[Federal Register Volume 59, Number 136 (Monday, July 18, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-16867]


[[Page Unknown]]

[Federal Register: July 18, 1994]


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DEPARTMENT OF THE TREASURY
26 CFR Parts 1 and 602

[TD 8555]
RIN 1545-AR73

 

Hedging Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations clarifying the 
character of gain or loss from business hedges. In general, the 
regulations treat gain or loss on most hedging transactions as ordinary 
rather than capital. The regulations are needed to provide guidance to 
businesses entering into hedging transactions and to serve as a basis 
for resolving pending cases involving gains and losses from hedging.

DATES: These regulations are effective July 18, 1994, except that the 
amendments relating to the removal of Sec. 1.1221-2T are effective 
October 1, 1994.
    For dates of applicability of these regulations, see the discussion 
in the Dates of Applicability paragraph in the Supplementary 
Information portion of the preamble.

FOR FURTHER INFORMATION CONTACT: Jo Lynn Ricks of the Office of the 
Assistant Chief Counsel (Financial Institutions and Products), Internal 
Revenue Service, 1111 Constitution Avenue, NW, Washington DC 20224 
(Attn: CC:DOM:FI&P). Telephone 202-622-3920 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h)) 
under control number 1545-1403. The estimated annual burden per 
recordkeeper varies from .1 to 10 hours, depending on individual 
circumstances, with an estimated average of .9 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP, 
Washington, DC 20224, and to the Office of Management and Budget, Attn: 
Desk Officer for the Department of the Treasury, Office of Information 
and Regulatory Affairs, Washington, DC 20503.

Background

    This document contains final regulations amending the Income Tax 
Regulations (26 CFR part 1) under section 1221 of the Internal Revenue 
Code (Code) (relating to the definition of capital asset). The 
provisions affected relate to the determination of the character of 
gain or loss from hedging transactions.
    On October 20, 1993, temporary regulations (TD 8493) providing that 
gain or loss on most common business hedges is ordinary rather than 
capital were published in the Federal Register (58 FR 54037). A notice 
of proposed rulemaking (FI-46-93) cross-referencing the temporary 
regulations was published in the Federal Register for the same day (58 
FR 54075). The regulations were intended to resolve questions that had 
arisen with respect to the tax treatment of business hedging following 
the decision of the United States Supreme Court in Arkansas Best Corp. 
v. Commissioner, 485 U.S. 212 (1988).
    Many comments were received on the proposed regulations, and a 
public hearing was held on January 19, 1994. Most commentators 
supported the general approach of the proposed regulations, but a 
number suggested specific revisions to the proposed rules or the 
addition of rules to resolve remaining issues.

Explanation of Provisions

    Paragraph (a) of Sec. 1.1221-2 provides basic rules for the 
treatment of hedging transactions. Only minor, clarifying changes have 
been made to the proposed regulations.
    Paragraph (a)(1) provides that property that is part of a hedging 
transaction, as defined in the regulations, is not a capital asset. 
Paragraph (a)(2) provides a similar rule for short sales and options. 
Where a short sale or option is part of a hedging transaction, as 
defined, any gain or loss on the short sale or option is ordinary. 
Final regulations under sections 1233 and 1234 provide that 
Sec. 1.1221-2 governs the character of gain or loss on short sales and 
options that are part of hedging transactions.
    Under paragraph (a)(3), if a transaction falls outside the 
regulations, gain or loss from the transaction is not made ordinary by 
the fact that property is a surrogate for a non-capital asset, that the 
transaction serves as insurance against a business risk, that the 
transaction serves a hedging function, or that the transaction serves a 
similar function or purpose.
    The provisions of this section generally apply to determine the 
character of gain or loss from transactions that also are subject to 
various international provisions of the Code. Paragraph (a)(4), 
however, provides that section 988 transactions are excluded from the 
character provisions of these regulations because gain or loss on those 
transactions is ordinary under section 988(a)(1). The regulations do 
apply to transactions that predate the effective date of section 988. 
Paragraph (a)(4) also provides that the definition of a hedging 
transaction under Sec. 1.1221-2(b) does not apply for purposes of the 
hedging exceptions to the subpart F rules of section 954(c) and certain 
hedging rules in the interest allocation regulations under section 
864(e). The IRS and Treasury are considering the possibility of using 
the definition of hedging transaction and other provisions of these 
regulations for purposes of various international tax provisions, 
except where a modification of the provisions is necessary to carry out 
the purposes of those international provisions. Comments on this 
subject are welcomed.
    In defining the term hedging transaction, paragraph (b) of 
Sec. 1.1221-2 retains the rule of the proposed regulations and adopts 
the concept of hedging in section 1256(e)(2)(A) of the Code. Under this 
rule, a hedging transaction generally is a transaction that a taxpayer 
enters into in the normal course of its business primarily to reduce 
the risk of interest rate or price changes or currency fluctuations.
    A number of commentators suggested that the IRS abandon the rule of 
the proposed regulations and adopt a definition of hedging that looks 
to risk management rather than risk reduction. This comment was not 
adopted because the IRS and Treasury believe that the definition in 
section 1256 represents the best indication of congressional intent 
with respect to business hedges. Although the risk reduction standard 
has been retained, the final regulations provide rules of application 
designed to ensure that the definition of hedging transaction is 
applied reasonably to include most common types of hedging 
transactions.
    Paragraph (c)(1) deals with the meaning of risk reduction. To enter 
into a hedging transaction, the taxpayer must have risk when all of its 
operations are considered--that is, there must be risk on a ``macro'' 
basis. Nonetheless, a hedge of a single asset or liability, or pool of 
assets or liabilities, will be respected if the hedge reduces the risk 
attributable to the item or items being hedged and if the hedge is 
reasonably calculated to reduce the overall risk of the taxpayer's 
operations. In addition, if a taxpayer hedges a particular asset or 
liability, or a pool of assets or liabilities, and the hedge is 
undertaken as part of a program to reduce the overall risk of the 
taxpayer's operations, the taxpayer need not show that the hedge 
reduces its overall risk.
    Paragraph (c)(1) also recognizes that fixed to floating hedges and 
certain types of written options may be risk reducing and may be used 
in hedging transactions. For example, a covered call with respect to 
assets held or a written put option with respect to assets to be 
acquired may reduce risk.
    In addition, paragraph (c)(1) provides that a hedging transaction 
includes a transaction that is entered into primarily to reverse or 
counteract a hedging transaction. This rule recognizes that some 
transactions are used to eliminate some or all of the risk reduction 
accomplished through a hedging transaction. Although the transactions 
are not risk reducing if viewed independently, they are considered to 
be part of the larger hedging transaction.
    Paragraph (c)(1) further provides that a taxpayer may hedge any 
part or all of its risk for any part of the period during which it has 
risk. The regulations also provide that the frequent entering into and 
termination of hedging positions is not relevant to whether 
transactions are hedging transactions.
    Finally, paragraph (c)(1) provides that a transaction that is not 
entered into primarily to reduce risk is not a hedging transaction. For 
example, the so-called ``store-on-the-board'' transaction, in which a 
taxpayer disposes of its production and enters into a long futures or 
forward contract, is not a hedging transaction because the long 
position does not reduce risk. Moreover, gain or loss on the contract 
is not made ordinary on the grounds that it is a surrogate for 
inventory.
    The IRS and Treasury understand that there are situations in which 
a taxpayer engages in a store-on-the-board transaction as a hedge of an 
expected payment under an agricultural price support program. In this 
situation, a long futures or forward contract may qualify as a hedging 
transaction with respect to the expected payment.
    Paragraph (c)(2) provides that a hedging transaction may be entered 
into by using a position that was a hedge of one asset or liability to 
hedge another asset or liability.
    Paragraph (c)(3) provides that the acquisition of certain assets, 
such as investments, may not be a hedging transaction. Even though 
these assets may reduce risk, they typically are not acquired primarily 
to reduce risk. For example, a taxpayer's interest rate risk from a 
floating rate borrowing may be reduced by the purchase of debt 
instruments that bear a comparable floating rate. The acquisition of 
the debt instruments, however, is not made primarily to reduce risk 
and, therefore, is not a hedging transaction. Similarly, borrowings 
generally are not made primarily to reduce risk.
    Paragraph (c)(4) defines the normal course requirement of paragraph 
(b) to include any transaction entered into in furtherance of a 
taxpayer's trade or business. Thus, for example, a liability hedge 
meets this requirement regardless of whether the liability is 
undertaken to fund current operations, an acquisition, or an expansion 
of a taxpayer's business. This definition does not apply to other uses 
of the term ``normal course'' in the Code or regulations.
    Paragraph (c)(5) retains the rule in the proposed regulations that 
a hedge of property or of an obligation is a hedging transaction only 
if a sale or exchange of the property, or performance or termination of 
the obligation, could not produce capital gain or loss. In response to 
the many comments received, however, a special rule has been added for 
noninventory supplies. Under this rule, if a taxpayer sells only a 
negligible amount of a noninventory supply, then, only for purposes of 
determining whether a hedge of the purchase of that noninventory supply 
is a hedging transaction, the noninventory supply is treated as 
ordinary property. In this case, the Service and Treasury believe that 
the theoretical possibility of ordinary loss on a hedge and capital 
gain on the sale of supplies should not prevent the transactions from 
qualifying as hedging transactions. The Service intends to issue 
guidance on the negligible amount standard. The comments received 
indicate that most taxpayers sell none of their supplies or a very 
small amount. Further comments are requested.
    For prior years, a transition rule provides a substantially more 
generous standard for noninventory supplies. If, in each prior year 
that is open for assessment on September 1, 1994, a taxpayer sold no 
more than 15 percent of the greater of the total amount of a supply 
held at the beginning of the year or the total amount of the supply 
acquired in that year and meets certain other requirements, hedges of 
purchases of that supply are hedging transactions.
    The final regulations do not provide a negligible sales rule for 
hedges of section 1231 assets. Sales of these assets are less 
predictable than sales of supplies and may occur many years after the 
transaction that hedges their purchase. The IRS and Treasury believe 
that it is inappropriate to provide ordinary treatment for the hedges 
when it is not known whether the assets will produce capital gains. 
Nonetheless, the regulations provide a special transition rule 
applicable to certain hedges of section 1231 assets entered into in 
prior years.
    Paragraph (c)(6) provides that the status of liability hedges as 
hedging transactions is determined without regard to the use that is 
made of the proceeds of a borrowing. The IRS and Treasury believe that 
a liability hedge should not fail to qualify as a hedging transaction 
because the proceeds of the borrowing being hedged are used to purchase 
a capital asset.
    Paragraph (c)(7) retains the rule in the proposed regulations that, 
in the case of hedges of aggregate risk, all but a de minimis amount of 
the risk being hedged must be attributable to ordinary property, 
ordinary obligations, and borrowings.
    Although the purpose of the rules in paragraph (c) is to ensure 
that the definition of hedging transaction will be interpreted 
reasonably to cover most common business hedges, not all hedges are 
intended to be covered. For example, the regulations do not apply where 
a taxpayer hedges a dividend stream, the overall profitability of a 
business unit, or other business risks that do not relate directly to 
interest rate or price changes or currency fluctuations. Moreover, the 
regulations do not provide ordinary treatment for gain or loss from the 
disposition of stock where, for example, the stock is acquired to 
protect the goodwill or business reputation of the acquirer or to 
ensure the availability of goods.
    The status of so-called ``gap'' hedges is not separately addressed 
in paragraph (c). Insurance companies, for example, sometimes hedge the 
``gap'' between their liabilities and the assets that fund them. Under 
the proposed regulations, a hedge of those assets does not qualify as a 
hedging transaction if the assets are capital. Commentators, therefore, 
suggested that the final regulations provide a rule that deems all gap 
hedges to be hedges of the liabilities rather than of the assets. The 
IRS and Treasury, however, are concerned that, where this type of hedge 
is more closely associated with the assets than the liabilities, there 
is a significant possibility of mismatch if the hedges are given 
ordinary treatment and the assets can be sold for capital gains. Thus, 
the final regulations do not include the suggested rule.
    Whether a gap hedge qualifies as a liability hedge is a question of 
fact and depends on whether it is more closely associated with the 
liabilities than with the assets. For example, a contract to purchase 
assets is generally not a liability hedge even if the assets are being 
purchased to fund the liability. Other gap hedges may be appropriately 
treated as liability hedges and, therefore, may qualify as hedging 
transactions.
    The IRS and Treasury understand that the most significant 
consequence of the failure of gap hedges to qualify as hedging 
transactions may be that they are then subject to the straddle rules of 
section 1092. Comments are requested on whether it would be appropriate 
to exempt these transactions from section 1092 and apply the hedge 
accounting rules of Sec. 1.446-4 even though the transactions are not 
hedging transactions and their character is not determined under 
Sec. 1.1221-2. The IRS and Treasury also note that there may be 
different considerations for determining whether income or loss from a 
gap hedge should be treated as an interest equivalent for purposes of 
international tax provisions, such as section 864(e). Comments are also 
requested on this point.
    Paragraph (d) is reserved in the final regulations to allow 
development of rules applicable to hedging by members of a consolidated 
group. Proposed regulations on this subject are published in the 
Proposed Rules section of this issue of the Federal Register.
    Paragraph (e)(1) retains the requirement of the proposed 
regulations that hedging transactions must be identified before the 
close of the day on which they are entered into. Paragraph (e)(2), 
however, relaxes the rule of the proposed regulations and requires that 
the item, items, or aggregate risk being hedged be identified 
substantially contemporaneously with entering into the hedging 
transaction. The identification must be made no more than 35 days after 
entering into the hedging transaction. This time period should make it 
possible for taxpayers to identify the hedged item, items, or aggregate 
risk at the time they prepare monthly reports for nontax purposes.
    Some commentators suggested eliminating entirely the requirement of 
identifying the item being hedged. The Service and Treasury believe, 
however, that this identification is needed to establish that the 
definition of hedging transaction is satisfied. Moreover, because 
special identification rules have been provided for hedges of aggregate 
risk and certain inventory hedges, the requirement of identifying the 
items being hedged should not be overly burdensome.
    A transition rule is provided to extend the time period for 
identifying a transaction that is a hedging transaction under the final 
regulations and that the taxpayer reasonably treated as other than a 
hedging transaction under the proposed regulations. If such a 
transaction was entered into before October 1, 1994, and remains in 
existence on that date, the identification and recordkeeping 
requirements of paragraph (e) apply, except that the identification of 
both the hedging transaction and the hedged item are timely if made 
before the close of business on October 1, 1994. However, if the 
transaction was entered into before October 1, 1994, and does not 
remain in existence on that date, the identification and recordkeeping 
requirements of paragraph (e) do not apply.
    Paragraph (e)(3) contains a series of special rules for identifying 
certain types of hedging transactions. In the case of inventory, the 
identification must specify the type or class of inventory to which the 
hedge relates. If particular inventory purchases or sales transactions 
are being hedged, the taxpayer must also identify the expected dates 
and the amounts to be acquired or sold. In the case of hedges of 
aggregate risk, the identification requirement is satisfied if a 
taxpayer's records contain a description of the hedging program and if 
the taxpayer establishes a system under which transactions are 
identified as being entered into as part of that program. The intent 
underlying this rule is to provide verifiable information with respect 
to the item being hedged without requiring the taxpayer to identify 
individually the many items that give rise to the aggregate risk being 
hedged.
    Paragraph (e)(4) generally retains and expands the rules of the 
proposed regulations with respect to how an identification is made. It 
must be clear that the identification is being made for tax purposes. 
In lieu of separately identifying each transaction, however, a taxpayer 
may establish a system in which identification is indicated by the type 
of transaction or the manner in which the transaction is consummated or 
recorded.
    Paragraph (e)(5) is reserved to deal with the required 
identification where the taxpayer is a member of a consolidated group, 
and paragraph (e)(6) provides that an identification for purposes of 
section 1256(e)(2)(C) is also an identification for purposes of 
Sec. 1.1221-2(e)(1).
    Paragraph (f) deals with the effect of identification and non-
identification and provides rules that generally are unchanged from the 
proposed regulations. The only significant change is the addition of a 
rule that allows correction of an inadvertent identification in some 
circumstances. If the correction is allowed, the transaction is not 
subject to the ordinary-gain, capital-loss rule that generally applies 
to transactions that are incorrectly identified as hedging 
transactions.
    Final regulations under section 1256 retain the rules of the 
proposed regulations that coordinate the identification of hedges for 
purposes of section 1256(e). In addition, the regulations provide that, 
if a taxpayer inadvertently identifies a transaction as a hedging 
transaction and corrects it in accordance with paragraph (f)(1)(ii) of 
Sec. 1.1221-2, the transaction is treated as if it were not identified 
as a hedging transaction for purposes of section 1256(e)(2)(C). Thus, 
section 1256(f)(1) does not impose ordinary-gain, capital-loss 
treatment on the transaction.

Dates of Applicability

    Except for the identification rules of paragraph (e), which apply 
to transactions that were entered into on or after January 1, 1994, or 
were entered into before that date and remained in existence on March 
31, 1994, these final regulations generally apply to all open taxable 
years. Taxpayers may, however, rely on any paragraph in Sec. 1.1221-2T 
(26 CFR part 1 revised as of April 1, 1994), for transactions entered 
into prior to October 1, 1994, provided that the taxpayer applies the 
paragraph reasonably and consistently.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in EO 12866. Therefore, a 
regulatory assessment is not required. It also has been determined that 
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) 
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to 
these regulations, and, therefore, a Regulatory Flexibility Analysis is 
not required. Pursuant to section 7805(f) of the Internal Revenue Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Small Business Administration for comment on its 
impact on small business.

Drafting Information

    The principal author of these regulations is Jo Lynn Ricks, Office 
of Assistant Chief Counsel (Financial Institutions and Products). 
However, other personnel from the IRS and Treasury Department 
participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. Effective July 18, 1884 the authority citation for 
part 1 is amended by adding an entry in numerical order to read as 
follows:

    Authority: 26 U.S.C. 7805 * * * Section 1.1221-2 also issued 
under 26 U.S.C. 6001. * * *

    Par. 2. Effective October 1, 1994, the authority citation for part 
1 is further amended by removing the entry for Sec. 1.1221-2T.
    Par. 3. Effective July 18, 1994, Sec. 1.1221-2 is added to read as 
follows:


Sec. 1.1221-2   Hedging transactions.

    (a) Treatment of hedging transactions--(1) In general. This section 
governs the treatment of hedging transactions under section 1221. 
Except as provided in paragraph (f)(2) of this section (and 
notwithstanding the provisions of Sec. 1.1221-1(a)), the term capital 
asset does not include property that is part of a hedging transaction 
(as defined in paragraph (b) of this section).
    (2) Short sales and options. This section also governs the 
character of gain or loss from a short sale or option that is part of a 
hedging transaction. See Secs. 1.1233-2 and 1.1234-4. Except as 
provided in paragraph (f)(2) of this section, gain or loss on a short 
sale or option that is part of a hedging transaction (as defined in 
paragraph (b) of this section) is ordinary income or loss.
    (3) Exclusivity. If a transaction is not a hedging transaction as 
defined in paragraph (b) of this section, gain or loss from the 
transaction is not made ordinary on the grounds that property involved 
in the transaction is a surrogate for a noncapital asset, that the 
transaction serves as insurance against a business risk, that the 
transaction serves a hedging function, or that the transaction serves a 
similar function or purpose.
    (4) Coordination with other sections--(i) Section 988. This section 
does not apply to determine the character of gain or loss realized on a 
section 988 transaction as defined in section 988(c)(1) or realized 
with respect to a qualified fund as defined in section 
988(c)(1)(E)(iii). This section does apply, however, to transactions or 
payments that would be subject to section 988 but for the date that the 
transactions were entered into or the date that the payments were made.
    (ii) Sections 864(e) and 954(c). Except as otherwise provided in 
regulations issued pursuant to sections 864(e) and 954(c), the 
definition of hedging transaction in paragraph (b) of this section does 
not apply for purposes of section 864(e) and 954(c).
    (b) Hedging transaction defined. A hedging transaction is a 
transaction that a taxpayer enters into in the normal course of the 
taxpayer's trade or business primarily--
    (1) To reduce risk of price changes or currency fluctuations with 
respect to ordinary property (as defined in paragraph (c)(5) of this 
section) that is held or to be held by the taxpayer; or
    (2) To reduce risk of interest rate or price changes or currency 
fluctuations with respect to borrowings made or to be made, or ordinary 
obligations incurred or to be incurred, by the taxpayer.
    (c) Rules of application. The rules of this paragraph (c) apply for 
purposes of the definition of the term hedging transaction in paragraph 
(b) of this section. These rules must be interpreted reasonably and 
consistently with the purposes of this section. Where no specific rules 
of application control, the definition of hedging transaction must be 
interpreted reasonably and consistently with the purposes of this 
section.
    (1) Reducing risk--(i) Transactions that reduce risk. Whether a 
transaction reduces a taxpayer's risk is determined based on all of the 
facts and circumstances surrounding the taxpayer's business and the 
transaction. In general, a taxpayer's hedging strategies and policies 
as reflected in the taxpayer's minutes or other records are evidence of 
whether particular transactions reduce the taxpayer's risk.
    (ii) Micro and macro hedges--(A) In general. A taxpayer has risk of 
a particular type only if it is at risk when all of its operations are 
considered. Nonetheless, a hedge of a particular asset or liability 
generally will be respected as reducing risk if it reduces the risk 
attributable to the asset or liability and if it is reasonably expected 
to reduce the overall risk of the taxpayer's operations. If a taxpayer 
hedges particular assets or liabilities, or groups of assets or 
liabilities, and the hedges are undertaken as part of a program that, 
as a whole, is reasonably expected to reduce the overall risk of the 
taxpayer's operations, the taxpayer generally does not have to 
demonstrate that each hedge that was entered into pursuant to the 
program reduces its overall risk.
    (B) Fixed-to-floating hedges. Under the principles of paragraph 
(c)(1)(ii)(A) of this section, a transaction that economically converts 
an interest rate or price from a fixed price or rate to a floating 
price or rate may reduce risk. For example, if a taxpayer's income 
varies with interest rates, the taxpayer may be at risk if it has a 
fixed rate liability. Similarly, a taxpayer with a fixed cost for its 
inventory may be at risk if the price at which the inventory can be 
sold varies with a particular factor. Thus, a transaction that converts 
an interest rate or price from fixed to floating may be a hedging 
transaction.
    (iii) Written options. A written option may reduce risk. For 
example, in appropriate circumstances, a written call option with 
respect to assets held by a taxpayer or a written put option with 
respect to assets to be acquired by a taxpayer may be a hedging 
transaction. See also paragraph (c)(1)(v) of this section.
    (iv) Extent of risk reduction. A taxpayer may hedge all or any 
portion of its risk for all or any part of the period during which it 
is exposed to the risk.
    (v) Transactions that counteract hedging transactions. If a 
transaction is entered into primarily to counteract all or any part of 
the risk reduction effected by one or more hedging transactions, the 
transaction is a hedging transaction. For example, if a written option 
is used to reduce or eliminate the risk reduction obtained from another 
position such as a purchased option, then it may be part of a hedging 
transaction.
    (vi) Number of transactions. The fact that a taxpayer frequently 
enters into and terminates positions (even if done on a daily or more 
frequent basis) is not relevant to whether these transactions are 
hedging transactions. Thus, for example, a taxpayer hedging the risk 
associated with an asset or liability may frequently establish and 
terminate positions that hedge that risk, depending on the extent the 
taxpayer wishes to be hedged. Similarly, if a taxpayer maintains its 
level of risk exposure by entering into and terminating a large number 
of transactions in a single day, its transactions may nonetheless 
qualify as hedging transactions.
    (vii) Transactions that do not reduce risk. A transaction that is 
not entered into to reduce a taxpayer's risk is not a hedging 
transaction. For example, assume that a taxpayer produces a commodity 
for sale, sells the commodity, and enters into a long futures or 
forward contract in that commodity in the hope that the price will 
increase. Because the long position does not reduce risk, the 
transaction is not a hedging transaction. Moreover, gain or loss on the 
contract is not made ordinary on the grounds that it is a surrogate for 
inventory. See paragraph (a)(3) of this section.
    (2) Entering into a hedging transaction. A taxpayer may enter into 
a hedging transaction by using a position that was a hedge of one asset 
or liability to hedge another asset or liability (recycling).
    (3) No investments as hedging transactions. If an asset (such as an 
investment) is not acquired primarily to reduce risk, the purchase or 
sale of that asset is not a hedging transaction even if the terms of 
the asset limit or reduce the taxpayer's risk with respect to other 
assets or liabilities. For example, a taxpayer's interest rate risk 
from a floating rate borrowing may be reduced by the purchase of debt 
instruments that bear a comparable floating rate. The acquisition of 
the debt instruments, however, is not a hedging transaction because the 
transaction is not entered into primarily to reduce the taxpayer's 
risk. Similarly, borrowings generally are not made primarily to reduce 
risk.
    (4) Normal course. Solely for purposes of paragraph (b) of this 
section, if a transaction is entered into in furtherance of a 
taxpayer's trade or business, the transaction is entered into in the 
normal course of the taxpayer's trade or business. This rule applies 
even if the risk to be reduced relates to the expansion of an existing 
business or the acquisition of a new trade or business.
    (5) Ordinary property and obligations--(i) In general. Except as 
provided in paragraph (g)(3) of this section (which contains transition 
rules), property is ordinary property to a taxpayer only if a sale or 
exchange of the property by the taxpayer could not produce capital gain 
or loss regardless of the taxpayer's holding period when the sale or 
exchange occurs. Thus, for example, property used in a trade or 
business within the meaning of section 1231(b) (determined without 
regard to the holding period specified in that section) is not ordinary 
property. An obligation is an ordinary obligation if performance or 
termination of the obligation by the taxpayer could not produce capital 
gain or loss. For purposes of the preceding sentence, termination has 
the same meaning as in section 1234A.
    (ii) Hedges of noninventory supplies. Notwithstanding paragraph 
(c)(5)(i) of this section, if a taxpayer sells only a negligible amount 
of a noninventory supply, then, only for purposes of determining 
whether a transaction to hedge the purchase of that noninventory supply 
is a hedging transaction, the supply is treated as ordinary property. A 
noninventory supply is a supply that a taxpayer purchases for 
consumption in its trade or business and that is not an asset described 
in sections 1221(1) through (5).
    (6) Borrowings. Whether hedges of a taxpayer's debt issuances 
(borrowings) are hedging transactions is determined without regard to 
the use of the proceeds of the borrowing.
    (7) Hedging an aggregate risk. The term hedging transaction 
includes a transaction that reduces an aggregate risk of interest rate 
changes, price changes, and/or currency fluctuations only if all of the 
risk, or all but a de minimis amount of the risk, is with respect to 
ordinary property, ordinary obligations, and borrowings.
    (d) Hedging by members of a consolidated group. [Reserved].
    (e) Identification and recordkeeping--(1) Same-day identification 
of hedging transactions. A taxpayer that enters into a hedging 
transaction (including recycling an existing hedge) must identify it as 
a hedging transaction. This identification must be made before the 
close of the day on which the taxpayer enters into the transaction.
    (2) Substantially contemporaneous identification of hedged item--
(i) Content of the identification. A taxpayer that enters into a 
hedging transaction must identify the item, items, or aggregate risk 
being hedged. Identification of an item being hedged generally involves 
identifying a transaction that creates risk, and the type of risk that 
the transaction creates. For example, if a taxpayer is hedging the 
price risk with respect to its June purchases of corn inventory, the 
transaction being hedged is the June purchase of corn and the risk is 
price movements in the market where the taxpayer buys its corn. For 
additional rules concerning the content of this identification, see 
paragraph (e)(3) of this section.
    (ii) Timing of the identification. The identification required by 
this paragraph (e)(2) must be made substantially contemporaneously with 
entering into the hedging transaction. An identification is not 
substantially contemporaneous if it is made more than 35 days after 
entering into the hedging transaction.
    (3) Identification requirements for certain hedging transactions. 
In the case of the hedging transactions described in this paragraph 
(e)(3), the identification under paragraph (e)(2) of this section must 
include the information specified.
    (i) Anticipatory asset hedges. If the hedging transaction relates 
to the anticipated acquisition of assets by the taxpayer, the 
identification must include the expected date or dates of acquisition 
and the amounts expected to be acquired.
    (ii) Inventory hedges. If the hedging transaction relates to the 
purchase or sale of inventory by the taxpayer, the identification is 
made by specifying the type or class of inventory to which the 
transaction relates. If the hedging transaction relates to specific 
purchases or sales, the identification must also include the expected 
dates of the purchases or sales and the amounts to be purchased or 
sold.
    (iii) Hedges of debt of the taxpayer--(A) Existing debt. If the 
hedging transaction relates to accruals or payments under an issue of 
existing debt of the taxpayer, the identification must specify the 
issue and, if the hedge is for less than the full adjusted issue price 
or the full term of the debt, the amount and the term covered by the 
hedge.
    (B) Debt to be issued. If the hedging transaction relates to the 
expected issuance of debt by the taxpayer or to accruals or payments 
under debt that is expected to be issued by the taxpayer, the 
identification must specify the following information: the expected 
date of issuance of the debt; the expected maturity or maturities; the 
total expected issue price of the issue; and the expected interest 
provisions. If the hedge is for less than the entire expected issue 
price of the debt or the full expected term of the debt, the 
identification must also include the amount or the term being hedged. 
The identification may indicate a range of dates, terms, and amounts, 
rather than specific dates, terms, or amounts. For example, a taxpayer 
might identify a transaction as hedging the yield on an anticipated 
issuance of fixed rate debt during the second half of its fiscal year, 
with the anticipated amount of the debt between $75 million and $125 
million, and an anticipated term of approximately 20 to 30 years.
    (iv) Hedges of aggregate risk--(A) Required identification. If a 
transaction hedges aggregate risk as described in paragraph (c)(7) of 
this section, the identification under paragraph (e)(2) of this section 
must include a description of the risk being hedged and of the hedging 
program under which the hedging transaction was entered. This 
requirement may be met by placing in the taxpayer's records a 
description of the hedging program and by establishing a system under 
which individual transactions are identified as being entered into 
pursuant to the program.
    (B) Description of hedging program. A description of a hedging 
program must include an identification of the type of risk being 
hedged, a description of the type of items giving rise to the risk 
being aggregated, and sufficient additional information to demonstrate 
that the program is designed to reduce aggregate risk of the type 
identified. If the program contains controls on speculation (for 
example, position limits), the description of the hedging program must 
also explain how the controls are established, communicated, and 
implemented.
    (4) Manner of identification and records to be retained--(i) 
Inclusion of identification in tax records. The identification required 
by this paragraph (e) must be made on, and retained as part of, the 
taxpayer's books and records.
    (ii) Presence or absence of identification must be unambiguous. The 
presence or absence of an identification for purposes of this paragraph 
(e) must be unambiguous. The identification of a hedging transaction 
for financial accounting or regulatory purposes does not satisfy this 
requirement unless the taxpayer's books and records indicate that the 
identification is also being made for tax purposes. The taxpayer may 
indicate that individual hedging transactions, or a class or classes of 
hedging transactions, that are identified for financial accounting or 
regulatory purposes are also being identified as hedging transactions 
for purposes of this section.
    (iii) Manner of identification. The taxpayer may separately and 
explicitly make each identification, or, so long as paragraph 
(e)(4)(ii) of this section is satisfied, the taxpayer may establish a 
system pursuant to which the identification is indicated by the type of 
transaction or by the manner in which the transaction is consummated or 
recorded. An identification under this system is made at the later of 
the time that the system is established or the time that the 
transaction satisfies the terms of the system by being entered, or by 
being consummated or recorded, in the designated fashion.
    (iv) Examples. The following examples illustrate the principles of 
paragraph (e)(4)(iii) of this section and assume that the other 
requirements of paragraph (e) of this section are satisfied.
    (A) A taxpayer can make an identification by designating a hedging 
transaction for (or placing it in) an account that has been identified 
as containing only hedges of a specified item (or of specified items or 
specified aggregate risk).
    (B) A taxpayer can make an identification by including and 
retaining in its books and records a statement that designates all 
future transactions in a specified derivative product as hedges of a 
specified item, items, or aggregate risk.
    (C) A taxpayer can make an identification by placing a designated 
mark on a record of the transaction (for example, trading ticket, 
purchase order, or trade confirmation) or by using a designated form or 
a record that contains a designated legend.
    (5) Identification of hedges involving members of the same 
consolidated group. [Reserved].
    (6) Consistency with section 1256(e)(2)(C). Any identification for 
purposes of section 1256(e)(2)(C) is also an identification for 
purposes of paragraph (e)(1) of this section.
    (f) Effect of identification and non-identification--(1) 
Transactions identified--(i) In general. If a taxpayer identifies a 
transaction as a hedging transaction for purposes of paragraph (e)(1) 
of this section, the identification is binding with respect to gain, 
whether or not all of the requirements of paragraph (e) of this section 
are satisfied. Thus, gain from that transaction is ordinary income. If 
the transaction is not in fact a hedging transaction described in 
paragraph (b) of this section, however, paragraphs (a)(1) and (a)(2) of 
this section do not apply and the character of loss is determined 
without reference to whether the transaction is a surrogate for a 
noncapital asset, serves as insurance against a business risk, serves a 
hedging function, or serves a similar function or purpose. Thus, the 
taxpayer's identification of the transaction as a hedging transaction 
does not itself make loss from the transaction ordinary.
    (ii) Inadvertent identification. Notwithstanding paragraph 
(f)(1)(i) of this section, if the taxpayer identifies a transaction as 
a hedging transaction for purposes of paragraph (e) of this section, 
the character of the gain is determined as if the transaction had not 
been identified as a hedging transaction if--
    (A) The transaction is not a hedging transaction (as defined in 
paragraph (b) of this section);
    (B) The identification of the transaction as a hedging transaction 
was due to inadvertent error; and
    (C) All of the taxpayer's transactions in all open years are being 
treated on either original or, if necessary, amended returns in a 
manner consistent with the principles of this section.
    (2) Transactions not identified--(i) In general. Except as provided 
in paragraphs (f)(2)(ii) and (iii) of this section, the absence of an 
identification that satisfies the requirements of paragraph (e)(1) of 
this section is binding and establishes that a transaction is not a 
hedging transaction. Thus, subject to the exceptions, the rules of 
paragraphs (a)(1) and (2) of this section do not apply, and the 
character of gain or loss is determined without reference to whether 
the transaction is a surrogate for a noncapital asset, serves as 
insurance against a business risk, serves a hedging function, or serves 
a similar function or purpose.
    (ii) Inadvertent error. If a taxpayer does not make an 
identification that satisfies the requirements of paragraph (e) of this 
section, the taxpayer may treat gain or loss from the transaction as 
ordinary income or loss under paragraph (a)(1) or (a)(2) of this 
section if--
    (A) The transaction is a hedging transaction (as defined in 
paragraph (b) of this section);
    (B) The failure to identify the transaction was due to inadvertent 
error; and
    (C) All of the taxpayer's hedging transactions in all open years 
are being treated on either original or, if necessary, amended returns 
as provided in paragraphs (a)(1) and (a)(2) of this section.
    (iii) Anti-abuse rule. If a taxpayer does not make an 
identification that satisfies all the requirements of paragraph (e) of 
this section but the taxpayer has no reasonable grounds for treating 
the transaction as other than a hedging transaction, then gain from the 
transaction is ordinary. Thus, a taxpayer may not elect to treat gain 
or loss from a hedging transaction as capital gain or loss. The 
reasonableness of the taxpayer's failure to identify a transaction is 
determined by taking into consideration not only the requirements of 
paragraph (b) of this section but also the taxpayer's treatment of the 
transaction for financial accounting or other purposes and the 
taxpayer's identification of similar transactions as hedging 
transactions.
    (3) Transactions by members of a consolidated group. [Reserved].
    (g) Effective dates and transition rules--(1) Effective date for 
identification requirements--(i) In general. Paragraph (e) of this 
section applies to transactions that--
    (A) Are entered into on or after January 1, 1994; or
    (B) Are entered into before that date and remain in existence on 
March 31, 1994.
    (ii) Transition rule. In the case of a hedging transaction that is 
entered into before January 1, 1994, and remains in existence on March 
31, 1994, an identification is timely if it is made before the close of 
business on March 31, 1994.
    (iii) Special rules for hedging transactions not described in 
Sec. 1.1221-2T(b). In the case of a transaction that is entered into 
before October 1, 1994, that is a hedging transaction within the 
meaning of paragraph (b) of this section (or is treated as a hedging 
transaction under paragraph (g)(3) of this section), and that the 
taxpayer reasonably treated as not being a hedging transaction within 
the meaning of paragraph (b) of Sec. 1.1221-2T (26 CFR part 1 revised 
as of April 1, 1994)--
    (A) If the transaction does not remain in existence on October 1, 
1994, paragraph (e) of this section does not apply; and
    (B) If the transaction remains in existence on October 1, 1994, 
paragraph (e) of this section applies, and an identification is timely 
if it is made before the close of business on October 1, 1994.
    (2) Reliance on Sec. 1.1221-2T--(i) General rule. A taxpayer may 
rely on any paragraph in Sec. 1.1221-2T (26 CFR part 1 revised as of 
April 1, 1994), for transactions entered into prior to October 1, 1994, 
provided that the taxpayer applies the paragraph reasonably and 
consistently.
    (ii) Identification. In the case of a transaction entered into 
before October 1, 1994, an identification is deemed to satisfy 
paragraph (e) of this section if it satisfies Sec. 1.1221-2T(c) (26 CFR 
part 1 revised as of April 1, 1994). For this purpose, identification 
of the hedged item is timely if it is made within the period specified 
in paragraph (e)(2)(ii) of this section.
    (3) Transition rules for hedges of certain property--(i) Transition 
rule for section 1231 assets. For all taxable years that ended prior to 
July 18, 1994 and that, as of September 1, 1994, were still open for 
assessment under section 6501, a taxpayer may treat as hedging 
transactions all transactions that were entered into during those years 
and that hedge property used in the trade or business within the 
meaning of section 1231(b) (a section 1231 asset) if the taxpayer can 
establish that, during those years--
    (A) Sales of section 1231 assets did not give rise to net gain 
treated as capital gain (after application of section 1231(c));
    (B) All of the hedges of section 1231 assets would be hedging 
transactions under paragraph (b) of this section if section 1231 assets 
were ordinary property; and
    (C) On original or amended returns, the taxpayer consistently 
treats all of the hedges of section 1231 assets as hedging 
transactions.
    (ii) Transition rule for noninventory supplies. For all taxable 
years that ended prior to July 18, 1994 and that, as of September 1, 
1994, were still open for assessment under section 6501, a taxpayer may 
treat as hedging transactions all hedges of purchases of noninventory 
supplies (as defined in paragraph (c)(5)(ii) of this section) that 
would not otherwise qualify as hedging transactions and that were 
entered into during those years if the taxpayer can establish that, 
during those years--
    (A) The taxpayer did not sell in any of those years more than 15 
percent of the greater of the total amount of the supply held at the 
beginning of the year or the total amount of the supply acquired during 
that year;
    (B) All of the hedges would be hedging transactions under paragraph 
(b) of this section if noninventory supplies were ordinary property; 
and
    (C) On original or amended returns, the taxpayer consistently 
treats all of the hedges of noninventory supplies as hedging 
transactions.
    (4) Effective date for hedges by members of a consolidated group. 
[Reserved].


Sec. 1.1221-2T  [Removed]

    Par. 4. Effective October 1, 1994, Sec. 1.1221-2T is effectively 
removed.
    Par. 5. Effective July 18, 1994 Sec. 1.1233-2T is redesignated 
Sec. 1.1233-2 and is revised to read as follows:


Sec. 1.1233-2  Hedging transactions.

    The character of gain or loss on a short sale that is (or is 
identified as being) part of a hedging transaction is determined under 
the rules of Sec. 1.1221-2.
    Par. 6. Effective July 18, 1994 Sec. 1.1234-4T is redesignated 
Sec. 1.1234-4 and is revised to read as follows:


Sec. 1.1234-4  Hedging transactions.

    The character of gain or loss on an acquired or a written option 
that is (or is identified as being) part of a hedging transaction is 
determined under the rules of Sec. 1.1221-2.
    Par. 7. Effective July 18, 1994 Sec. 1.1256(e)-1 is added to read 
as follows:


Sec. 1.1256(e)-1  Identification of hedging transactions.

    (a) Identification and recordkeeping requirements. Under section 
1256(e)(2)(C), a taxpayer that enters into a hedging transaction must 
identify the transaction as a hedging transaction before the close of 
the day on which the taxpayer enters into the transaction.
    (b) Requirements for identification. The identification of a 
hedging transaction for purposes of section 1256(e)(2)(C) must satisfy 
the requirements of Sec. 1.1221-2(e)(1). Solely for purposes of section 
1256(f)(1), however, an identification that does not satisfy all of the 
requirements of Sec. 1.1221-2(e)(1) is nevertheless treated as an 
identification under section 1256(e)(2)(C).
    (c) Consistency with Sec. 1.1221-2. Any identification for purposes 
of Sec. 1.1221-2(e)(1) is also an identification for purposes of this 
section. If a taxpayer satisfies the requirements of paragraph 
(f)(1)(ii) of Sec. 1.1221-2, the transaction is treated as if it were 
not identified as a hedging transaction for purposes of section 
1256(e)(2)(C).
    (d) Effective date. This section applies to transactions entered 
into on or after October 1, 1994.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

    Par. 8. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 9. Effective July 18, 1994 Sec. 602.101(c) is amended by 
adding an entry in numerical order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (c) * * *

------------------------------------------------------------------------
                                                             Current OMB
     CFR part or section where identified and described        control  
                                                                number  
------------------------------------------------------------------------
                                                                        
                                  *****                                 
1.1221-2...................................................    1545-1403
                                                                        
                                  *****                                 
------------------------------------------------------------------------

    Par. 10. Effective October 1, 1994, in Sec. 602.101(c), the entry 
for Sec. 1.1221-2T(c) is removed.
Margaret Milner Richardson,
Commissioner of Internal Revenue.

    Approved: June 3, 1994.
Samuel Y. Sessions,
Acting Assistant Secretary of the Treasury.
[FR Doc. 94-16867 Filed 7-13-94; 9:10 am]
BILLING CODE 4830-01-U