CSJN Rules Favorably on Tax Loss Carry Forward in Hedging Transactions

1. Introduction

Hedging transactions can generally be defined as a financial technique that aims at reducing risks of losses derived from unfavorable prices fluctuations regarding interest and foreign exchange rates. They consist of taking a position for a term that is equivalent or opposite to another term-position that has been carried out or will be carried out in the on-spot market.

Therefore, hedging transactions are those that are aimed at reducing or cancel the risk of a financial asset or liability held by a company or an individual.

Section 19 of the Income Tax Law (“ITL”) states that, for tax loss carry forward purposes “…a transaction or agreement of derivative products will be considered a ‘hedging operation’ if its objective is to reduce the effect of future prices or rates fluctuations in the market over the business’ main economic activity or activities”.

Generally, these transactions are differentiated from speculative transactions. While hedging transactions means a protection element against price-risk, speculative transactions, subject to many other variables, means to freely take on the risk of fluctuation, whether rise or fall of prices, with the objective of obtaining a benefit.

Section 19 foresees that losses generated by rights and obligations that arise from derivative instruments and/or agreements, except for hedging transactions, can only be cancelled against net gains that have their origin in these same type of rights. That is, they are considered specific tax losses, and not general tax losses likes those arising from hedging transactions.

This discussion took place in the Argentine Supreme Court (“CSJN” after its Spanish acronym) ruling Tecpetrol SA[1] (“Tecpetrol”).

2. The Tecpetrol case

Tecpetrol’s main activity is the development and operation of hydrocarbon deposits and its derived products, as well as commercialization of hydrocarbon and derivatives.

The Argentine Tax Authority (“AFIP” or “Tax Authority”) challenged Tecpetrol’s tax loss carry forward for fiscal years 2000 and 2001.

The ruling also contains certain matters related to the definition and concept of “accruing” but that goes beyond the scope of this article.

1. Tax Authority’s arguments

The Tax Authority argued that Tecpetrol should have compensated the losses only against net gains that arose from other derivative transactions as the AFIP’s point of view, Tecpetrol’s transactions had a speculative end, as opposed to a hedging objective.

To support that conclusion, the Tax Authority stated that Tecpetrol had breached the ITL as it did not prove the hedging purpose of the transactions; that is, that through these transactions it tried to reduce the activity risk that meant being exposed to the high fluctuations of market prices of crude oil.

The Tax Authority states that the documentation of a hedging strategy was not proven, which would have allowed the company’s policy regarding those matters, as “mandated” by “comparative law” and by “later codification of accounting principles”, and did not prove the correlation in quantity, quality and simultaneousness between transactions in the on-spot market –quantity of crude oil barrels it has agreed to sell or it sold to commercial customers- and the derivative transactions in the futures market with hedging purpose –quantity of crude oil barrels it has agreed to sell and negotiated in the market-.

As a side note, the Tax Authority states that the existence of recurring negative results in the futures market demonstrate that the taxpayer’s objective was not exactly taking cover against price fluctuations.

2. Tecpetrol’s arguments

In the day-to-day business of its transactions, the company does not know what will happen to the hydrocarbon prices by the time it physically delivers the products and, to take cover for a given price, it enters into a derivative financial instrument.

Tecpetrol understands that the hedging transactions carried out by them are aimed at reducing the risk that arises from price fluctuations over the price of the underlying asset, with the purpose of compensating the result from the on-spot hydrocarbon market against the result derived from the derivative agreements market, ensuring, this way, an appropriate cash flow to face commitments, obligations and investments entered into in a given fiscal year.

Tecpetrol also states that Section 19 of ITL only sets two requirements for transactions to be considered as a hedging derivative instrument, or not. They are: i). that the operation has as an objective to reduce the effect of future fluctuations in prices and ii). that the hedging operation covers results that arise from the company’s main economic activity.

As to questioning by the Tax Authority for recurrent losses from derivative instruments, Tecpetrol understands that the Tax Authority’s role is not that of evaluating the good or bad performance of businesses carried out by taxpayers, but that its role is to supervise compliance with tax laws under strict respect for the legality principle.

For this reason, Tecptetrol concludes that the concept of hedging set forth by the law is undoubtfully fulfilled in the Tecpetrol case; therefore, the Tax Authority’s claim, based on compliance with requirements that are not set forth by the ITL, violates the legality principle that rules over tax matters and that has constitutional hierarchy.

3. The CSJN ruling

This matter was brought before the CSJN by means of the appeal presented by the Tax Authority against the Argentine Court of Appeals in Administrative Matters (“NCAAM”) that confirmed the Argentine Tax Court (“ATC”) ruling that revoked the adjustment claimed by the Tax Authority.

The CSJN expressly stated that the quid to be resolved consists in determining if the performed transactions can be considered as hedging transactions in the terms set forth by Section 19 of the ITL, that states that “…for purposes of what is stated in the paragraph above, a transaction or contract of derivative products is considered a ‘hedging operation’ if its aim is to reduce the effect of future fluctuations in prices or rates over the results of the main economic activity or activities”.

The CSJN insists that the legal norm states that the operation must be carried out with the objective of reducing the impact of those fluctuations over the company’s main economic activities, this circumstance is not being discussed in the present case, as all the agreements entered into have as an objective the purchase-and-sale of crude oil and, one of Tecpetrol’s main activities, as set forth in its By-Laws, consists of the commercialization of hydrocarbons.

The CSJN also repeats the ATC argument that although Technical Resolution No. 20 of the Professional Accounting Rules sets a definition of hedging that takes into consideration some of the criteria proposed by the Tax Authority for Tecpetrol to prove of the “hedging objective” of the transactions, as mentioned by the Tax Authority, said Technical Resolution is not applicable to the fiscal years under discussion in the ruling, reason why a loophole existed, and loopholes cannot be completed with requirements as those set by the Tax Authority without breaching the legality principle. This argument was not answered by the Tax Authority in its appeal writ.

CSJN concludes that, even when it is true that the taxpayer had the burden to prove that the transactions had a hedging purpose, the “total lack of refute regarding that compliance with the requirements that the appealing party mentions is not included in Section 19 of the tax law nor is it in any other law applicable to this case (…) leads to confirming what was decided to this respect by the previous Court”. However, it was also considered that the proof provided by Tecpetrol showed, in a certain manner, that the transactions had a hedging purpose.

In its conclusion, the CSJN stated that “the detail and specific characteristic of the requirements that the Tax Authority considers as unaccomplished to understand that the transactions has a hedging nature, could only be found in a legal provision in that sense, as it refers to very specific requirements that have even changed alongside accounting regulations” the reason why the Tax Authority’s actions would be in breach of the legality principle in tax matters.

[1] Tecpetrol SA (TF 27621-I) c/DGI”, CSJN, dated September 12, 2017.