ECI), § 882(c)(1)(A) (same for corporations), and thus non-U.S. persons have been exposed to a gross withholding tax on investment strategies in which they incur nondeductible expenses. See Yaron Z. Reich, Taxing Foreign Investors' Portfolio Investments: Developments & Discontinuities, 79 Tax Notes 1465, 1478-79, 1499 (June 15, 1998) (discussing leveraged stock investments and stock arbitrage transactions involving long positions in stock and offsetting derivative positions, and recommending a portfolio dividends exemption from withholding tax). The arguments for addressing these dividend-related mismatches have been weakened as a result of the enactment of § 871(m), providing for a withholding tax on dividend equivalent amounts. 119Reg. § 1.861-8(a)-(d).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: velopment expenses generally results in a disproportionate allocation 120 against U.S. source income. These rules also can result in a disproportionate allocation of deductions against U.S. source income because expenses other than interest are allocated on the basis of their relationship to U.S. and foreign source gross income, as noted above,1 21 whereas the non-subpart F income of a U.S. multinational group's foreign subsidiaries is taken into account only if and when distributed. To address this perceived distortion and better match deductions with related income, the proposed Tax Reform and Reduction Act of 2007, which was not enacted, would have added a provision to the Code (§ 975) that would have (1) required deferred foreign income (that is, income of foreign subsidiaries that is not currently repatriated or taxed under subpart F) to be taken into account in calculating the allocation of deductions between U.S. and foreign sources, and (2) deferred the deductions attributable to the deferred foreign income until such income is 122 repatriated.

b. Interest Expense In the case of interest expense, the U.S. tax treatment of foreign subsidiaries can produce the reverse result, of a disproportionate allocation of interest deductions against foreign source income. In general, under § 1.861-9T of the regulations, interest is allocated proportionately, based on the relative (tax book or fair market) value of U.S. and foreign source assets, on the theory that money is fungible. For this purpose, the stock of a foreign subsidiary is taken into account as an asset that produces foreign source income, and thus a proportionate amount of interest expense on U.S. borrowings of a U.S. multinational corporation would be treated as foreign source on account of the (tax book or fair market) value of the stock of its foreign subsidiaries.' 23 Where the foreign subsidiaries are leveraged at a comparable level to the U.S. group-as is often the case with securities dealers, which finance their securities inventories through repo or securities lending transactions and are highly leveraged both within and outside the United States-the allocation of a portion of the interest paid by the U.S. group to the stock of the foreign subsidiaries

120 See IRC § 864(g)(1) (allocating and apportioning 50% of research and development expenditures attributable to activities conducted in the United States to U.S. source income and the remainder, in general, on the basis of gross sales or gross income); Yaron Z. Reich, International Arbitrage Transactions Involving Creditable Taxes, 85 Taxes 53, 66 (2007). 121Reg. § 1.861-8(a)-(d). 122 H.R. 3970, note 1, § 3201. 123Reg. § 1.861-9T(g).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE results in a disproportionate allocation of interest expense to foreign sources, when viewed from a worldwide aggregate perspective. In response to a lengthy lobbying process by the financial industry, 124 in 2004 Congress finally enacted § 864(f) providing taxpayers with a one- time election to allocate interest expense on a worldwide group basis, taking into account the assets and third-party liabilities of foreign subsidiaries. 25 The effective date of this provision, however, has continued to be delayed (it now is 2021) due to the revenue cost of making this correction to a flawed matching rule. 12 6 Apart from the foregoing mismatches, which are attributable to the structural features of the Code's treatment of foreign subsidiaries, other mismatches arise due to the details of the relevant rules. Thus, as noted above, the guiding principle underlying the allocation of interest expense for sourcing purposes is that because money is fungible and can be used interchangeably to fund all of a taxpayer's activities, interest expense should be allocated based on the relative (tax book or fair market) value of the assets that give rise to U.S. source vs. foreign source income. 127 Only in very limited circumstances is interest expense directly allocable against income from a specific transac-

124 See, e.g., Marty A. Sullivan, Interest Allocation Reform: Time to Talk or Time to Act?, 84 Tax Notes 1223, 1225 (Aug. 30, 1999) (recognizing that the lobbying efforts of U.S. multinational corporations have been successful in pushing through reform of the interest allocation rules in the 1999 Taxpayer Refund and Relief Act, which was vetoed by Presi- dent Clinton). 125This provision had been proposed in Congress in 1986. See Tax Reform Act of 1986, S. 3838, 99th Cong. § 914 (as passed by the Senate, June 24, 1986) (proposing to amend § 864(e) to allocate interest of an affiliated group by taking into account foreign subsidiaries). 126See Hiring Incentives to Restore Employment (HIRE) Act, Pub. L. No. 111-147, § 551, 124 Stat. 71, 117 (2010) (codified at 26 U.S.C. § 864). 127Reg. § 1.861-9T(a) ("The method of allocation and apportionment for interest set forth in this section is based on the approach that, in general, money is fungible and that interest expense is attributable to all activities and property regardless of any specific purposes for incurring an obligation on which interest is paid."). Reg. § 1.882-5(a) applies the same fungibility principle in the context of a foreign corporation to determine its interest expense that is allocable to ECI under a three-step formula. In Step 1, the amount of U.S. assets for the taxable year is determined based on the assets that give rise to ECI. In Step 2, the amount of U.S.-connected liabilities for the taxable year is determined by multiply- ing the amount of U.S. assets in Step 1 by either a fixed ratio (95% in the case of a bank and 50% in other cases) or the actual ratio of worldwide liabilities to worldwide assets. In Step 3 the amount of interest expense on U.S.-connected liabilities is determined either under the adjusted U.S. booked liabilities method or the separate currency pools method.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: tion or activity. 128 These rules apply to both U.S. persons129 and 30 foreign corporations that have ECI.1 The failure of the tax rules to accept direct matching of interest expense against related income in a wider range of circumstances has resulted in severe distortions that have adversely affected both taxpayers and the government. Thus, as indicated above, securities dealers (and banks) can finance their securities inventories through repo or securities loan transactions, which in the case of U.S. Treasuries and certain other government securities can be financed in this manner at close to 100% leverage. A foreign bank whose U.S. branch is a primary dealer in U.S. Treasuries, however, is limited to an interest deduction determined under § 1.882-5, either using the bank's worldwide leverage ratio or a 95% fixed ratio, both of which are below the bank's demonstrably higher actual interest expense in respect of its repoed U.S. Treasuries portfolio, but must treat as ECI all of the income from the portfolio, which can actually produce an economic after-tax loss. Conversely, in certain economic environments, U.S. securities dealers have been able to utilize the interest allocation rules, as self-help, to improve their foreign tax credit position by holding repoed positions in low-yield foreign debt (for example, Japanese gov- 31 ernment bonds). 1 The uncertainties relating to the treatment of conduit-type interbranch loans and related hedges by U.S. branches of foreign banks exemplify the mismatches that can arise from gaps in, and inconsistencies between, intersecting rules (in this case, the interest allocation rules under § 1.882-5, the ECI rules under § 864, and the foreign currency rules under § 988). For example, suppose a European bank sees a market opportunity to raise euros for its business at an attractive cost by having its U.S. branch borrow dollars, enter into a dollar-euro currency swap, and lend euros to its head office. Alternatively, because the U.S. branch is able to access euros at an attractive rate, the

128 Section 1.861-10T contains three exceptions to the fungibility principle, permitting direct tracing of interest expense against (1) income that is generated by assets that are subject to qualified nonrecourse indebtedness; (2) income generated by certain assets that are acquired in an integrated financial transaction with the debt, but this exception is not applicable to a financial services entity; and (3) "excess related person indebtedness" from a controlled foreign corporation to its U.S. affiliate. 129 Reg. § 1.861-9T. 130 Reg. § 1.882-5. 131 In Notice 2001-59, 2001-2 C.B. 315, the IRS requested comments regarding these mismatches, but it has not issued any guidance in response to the comments that it received. The failure to issue guidance addressing these mismatches does not appear to be based on strong policy grounds, since those foreign banks that are eligible, under certain treaties, to apply the OECD risk-weighted allocation method for determining interest expense attributable to a permanent establishment can avoid the mismatch by electing to apply such an approach. See note 151 and accompanying text.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE bank causes the U.S. branch to borrow euros and on-lend the proceeds to its head office. In both situations, it would appear that the appropriate result would be to treat all of the interest expense (on the market borrowing), income (on the interbranch loan), and related foreign currency gain or loss on a consistent basis for sourcing and ECI purposes. Assuming all these items are excluded from the calculation of ECI (because the interbranch items are disregarded), the branch should be allocated a fee for the services it provided to its head office under § 482 arm's length principles. Indeed, because the interbranch loans are disregarded and are not treated as assets of the U.S. branch for federal income tax purposes, under regulation § 1.882-5 the bank is (appropriately) not entitled to an interest expense for the funding of the interbranch loans.132 It is less clear, however, whether the related foreign currency gains or losses would also be excluded from the calculation of ECI.133 If the foreign currency gains and losses cannot be excluded, changes in the dollar-euro currency exchange rate could give rise to significant amounts of taxable gains or losses notwithstanding that there are offsetting but unrecognized losses or gains on the disregarded interbranch transactions, thereby resulting in substantial distortions in taxable income that could adversely affect the taxpayer or the government depending on the direction of the currency movement. 134

132 See Reg. § 1.882-5(b)(1)(iv) (interbranch transactions do not create U.S. assets for purposes of Step 1 of the formula described in note 127); Reg. § 1.882-5(c)(1) (calculation of U.S.-connected liabilities under Step 2 of the formula by reference to the amount of U.S. assets). 133 While § 1.882-5 (and the proposed regulations thereunder) contain several provisions that are intended to take hedging transactions into account in the calculation of the various steps of the formula described in note 127, they do not specifically address hedges of interbranch items, and it is unclear whether the foreign currency hedges in the example in the text should be viewed as hedges of the interbranch loans or, instead, of the market borrowings. Additionally, while certain provisions of the regulations indicate that items of income, expense, gain, or loss from hedging transactions should be adjusted in a manner consistent with the treatment of the related liability, see, e.g., § 1.882-5(d)(4) (in the context of the "scaling ratio" that reduces interest expense where the amount of U.S.-booked liabilities exceeds the amount of U.S.-connected liabilities under Step 2 of the formula), other provisions do not explicitly so provide. T.D. 8658, 1996-1 C.B. 161, accompanying the issuance of § 1.882-5, indicates that, at least in the case of an unhedged liability denominated in a nonfunctional currency, "[t]he amount and source of exchange gain or loss from a section 988 transaction will therefore continue to be determined under section 988, without any reduction as a result of the scaling ratio in § 1.882-5." The Treasury Decision's statement could apply to the example in the text where the branch borrows euros and on- lends the euro proceeds to the head office if the euro borrowing is viewed as unhedged because the intercompany loan is disregarded. Moreover, there is no provision that clearly excludes the foreign currency gain or loss from the calculation of ECI under § 864 in all relevant circumstances. 134 There is also no clear provision for allocating to the branch a fee for the services it provided to its head office under § 482 principles, since interbranch transactions generally

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: c. Interest Equivalents Section 1.861-9T(b) of the regulations contains several targeted rules intended to better match the sourcing of expenses or losses (and in some cases, gains) from "interest equivalents" with the sourcing of interest expense. A number of these rules, however, are exceedingly narrow, and fail to address obvious and common mismatches. 135 d. Foreign Currency Sourcing Rules Foreign currency gain or loss is generally sourced based on the residence of the qualified business unit of the taxpayer. 136 By contrast, interest income is sourced based on the residence of the payor 137 while interest expense is apportioned under the rules under §§ 1.861- 9T and 1.882-5 of the regulations (and related provisions) as applicable. 138 Given the relationship between foreign currency gain or loss in respect of a debt instrument (or a hedge thereof) and interest income and expense from such debt instrument, it should be no surprise that mismatched sourcing outcomes arise where the hedging rules do not apply. For example, suppose an investor holds U.K. government bonds and enters into a series of rolling sterling/dollar forward contracts to hedge a portion of the foreign currency exposure. Neither the § 988(d) nor the general § 1221(a)(7) hedging rules will apply in this situation, and accordingly the interest income on the bonds will be are disregarded for federal income tax purposes and the market borrowing is not a transaction that gives rise to gross income that is susceptible to allocation. The results in the inter-branch euro loan examples may differ under an income tax treaty that follows the OECD approach described in note 151 and accompanying text, since in general under that approach, interbranch transactions are recognized. See OECD, Report on the Attribution of Profits to Permanent Establishments 12-13 (2008), available at www. oecd.org/dataoecd/20/36/41031455.pdf. A branch may provide "agency or conduit functions" for raising funds on a foreign capital market for the head office or another branch, in which case the branch raising the funds would simply earn a fee for the services provided to the head office or other branch. Id. at 115-17. 135 Thus, § 1.861-9T(b)(1) provides that any expense or loss in a series of integrated or related transactions in which the taxpayer secures the use of funds for a period of time is allocated under the rules for interest expense if the expense or loss is incurred in consideration of the time value of money. This rule applies to currency or interest rate hedges on debt, but not to the net gain from such hedged positions. Section 1.861-9T(b)(2) applies only to net loss on hedges of borrowings in strong currencies. Section 1.861-9T(b)(6) expands on § 1.861-9T(b)(1) with respect to losses (and, if taxpayer makes a proper identification, gains) on financial products such as swaps, options, and forwards that alter the effective cost of borrowing, but only if the hedge is in the same currency as the borrowing. This rule does not apply to dealers and its application to financial services entities is re- served. For a good discussion of potential mismatches arising from these rules, see Mc- Donald et al., note 77, at 232-36. 136 IRC § 988(a)(3)(A); Reg. § 1.988-4. 137 IRC §§ 861(a)(1), 862(a)(1). 138 See Subsection III.D.l.b.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE foreign source while the foreign currency gain or loss on the forward 139 contracts will be U.S. source. e. Personal Property Sales Section 865 and the regulations thereunder generally adopt a matching concept to allocate loss recognized with respect to personal property in the same manner as gain would have been allocated under § 865.140 The regulations also contain specific rules for special cases 141 that are consistent with a matching concept. In addition, the anti-abuse provisions in the regulations include matching rules for offsetting positions of the taxpayer or a related person.142 Thus, if a taxpayer "recognizes loss with respect to personal property and the taxpayer [or a related person] holds (or held) offsetting positions with respect to such property with a principal purpose of recognizing foreign source income and United States source loss, the loss shall be allocated and apportioned against such foreign source income.1 43 Because these matching rules are formulated as anti- abuse provisions, however, they are one-directional and dependent on a principal purpose test. There is no clear rule that would enable a taxpayer to match foreign source loss and offsetting U.S. source income or gain.

2. Global Dealing Global dealing refers to the intercompany, interbranch, and other cross-border operations of banks and securities firms relating to the conduct of their securities, swaps, foreign currency, and derivatives

139 The § 988(d) integration rules do not apply for the reasons discussed in notes 108-09 and accompanying text. The § 1221(a)(7) hedging rules do not apply to transactions that manage risks of assets that can produce capital gains or losses. See note 61 and accompanying text. In this example, if the foreign currency hedges are viewed as relating to the receivable itself rather than as managing foreign currency risk of the principal amount, they would not qualify as a hedging transaction for tax purposes. This problem might be cured by identifying the hedges as hedging the currency to be received upon repayment of the loan receivable (which would be ordinary property) rather than the receivable itself. See McDonald et al., note 77, at 240. 140Reg. § 1.865-1(a)(1) (personal property generally); Reg. § 1.865-2(a)(1) (stock). 141 See, e.g., Reg. § 1.865-1(a)(2), -2(a)(2) (loss attributable to a foreign office or stock attributable to a foreign office); Reg. § 1.865-1(c)(4) (unamortized bond premium); Reg. § 1.865-1(c)(5) (loss attributable to accrued interest); Reg. § 1.865-2(b)(1) (dividend recapture exception). 142 See Reg. § 1.865-1(c)(6), -2(b)(4). 143 Reg. § 1.865-1(c)(6)(ii); see also Reg. § 1.865-2(b)(4)(ii) (containing a similar rule for offsetting positions relating to stock); Reg. § 1.865-1(c)(6)(iii), -2(b)(4)(iii) (containing matching rules for transactions with a principal purpose to recognize foreign source income that results in the creation of a corresponding loss (for example, as a consequence of the rules regarding the timing of recognition of income)).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: dealing businesses.1 44 These activities emerged in a significant way in the past twenty-five years and now comprise a substantial portion of the businesses of these financial institutions. Mismatches attributable to the interplay of various formalistic tax rules in a commercial context that were not contemplated when those rules were put into place gave rise to the very serious concerns of multinational banks and securities firms engaged in global dealing operations. In particular, with respect to the non-U.S. participants in such activities, the rules for determining ECI in respect of transactions involving financial instruments took an "all or nothing" approach to allocate to U.S. sources and treat as ECI all of the gain on the financial instruments entered into as part of a global dealing operation if the activities of the U.S. branch (or deemed branch) was a material factor in the realization of the income. 145 Those rules resulted in a substantial over-inclusion of income for U.S. tax purposes and the serious risk of double taxation, because those rules fail to take into account the relative business contributions of the U.S. branch (or deemed branch) and other offices or affiliates.146 They also exposed financial institutions to the risk of "split hedges," whereby for U.S. tax purposes, income or loss on one leg of a hedged transaction would be ECI while income or loss on the other leg would be exempt from U.S. tax, thereby resulting in the serious mismatching of income and loss from integrated transactions. 147 Proposed regulations issued in 1998148 achieve an overall matching of results from a global dealing operation by, in general, allocating for source and ECI purposes all of the income, gain, loss, and deduction on the financial instruments that are attributable to that activity based on an allocation method that is consistent with the arm's length princi-

144See Yaron Z. Reich, U.S. Federal Income Taxation of U.S. Branches of Foreign Banks: Selected Issues and Perspectives, 2 Fla. Tax Rev. 1, 16-17 (1994); Leslie B. Samuels & Patricia A. Brown, Observations on the Taxation of Global Securities Trading, 45 Tax L. Rev. 527, 529-44 (1990). 145 This all-or-nothing rule is embodied in several regulations. See, e.g., Reg. § 1.863- 7(b)(3) (notional principal contracts); Reg. § 1.864-4(c)(1)(i) (business-activities test); Reg. § 1.864-4(c)(5)(iii) (special rule for a banking, financing, or similar business); Reg. § 1.988- 4(c) (foreign exchange gain or loss). 146 See Reich, note 144, at 19-20; Yaron Z. Reich, Erika W. Nijenhuis & Monalee Zarapkar, Proposed Regs on Global Dealing Operations, 78 Tax Notes 1689, 1690 (Mar. 30, 1998); Samuels & Brown, note 144, at 557. 147 Reich et al., note 146, at 1690. The "split hedges" mismatch is an example of the U.S. tax mismatch problem described in Part II, whereas the misallocation mismatch described in note 146 and accompanying text is a multi-jurisdictional tax and economic mismatch issue that technically is beyond the scope of the mismatch problem described in Part II. 148 Allocation and Sourcing of Income and Deductions Among Taxpayers Engaged in a Global Dealing Operation, 63 Fed. Reg. 11,177 (Mar. 6, 1998) (containing proposed regulations under §§ 475, 482, 863, 864, 894, and 988).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE ples under § 482.149 In the treaty context, a similar approach was adopted by the OECD in its guidance regarding the attribution of profits to a permanent establishment, 150 and the United States has been incorporating that approach in recently negotiated treaties and protocols to existing treaties.151

3. Subpart F The subpart F provisions are replete with matching rules, but some of them are imperfect and present mismatch problems. The concen- tration of matching rules is primarily due to the need to differentiate between financial transactions that should appropriately give rise to foreign personal holding company income ("FPHCI") 152 and those- including in particular bona fide hedging transactions-that should appropriately be excluded from subpart F income. Matching consid-

149 See id. at 11,178 ("The combination of these allocation, sourcing, and effectively connected income rules is intended to enable taxpayers to establish and recognize on an arm's length basis the contributions provided by separate [qualified business units] to a global dealing operation.");'see also Reich et al., note 146, at 1692 (noting IRS receptiveness to permitting taxpayers to rely on the proposed regulations). 150 OECD, note 134, at 10-75, 119-80. 151 See, e.g., 2006 Protocol to the 1989 Income Tax Treaty Between Germany and the United States, art. XVI, June 1, 2006, U.S. Tax Treaties (CCH) 3209 ("It is understood that the business profits to be attributed to a permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment."); Staff of the Joint Comm. on Tax'n, Explanation of Proposed Income Tax Treaty Between the United States and Belgium art. 7, par. 2 (July 17, 2007), U.S. Tax Treaties (CCH) 1350 (adopting the OECD model and attributing "to a permanent establishment the business profits that the permanent establishment might be expected to make if it were a distinct and independent enterprise in the same or similar activities under the same or similar conditions"). While the OECD approach is commendable in many respects, in an unpublished paper I criticized the (then-proposed) OECD approach for applying a functional analysis to define and determine the contents of a permanent establishment (an "ownership model" for the attribution of assets and liabilities among an enterprise's permanent establishments) on the grounds that it raises significant practical, administrative, and business issues because it requires enterprises to set up separate, sophisticated tax accounting systems that do not parallel the systems and records that are maintained for regulatory, financial accounting, or management reporting purposes. Yaron Z. Reich, Developing a Rational Framework for the Taxation of Branches Under Income Tax Treaties 31-36 (Sept. 24, 2002) (unpublished manuscript), available at http://www.cgsh.com/Developing-a-Rational-Framework-for theTaxation of BranchesUnderIncome Tax Treaties. I suggested that similar results could be achieved under a "joint venture-service provider model," which would accept the contents ascribed to each permanent establishment for financial accounting purposes and instead would apply a functional analysis to determine the profits attributable to the various permanent establishments. Id. at 98. I also criticized the OECD methodology for attributing capital to a permanent establishment. Id. at 90-97. 152 FPHCI generally includes dividends, interest, royalties, rents and annuities, certain property transactions, commodities transactions, foreign currency gains, income equivalent to interest, income from. notional principal contracts, payments in lieu of dividends, and personal service contracts. IRC § 954(c).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: erations are also important in respect of the calculation of income and expense associated with particular categories of FPHCI.153 Because losses in one category of FPHCI cannot offset subpart F income of another category of FPHCI unless the controlled foreign corporation ("CFC") has a deficit in earnings and profits for the year (the "E&P deficit rule"), 154 the potential for mismatches arises to the extent related items fall in different categories of FPHCI. Thus, subpart F contains extensive hedging rules for positions that hedge inventory and dealer property,155 as well as special rules for commodity hedging transactions 156 and notional principal contracts that hedge other categories of subpart F income.157 Because of its context, the definition of a bona fide hedging transaction in subpart F expands upon the definition under § 1221(b) to include risks of § 1231 property and § 988 transactions, but excludes assets, liabilities, or risks 8 of a related person. 15 Subpart F also contains complicated rules relating to foreign currency gain or loss, which can give rise to serious mismatches. 159 The excess of foreign currency gains over foreign currency losses attributable to any § 988 transaction is a separate category of FPHCI, unless the transaction is "directly related to the business needs" of the CFC.1 60 Thus, unless the business-needs exception applies, any net foreign currency gain of a CFC would be subpart F income, but any net foreign currency loss would not reduce other categories of FPHCI (except under the E&P deficit rule), thereby presenting a serious mismatch risk for taxpayers.1 61

153 Reg. § 1.954-1(c)(1)(i) treats the different types of FPHCI as separate categories, and expenses must be allocated within those categories. 154 IRC § 952(c)(1); Reg. § 1.954-1(c)(1)(ii). 155 Reg. § 1.954-2(a)(4)(ii) (definition of bona fide hedging transaction), (iii) (inventory hedging), (iv) (definition of dealer), (v) (dealer property and hedges thereof). 156 IRC § 954(c)(1)(C)(i), (c)(2)(C), (c)(5). 157 IRC § 954(c)(1)(F)(ii). 158 Reg. § 1.954-2(a)(4)(ii). The subpart F hedging rules generally require the taxpayer to satisfy the identification and recordkeeping requirements of Reg. § 1.1221-2(f). Reg. § 1.954-2(a)(4)(ii)(B). The regulations contain an exception where the failure to identify was due to inadvertent error and all of the taxpayer's bona fide hedging transactions in all open years are being treated as bona fide hedging transactions. Reg. § 1.954- 2(a)(4)(ii)(C)(4). Furthermore, there is an anti-abuse rule that allows the IRS to recharacterize a transaction as a bona fide hedging transaction even where the taxpayer has not made an identification if "the taxpayer has no reasonable grounds for treating the transaction as other than a bona fide hedging transaction." Reg. § 1.954-2(a)(4)(ii)(C)(5). 159 See McDonald et al., note 77, at 229-32. 160 IRC § 954(c)(1)(D); Reg. § 1.954-2(g)(2)(ii). 161 Under the regulations, the business-needs exception applies only to foreign currency gain that falls solely within the foreign currency gains category of FPHCI and does not otherwise generate subpart F income. Reg. § 1.954-2(g)(2)(ii)(B)(1)(ii). This means that the business-needs exception is not available for, for example, (1) any foreign currency gains that are treated as interest income (for example, under § 988(a)(2)), (2) any foreign

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE Another source of potential mismatch arises from the fact that foreign currency gain or loss with respect to an interest-bearing liability of a CFC is allocated among the different categories of FPHCI and non-subpart F income on the same basis as the interest expense on that liability. 162 On the other hand, if the CFC enters into a currency hedge with respect to that liability, all of the foreign currency gain or loss in respect of the hedge will fall within the foreign currency FPHCI category. 163 Similarly, if the CFC holds accounts receivable that are funded, on an overall matched basis, by liabilities issued by it, there will be a mismatch because all of the foreign currency gain or loss in respect of the accounts receivable will fall in a single category of FPHCI while any foreign currency gain or loss on the loans payable would be allocated among different categories of FPHCI and non-sub- 164 part F income.

4. Foreign Tax Credit As I developed elsewhere, the foreign tax credit (FTC) area is infused with the matching principle, with some notable departures and opportunities for mismatches.1 65 Indeed, implicit in the principal policy objective of the FIFC rules-preventing double taxation of a taxpayer's foreign source income-is the imperative to properly and reasonably match foreign tax with the associated income, by whatever criteria are selected based on various policy and administrative considerations. Thus, (1) the "[§] 904 limitation mandates that there be an overall correspondence between the levels of foreign income and creditable foreign taxes, as well as between the income and creditable foreign taxes in particular baskets" because "the U.S. tax rules eschew an item-by-item matching in favor of a liberal basket [matching] ap- currency gains that are reclassified as a different category of FPHCI under the FPHCI priority rules that apply to certain overlap situations, Reg. § 1.954-2(a)(2), or (3) any foreign currency gains that are reclassified as a different category of FPHCI as a result of the taxpayer's election under § 1.954-2(g)(3) to treat foreign currency gain or loss that arises with respect to a specific category of subpart F income as gain or loss in that category. The IRS has narrowly interpreted business needs. See McDonald et al., note 77, at 229-32 (explaining IRS' restrictive application of business needs exception); N.Y. St. Bar Ass'n Tax Sec., Comments on Section 954 Definitions Relating to Foreign Base Company In- come (Feb. 13, 1989), 89 TNT 41-31, Feb. 21, 1989, available in LEXIS, Tax Analysts File (criticizing the regulations as "overly restrictive"). 162 Reg. § 1.954-2(g)(2)(iii). 163 See McDonald et al., note 77, at 230. 164 See id. at 231. 165 See Reich, note 120, at 63, 74-76 (discussing the degree to which the FTC rules do and should reflect matching principles); see also F. Scott Farmer, Tax Year Splitters: It's Accrual Method Annual Accounting, 133 Tax Notes 1491, 1491-94 (Dec. 19, 2011) (discussing the mismatch between FTCs and related income that can arise when the taxpayer's U.S. and foreign tax years end on different dates).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: proach,"'166 (2) "the indirect credit under [§] 902 has a matching rule for tracking creditable taxes and the earnings pool to which the taxes relate,' 1 67 and (3) the provisions addressing timing and absolute differences between U.S. and foreign tax bases, 168 overall foreign losses, 169 overall domestic losses, 170 and the allocation of creditable foreign tax expenditures of partnerships 171 each reflect the matching concept. The source rules discussed previously 172 obviously play a large role in the calculation of the FFC, and the distortions and mismatches described therein impact the amount of creditable taxes. One notable exception to the matching concept is the "legal liability" or "technical taxpayer" rule, which provides that the person who is deemed to pay a foreign tax is the person who bears the legal liability for the tax. 173 This rule of administrative convenience Spawned a raft of tax planning structures that were "employed by multinational corporations (and, less frequently, by other investors) to separate the foreign tax credit from the tax base to which it relates, so that the taxpayer can benefit from the credit without having to include the related income . . . under the consolidated tax regimes of particular countries as well as through the use of reverse hybrid entities, hybrid securities or other techniques."'1 74 Treasury and the IRS responded to these FTC "splitter" transactions by issuing proposed regulations in 2006 that would modify the technical taxpayer rule so as to consider the entity that earns the income to have legal liability for the related foreign taxes, thereby matching the taxes and the related income in the same taxpayer.175 Congress, however, took a different approach to the mismatch problems created by the technical taxpayer rule. Section 909, enacted in 2010,176 respects the separation of taxes and income in different entities, but suspends the taxes from being taken into account until the taxable year in which the related income is taken into account.

166 Reich, note 120, at 75. 167 Id. 168 See IRC § 904(d)(2)(H) (providing special rules for base and timing differences); Reg. § 1.904-6(a)(1)(iv) (same). 169 IRC § 904(f). 170 IRC § 904(g). 171 Reg. § 1.704-1(b)(4)(viii). 172 See Subsection III.D.1. 173 Reg. § 1.901-2(f)(1). 174 Reich, note 120, at 55-56; see also N.Y. St. Bar Ass'n Tax Sec., Report on Regulation Section 1.901-2(f)(3) and the Allocation of Foreign Taxes Among Related Persons (Apr. 4, 2005), 2005 TNT 64-26, Apr. 5, 2005, available in LEXIS, Tax Analysts File (discussing FTC splitting problems and making recommendations). 175 Prop. Reg. § 1.901-2(f), 71 Fed. Reg. 44240 (2006), withdrawn by T.D. 9576 (2012). 176 Act of August 10, 2010, Pub. L. No. 111-226, § 211, 124 Stat. 2389, 2394-96.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE Thus, the 2006 proposed regulations and § 909 represent two different 7 approaches to addressing a particularly serious mismatch problem. 17

E. Related Party Transactions The tax law has followed several different approaches to achieving matching in the context of related party transactions. In this context, the objective, very generally, is to treat the related parties as a single economic tax unit to one extent or another, as deemed appropriate. This Section focuses on consolidated tax groups, § 267 (including both nonconsolidating affiliated corporations and other related parties), and partnerships.

1. Consolidated Tax Groups The consolidated return tax regulations contain an elaborate and detailed set of rules for intercompany transactions between members of a group that files a consolidated tax return, with a view "to clearly reflect the taxable income (and tax liability) of the group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income (or consolidated tax liability)."1 78 The regulations' basic approach is laid out in two introductory provisions:

Separate entity and single entity treatment. Under this section, the selling member (S)and the buying member (B) are treated as separate entities for some purposes but as divisions of a single corporation for other purposes. The amount and location of S's intercompany items and B's corresponding items are determined on a separate entity basis (separate entity treatment). For example, S determines its gain or loss from a sale of property to B on a separate entity basis, and B has a cost basis in the property. The timing, and the character, source, and other attributes of the intercompany items and corresponding items, although initially determined on a separate entity basis, are redetermined under this section to

177 See N.Y. St. Bar Ass'n Tax Sec., Report on Issues Under Section 909 of the Code (Nov. 8, 2010), 2010 TNT 216-25, Nov. 9, 2010, available in LEXIS Tax Analysts File (com- paring the approach of the 2006 proposed regulations with § 909 and recommending that Treasury generally finalize the proposed regulations and have them apply, where applicable, instead of § 909 due to their administrability advantages). The IRS recently issued final regulations under § 901 and temporary regulations under § 909 that generally adopt the approach of § 909 rather than the approach of the 2006 proposed regulations. Reg. § 1.901-2(f); Temp. Reg. § 1.909-iT - 6T; see also T.D. 9576 (2012); T.D. 9577 (2012). 178 Reg. § 1.1502-13(a)(1).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: produce the effect of transactions between divisions of a single corporation (single entity treatment). For example, if S sells land to B at a gain and B sells the land to a nonmember, S does not take its gain into account until B's sale to the nonmember. 179 Overview. (i) In general. The principal rules of this section that implement single entity treatment are the matching rule and the acceleration rule of paragraphs (c) and (d) of this section. Under the matching rule, S and B are generally treated as divisions of a single corporation for purposes of taking into account their items from intercompany transactions. The acceleration rule provides additional rules for taking the items into account if the effect of treating S and B as divisions cannot be achieved (for example, if S or B becomes a nonmember). 180

Thus, with respect to the timing, character, source, and certain other attributes, the regulations seek to match the results of the seller's intercompany items and the buyer's corresponding items through the matching rule. While this objective is simple to enunciate, the details are extremely complex, and are laid out in the regulations in the form of broad rules articulating the general principles and their application to types of situations (or exceptions thereto), which are illustrated through numerous examples and buttressed with anti-abuse rules. Overall, despite their complexity, the regulations appear to achieve their intended objective of conforming the timing, character, source, and certain attributes to the results that would be obtained if the members were divisions of a single corporation. It is noteworthy, however, for purposes of this discussion that what "matching" means in a particular context-for example, precisely which items are to be matched and how-is not always self-evident. The regulations do not leave much leeway for taxpayers to determine how best to achieve matching (or precisely what items should be matched), which makes sense in this context, but some of the policy judgments that were made might be questioned.

Example 9: S sells subsidiary T to B and recognizes gain of $100, which is deferred. A few years later, in a separate transaction, T liquidates into B in a transaction that qualifies under § 332.

179 Reg. § 1.1502-13(a)(2). 180 Reg. § 1.1502-13(a)(6).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE Notwithstanding that no assets have left the group and that the group has not realized any economic gain, the regulations provide that Ts liquidation triggers the $100 of deferred gain because the disap- pearance of the T stock as a result of T's liquidation means that there is no longer an opportunity to continue to defer the gain under the 181 matching and acceleration rules. In response to strong criticism of this harsh and counterintuitive re- 182 sult, the regulations have gone through several iterations of providing relief that, effectively, would permit a taxpayer that inadvertently triggered this gain to undo the damage by reinstating T with substantially all of its assets.183 Nonetheless, it appears that the regulations made a fundamental error in deciding that the matching that needs to occur in this situation is with respect to T's stock rather than its assets. A better approach would have been to leave that question in suspense until it is determined whether or not the stock is relevant-that is, whether T leaves the group. In Example 9, where T is liquidated under § 332, the deferred gain on its stock should disappear without recognition, since that result would be more consistent with treating the members as divisions of a single entity. Indeed, the wisdom of this alternative approach seems increasingly compelling in light of developments over the past few years that expand the flexibility of taxpayers to move subsidiaries and assets within a consolidated group in tax- free transactions, since it seems foolhardy (and a trap for the unwary) to require taxpayers to go through the machinations of such tax-free restructurings in order to avoid creating deferred gain that might be 4 triggered in the future.18

181 Reg. § 1.1502-13(c)(6)(ii), (f)(5)(i) (also providing for a similar result if B merges into 7); see also T.D. 8597, 1995-2 C.B. 147 (justifying result as "necessary to prevent the transfer and liquidation of subsidiaries from being used to affect consolidated taxable income or tax liability by changing the location of items within a group .. "). The pre-1995 regulations provided for a similar result in the case of a sale of T to B followed by a § 332 liquidation of T, but permitted the intercompany gain to be eliminated upon a downstream merger of B into T, thereby enabling well-advised taxpayers to avoid the harsh result of this rule. See Reg. § 1.1502-13(f)(1)(vi) (1994). 182 See T.D. 8597, note 181; see also Lisa M. Zarlenga, Corporate Liquidations, 784 Tax Mgmt. Portfolio (BNA) § XII.B.3. (2011) (pointing out that this result is at odds with what one would expect under single-entity treatment and noting that the rule can "lead to harsh results for consolidated group members"). 183 See Reg. § 1.1502-13T(f)(5)(ii)(B). 184 See, e.g., Reg. § 1.368-2(d)(4) (reversing the Bausch & Lomb rule to permit an up- stream Type C reorganization of an "old and cold" subsidiary into its parent corporation); Reg. §1.368-2(k) (permitting a broad range of post-reorganization transfers of assets or stock within the acquiring group); Reg. § 1.368-2(1) (permitting all-cash Type D reorganization); Ltr. Rul. 200952032 (Dec. 24, 2009) (treating as a Type C reorganization followed by asset transfers in which no gain was recognized, a transaction involving members of a consolidated group in which, pursuant to a plan, the seller converted into a LLC, transferred certain assets to a sister corporation and immediately thereafter converted back into a

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: 2. Section 267

The principal provision addressing matching concerns outside the consolidated tax group context is § 267, which disallows any loss arising in a sale or exchange of property between related persons, as de- fined in § 267(b).185 The transferee may offset gain on a subsequent disposition of the property up to the amount of the disallowed loss. 18 6 Section 267 also requires matching of a deduction for certain payments between related persons to the timing of the income inclusion by the payee.'8 7 This matching principle also applies certain deductible payments made to a foreign related person1ss Section 267(f) adopts a different approach, patterned on the consolidated return intercompany transaction regulations, and applies to transactions between affiliated corporations that are not members of a consolidated tax group. 1 9 Section 267(a) follows the model of matching provisions that are targeted anti-abuse rules, by operating in one direction, to disallow losses, but not deferring gain. In this respect, it stands in contrast to the approach for affiliated corporations. As illustrated by this contrast, an important question in crafting a solution to a matching concern is which paradigm is more appropriate for the particular situation. Putting aside the question whether it is appropriate to match the timing of gains as well as losses outside the affiliated group context, the structural approach to matching that is embodied in § 267(a) is sub-optimal to say the least. corporation). While some of these rules (including in particular an all-cash Type D reorganization under Reg. § 1.368-2(1)) often will result in the creation of deferred intercompany gain in respect of stock, depending on the circumstances such gain can be avoided by structuring a transaction to take advantage of other rules. See James Stanislaw, Tax Plan- ning for Transfers of Business Interests 4.01[5] (2011) (noting the end of the liquidation- reincorporation doctrine inside corporate groups); Jasper L. Cummings, Jr., Liquidation, Reorganization, or Both: Unrestrained Complexity is Not a Joy, 111 J. Tax'n 269, 271-74 (2009) (discussing the foregoing § 368 and § 1.1502-13 regulations); Robert Willens, Up- stream Transfer Ruled a C Reorganization, 126 Tax Notes 867, 867 (Feb. 15, 2010) (discussing flexibility afforded by Private Letter Ruling 200952032 to avoid creating intercompany gain). 185IRC § 267(a)(1). 186 IRC § 267(d). 187 IRC § 267(a)(2). 188 IRC § 267(a)(3). 189 IRC § 267(f). The definition of affiliated group for purposes of § 267(f) is based on § 1563(a), and thus includes both parent-subsidiary controlled groups (where the parent is a corporation, but applying a 50% voting power or value test instead of an 80% test) and brother-sister controlled groups (where corporations are owned by five or fewer individuals, estates, or trusts, applying a 50% threshold of cross-ownership). IRC § 267(f)(1).

Imaged with the permission of Tax Law Review of New York University School of Law 20121 THE CASE FOR A "SUPER-MATCHING" RULE Example 10: Individuals A and B own X, a U.S. partnership, and Y, a U.K. corporation. 190 Both X and Y are engaged in an active business. X sells an asset to Y for $200, incurring a $100 loss. Two years later, Y sells the asset to a third party for $200.

X's $100 loss is disallowed because it is a sale to a related party. Even after Y sells the asset to a third party and the X-Y economic group suffers an overall loss of $100, no portion of that loss is allowed.

Example 11: Same as Example 10 except that Y is a U.S. partnership and it eventually sells the asset, alternatively, for $200 or $250.

Where Y sells the asset for $200, the $100 economic loss would not be recognized by the X-Y economic group, because the disallowed loss is an offset against the transferee's subsequent gain ($0 in this case) rather than increasing its tax basis in the asset.191 Where Y sells the asset for $250, it can utilize $50 of X's disallowed loss to offset its $50 gain, so that no tax is paid by Y, but neither X nor Y could claim a benefit for the remaining $50 economic loss.

Example 12: Same as Example 10 except that X is a corporation.

Section 267(f) governs this case, and upon Y's sale of the asset to a third party, X's deferred loss of $100 is triggered (rather than being disallowed, as with Example 10). Moreover, in contrast to § 267(a), the loss is recognized by X, the party that incurred the loss rather than being shifted (as in Example 11) to Y as an offset to its gain. It is unclear what policy considerations, if any, led to the very different approaches in these two provisions. The definition of related persons and the accompanying attribution rules1 92 are anachronistic and flawed in troubling ways, which can lead to serious mismatches from economically sound results. Perhaps the most troubling aspect is the rule that attributes to an individual who

190 X and Y are related persons under § 267(b)(10) (a corporation and a partnership are related if the same persons own more than 50% of the corporation's stock value and 50% of the partnership capital or profits interests). 191 Because X and Y are partnerships, the loss is disallowed under § 707(b), which applies rules similar to § 267(a) and (d) with respect to transactions between a partner and a partnership or two partnerships, in each case where a greater-than-50% ownership threshold (in capital or profits interests) is met. 192 IRC § 267(c).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: owns any stock in a corporation the stock in that corporation that is 193 owned by or for his partner.

3. Partners and Partnerships When a partner and a partnership, or two related partnerships, enter into transactions with one another, there is a potential for mismatch if the items arising from both sides of the transaction are char- acterized differently, so that the partner must report income or gain on one side of the transaction without an offsetting deduction or loss for the corresponding item on the other side of the transaction. For example, this concern arose in the context of the § 469 passive activity loss rules, and was addressed to some extent in regulations thereunder 194 dealing with "self-charged" items of interest income and deduction.

Example 13: Individuals A and B each own 50% of partnership AB, which is engaged in a single rental activity. AB borrows $50,000 from A on an unsecured basis and uses the loan proceeds in the rental activity. AB pays $5000 of interest to A for the taxable year, giving rise to a $2500 interest expense for each of A and B. Assume AB has a passive activity loss for the taxable year of at least $5000. In the absence of a special rule, A would report $5000 of investment interest income while its $2500 interest expense would be subject to the passive activity loss limitation. The regulations, however, recharacterize the $2500 of self-charged interest income and expense, as passive activity gross income and deduction, respectively. 195 But the § 469 regulations are not as broad as commentators had requested,1 96 and therefore mismatches continue to arise. For exam-

193 IRC § 267(c)(3). For an extreme illustration of the application of this rule, see Reve- nue Ruling 82-107, 1982-1 C.B. 103 (holding that a corporation loses its status as a regulated investment company when it becomes a personal holding company because several of its shareholders are also partners in a partnership and therefore all of their stock ownership is attributed to a single individual partner as a result of the partnership attribution rule of § 267(c)(3)). 194 Reg. § 1.469-7. 195 Reg. § 1.469-7(h) (Ex.1). 196 See, e.g., Laura R. Blasberg & Richard M. Lipton, Long Awaited 469 Final Regs. On Self-Charged Items: IRS Holds the Line of Interest Only, 97 J. of Tax'n 283, 283 (2002) ("Despite requests from practitioners that the relief be expanded to include non-interest items such as management fees, the final Regulations continue the interest-only approach."); Timothy M. Larson, Attorneys Want Limitations Removed From Self-Charged Interest Regs. (June 12, 1991), 91 TNT 141-23, July 3, 1991, available in LEXIS, Tax Ana- lysts File (suggesting removal of several restrictions from the self-charged interest provisions in the proposed regulations); New York State Society of Certified Public Accountants, New York CPAs Comment on Self-Charged Items (May 31, 1991), 91 TNT

Imaged with the permission of Tax Law Review of New York University School of Law 20121 THE CASE FOR A "SUPER-MATCHING" RULE 287 ple, the rule for lending transactions between related partnerships applies only if their ownership is identical,197 which is an extremely limiting and arbitrary condition that significantly increases the risk of mismatches. Moreover, items other than interest (such as management fees and rent) do not qualify for a self-charged item relief under § 469.198

Example 14: Same as Example 13, except that A and B also each owns 50% of partnership CD, which manages the properties of partnership AB and other real estate partnerships. AB pays CD a management fee of $10,000 for the taxable year.

Because the self-charged rule of the § 469 regulation does not apply to the management fee, A and B must each report $5000 of management fee income while the offsetting deduction is disallowed. 99 Other situations not relating to § 469 do not benefit from a matching provision, and taxpayers may suffer unfortunate mismatches.

Example 15: Same as Example 13, except that in Year 3, AB is insolvent by at least $50,000, and A cancels its $50,000 loan for no consideration. Neither A nor B is insolvent.

A and B will each report $25,000 of COD income. Assuming the loan is a nonbusiness loan with respect to A, its $50,000 loss will be a short-term capital lOSS,20 0 and could not offset the COD income.

Example 16: Private equity fund sponsor wishes to induce individual E to be an "anchor" investor in its new fund (to be organized as a partnership), and therefore agrees that E can also acquire a 20% interest in the fund's general partner and

125-74, June 11, 1991, available in LEXIS, Tax Analysts File (commenting that the passive activity regulations should not be limited to self-charged interest expense, but should include all self-charged items). 197 See Reg. § 1.469-7(e)(1); T.D. 9013, 2002-2 C.B. 542 (specifying the rationale for this limitation to identically owned entities as "concerns regarding the difficulty of identifying self-charged items in transactions between less closely related or unrelated entities"). 198 See T.D. 9013, note 197 (rejecting various recommendations for expansion of the rule). 199 See Hillman v. Commissioner, 250 F.3d 228 (4th Cir.), rev'g 114 T.C. 103 (2000), aff'd on reh'g and rem'd on other grounds, 263 F.3d 338 (4th Cir. 2001) (holding that management fees could not be treated as a self-charged item); see also Samuel P. Starr & Horatio E. Sobol, S Corporations: Operations, 731 Tax Mgmt. Portfolio (BNA) § II.B.6.c. (2011) (noting that, although the legislative history suggests that Congress granted the Service broad discretion to extend the self-charged concept to items other than interest, it did not exercise this discretion). 200 IRC § 166(d).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: management company (both of which are also to be organized as partnerships). Thus, E will be entitled to, and be taxed on, 20% of the management fees earned by the management company (net of E's share of the management company's expenses).

E must report his share of the management fee as gross income, even though the economically offsetting management fees that he pays as an investor in the fund will be subject to the § 67 floor on deductibility of miscellaneous itemized deductions 201 and the § 68 overall limitation on itemized deductions20 2 and will not be deductible for alternative minimum tax (AMT) purposes. 20 3

F. Limitations on Individual Deductions In addition to illustrating mismatches that arise in the context of transactions between partners and partnerships, Examples 13-16 also illustrate mismatches that arise as a result of the application of the various limitations on individual deductions, including the § 67 floor on miscellaneous itemized deductions and disallowance of such deductions for AMT purposes, § 68 limitation on itemized deductions, § 166(d) capital loss treatment of nonbusiness debts, and § 469 passive activity losses. These limitations reflect important tax policy decisions made by Congress. As the examples illustrate, in certain discrete situations they produce mismatches by denying deductions where offsetting or other related items are required to be included in income, and it is reasonable to believe that these patently unfair results were not intended by Congress. 20 4

201 An individual is allowed to deduct miscellaneous itemized deductions only to the extent they exceed 2% of adjusted gross income. IRC § 67. 202 Subject to the sunsetting provision described below, an individual whose adjusted gross income exceeds a specified applicable amount must reduce the amount of otherwise allowable itemized deductions by the lesser of 3% of the excess of adjusted gross income over the applicable amount, or 80% of the amount of otherwise allowable itemized deductions. IRC § 68. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGT- RRA) phased out the § 68 limitation from 2006-2010, but this provision was to sunset at the end of 2010. IRC § 68(f); Economic Growth and Tax Reconciliation Act of 2001, Pub. L. No. 107-16, § 901, 115 Stat. 38, 150. The Tax Relief, Unemployment Insurance and Job Creation Act of 2010 extended the elimination of the § 68 limitation for two additional years (through 2012). Tax Relief, Unemployment Insurance Reauthorization, and Job Cre- ation Act of 2010, Pub. L. No. 111-312, § 101(a)(1), 124 Stat. 3296, 3298. The Obama administration has proposed to reinstate the § 68 limitation for upper-income taxpayers starting in 2013. Dept. of the Treasury, General Explanations of the Administration's Fis- cal Year 2013 Revenue Proposals 67-68 (2012), available at http://www.treasury.gov/ resource-center/tax-policy/Documents/General-Explanations-FY2013.pdf. 203 IRC § 56(b)(1)(i). 204 The limitations on individual deductions have also caused harsh mismatches where they deny a deduction for contingent attorneys' fees paid by claimants whose recoveries

Imaged with the permission of Tax Law Review of New York University School of Law 20121 THE CASE FOR A "SUPER-MATCHING" RULE G. Financial Transactions and Products Many of the matching rules and mismatches described above relate to financial transactions. With the proliferation of derivatives and other new financial products over the past twenty-five years or so, the government, tax practitioners, and academics have struggled with the practical and conceptual questions of how these various financial instruments should be taxed. 20 5 A significant issue has been the tax law's tendency to "cubbyhole" different instruments under different tax rules, with the result that economically comparable transactions can produce very different tax consequences depending on the financial instrument building blocks used to structure the transaction. 206 Some commentators have focused on the importance of achieving consistent treatment of different financial instruments that produce economically comparable results, which has led some to suggest a bifurcation/decomposition approach of taxing complex financial instruments in accordance with their underlying components, 207 while others have advocated integrat- ing related positions into a synthetic financial instrument for tax purposes,20 and yet other commentators have argued that such are taxable income. See, e.g., Commissioner v. Banks, 543 U.S. 426, 433-38 (2005) (holding attorneys' contingent fee in employment discrimination suit is taxable income to claimant under anticipatory assignment of income principle, and therefore may be subject to limitations on the deductibility of miscellaneous itemized deductions). This problem has been cured for many but not all types of claims as a result of the enactment of § 62(a)(20), (e) in 2004. See, e.g., Robert W. Wood, Jobs Act Attorney Fee Provision: Is It Enough?, 105 Tax Notes 961, 961 (Nov. 15, 2004). 205 See, e.g., Reed Shuldiner, A General Approach to the Taxation of Financial Instru- ments, 71 Tex. L. Rev. 243, 245 (1992) ("The tax law has struggled to keep up with the development of new financial instruments, responding to such instruments on an ad hoc and piecemeal basis."); Alvin C. Warren, Jr., Financial Contract Innovation and Income Tax Policy, 107 Harv. L. Rev. 460, 461 (1993) ("Continuous disaggregation, recombination, and risk reallocation have produced a changing array of new financial contracts that pose a serious challenge for the income tax"). 206 See, e.g., Kau, note 4, at 1004-05 ("[C]ombinations of transactions producing approx- imately identical cash flows will necessarily yield different tax consequences."); Edward D. Kleinbard, Equity Derivative Products: Financial Innovation's Newest Challenge to the Tax System, 69 Tex. L. Rev. 1319, 1320 (1991) ("Our tax system works by describing a* finite number of idealized transactions and attaching to each a set of operative rules-what might be termed a set of tax cubbyholes."); David A. Weisbach, Tax Responses to Finan- cial Contract Innovation, 50 Tax L. Rev. 491, 494 (1995) ("A consequence of this [cubbyhole] system is that the tax rules for various classes of products can be inconsistent ... with respect to timing, source, character or other attributes."). 207 See Weisbach, note 206, at 539 ("[B]ifurcation is the best theoretical method of taxing hybrid instruments."). But see Kleinbard, note 49, at 947-52 (discussing problems with bifurcation). 208 See Kau, note 4, at 1007 (advocating integration over either bifurcation or any of the various politically impractical options); Jeff Strnad, Taxing New Financial Products: A Conceptual Framework, 46 Stan. L. Rev. 569, 599 (1994) (advocating integration approaches over bifurcation methods for both theoretical and practical reasons).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: consistency is not achievable due to political, administrative, and other hurdles. 209 Still other commentators have emphasized the desir- ability of having symmetrical tax treatment of both parties to a transaction, 210 although, as has been pointed out, that objective seems unattainable given the substantial number of counterparties that are tax-exempt or foreign investors or securities dealers that mark to mar- 211 ket their positions. In practice, Congress, Treasury and the IRS appear to be addressing the issues presented by financial products through an episodic, delib- erative process that deals with discrete areas, issues, and transactions on a contextual basis, without attempting to devise a grand scheme (which thus far appears unattainable in any event).212 Regardless of what specific or more general approaches are adopted for the issues presented by financial products, it would appear that a proper and appropriate matching of items by a taxpayer needs to be a principal consideration in devising an approach. Indeed, matching would seem to be more important than symmetrical treatment by the counterparties to a transaction (particularly since counterparties often have disparate tax or tax-exempt positions from one another) or than trying to achieve consistent treatment between the transaction and various alternative financial transactions that could have been employed to produce comparable economic results, since matching is more readily achievable than transactional consistency and should produce results that are consistent with the taxpayer's economic income. Of course, how matching might be achieved, and what items should be matched with one another, in any particular context are very important questions, on which I offer some thoughts in Part VI below. Moreover, it has been suggested that, in appropriate circumstances-namely, derivative transactions involving risk-based returns (as opposed to time-value returns or wages), where taxpayers can ad-

209 See David S. Miller, Reconciling Policies and Practice in the Taxation of Financial Instruments, Taxes, Mar. 1999, at 236, 259-60 (favoring calibrated improvements in view of "bleak prospects" for comprehensive financial instrument tax reform); Schizer, note 4, at 1889-90 (arguing that only fundamental reforms could achieve consistency yet saying that "political and administrative barriers stand in the way, rendering consistency unattainable for now"). 210 See, e.g., Roin, note 4, at 814 (advocating "examining tax rules for compliance with such a [symmetry] standard"). 211 Kleinbard, note 206, at 1362 ("[S]ymmetry of tax result between issuers and investors is a false goal."); Schizer, note 4, at 1894-95 (pointing out that tax planning is facilitated and therefore symmetry unattainable when tax-exempt organizations, foreigners, and securities dealers are counterparties to a transaction). 212 See Kleinbard, note 206, at 1349-52 (summarizing typical explanations for "the gla- cial pace of legislative and regulatory responses to financial innovation"); Shuldiner, note 205, at 245.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE just the size of their risky bets costlessly-one form of matching, described as balancing the tax treatment of gains and losses (so that the government's share of gains matches its share of losses from each risky position), can provide a solution to the taxation of those financial products without having to chase the seemingly impossible goal of 213 taxing different financial products consistently.

H. Tax Shelters

As illustrated above, among the techniques used by taxpayers to structure financial transactions that generate tax benefits that have been considered inappropriate are those that exploit mismatches in the timing, character, source, or other tax characterization rules or that split tax items between different taxpayers. The tax law's response to these transactions has sought to better match those items 214 and to identify certain of these transactions as abusive tax shelters. Some of these responses have been based on existing technical rules, 215 others have been based on broad tax principles or anti-abuse rules (such as on lack of business purpose or economic substance, or sham transaction grounds) 216 and yet others have been through the promulgation of new legislation or regulations. 217 It is worth considering whether and to what extent a super-matching rule would dis- suade taxpayers from exploiting mismatches to structure tax shelters.

213 Schizer, note 4, at 1945 ("By focusing on balance, policymakers can leave inconsistencies in place in the taxation of risk-based returns without prompting planning."). 214 See, e.g., notes 95 and 174 and accompanying text; see also Lerman v. Commissioner, 939 F.2d 44 (3rd Cir. 1991) (pre-§ 1092 silver option straddles held to be sham transactions); Glass v. Commissioner, 87 T.C. 1087 (1986) (same type of pre-§ 1092 straddle transactions involving over 1000 taxpayers). 215 See, e.g., Rev. Rul. 2000-12, 2000-1 C.B. 744, (describing a listed transaction involving two privately-placed debt instruments whose values were expected to move inversely to each other; loss disallowed under IRS authority to integrate the notes under Reg. § 1.1275- 6(c)(2)). 216 See, e.g., id. (describing a listed transaction involving two privately-placed debt instruments whose values were expected to move inversely to each other; loss disallowed for lacking economic substance; also describing a listed transaction involving two privately- placed debt instruments whose values were expected to move inversely to each other; loss disallowed under anti-abuse rule of Reg. § 1.1275-2(g)(2)). 217 See, e.g., IRC § 909 and Prop. Reg. § 1.901-2(f) (legislative and regulatory responses to the FTC splitting transactions described in text accompanying notes 173-74); IRC § 1092 (straddle rules promulgated to address situations described in note 214).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65:

IV. OBSERVATIONS AND SPECIFIC RECOMMENDATIONS REGARDING MATCHING AND MISMATCHES A. Observations The foregoing selective canvassing of the tax law demonstrates that indeed the matching principle's presence is pervasive in many disparate areas. The widespread presence of the matching principle should not be surprising since, as much of the discussion in Parts II and III illustrates, it is a powerful device for ensuring tax consequences that are balanced, neutral, and fair to the taxpayer and to the government. In addition, to the extent that a high level of matching occurs, a taxpayer and related persons are generally taxed on a basis that is consistent with the economic income generated by the matched items. Of course, as noted above, matching is usually achieved within a structural framework that takes account of other policy and practical considerations. Accordingly, depending on the context, the result may be only partial or selective matching. Thus, for example, with respect to timing issues, the decision to use an accrual or cash method necessarily means less perfect matching than a mark-to-market method; and within that decision tree, the decision to address the matching of investment interest expense through the mechanism of § 163(d) rather than a direct matching of interest expense against income and gain from the specific assets financed with the debt leads to a different overall matching result than had a direct tracing approach been adopted.' 8 The extent to which matching is implemented may also depend on revenue considerations, as evidenced by the continued deferral of the effective date of § 864(f) 219 and, one might presume, the absence to date of a remedy for the capital loss limitation mismatches. 220 Simi- larly, more expansive matching may give way to other tax policies, such as the incentives of LIFO inventory or accelerated 21 depreciation. 2 This review also sheds light on the types of approaches that have been adopted to achieve matching, to one degree or another, with va- rying levels of success. While generalizations can be misleading, it appears that as one moves along the spectrum from (1) full integration 222 to (2) comprehensive matching regimes223 to (3)

218 See Section III.B. 219 See notes 125-26 and accompanying text. 220 See notes 35-37 and accompanying text. 221See note 44 and accompanying text. 222 E.g., Reg. §§ 1.1275-6, 1.988-5(a); see note 111 and accompanying text. 223 See, e.g., the discussion of hedging at Subsection III.C.1, § 482 and global dealing at Subsection III.D.2, and consolidated return intercompany transactions at Subsection III.E.1.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE targeted anti-abuse rules, 224 the overall efficacy and fairness of the matching approach tends to decline and the prospect for mismatches increases. Thus, the hedging rules seem more efficacious than the straddle rules, and the § 1.1502-13 and § 267(f) approach seems more efficacious than § 267(a). Whereas in full integration or comprehensive matching regimes a mismatch is most likely to arise due to the inapplicability of the regime to situations outside the scope of the matching rule, in a targeted anti-abuse rule context a mismatch is more common. 225 On the other hand, certain matching approaches are more practical to implement in particular contexts than others (for example, full integration generally makes sense only in limited circumstances), and there clearly is a role for limited anti-abuse rules. Nonetheless, where matching is viewed as a paramount consideration, to the extent feasible it would be best to use broader matching rules than more limited ones. Whether the level of complexity and detail affects the efficacy of a matching rule appears to depend on how well-crafted the rule is. The § 1.1502-13 and § 267(f) rules are quite detailed and complex but they generally are very efficacious from a matching perspective. By contrast, the § 988(d) hedging, subpart F, and interest sourcing rules are also quite detailed and complex but appear to be less efficacious in avoiding mismatches. To some extent, the mismatch issues arising under those rules seem to be attributable to a failure to fully appreci- ate the commercial realities that need to be addressed, as evidenced by the fact that subsequent promulgations of similar rules show a greater sophistication on the part of the Service. 226 Also, perhaps the IRS took a narrower approach in certain respects than it might have under those rules out of a concern that a broader approach could be utilized by taxpayers to achieve inappropriate results. Furthermore, in contrast to § 1.1502-13, these rules seem to suffer from the absence of an organizing principle to inform the application of the myriad discrete provisions within these rules. The matching rules that are discussed in Parts II and III also vary in the degree to which they are formulated as precise and detailed rules as opposed to more general principles. The clear-reflection-of-income principle under § 446(b), the tax benefit rule, and § 482 and its articu-

224 See, e.g., the discussion of the straddle rules at Subsection III.C.3, and § 267(a) at Subsection III.E.2. 225 See, e.g., the discussion of straddles in the text accompanying notes 90-95, § 865 in the text accompanying notes 140-43, and § 267(a) in the text accompanying 185-93. 226 See, e.g., note 111. It has also been suggested that the prevalence of mismatch problems under the § 988, subpart F, and interest sourcing rules is the result of an undue emphasis on a bifurcation approach when the regulations implementing these rules were promulgated. See Kau, note 4, at 1005-07.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: lation in the proposed global dealing regulations are examples of principles-based matching rules. As such, they appear to tolerate a more flexible application that would likely result in fewer mismatches than precise and detailed rules. Many mismatches seem to be the result of the application of precise and detailed rules in unforeseen circumstances, the lack of guidance as to the proper interplay between two sets of rules, or the absence of consideration of potential mismatches.227 Some mismatches, however, appear to be the result of conscious judgments made by Congress, Treasury, or the IRS.228 Obviously the former situations are more appropriate candidates for a possible remedy through a super-matching rule than the latter, and any such rule would need to differentiate between those situations. With the benefit of the foregoing observations and review of matching and mismatches, Part V discusses policy considerations that are relevant to developing a super-matching rule, while Part VI makes recommendations as to the possible scope and terms of a super- matching rule. Before turning to that discussion, however, Section IV.B makes specific recommendations regarding some of the key mismatches described in Part III.

B. Specific Recommendations Even if a super-matching rule were not adopted, Congress, Trea- sury, and the IRS can significantly mitigate mismatch problems by making changes to the existing rules to address the concerns identified in Part III. Putting aside some of the more technical and discrete problems discussed above (which are also very much deserving of relief),229 this Section describes several changes that would likely have a significant beneficial impact for taxpayers and the government. As

227 See, e.g., Example 4 (where the failure to qualify for hedging treatment is the result of a technical rule regarding disregarded entities owned by banks rather than an apparent policy decision to distinguish that case from Example 5); Example 6 (where, as described in note 87, there are persuasive policy and technical reasons for concluding that the regulation that precludes an issuer from marking to market its own debt should not prevent § 475 from applying to an equity-linked CD and its hedge); note 265. 228 See, e.g., Section III.A (capital loss limitation); note 44 and accompanying text (LIFO inventory accounting and accelerated depreciation); and other cases described in note 264. 229 These include, inter alia, the mismatches discussed in Examples 4-5 (arising from Reg. § 301.7701-2(c)(2)(ii) that treats a disregarded entity owned by a bank as a separate entity for purposes of the special rules applicable to a bank); Example 6 (application of Reg. § 1.475(c)-2(a)(2) to structured note, which precludes a dealer-issuer from marking to market its own debt); the application of § 1.882-5, § 864, and § 988 to conduit-type foreign currency funding arrangements involving U.S. branches of foreign banks, see text accompanying notes 132-34; and Example 9 (intercompany sale of a subsidiary within a consolidated group followed by its liquidation, under § 1.1502-13(c)(6)(ii)).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE discussed below, these changes would also be salutary in connection with a super-matching rule. (1) Hedging of nonordinary property.230 Taxpayers should be permitted to identify hedges of business and investment positions that may give rise to capital gain or loss, with appropriate matching of character. (2) Charactermismatch in a single or integrated transaction that is not subject to the hedging rules.231 Congress should amend the Code to permit a taxpayer to recharacterize a capital loss as an ordinary loss to the extent of previously (or currently) included offsetting income from the position or a hedge position. Conversely, in a single or integrated transaction that first produces capital losses and later produces ordinary income, the subsequently included ordinary income should be permitted to be treated as capital gain to the extent of the previously (or currently) claimed capital losses. (3) Distressed debt mismatches.232 Congress and/or Treasury should address the timing and character mismatches of distressed debt. This is an area where it would appear that instead of having to formulate and prescribe a detailed set of rules, guidance could be provided in the form of a general requirement that the taxpayer may specify, and thereby adopt, a method for matching the timing and character of items of income, gain, loss, and deduction in respect of distressed debt that clearly reflects income (that is, a "mini" matching rule). (4) Interest sourcing, § 988, and subpart F rules.233 These rules un- necessarily impede normal commercial activity, including securities repo funding, rolling hedges, hedging of receivables, and use of centralized hedging centers, and should be rationalized to fix glitches. (5) § 267(a)-(d) and § 707(b).234 The treatment of losses between related parties outside the affiliated corporate group context (and the associated related party definitions and attribution rules) should be rethought. (6) Relax limitations on individual deductions.235 The various limitations regarding deductions by individuals and certain other noncorporate taxpayers (including the § 67 floor on miscellaneous itemized deductions, § 68 limitation on itemized deductions, § 166(d) capital loss treatment of nonbusiness debts, and § 469 passive activity losses) should be revised to ensure that they do not preclude a deduction where offsetting or other related amounts are included in income.

230 See Examples 1 & 4. 231 See Examples 1 & 2. 232 See Examples 2 & 3. 233See Subsections III.C.4, III.D.1, and III.D.3. 234 See Subsection III.E.2. 235See Subsections III.E.3, III.F.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: (7) Uniform identification and inadvertent error rules.236 To the extent practicable, the same standard should apply under various provisions to determine whether a taxpayer has timely and properly identified related positions or made certain elections, and for excusing inadvertent errors. In assessing whether an inadvertent error should be excused, all the facts and circumstances should be taken into account, including, where relevant, the consistency of the taxpayer's treatment of similar items in the same and different tax years, whipsaw considerations, and the treatment of such items for financial and management reporting purposes. Given the technicalities of some of these provisions (such as those referred to in recommendations three, four, and five), rather than attempting to fix the problems (only) through numerous discrete modi- fications to the rules, it may make sense to promulgate mini-matching rules for those particular provisions (for example, source, § 988, and the subpart F rules, or as noted above, the rules for distressed debt) that would enunciate a matching principle with general guidelines for the particular context.

V. POLICY CONSIDERATIONS IN FORMULATING A SUPER-MATCHING RULE A. The Benefits of a Super-Matching Rule Compared to the Status Quo and to Alternative Approaches to Mismatches A basic consideration in evaluating a proposed super-matching rule is whether the current state of affairs is in need of remediation and whether the proposed solution is preferable to alternative approaches to addressing mismatches. The thesis of this Article is that notwithstanding the prevalence of the matching concept, there are serious mismatch problems throughout the tax law and that these mismatches are problematic for both taxpayers and the government. The traditional approach to addressing mismatch problems has been for Congress or Treasury and the IRS to promulgate rules designed to mitigate those issues. As illustrated in Part III, the effective- ness of these solutions has varied depending on the context. Such remediation efforts should continue and be encouraged. Indeed, as noted above, prioritized action on several key issues would significantly improve a number of significant mismatches regularly faced by taxpayers. The legislative or regulatory path for addressing mismatches can be extremely protracted, even on major issues of widespread importance. For example, it took Congress, Treasury, and the IRS over ten years to

236 See notes 75-78, 88, and 112-14 and accompanying text.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE address the problems created by the Arkansas Best decision, which affected core commercial hedging activities of businesses.237 Simi- larly, it was about ten years after the securities industry and its tax advisers began to express grave concerns regarding the taxation of global dealing before Treasury and the IRS issued proposed regulations, and those regulations have not yet been finalized. 238 And several years' worth of benefits from FTC splitter transactions were generated, even after these structures became widely known and the IRS began auditing them, before Treasury and the IRS issued proposed regulations in 2006 and Congress enacted § 909 generally effective in 2011.239 Moreover, even where guidance is provided regarding the matching of offsetting or other related items, invariably there are gaps or glitches in the guidance, leaving residual mismatch issues. Experience has shown that once Congress or Treasury and the IRS have promulgated rules in an area, it is very difficult to obtain follow-up clarifica- tions due to the demands of other matters. Furthermore, in the absence of a clear mandate favoring matching, unless there are very strong countervailing considerations, it appears that too often IRS personnel (perhaps understandably) take a conservative position and are reluctant to depart from a literal application of the rules that give rise to a potential mismatch, either through the guidance process or in audits. While Congress can always exercise its prerogative to subordinate matching to other considerations, were Congress to embrace the matching principle as a primary guiding principle in the tax law, against which specific promulgations should be measured and any serious deviations should be consciously considered and justified, it is likely that tax legislation, regulations, and other guidance, on balance, would be more neutral and fairer to the government and the taxpayer. Finally, a more general and explicit acknowledgement of the centrality of the matching principle could assist the IRS, taxpayers, and the courts in navigating the gaps and glitches that complicate their inter-

237 See notes 58-60 and accompanying text. 238 See notes 144-51 and accompanying text. 239 Guardian Industries Corporation filed its refund claim in respect of its FTC splitter transaction in the U.S. Court of Federal Claims in 2002. Guardian Industries Corp. v. United States, 65 Fed. Cl. 50 (2005). Prop. Reg. § 1.901-2(f) was initially proposed to be effective for taxable years beginning on or after January 1, 2007, but in Notice 2007-95, 2007-2 C.B. 1091, the effective date was deferred until final regulations are published in the Federal Register. Section 909 became effective generally for foreign taxes paid or accrued in taxable years beginning after December 31, 2010 (including § 902 credits in respect of post-2010 distributions from pre-2011 earnings). Act of August 10, 2010, Pub. L. No. 111- 226, § 211, 124 Stat. 2389, 2394-96 (codified at § 909).

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: pretation of how specific tax rules should be applied in particular situations. Thus, the current state of affairs could be improved. Any such improvement in the form of a super-matching rule should operate as a complementary addition to the existing practice whereby Congress, Treasury, and the IRS address particular problem areas through substantive guidance that seeks to mitigate mismatches. Any super- matching rule should ideally serve at least two functions. First, it should provide a guiding principle to Congress, Treasury, and the IRS in promulgating rules, to be weighed with other policy considerations. Second, it should provide substantive direction to taxpayers, the IRS, and the courts in interpreting existing law and determining whether a mismatch should be accepted or overridden.

B. Rules vs. Principles, Certainty vs. Flexibility A super-matching rule perforce would not prescribe specific solutions for each conceivable, particular mismatch problem, but instead would be a broader, principle-based articulation. As such, this approach directly implicates the fundamental question of what sort of tax law-or indeed, any set of laws-is desirable: a system that is limited to detailed, prescribed rules or one that leavens those rules with 240 general principles, and if the latter, the extent of such leavening. An important perceived benefit of a system that is based on detailed, prescribed rules is certainty.241 Ostensibly, a taxpayer can read and apply the literal rules without having to be concerned that it will

240 See generally John A. Miller, Indeterminacy, Complexity, and Fairness: Justifying Rule Simplification in the Law of Taxation, 68 Wash. L. Rev. 1, 2 (1993) (addressing the appropriateness of elaborate tax rules as opposed to broader standards, and noting that, "[iun tax we love rules"); Louis Kaplow, Rules Versus Standards: An Economic Analysis, 42 Duke L.J. 557 (1992) (containing an economic analysis of the extent to which legal commands should be promulgated as rules or standards); Joseph Isenbergh, Musings on Form and Substance in Taxation, 49 U. Chi. L. Rev. 859, 881 (1982) (book review) (oppos- ing a perceived shift towards "creative" jurisprudence in favor of strict, rule-bound jurisprudence in the administration of tax law). One side of this debate was recently and succinctly set forth in M. Carr Ferguson, How to Save the Corporate Income Tax, 132 Tax Notes 951, 954 (Aug. 29, 2011): If a statutory recipe is detailed enough, literalists urge, all will know how to apply and rely on it, leaving no room for lawyers' schemes or judges' retrospec- tive interpretations to obscure its clarity. Experience teaches us the contrary. Complexity leads not to clarity but to confusion. A shorter, simpler corporate income tax can be written by Congress, if the drafters can agree on first principles and then set them out in more broadly stated rules. This would leave room for flexible application by administrators, lawyers and judges whose nat- ural function is to provide interstitial interpretations. 241 See Duncan Kennedy, Form and Substance in Private Law Adjudication, 89 Harv. L. Rev. 1685, 1688 (1976) (identifying certainty as one of "the two great social virtues of formally realizable rules, as opposed to standards or principles").

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE be second-guessed by the Service or a court.242 The importance of certainty should not be underestimated. On the other hand, there are likely to be gaps, unaddressed issues, and inconsistencies in any set of rules, and in any event a literal application of detailed rules can produce inappropriate or erroneous results in certain situations.243 These problems and the daunting complexity often associated with detailed rules can be as corrosive as uncertainty and indeed can themselves breed uncertain, arbitrary, and unfair consequences. 244 Therefore, the tax law has long accepted the proposition that the Code and regulations need to be applied taking into account basic tax principles and other principles-based guidelines, some of which are judicially developed and others are in the Code or regulations. Thus, the substance-over-form, step transaction, and economic substance doctrines have been enshrined components of the tax law for many decades.245 More recently, many Code and regulatory provisions have been promulgated with general or specific anti-abuse rules intended to constrain inappropriate literal applications of those provisions in specific fact patterns so as to ensure that they produce results that are consistent with their purpose. One noteworthy example of such a principles-based rule is the general partnership anti-abuse rule in § 1.701-2, which describes what the partnership tax rules are intended to do (and when treating the partnership as an entity rather than as an aggregate of its partners is clearly contemplated), then provides for the recharacterization of transactions that are inconsistent with that purpose (or contemplated treatment), and contains examples illustrating types of situations that would or would not be subject to recharacterization. Another recent

242 See Kaplow, note 240, at 559-60 (emphasizing the distinction that rules give content to the law ex ante, before an individual acts, whereas standards give content ex post). But see Miller, note 240, at 71 (noting the "improbability of obtaining absolute legal certainty through elaboration of rules"). 243 See Miller, note 240, at 70 ("[T]he simultaneous effort to achieve both fairness and certainty through great elaboration of the rules of taxation is inherently contradictory."). 244 Gordon D. Henderson, Controlling Hyperlexis-The Most Important "Law And ., 43 Tax Law. 177, 197-99 (1989) (containing proposals for getting the "hyperlexis- creating legal machine under control"); Lawrence Zelenak, Thinking About Nonliteral In- terpretations of the Internal Revenue Code, 64 N.C. L. Rev. 623, 674-76 (1986) (discussing the problems of statutory complexity and presenting principles for courts to determine when a nonliteral interpretation is appropriate); Edward Zelinsky, Another Look at Tax Law Simplicity, 47 Tax Notes 1225, 1225-28 (June 4, 1990) (focusing on relationship between the tax law's complexity and substantive tax policy). 245 See Bittker & Lokken, note 11, at T 4.3.1 (stating that these and similar doctrines "are so pervasive that they resemble a preamble to the Code, describing the framework within which all statutory provisions are to function. But these judicial presuppositions, like the canons of statutory construction, are more successful in establishing attitudes and moods than in supplying crisp answers to specific questions.").

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: example is the codification of the economic substance doctrine in § 7701(o). The extensive and vociferous debates over the promulgation of both § 1.701-2 and § 7701(o) are evidence that the extent to which technical rules should be subjected to principles-based "super-rules" can be very controversial. 246 Similarly, it is not uncommon for commentators to object to proposed anti-abuse provisions on the grounds 247 that they are too vague and engender uncertainty. In evaluating whether a super-matching rule should be added to the constellation of principles-based super-rules, it is important to consider whether on balance the flexibility that it provides to soften or correct some of the mismatches that arise under current law-including (in contrast to some of the more controversial principles-based super-rules) mismatches that adversely affect taxpayers-overcomes concerns regarding its vagueness or the uncertainty that it might engender. To a large degree, this likely depends on the terms and scope of such a rule.

C. The Substance of Matching: When, What, and How to Match A critical issue in formulating a super-matching rule is determining how it would operate in practice, and whether it necessarily would be so general that it provides insufficient guidance as to its application and therefore would engender too much uncertainty to be beneficial or workable. This issue is related to three sub-issues. First, when is it appropriate to match offsetting or other related items? As noted above, some mismatches appear to be the result of inadvertent oversights as to how technical rules should apply and in- teract with each other in unforeseen situations, whereas others seem to be the result of conscious judgments by Congress, Treasury, or the IRS. Is it possible to craft a rule that distinguishes between these cat-

246 See, e.g., Sheldon I. Banoff, Anatomy of an Antiabuse Rule: What's Really Wrong with Reg. Section 1.701-2, 66 Tax Notes 1859, 1859 (Mar. 20, 1995) ("[M]any practitioners might point to reg. section 1.701-2 as the perfect blueprint of how not to derive and draft antiabuse rules."); Juliann Avakian Martin, Support Split over Controversial Partnership Reg., 94 TNT 142-5, July 22, 1994, available in LEXIS, Tax Analysts File ("The antiabuse regulation is clearly the most controversial tax guidance released by the Clinton administration to date."); Samuel C. Thompson Jr., Despite Widespread Opposition, Congress Should Codify the ESD, 110 Tax Notes 781, 781 (Feb. 13, 2006) ("The American Bar Asso- ciation Section of Taxation, the American Institute of Certified Public Accountants, and the Tax Executives Institute ... all have recently come out in strong opposition to codification of the ESD [economic substance doctrine]."). 247 See, e.g., Michael Schler, Effects of Anti-Tax-Shelter Rules on Nonshelter Tax Prac- tice, 109 Tax Notes 915, 915 (Nov. 14, 2005) (noting that anti-abuse rules "are quite controversial because of their vagueness and their resulting potential to inhibit normal business transactions," but expressing the view that they are necessary to combat tax shelters).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE egories? Of the three sub-issues, this is the most difficult. To the extent it is possible to make such a distinction, it should be feasible to adopt a.super-matching rule that taxpayers could apply. Otherwise, it is likely that any such rule generally would need to be circumscribed to use by Treasury and the IRS as a guideline in issuing regulations and other guidance and by the IRS or a court in interpreting existing provisions. Second, if matching is appropriate in a particular situation, what items should be matched? Given the complexity and diversity of the activities of taxpayers, how does one determine whether an item off- sets or otherwise relates to one particular item or another? Thus, to illustrate using a common example for which the tax law does provide guidance, to what extent should interest expense be associated with personal expenditures, business activity, or investment activity, and to the extent attributed to investment activity, to what extent should it be allocated to dividend (or nondividend) paying stocks, tax-exempt bonds, or corporate bonds in the taxpayer's investment portfolio? Third, once it is determined that two offsetting or other related items should be matched to one another, how should the matching be performed? As noted, the Code and regulations adopt a variety of matching approaches. If matching is to be done pursuant to a super- matching rule, which approach should be utilized in a particular situation? Suggested approaches to these three sub-issues are included in the super-matching rule proposal set forth in Part VI.

D. Relevance of Accounting or Business Treatment In determining when, what, and how to match offsetting or other related items in a particular context, confirmation of the appropriate answer often may be found in the manner that the taxpayer has identified and treated those items for business or accounting purposes. Bus- iness or investment decisions regarding related transactions (whether they are integrated strategies, economic hedges, or related in some other manner) usually will be reflected in contemporaneous business records and, depending on the circumstances, in their treatment for management reporting or accounting purposes. While not necessarily dispositive as to the economic relationship or appropriate tax treatment, the treatment of such items in such records and for such other purposes should be accepted as important evidence, where and to the

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: extent relevant, in answering the "when, what, and how to match" 48 questions. 2

E. Elective or Mandatory, and by Whom

Another set of considerations is whether a super-matching rule may be invoked at the behest of the taxpayer, the IRS (as an anti-abuse rule), or either, and whether it should be a normative rule to be layered by the taxpayer on technical rules whenever and to the extent applicable (such as the step transaction, economic substance, or substance-over-form 249 doctrines) or, instead, be elective. A strong case can be made for a neutral and nonelective application of a super-matching rule by taxpayers, the IRS, and the courts on the grounds that mismatches can prejudice both taxpayers and the IRS. Moreover, if taxpayers have discretion whether or not to invoke a super-matching rule (and the IRS or a court cannot apply it), the government would be whipsawed because taxpayers would apply it only when it benefitted them. It would seem essential to require a taxpayer to timely identify situations in which it is invoking a super-matching rule and to specifically disclose its decision on its tax return so that the Service can determine whether such a departure from the technical rules is appropriate. Consequently, a taxpayer in effect can make the provision elective (absent the IRS identifying a mismatch that had not been disclosed by

248 Historically, there has been considerable skepticism as to the appropriateness of having the tax treatment of an item take into account the management reporting or accounting treatment thereof. See generally Linda M. Beale, Book-Tax Conformity and the Corpo- rate Tax Shelter Debate: Assessing the Proposed Section 475 Mark-to-Market Safe Har- bor, 24 Va. Tax Rev. 301, 355-59 (2004) (reviewing the history of book-tax conformity and generally arguing against such conformity); Alvin D. Knott & Jacob D. Rosenfeld, Book and Tax: A Selective Exploration of Two Parallel Universes (pts. 1 & 2), 99 Tax Notes 865 (May 12, 2003), 99 Tax Notes 1043 (May 19, 2003) (extensive review of the relationship between book and tax differences). For two examples of cases in which the regulations rely on management reporting or accounting treatment, see Reg. § 1.475(a)-4(a)(1) (set- ting forth a safe harbor election to use the values of positions reported on financial state- ments as the fair market values, provided the method used for financial reporting is sufficiently consistent with § 475 and the financial statement has indicia of reliability); Prop. Reg. § 1.482-8(e)(5)(iii) (in the context of global dealing, noting that the reliability of the profit split method increases where the allocation has economic significance for other purposes (like satisfying regulatory standards and reporting)). 249 In general, as a condition to permitting a taxpayer to invoke the substance-over-form doctrine, the Tax Court and several of the Circuit Courts require that the taxpayer present "strong proof" that the substance of the transaction is different- than its form, and also require that the government not be exposed to whipsaw due to inconsistent treatment of the transaction by the parties thereto. See, e.g., Illinois Power Co. v. Commissioner, 87 T.C. 1417, 1434 (1986) (affirming "strong proof" standard and citing numerous Tax Court and circuit court opinions holding the same).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE the taxpayer) by not making a proper identification and disclosure on its tax return. Such electivity can be curtailed by penalizing taxpayers for failing to apply the super-matching rule where it is applicable and for failing to make proper identifications and disclosures, but it would seem appropriate to do so only in those tax shelter-type situations in which the mismatch is the result of intentional planning by the taxpayer for a principal purpose of benefitting from the mismatch. A penalty appears inappropriate, however, in other cases, where the mismatch is supported by a plain reading of the rules and the taxpayer did not structure a transaction with a principal purpose to avail itself of the mismatch.

F. Legislative or Regulatory Guidance, General or Tailored

A final set of considerations is whether a super-matching rule, if promulgated, should be a Code or instead a regulatory provision, and whether it should be a single rule of general applicability or multiple rules tailored for different contexts. While the enactment of a Code provision would allay any concerns that might be raised regarding regulatory authority, there would appear to be ample regulatory authority to promulgate the sort of general super-matching rule I propose. On the other hand, as explained below, the efficacy of such a rule would be enhanced to the extent Congress were to issue guidance clarifying some of the key mismatch issues raised in the different contexts discussed above,250 since such guidance would likely reduce the number of areas in which mismatches could be considered to be the result of conscious judgments by Congress. A super-matching rule of general applicability would be beneficial for the reasons discussed earlier, 251 assuming its terms fairly and ade- quately take into account the relevant considerations that have previously been identified. 252 In addition to a general super-matching rule, mini-matching rules may serve an important and useful role in providing guidance and authority to address mismatch issues in certain complex areas, such as the source, § 988, and subpart F provisions.

250 See Section IV.B. 251 See Section V.A. 252 See Sections V.B, V.C.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65:

VI. A PROPOSED SUPER-MATCHING RULE

A. Description of Proposal This Article proposes that consideration be given to adopting a super-matching rule with the following features: * The provision-whether enacted by Congress or promulgated as a regulation-should contain a "statement of intent" and an opera- tional rule to the effect that in applying Chapter 1 of the Code, offsetting or other related items should be taken into account consistently (on a "matched" basis) for character, timing, source, and other characterization purposes, except to the extent that a contrary result is clearly intended by the Code or regulations. Such matched treatment should not affect the treatment of any portion of an item that is not offsetting or otherwise related to the matched item. • The super-matching rule would be a neutral, normative rule of construction, to be applied by taxpayers, the IRS, and the courts. It would also be an expression of policy that Congress would undertake to consider whenever it amends the Code and that Treasury and the IRS would need to consider in issuing regulations and other guidance. As such, it would not preclude Congress, Treasury, or the IRS from issuing rules that depart to one extent or another from matching but would require that consideration be given to the balance to be struck between the matching principle and other policy objectives before do- ing so. * The accompanying explanation of the provision should provide examples of situations that are intended to be covered by the super- matching rule and examples of situations that are not intended to be covered. In general, the matching rule would not cover mismatches arising under those basic structural aspects of the Code and other situations in which Congress and Treasury have expressed a clear intention to give effect to another policy consideration in priority to achieving matching.253 Those situations would be narrowed if and to the extent that the specific recommendations made above were adopted. 254 In the absence of such a clear intention, in general the matching rule would cover mismatches arising from overlaps and gaps in specific rules, including where Treasury and the IRS determined not to issue guidance to address mismatch concerns because they concluded that those concerns were not sufficiently weighty to justify the

253 See note 264 for examples. 254 Not all of the specific recommendations made in Section IV.B address basic structural aspects or other situations in which Congress and Treasury have expressed a clear judgment to give effect to another policy consideration in priority to achieving matching. See notes 264-66 and accompanying text.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE effort to address them or the additional administrative complexity that 2 5 such guidance might engender. - 0 If the taxpayer or the IRS makes a prima facie case for matching under the foregoing rule, the burden of proof is on the other party to show that a contrary result is clearly intended by the Code or regulations. * The items to be matched and the manner in which matching is to be achieved should be determined under a "best matching method" based on the particular context, taking account of the approach to matching that has been adopted by the Code and regulations in related or analogous contexts. Due consideration should also be given to the taxpayer's treatment of such items for business or financial reporting purposes. A taxpayer's selection of a matching method that produces acceptable matching under the foregoing standard should not be overturned by the IRS or a court unless it does not achieve matching in a manner that is consistent with congressional or regula- 6 tory intent.25 * In order to apply the matching rule to a particular situation, the taxpayer generally must (1) timely identify the situation, the matched items, and the manner in which it is matching those items and (2) disclose the details of such identification on a schedule to its tax return.257 The timeliness of the identification in a particular context would depend on the nature of the items being identified.25 8 A tax-

255 These situations would appear to include self-charged interest and management fees under § 469. See Examples 13 & 14. 256 This recommendation is patterned after the best method rule under § 1.482-1(c) of the regulations as well as the deference standard applicable to a taxpayer's selection of a method of accounting that clearly reflects income. See, e.g., Bank One Corp. v. Commis- sioner, 120 T.C. 174, 288 (2003), aff'd in part, vac'd in part & rem'd sub nom. JPMorgan Chase & Co. v. Commissioner, 458 F.3d 564 (7th Cir. 2006) ("The fact that the Commis- sioner possesses broad authority under section 446(b), however, does not mean that the Commissioner may change a taxpayer's method of accounting with impunity. For example, the Commissioner may not change a method of accounting which clearly reflects income to another method that the Commissioner believes reflects income more clearly.... Nor may the Commissioner change an accounting method that clearly reflects income to a method that does not clearly reflect income."). Thus, whereas for transfer pricing purposes, the best method rule under § 1.482-1(c) generally requires that the single method that produces the most reliable measure of an arm's length result be selected but allows for acceptable results within an arm's length range under § 1.482-1(d), the proposed "best matching rule" deference standard envisions that in certain circumstances more than one method might be acceptable. See note 268 and accompanying text. 257 In light of this identification requirement, where the other conditions for matching are satisfied, a taxpayer or the IRS should be eligible to apply the matching rule to related or offsetting positions held by related persons. 258 For example, an economic hedge of a capital asset generally should be subject to the same-day and contemporaneous identification rules (and inadvertent error exception) that apply under the hedging regulations. See notes 62-63, 75-78 and accompanying text. On the other hand, if matching were to apply to the partner debt cancellation situation de-

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: payer should be able to cure an inadvertent failure to timely identify an item if similar items are treated consistently.25 9 0 A taxpayer must take a consistent approach to the application of the matching rule to similar circumstances in the current and all subsequent years (unless the IRS consents to a change in approach). Simi- larly, the IRS should apply the matching rule on a consistent basis except where appropriate to prevent being whipsawed by a taxpayer. * A taxpayer's failure to apply the matching rule where it is clearly applicable and to make proper identifications and disclosures would be penalized only in those tax shelter-type situations in which the mismatch is the result of intentional planning by the taxpayer for a principal purpose of benefitting from the mismatch. No penalty would apply in other cases, where the mismatch is supported by a plain reading of the rules and the taxpayer did not structure a transaction with a principal purpose to avail itself of the mismatch. 0 Before the IRS can assert the super-matching rule in an examination, it must perform a multi-step analysis and obtain higher-level 60 approval.2 * Mini-matching rules should be promulgated by Congress or in regulations as appropriate, under provisions (such as those affecting distressed debt and the source, § 988, and subpart F provisions) where there are numerous detailed rules that tend to give rise to mismatches. * The IRS should provide guidance through existing avenues (including revenue rulings, private letter rulings, and technical advice memoranda) regarding the application of the super-matching rule and mini-matching rules to particular situations and contexts.

B. Discussion The super-matching rule proposed in this Article is patterned after the principles-based rules that apply in addition to the detailed technical provisions of the Code and regulations, such as the general partnership anti-abuse rules in § 1.701-2 of the regulations, the economic substance doctrine of § 7701(o), and the substance-over-form and step transaction doctrines. It also draws inspiration from the arm's length scribed in text accompanying note 200 or to the self-charged items described in text accompanying notes 196-99, identification on the tax return would seem to be sufficiently timely. 259 Cf. Reg. § 1.1221-2(g)(2)(ii) (inadvertent error exception in hedging rules). 260 Cf. LB&I Guidance for Examiners and Managers on the Codified Economic Sub- stance Doctrine and Related Penalties, LB&I-4-0711-015 (July 15, 2011), 2011 TNT 137-17, July 18, 2011, available in LEXIS, Tax Analysts File (directive requiring an IRS examiner to apply a four-step process to evaluate whether to assert that a transaction lacks economic substance under § 7701(o) and to obtain approval of his or her manager, in consultation with local counsel, and his or her director of field operations).

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE principle of § 482 and the consolidated return intercompany transactions in § 1.1502-13. The proposal seeks to address the scope concern of when it is appropriate to apply a super-matching rule and when it must give way to a congressional or regulatory judgment that matching should be subordinated to other considerations in the same manner as similar questions are addressed under § 7701(0)261 and § 1.701-2.262 In addition, the proposal seeks to achieve greater clarity regarding those key areas of mismatches as to which Congress, Treasury, or the IRS have (arguably) expressed a judgment that matching should be subordinated to other policy considerations by combining the super-matching rule with the specific recommendations made above2 63 for addressing those mismatches. To the extent Congress addresses these key macro mismatch concerns in conjunction with the promulgation of a super- matching rule, the number of significant mismatch problems that are outside the scope of the super-matching rule would be reduced, while the scope of technical micro mismatch issues that can effectively be resolved through the super-matching rule would be increased. This dual approach should provide a satisfactory basis for determining when to apply a super-matching rule. While a clear demarcation may not be evident in every case, the quantity of "gray area" cases and the qualitative nature of the issues raised should be comparable to those presented under other generally applicable tax principles, such as the step transaction, substance-over-form, and economic substance doctrines. As in those contexts, future legislative, regulatory, and judicial guidance should clarify and reduce those gray area cases. The proposal distinguishes between those situations in which Con- gress, Treasury, or the IRS have expressed a clear intention to give effect to another policy consideration in priority to achieving matching, on the one hand,2 64 and on the other hand those situations that

261See Staff of the Joint Comm. on Tax'n, 111th Cong., Technical Explanation of the Revenue Provisions of the Reconciliation Act of 2010, at 152 n.344 (Comm. Print 2010) ("If the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed."). 262 See Reg. § 1.701-2(a)(3) (proper reflection of income requirement satisfied "to the extent that the application of such a provision to the transaction and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by that provision"); Reg. § 1.701-2(e)(2)(ii) (partnership will not be treated as an aggregate of its partners where entity treatment "and the ultimate tax results, taking into account all the relevant facts and circumstances, are clearly contemplated by that provision"). 263 See Section IV.B. 264 Absent further guidance from Congress, Treasury or the IRS along the lines suggested in Section IV.B, the following mismatches generally would not be addressed through a super-matching rule because it appears that Congress or Treasury and the IRS have made a conscious judgment to subordinate matching to other policy considerations:

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: appear to be the result of technical glitches or gaps rather than a decision to subordinate matching to another policy consideration 265 or in which Treasury and the IRS determined not to issue guidance to address mismatch concerns because they concluded that those concerns were not sufficiently weighty to justify the effort to address them or the additional administrative complexity that such guidance might engender. 266 Applying a super-matching rule to the latter class of situations would enable Treasury and the IRS to streamline the regulatory and other guidance process while providing a flexible safety valve to address residual mismatches. Most of the designations set forth in the notes above as to which of the mismatch examples discussed in this Article would or would not be eligible for the application of the super-matching rule under the standard set forth herein seem pretty straightforward, while a few are a closer call and might lend themselves to a different judgment. Nonetheless, if at the margin it is not entirely clear whether the pro-

(1) character and timing mismatches relating to business hedges of nonordinary property, Examples 1, 4 & 5; (2) character and timing mismatches relating to distressed debt, Exam- ples 2 & 3; (3) the source rules for research and development, see note 120 and accompanying text; for deductions generally, see text accompanying notes 121-22; and for interest expense under worldwide apportionment and on repoed securities, see text accompanying notes 123-34; (4) subpart F mismatches arising from the E&P deficit rule, see note 154 and accompanying text; (5) the § 1.1502-13 and § 267(a) related party mismatches, see text accompanying notes 178-93; (6) the partner debt cancellation case of Example 15; and (7) the mismatches relating to the limitations on itemized deductions, see Example 16. 265 These cases would appear to encompass (1) Example 4 (where the failure to qualify for hedging treatment is the result of a technical rule regarding disregarded entities owned by banks rather than an apparent policy decision to distinguish that case from Example 5); (2) Example 6 (where, as described in note 87, there are persuasive policy and technical reasons for concluding that the regulation that precludes an issuer from marking to market its own debt should not prevent § 475 from applying to an equity-linked CD and its hedge); (3) failures to identify that should be excused, see text accompanying notes 88-89, 112-14; (4) series of rolling § 988 hedges of a foreign-currency denominated note, where the problem appears to be the result of a technical gap in the regulations and is arguably curable, see notes 109, 139, and accompanying text; (5) hedging foreign currency risk through a centralized entity, where the problem appears to be technical rather than a considered judgment since a closely analogous, subsequently issued regulation permits hedging through a related party, see notes 110-11 and accompanying text; (6) conduit-type interbranch lending and related hedges, where the mismatch appears to arise from technical gaps, see notes 132-34 and accompanying text; (7) mismatches arising from technical gaps or glitches in the sourcing rules for interest equivalents, see note 135 and accompanying text; and (8) subpart F mismatches illustrated in the text accompanying notes 159-64 (where, in contrast to mismatches directly attributable to the E&P deficit rule, the mismatches arising from the application of the business needs exception or the allocation rules for foreign currency gain or loss with respect to an interest bearing liability of a CFC do not appear to be the result of a conscious decision to override a matching principle). Tax shelter-type situations, of the sort described in Section III.H, would also be covered by the super-matching rule. 266 These situations would include self-charged interest and management fees under § 469, see Examples 13-14, 16.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE posed super-matching rule should apply in a few mismatch situations, this uncertainty should not be considered problematic for the viability of a super-matching rule. After all, there are many uncertainties under the tax law; the fact that there are a few lingering uncertainties in the application of a macro rule that is intended to reduce uncertainties relating to mismatches in a broad range of circumstances should not be disqualifying. Moreover, the features of the proposed super-matching rule (including in particular its production of matched results on a consistent basis using a "best matching method" and in a manner consistent with the intent of Congress and Treasury, with timely identification and disclosure by the taxpayer) contain intrinsic safeguards against inappropriate consequences from a tax policy perspective, so that even if a taxpayer were to invoke the super-matching rule in a situation that arguably is not within the scope of the rule (and were to prevail in court if challenged by the IRS), the government should not be prejudiced. Furthermore, Treasury and the IRS can influence the development of the super-matching rule by providing general guidance regarding its intended scope and application. In general, taxpayers should also not be exposed to inappropriate adverse consequences from the assertion by the IRS that the super- matching rule applies in a particular situation. The intrinsic safeguards described above should also protect taxpayers, as would the proposals that the application of the super-matching rule by the IRS in an examination must follow certain approval procedures and that no penalty would apply to a taxpayer's failure to apply the matching rule even where it is clearly applicable unless the taxpayer intention- ally structured a mismatch in a tax shelter-type situation. As for the questions of what items to match and how, absent unusual circumstances, the answer to each of these questions generally should be apparent from the particular context, taking account of the approach to matching that has been adopted by the Code and regulations in related or analogous contexts and giving due consideration to (among other factors) contemporaneous business records of the taxpayer as well as its business and financial reporting treatment of the relevant items. Furthermore, under the proposal, a determination of what items to match and how to achieve matching in any particular situation would be made based on the best matching method. This feature of the proposal, which is patterned after the approach of the § 482 transfer pricing regulations and the clear reflection of income standard under § 446(b) 267-together with the consistency, identification, and disclosure requirements as well as the other intrinsic safe-

267 See note 256 and accompanying text.

Imaged with the permission of Tax Law Review of New York University School of Law TAX LAW REVIEW [Vol. 65: guards-should provide appropriate parameters for arriving at answers regarding what items and how to match that are acceptable as a tax administration and policy matter, for reasons similar to those discussed above with respect to the question of when it is appropriate to apply a super-matching rule. In this regard, it does not appear to be essential to an efficacious and proper working of a super-matching rule that there be only one answer to the questions of what and how to match, because these intrinsic safeguards should produce acceptable results (although it would appear that absent unusual circumstances the answer to each of these questions should generally be apparent from the particular context). 268 Indeed, in reviewing the examples of technical micro mismatches discussed in this Article that would be the subject of the proposed super-matching rule, 26 9 it does not appear that the questions of what items to match and how present particularly nettlesome challenges.

VII. CONCLUSION This Article has endeavored to advance the proposition that the influence of the matching principle is widespread throughout the tax law, although its pervasiveness and significance as a core foundational policy appears to be understated and perhaps underappreciated. It is a powerful device for ensuring tax consequences that are balanced, neutral, and fair to the taxpayer and to the government. While matching is usually achieved within a structural framework as well as other policy and practical considerations that, depending on the context, may produce only partial or selective matching, the fundamental proposition stands. The many mismatches that arise notwithstanding the matching principle are problematic for both taxpayers and the government because they undermine the fairness, efficiency, predictability, and administrability of the tax system. Most mismatches seem to be the result of the application of precise and detailed rules in unforeseen circumstances, the lack of guidance as to the proper interplay between two sets of rules or the absence of consideration of potential mismatches, although some mismatches appear to be the result of conscious judgments made by Congress, Treasury, or the IRS. Putting aside inten-

268 For instance, absent the promulgation of guidance mandating a particular approach, acceptable matching generally could be achieved in the case of the FTC splitter transactions discussed in text accompanying notes 173-77 under either the approach of Prop. Reg. § 1.901-2(f) or the approach of § 909. Under the proposal, deference would be given to the taxpayer's selection of a matching method so long as it satisfied the "best matching method" standard in a manner that is consistent with Congressional or regulatory intent. See note 256 and accompanying text. 269 See notes 265-66.

Imaged with the permission of Tax Law Review of New York University School of Law 2012] THE CASE FOR A "SUPER-MATCHING" RULE tional mismatches, it would seem to be highly desirable to minimize mismatches and to provide mechanisms for their avoidance and resolution. The proposals contained herein regarding a super-matching rule, mini-matching rules, and specific recommendations for clarifying the application of certain provisions are intended to provide a framework for the tax law to more consciously and directly effectuate the matching principle within the context of other policy and practical considerations and thereby to mitigate the problems presented by mismatches. There might be reticence in some quarters to the creation of a new principles-based rule, particularly after the recent codification of the economic substance doctrine. These concerns appear to be out- weighed by the benefits of such a rule. The current state of affairs is unsatisfactory, and the proposals set forth herein would significantly improve the tax law and its administration.

Imaged with the permission of Tax Law Review of New York University School of Law 312 TAX LAW REVIEW

Imaged with the permission of Tax Law Review of New York University School of Law