[Federal Register Volume 67, Number 54 (Wednesday, March 20, 2002)]
[Rules and Regulations]
[Pages 12863-12871]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-6622]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8985]
RIN 1545-AY02


Hedging Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the 
character of gain or loss from hedging transactions. The regulations 
reflect changes to the law made by the Ticket to Work and Work 
Incentives Improvement Act of 1999. The regulations affect businesses 
entering into hedging transactions.

DATES: Effective Date: These regulations are effective March 20, 2002.
    Applicability Dates: 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: Elizabeth Handler, (202) 622-3930 or 
Viva Hammer at (202) 622-0869 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collections of information contained in these final regulations 
have been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 
3507(d)) under control number 1545-1480. Some responses to these 
collections of information are mandatory, and others are required to 
obtain the benefit of the separate-entity election.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    The estimated annual burden per respondent or recordkeeper varies 
from .1 to 40 hours, depending on individual circumstances, with an 
estimated average of 5.9 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, W:CAR:MP:FP:S, 
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.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any Internal Revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains amendments to 26 CFR Part 1 under section 
1221 of the Internal Revenue Code (Code). Prior to amendment in 1999, 
section 1221 generally defined a capital asset as property held by the 
taxpayer other than: (1) Stock in trade or other types of assets 
includible in inventory; (2) property used in a trade or business that 
is real property or property subject to depreciation; (3) certain 
copyrights (or similar property); (4) accounts or notes receivable 
acquired in the ordinary course of a trade or business; and (5) U.S. 
government publications.
    In 1994, the IRS published in the Federal Register (59 FR 36360) 
final Treasury regulations under section 1221 providing for ordinary 
character treatment for certain business hedges. The regulations 
generally apply to transactions that reduce risk with respect to 
ordinary property, ordinary obligations, and borrowings of the taxpayer 
and that meet certain identification requirements. (Sec. 1.1221-2). In 
1996, the IRS published in the Federal Register (61 FR 517) final 
regulations on the character and timing of gain or loss from hedging 
transactions entered into by members of a consolidated group. In this 
preamble, the final regulations published in 1994 and 1996 are referred 
to collectively as the Treasury regulations.
    On December 17, 1999, section 1221 was amended by section 532 of 
the Ticket to Work and Work Incentives Improvement Act of 1999 (113 
Stat 1860) to provide ordinary gain or loss treatment for hedging 
transactions and consumable supplies. Section 1221(a)(7) provides 
ordinary treatment for hedging transactions that are clearly identified 
as such before the close of the day on which they were acquired, 
originated, or entered into.
    The statute defines a hedging transaction as a transaction entered 
into by the taxpayer in the normal course of business primarily to 
manage risk of interest rate, price changes, or currency fluctuations 
with respect to ordinary property, ordinary obligations, or borrowings 
of the taxpayer. Sections 1221(b)(2)(A)(i) and (ii). The statutory

[[Page 12864]]

definition of hedging transaction also includes transactions to manage 
such other risks as the Secretary may prescribe in regulations. Section 
1221(b)(2)(A)(iii). Further, the statute grants the Secretary the 
authority to provide regulations to address the treatment of 
nonidentified or improperly identified hedging transactions, and 
hedging transactions involving related parties (sections 1221(b)(2)(B) 
and (b)(3), respectively). The statutory hedging provisions are 
effective for transactions entered into on or after December 17, 1999. 
Congress intended that the hedging rules be the exclusive means through 
which the gains and losses from hedging transactions are treated as 
ordinary. S. Rep. No. 201, 106th Cong., 1st Sess. 25 (1999).
    Section 1221(a)(8) provides that supplies of a type regularly 
consumed by the taxpayer in the ordinary course of a taxpayer's trade 
or business are not capital assets. That provision is effective for 
supplies held or acquired on or after December 17, 1999.
    A notice of proposed rulemaking (REG-107047-00, 2001-14 I.R.B. 
1002) was published in the Federal Register (66 FR 4738) on January 18, 
2001. On May 16, 2001, the IRS held a public hearing on the proposed 
regulations. Written comments responding to the notice of proposed 
rulemaking were also received. In response to these comments, the 
proposed regulations were modified and as so modified are adopted as 
final regulations. The principal changes to the proposed regulations 
are discussed below.

Explanation of Provisions

Coordination With International Provisions of the Code

    The provisions of these regulations generally apply to determine 
the character of gain or loss from transactions that are also subject 
to various international provisions of the Code. Paragraph (a)(4) of 
the regulations, however, provides that the character of gain or loss 
on section 988 transactions is not determined under these regulations 
because gain or loss on those transactions is ordinary under section 
988(a)(1). In addition, no implication is intended as to what 
constitutes ``risk management'' or ``managing risk'' for purposes of 
proposed or final regulations under section 482.
    Paragraph (a)(4) of the proposed regulations provided that the 
definition of a hedging transaction under Sec. 1.1221-2(b) of the 
proposed regulations would apply for purposes of certain other 
international provisions of the Code only to the extent provided in 
regulations issued under those provisions. Technical changes have been 
made in the final regulations to eliminate references to proposed 
regulations as well as Code sections for which the relevant regulations 
have not been issued in final form. Subsequent regulations will specify 
the extent to which the rules relating to hedging transactions that are 
contained in Sec. 1.1221-2 will be applicable for purposes of those 
other regulations and related Code sections.

Risk Management Standard

    Several commentators noted that the proposed regulations used risk 
reduction as the operating standard to implement the risk management 
definition of hedging introduced by section 1221(b)(2)(A). These 
commentators found that risk reduction is too narrow a standard to 
encompass the intent of Congress which defined hedges to include 
transactions that manage risk of interest rate, price changes or 
currency fluctuations. They urged the IRS and Treasury to adopt a 
broader definition of hedging to reflect Congress' intent. With one 
exception, the commentators did not suggest a definition of risk 
management.
    In response to these comments, the final regulations have been 
restructured to implement the risk management standard. No definition 
of risk management is provided, but instead, the rules characterize a 
variety of classes of transactions as hedging transactions because they 
manage risk. Risk reducing transactions still qualify as one class of 
hedging transactions, but there are also others. In addition, specific 
provision is made for the recognition of additional types of qualifying 
risk management transactions through published guidance or private 
letter rulings. Under the final regulations, as under the proposed 
regulations, transactions entered into for speculative purposes will 
not qualify as hedging transactions. See S. Rep. No. 201, 106th Cong., 
1st Sess. 24 (1999).

Application on the Basis of Separate Business Units

    The proposed regulations provided that a taxpayer has risk of a 
particular type only if it is at risk when all of its operations are 
considered. That is, risk must exist on a ``macro'' basis. For this 
purpose, under the proposed regulations, a taxpayer has to show that 
hedges of particular assets or liabilities, or groups of assets or 
liabilities, are reasonably expected to reduce the overall risk of the 
taxpayer's operations.
    Commentators pointed out that this entity-based approach to hedging 
is no longer uniform business practice. Instead, businesses often 
conduct risk management on a business unit by business unit basis. In 
response to these comments, the final regulations permit the 
determination of whether a transaction manages risk to be made on a 
business unit basis provided that the business unit is within a single 
entity or consolidated return group that adopts the single-entity 
approach. An example was added to the final regulations in which for 
one taxpayer, the determination of whether hedging activities reduce 
risk is made at the business unit level. In the example, the conduct of 
risk management activities within separate business units is undertaken 
as part of a program to reduce the overall risk of the taxpayer's 
operations.

Fixed-to-Floating Interest Rate Hedges

    Paragraph (c)(1) of the proposed regulations recognized that a 
transaction that economically converts an interest rate or price from a 
fixed rate or price to a floating rate or price may manage risk. 
Commentators suggested that the rule in the proposed regulations 
provides insufficient guidance in that it states only that fixed-to-
floating interest rate or price hedges may be hedging transactions. In 
response to these comments, the regulations have been restructured to 
separately address interest rate hedges and price hedges.
    Commentators suggested that in the case of interest rate 
conversions, a taxpayer may choose to convert from a floating to a 
fixed rate to fix the amount payable on the obligation. However, a 
taxpayer could also elect to convert from a fixed to a floating rate to 
insure that the value of the liability remained relatively constant. In 
response to these comments, the final regulations provide that a 
transaction that converts an interest rate from a fixed rate to a 
floating rate or from a floating rate to a fixed rate manages risk. 
With respect to fixed-to-floating price hedges, the final regulations 
adopt the proposed rules without change.

Transactions Not Entered Into Primarily To Manage Risk

    Paragraph (c)(3) of the proposed regulations provided that the 
purchase or sale of certain assets will not qualify as a hedging 
transaction if the assets are not acquired primarily to manage risk. 
This rule was illustrated by the example of a taxpayer that has an 
interest rate risk from a floating rate borrowing and that acquires 
debt instruments bearing a comparable floating interest rate.

[[Page 12865]]

Although the taxpayer's interest rate risk from the floating rate 
borrowing may be reduced by the purchase of the floating rate debt 
instruments, the proposed regulations provided that the acquisition of 
the debt instruments is not made primarily to reduce risk and, 
therefore, is not a hedging transaction.
    The IRS and Treasury understand that some employers may invest in 
assets (such as shares of a mutual fund) that are used as a reference 
investment for purposes of computing their liability to employees under 
a nonqualified deferred compensation plan. A question may arise whether 
such an investment may constitute a hedging transaction and, if so, 
whether income from the investment may be deferred by the employer 
until payments of deferred compensation are made to employees. See 
Sec. 1.446-4(b); but compare Albertson's, Inc. v. Commissioner, 42 F.3d 
537 (9th Cir. 1994).
    The rule in the proposed regulations is based on Sec. 1.1221-
2(c)(1)(vii). The rule has been restated in the final regulations to 
refer specifically to investments in debt instruments, equity 
securities, and annuity contracts so as to provide greater certainty in 
its application. For this purpose certain transactions in instruments 
that are not themselves debt instruments may include a debt investment. 
See, e.g., Sec. 1.446-3(g)(4). Further, the final regulations provide 
that the IRS may identify by future published guidance specified 
transactions that are determined not to be entered into primarily to 
manage risk. An example has been added to the final regulations to 
illustrate that an investment in mutual fund shares in the case 
described in the preceding paragraph does not qualify as a hedging 
transaction. A similar example is added with respect to an investment 
in an annuity contract.

Hedging Risks Other Than Interest Rate or Price Changes, or Currency 
Fluctuations

    Paragraph (c)(8) of the proposed regulations provided that the 
Commissioner may, by published guidance, provide that hedging 
transactions include transactions entered into to manage risks other 
than interest rate or price changes, or currency fluctuations.
    The notice of proposed rulemaking solicited comments regarding the 
expansion of the definition of hedging transactions to include 
transactions that manage risks other than interest rate or price 
changes, or currency fluctuations with respect to ordinary property, 
ordinary obligations or borrowings of the taxpayer. Some comments were 
received in response to that request. Because the comments described 
hedging transactions that related to the general operating results of a 
business (such as gross sales) rather than specific ordinary property, 
ordinary obligations or borrowings of the taxpayer, the implementation 
of rules respecting such hedges would present a number of issues not 
easily dealt with by the rules contained in the final regulations. 
Thus, the expansion of the scope of operation of the hedging rules is 
not being proposed at this time, so as not to delay the publication of 
guidance on the matters that are covered by the final regulations. 
However, the IRS is continuing to consider whether to expand the 
definition of hedging transactions to cover hedges of such other risks. 
The IRS and Treasury invite comments on the types of risks that should 
be covered, including specific examples of derivative transactions that 
may be incorporated into future guidance, as well as the appropriate 
timing of inclusion of gains and losses with respect to such 
transactions. Send submissions to: CC:ITA:RU (REG-107047-00), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044.

``Gap'' Hedges

    The status of so-called gap hedges was not separately addressed in 
the proposed regulations and is not covered in the final regulations. 
Insurance companies, for example, sometimes hedge the gap between their 
liabilities and the assets that fund them. Under the final regulations, 
a hedge of those assets would not qualify as a hedging transaction if 
the assets are capital assets. 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.

Identification Requirement

    A rule has been added specifying additional information that must 
be provided for a transaction that counteracts a hedging transaction.

Dates of Applicability

    The regulations generally apply to all transactions entered into on 
or after March 20, 2002. However, the IRS will not challenge any 
transaction entered into on or after December 17, 1999, and before 
March 20, 2002, that satisfies the provisions of either Sec. 1.1221-2 
of REG-107047-00, published in the Federal Register (66 FR 4738) on 
January 18, 2001, or the provisions of this final regulation.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It is hereby 
certified that the collection of information in these regulations will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that very few small 
businesses enter into hedging transactions due to their cost and 
complexity. Further, those small businesses that hedge enter into very 
few hedging transactions because hedging transactions are costly, 
complex, and require constant monitoring and a sophisticated 
understanding of the capital markets. Therefore, a Regulatory 
Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) is not required. Pursuant to section 7805(f) of the Code, 
the notice of proposed rulemaking preceding these regulations was 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal author of these regulations is Elizabeth Handler, 
Office of the Associate 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. The authority citation for part 1 is amended by 
revising the entry for Sec. 1.1221-2 to read as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.1221-2 also issued under 26 U.S.C. 1221(b)(2)(A)(iii), 
(b)(2)(B), and (b)(3); 1502 and 6001. * * *

    Par. 2. In the list below, for each location indicated in the left 
column,

[[Page 12866]]

remove the language in the middle column from that section, and add the 
language in the right column.

----------------------------------------------------------------------------------------------------------------
            Affected section                            Remove                                Add
----------------------------------------------------------------------------------------------------------------
1.446-4(d)(2), first sentence...........  1.1221-2(e).......................  1.1221-2(f).
1.446-4(d)(2), last sentence............  1.1221-2(e)(2)....................  1.1221-2(f)(2).
1.446-4(d)(3), first sentence...........  1.1221-2(e).......................  1.1221-2(f).
1.446-4(d)(3), first sentence...........  1.1221-2(a)(4)(i).................  1.1221-2(a)(4).
1.446-4(e)(7), first sentence...........  1.1221-2(c)(2)....................  1.1221-2(d)(4).
1.446-4(e)(9)(ii), first sentence.......  1.1221-2(d)(2)....................  1.1221-2(e)(2).
1.446-4(e)(9)(ii), last sentence........  1.1221-2(d)(2)(ii)................  1.1221-2(e)(2)(ii).
1.475(b)-1(d)(2)........................  1.1221-2(e).......................  1.1221-2(f).
1.954-2(a)(4)(ii)(A), first sentence....  1.1221-2(a) through (c)...........  1.1221-2(a) through (d).
1.954-2(a)(4)(ii)(B), first sentence....  1.1221-2(e).......................  1.1221-2(f).
1.954-2(g)(2)(ii)(B)(2), last sentence..  1.1221-2(c)(7)....................  1.1221-2(c)(3).
1.954-2(g)(3)(i)(B), last sentence......  1.1221-2(c)(7)....................  1.1221-2(c)(3).
1.1256(e)-1(b), first and last sentences  1.1221-2(e)(1)....................  1.1221-2(f)(1).
1.1256(e)-1(c), first sentence..........  1.1221-2(e)(1)....................  1.1221-2(f)(1).
1.1256(e)-1(c), last sentence...........  paragraph (f)(1)(ii) of Sec.        1.1221-2(g)(1)(ii).
                                           1.1221-2.
----------------------------------------------------------------------------------------------------------------

    Par. 3. Section 1.1221-2 is revised 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(a)(7). 
Except as provided in paragraph (g)(2) of this section, 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. Except as provided in paragraph (g)(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 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 
any qualified fund as defined in section 988(c)(1)(E)(iii).
    (b) Hedging transaction defined. Section 1221(b)(2)(A) provides 
that a hedging transaction is any transaction that a taxpayer enters 
into in the normal course of the taxpayer's trade or business 
primarily--
    (1) To manage risk of price changes or currency fluctuations with 
respect to ordinary property (as defined in paragraph (c)(2) of this 
section) that is held or to be held by the taxpayer;
    (2) To manage 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; or
    (3) To manage such other risks as the Secretary may prescribe in 
regulations (see paragraph (d)(6) of this section).
    (c) General rules--(1) 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 includes managing risks relating to the expansion of an 
existing business or the acquisition of a new trade or business.
    (2) Ordinary property and obligations. 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 under any 
circumstances. 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 this paragraph (c)(2), the term termination has the 
same meaning as it does in section 1234A.
    (3) Hedging an aggregate risk. The term hedging transaction 
includes a transaction that manages 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, or borrowings.
    (4) Managing risk--(i) In general. Whether a transaction manages a 
taxpayer's risk is determined based on all of the facts and 
circumstances surrounding the taxpayer's business and the transaction. 
Whether a transaction manages a taxpayer's risk may be determined on a 
business unit by business unit basis (for example by treating 
particular groups of activities, including the assets and liabilities 
attributable to those activities, as separate business units), provided 
that the business unit is within a single entity or consolidated return 
group that adopts the single-entity approach. A taxpayer's hedging 
strategies and policies as reflected in the taxpayer's minutes or other 
records are evidence of whether particular transactions were entered 
into primarily to manage the taxpayer's risk.
    (ii) Limitation of risk management transactions to those 
specifically described. Except as otherwise determined by published 
guidance or by private letter ruling, a transaction that is not treated 
as a hedging transaction under paragraph (d) does not manage risk. 
Moreover, a transaction undertaken for speculative purposes will not be 
treated as a hedging transaction.
    (d) Transactions that manage risk--(1) Risk reduction 
transactions--(i) In general. A transaction that is entered into to 
reduce a taxpayer's risk, manages a taxpayer's risk.
    (ii) Micro and macro hedges--(A) In general. A taxpayer generally 
has risk of a particular type only if it is at risk

[[Page 12867]]

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) Example. The following example illustrates the rules stated in 
paragraph (d)(1)(ii)(A) of this section:

    Example. Corporation X manages its business operations by 
treating particular groups of activities, including the assets and 
liabilities attributable to those assets, as separate business 
units. A separate set of books and records is maintained with 
respect to the activities, assets and liabilities of separate 
business unit y. As part of a risk management program that 
Corporation X reasonably expects to reduce the overall risks of its 
business operations, Corporation X enters into hedges to reduce the 
risks of separate business unit y. Corporation X may demonstrate 
that the hedges reduce risk by taking into account only the 
activities, assets and liabilities of business unit y.

    (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 (d)(3) of this section.
    (iv) Fixed-to-floating price hedges. Under the principles of 
paragraph (d)(1)(ii)(A) of this section, a transaction that 
economically converts a price from a fixed price to a floating price 
may reduce risk. For example, 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, for such a taxpayer a 
transaction that converts its fixed price to a floating price may be a 
hedging transaction.
    (2) Interest rate conversions. A transaction that economically 
converts an interest rate from a fixed rate to a floating rate or that 
converts an interest rate from a floating rate to a fixed rate manages 
risk.
    (3) Transactions that counteract hedging transactions. If a 
transaction is entered into primarily to offset all or any part of the 
risk management 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 a hedging 
transaction.
    (4) Recycling. A taxpayer may enter into a hedging transaction by 
using a position that was a hedge of one asset or liability as a hedge 
of another asset or liability (recycling).
    (5) Transactions not entered into primarily to manage risk--(i) 
Rule. Except as otherwise determined in published guidance or private 
letter ruling, the purchase or sale of a debt instrument, an equity 
security, or an annuity contract is not a hedging transaction even if 
the transaction limits or reduces the taxpayer's risk with respect to 
ordinary property, borrowings, or ordinary obligations. In addition, 
the Commissioner may determine in published guidance that other 
transactions are not hedging transactions.
    (ii) Examples. The following examples illustrate the rule stated in 
paragraph (d)(5)(i) of this section:

    Example 1. Taxpayer borrows money and agrees to pay a floating 
rate of interest. Taxpayer purchases debt instruments that bear a 
comparable floating rate. Although taxpayer's interest rate risk 
from the floating rate borrowing may be reduced by the purchase of 
the debt instruments, the acquisition of the debt instruments is not 
a hedging transaction, because the transaction is not entered into 
primarily to manage the taxpayer's risk.
    Example 2. Taxpayer undertakes obligations to pay compensation 
in the future. The amount of the future compensation payments is 
adjusted as if amounts were invested in a specified mutual fund and 
were increased or decreased by the earnings, gains and losses that 
would result from such an investment. Taxpayer invests funds in the 
shares of the mutual fund. Although the investment in shares of the 
mutual fund reduces the taxpayer's risk of fluctuation in the amount 
of its obligation to employees, the investment was not made 
primarily to manage the taxpayer's risk. Accordingly, the 
transaction is not a hedging transaction.
    Example 3. Taxpayer provides a nonqualified retirement plan for 
employees that is structured like a defined contribution plan. Based 
on a schedule that takes into account an employee's monthly salary 
and years of service with the taxpayer, the taxpayer makes monthly 
credits to an account for each employee. Each employee may designate 
that the account will be treated as if it were used to pay premiums 
on a variable annuity contract issued by the M insurance company 
with a value that reflects a specified investment option. M offers a 
number of investment options for its variable annuity contracts. 
Taxpayer invests funds in M company variable annuity contracts that 
parallel the investment options selected by the employees. The 
investment is not made primarily to manage the taxpayer's risk and 
is not a hedging transaction.

    (6) Hedges of other risks. The Commissioner may, by published 
guidance, determine that hedging transactions include transactions 
entered into to manage risks other than interest rate or price changes, 
or currency fluctuations.
    (7) Miscellaneous provision--(i) Extent of risk management. 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.
    (ii) 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.
    (e) Hedging by members of a consolidated group--(1) General rule: 
single-entity approach. For purposes of this section, the risk of one 
member of a consolidated group is treated as the risk of the other 
members as if all of the members of the group were divisions of a 
single corporation. For example, if any member of a consolidated group 
hedges the risk of another member of the group by entering into a 
transaction with a third party, that transaction may potentially 
qualify as a hedging transaction. Conversely, intercompany transactions 
are not hedging transactions because, when considered as transactions 
between divisions of a single corporation, they do not manage the risk 
of that single corporation.
    (2) Separate-entity election. In lieu of the single-entity approach 
specified in paragraph (e)(1) of this section, a consolidated group may 
elect separate-entity treatment of its hedging transactions. If a group 
makes this separate-entity election, the following rules apply:
    (i) Risk of one member not risk of other members. Notwithstanding 
paragraph (e)(1) of this section, the risk of one member is not treated 
as the risk of other members.
    (ii) Intercompany transactions. An intercompany transaction is a 
hedging transaction (an intercompany hedging transaction) with respect 
to a member of

[[Page 12868]]

a consolidated group if and only if it meets the following 
requirements--
    (A) The position of the member in the intercompany transaction 
would qualify as a hedging transaction with respect to the member 
(taking into account paragraph (e)(2)(i) of this section) if the member 
had entered into the transaction with an unrelated party; and
    (B) The position of the other member (the marking member) in the 
transaction is marked to market under the marking member's method of 
accounting.
    (iii) Treatment of intercompany hedging transactions. An 
intercompany hedging transaction (that is, a transaction that meets the 
requirements of paragraphs (e)(2)(ii)(A) and (B) of this section) is 
subject to the following rules--
    (A) The character and timing rules of Sec. 1.1502-13 do not apply 
to the income, deduction, gain, or loss from the intercompany hedging 
transaction; and
    (B) Except as provided in paragraph (g)(3) of this section, the 
character of the marking member's gain or loss from the transaction is 
ordinary.
    (iv) Making and revoking the election. Unless the Commissioner 
otherwise prescribes, the election described in this paragraph (e)(2) 
must be made in a separate statement saying ``[Insert Name and Employer 
Identification Number of Common Parent] HEREBY ELECTS THE APPLICATION 
OF SECTION 1.1221-2(e)(2) (THE SEPARATE-ENTITY APPROACH).'' The 
statement must also indicate the date as of which the election is to be 
effective. The election must be signed by the common parent and filed 
with the group's Federal income tax return for the taxable year that 
includes the first date for which the election is to apply. The 
election applies to all transactions entered into on or after the date 
so indicated. The election may be revoked only with the consent of the 
Commissioner.
    (3) Definitions. For definitions of consolidated group, divisions 
of a single corporation, group, intercompany transactions, and member, 
see section 1502 and the regulations thereunder.

    (4) Examples. General Facts. In these examples, O and H are 
members of the same consolidated group. O's business operations give 
rise to interest rate risk ``A,'' which O wishes to hedge. O enters 
into an intercompany transaction with H that transfers the risk to 
H. O's position in the intercompany transaction is ``B,'' and H's 
position in the transaction is ``C.'' H enters into position ``D'' 
with a third party to reduce the interest rate risk it has with 
respect to its position C. D would be a hedging transaction with 
respect to risk A if O's risk A were H's risk. The following 
examples illustrate this paragraph (e):
    Example 1. Single-entity treatment--(i) General rule. Under 
paragraph (e)(1) of this section, O's risk A is treated as H's risk, 
and therefore D is a hedging transaction with respect to risk A. 
Thus, the character of D is determined under the rules of this 
section, and the income, deduction, gain, or loss from D must be 
accounted for under a method of accounting that satisfies 
Sec. 1.446-4. The intercompany transaction B-C is not a hedging 
transaction and is taken into account under Sec. 1.1502-13.
    (ii) Identification. D must be identified as a hedging 
transaction under paragraph (f)(1) of this section, and A must be 
identified as the hedged item under paragraph (f)(2) of this 
section. Under paragraph (f)(5) of this section, the identification 
of A as the hedged item can be accomplished by identifying the 
positions in the intercompany transaction as hedges or hedged items, 
as appropriate. Thus, substantially contemporaneous with entering 
into D, H may identify C as the hedged item and O may identify B as 
a hedge and A as the hedged item.
    Example 2. Separate-entity election; counterparty that does not 
mark to market. In addition to the General Facts stated above, 
assume that the group makes a separate-entity election under 
paragraph (e)(2) of this section. If H does not mark C to market 
under its method of accounting, then B is not a hedging transaction, 
and the B-C intercompany transaction is taken into account under the 
rules of section 1502. D is not a hedging transaction with respect 
to A, but D may be a hedging transaction with respect to C if C is 
ordinary property or an ordinary obligation and if the other 
requirements of paragraph (b) of this section are met. If D is not 
part of a hedging transaction, then D may be part of a straddle for 
purposes of section 1092.
[GRAPHIC] [TIFF OMITTED] TR20MR02.002

    Example 3. Separate-entity election; counterparty that marks to 
market. The facts are the same as in Example 2 above, except that H 
marks C to market under its method of accounting. Also assume that B 
would be a hedging transaction with respect to risk A if O had 
entered into that transaction with an unrelated party. Thus, for O, 
the B-C transaction is an intercompany hedging transaction with 
respect to O's risk A, the character and timing rules of 
Sec. 1.1502-13 do not apply to the B-C transaction, and H's income, 
deduction, gain, or loss from C is ordinary. However, other 
attributes of the items from the B-C transaction are determined 
under Sec. 1.1502-13. D is a hedging transaction with respect to C 
if it meets the requirements of paragraph (b) of this section.
    (f) Identification and recordkeeping--(1) Same-day identification 
of hedging transactions. Under section 1221(a)(7), a taxpayer that 
enters into a hedging transaction (including recycling an existing 
hedging transaction) must clearly identify it as a hedging transaction 
before the close of the day on which the taxpayer acquired, originated, 
or entered into the transaction (or recycled the existing hedging 
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 (f)(3) of this section.
    (ii) Timing of the identification. The identification required by 
this paragraph

[[Page 12869]]

(f)(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 
(f)(3), the identification under paragraph (f)(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 issue price or the 
full term of the debt, the amount of the issue price 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; 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)(3) of 
this section, the identification under paragraph (f)(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 can be 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.
    (v) Transactions that counteract hedging transactions. If the 
hedging transaction is described in paragraph (d)(3) of this section, 
the description of the hedging transaction must include an 
identification of the risk management transaction that is being offset 
and the original underlying hedged item.
    (4) Manner of identification and records to be retained--(i) 
Inclusion of identification in tax records. The identification required 
by this paragraph (f) must be made on, and retained as part of, the 
taxpayer's books and records.
    (ii) Presence of identification must be unambiguous. The presence 
of an identification for purposes of this paragraph (f) 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 
(f)(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) Principles of paragraph (f)(4)(iii) of this section 
illustrated. Paragraphs (f)(4)(iv)(A) through (C) of this section 
illustrate the principles of paragraph (f)(4)(iii) of this section and 
assume that the other requirements of this paragraph (f) 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 designating a certain 
mark, a certain form, or a certain legend as meaning that a transaction 
is a hedge of a specified item (or of specified items or a specified 
aggregate risk). Identification can be made by placing the designated 
mark on a record of the transaction (for example, trading ticket, 
purchase order, or trade confirmation) or by using the designated form 
or a record that contains the designated legend.
    (5) Identification of hedges involving members of the same 
consolidated group--(i) General rule: single-entity approach. A member 
of a consolidated group must satisfy the requirements of this paragraph 
(f) as if all of the members of the group were divisions of a single 
corporation. Thus, the member entering into the hedging transaction 
with a third party must identify the hedging transaction under 
paragraph (f)(1) of this section. Under paragraph (f)(2) of this 
section, that member must also identify the item, items, or aggregate 
risk that is being hedged, even if the item, items, or aggregate risk 
relates primarily or entirely to other members of the group. If the 
members of a group use intercompany transactions to transfer risk 
within the group, the requirements of paragraph (f)(2) of this section 
may be met by identifying the intercompany transactions, and the risks 
hedged by the intercompany transactions, as

[[Page 12870]]

hedges or hedged items, as appropriate. Because identification of the 
intercompany transaction as a hedge serves solely to identify the 
hedged item, the identification is timely if made within the period 
required by paragraph (f)(2) of this section. For example, if a member 
transfers risk in an intercompany transaction, it may identify under 
the rules of this paragraph (f) both its position in that transaction 
and the item, items, or aggregate risk being hedged. The member that 
hedges the risk outside the group may identify under the rules of this 
paragraph (f) both its position with the third party and its position 
in the intercompany transaction. Paragraph (e)(4) Example 1 of this 
section illustrates this identification.
    (ii) Rule for consolidated groups making the separate-entity 
election. If a consolidated group makes the separate-entity election 
under paragraph (e)(2) of this section, each member of the group must 
satisfy the requirements of this paragraph (f) as though it were not a 
member of a consolidated group.
    (6) Consistency with section 1256(e)(2). Any identification for 
purposes of section 1256(e)(2) is also an identification for purposes 
of paragraph (f)(1) of this section.
    (g) 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 (f)(1) 
of this section, the identification is binding with respect to gain, 
whether or not all of the requirements of paragraph (f) 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 (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 
(g)(1)(i) of this section, if the taxpayer identifies a transaction as 
a hedging transaction for purposes of paragraph (f) 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 (g)(2)(ii) and (iii) of this section, the absence of an 
identification that satisfies the requirements of paragraph (f)(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 (f) of this 
section, the taxpayer may treat gain or loss from the transaction as 
ordinary income or loss under paragraph (a)(1) or (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 (2) of this section.
    (iii) Anti-abuse rule. If a taxpayer does not make an 
identification that satisfies all the requirements of paragraph (f) 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. 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--(i) Single-
entity approach. If a consolidated group is under the general rule of 
paragraph (e)(1) of this section (the single-entity approach), the 
rules of this paragraph (g) apply only to transactions that are not 
intercompany transactions.
    (ii) Separate-entity election. If a consolidated group has made the 
election under paragraph (e)(2) of this section, then, in addition to 
the rules of paragraphs (g)(1) and (2) of this section, the following 
rules apply:
    (A) If an intercompany transaction is identified as a hedging 
transaction but does not meet the requirements of paragraphs 
(e)(2)(ii)(A) and (B) of this section, then, notwithstanding any 
contrary provision in Sec. 1.1502-13, each party to the transaction is 
subject to the rules of paragraph (g)(1) of this section with respect 
to the transaction as though it had incorrectly identified its position 
in the transaction as a hedging transaction.
    (B) If a transaction meets the requirements of paragraphs 
(e)(2)(ii) (A) and (B) of this section but the transaction is not 
identified as a hedging transaction, each party to the transaction is 
subject to the rules of paragraph (g)(2) of this section. (Because the 
transaction is an intercompany hedging transaction, the character and 
timing rules of Sec. 1.1502-13 do not apply. See paragraph 
(e)(2)(iii)(A) of this section.)
    (h) Effective date. The rules of this section apply to transactions 
entered into on or after March 20, 2002.
    Par. 4. Section 1.1256(e)-1 is revised to read as follows:


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

    (a) Identification and recordkeeping requirements. Under section 
1256(e)(2), 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) must satisfy the 
requirements of Sec. 1.1221-2(f)(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(f)(1) is nevertheless treated as an 
identification under section 1256(e)(2).
    (c) Consistency with Sec. 1.1221-2. Any identification for purposes 
of Sec. 1.1221-2(f)(1) is also an identification for purposes of this 
section. If a taxpayer satisfies the requirements of Sec. 1.1221-
2(f)(1)(ii), the transaction is treated as if it were not identified as 
a hedging transaction for purposes of section 1256(e)(2).
    (d) Effective date. The rules of this section apply to transactions 
entered into on or after March 20, 2002.

[[Page 12871]]

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

    Par. 5. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

    Par. 6. In Sec. 602.101, paragraph (b) is amended by removing the 
entries for ``1.1221-2,'' ``1.1221-2(d)(2)(iv),'' ``1.1221-2(e)(5),'' 
``1.1221-2(g)(5)(ii),'' ``1.1221-2(g)(6)(ii),'' ``1.1221-
2(g)(6)(iii),'' and ``1.1221-2T(c)'' and adding an entry in numerical 
order to the table to read as follows:


Sec. 602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                  *        *        *        *        *
1.1221-2................................................       1545-1480
 
                  *        *        *        *        *
------------------------------------------------------------------------


Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
    Approved: March 14, 2002.
Mark Weinberger,
Assistant Secretary of the Treasury.
[FR Doc. 02-6622 Filed 3-15-02; 8:54 am]
BILLING CODE 4830-01-P