The integration approach which requires hedging derivatives to be ‘integrated’ with the underlying hedged transaction for tax purposes now enjoys broad acceptance. It functions effectively for domestic transactions, however, its application to cross-border hedging transactions introduces complexity and ambiguity. This article contends that, under the integration approach, income characterization and timing rules for hedging derivatives must align with those of the underlying hedged transactions. This is a principle that should be systematically incorporated into domestic tax law. Friction arises in cross-border hedged transactions particularly from withholding taxes on outbound payments. Source jurisdictions cannot be expected to unilaterally waive the taxes, therefore, effectively implementing the integration approach requires inter-jurisdictional cooperation. Potential solutions include bilateral withholding tax exemptions and formulary apportionment of integrated income as well as enhanced information exchange mechanisms. Until such cooperation is forthcoming, however, this article proposes that hedging derivatives and hedged transactions subject to withholding taxes should be treated in accordance with the separation approach. This conclusion is also applicable for determining beneficial ownership in hedging transactions because the transaction’s derivative component should not influence the analysis of beneficial ownership.
Intertax