308 JOURNAL OF ECONOMICS AND FINANCE 9 Volume 25 9 Number 3 9 Fall 2001 Corporate Income Tax and Futures Hedging Donald Lien and Michael Metz* Abstract Our research is motivated by the Corn Products vs. Arkansas Best Supreme Court decisions that pitched the controversy of the tax treatment of gains and losses from futures hedging. The use of futures contracts as risk management tools depends on the tax code. In this paper we address complications in the current tax code that allow for asymmetric offset: Ordinary losses can be applied against capital gains; however, capital losses cannot by applied against ordinary gains. Also we consider the issue of tax loss carryover. We investigate the optimal hedge ratios under these scenarios analytically where possible, and numerically where necessary. (JEL GI 1, K34) Introduction Futures contracts provide a useful tool for risk management. Specifically, to reduce risk a hedger assumes a futures position opposite to the spot position expecting the gains from one position to offset the losses from the other position. The extent of offsetting, however, is governed by the tax rules. Consequently, the usefulness of the futures contract as a hedging instrument hinges critically on the income tax rules. While spot gains or losses are unequivocally ordinary, futures gains or losses may be classified as capital or ordinary. Under the Corn Products (CP) court decision (1955), they were classified as ordinary income; thus, futures and spot gains or losses were allowed to offset each other when determining the tax liability. After the Arkansas Best (AB) court decision (1988), futures gains or losses that did not fall into a narrowly defined class of transactions would be treated as capital gains or losses. Consequently, the hedger was unable to offset the capital gains (losses) from the futures position with the ordinary losses (gains) from the cash position when determining the tax liability. The Arkansas Best ruling was superseded in 1993 with the Federal National Mortgage Association ruling, which allowed gains or losses from hedging to be treated as 9 Donald Lien, Professorof Economicsand Finance, College of Business, Universityof Texas - San Antonio, 6900 North Loop 1604 West, San Antonio, Texas 78249-0631, dlien@utsa.edu. Michael Metz is an independent commodity market consultant. The authors wish to acknowledge the editor and two anonymousreferees for helpful commentsand suggestions. The usual disclaimers apply.