[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