[Federal Register Volume 67, Number 92 (Monday, May 13, 2002)]
[Proposed Rules]
[Pages 31995-31998]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-11891]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-154920-01]
RIN 1545-BA33


Guidance Regarding the Definition of Foreign Personal Holding 
Company Income

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that provide that 
gain or loss arising from certain commodities hedging transactions and 
currency gain or loss arising from certain interest-bearing liabilities 
do not constitute (or are not netted against) foreign personal holding 
company income. This treatment is proposed because the applicable 
commodities hedging transactions and interest-bearing liabilities 
typically offset transactions that do not generate foreign personal 
holding company income. This document also provides notice of a public 
hearing on these proposed regulations.

DATES: Written or electronic comments must be received by August 21, 
2002. Requests to speak (with outlines of oral comments to be 
discussed) at the public hearing scheduled for September 11, 2002, at 
10 a.m. must be submitted by August 21, 2002.

ADDRESSES: Send submissions to: CC:ITA:RU (REG-154920-01), room 5226, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand delivered Monday through Friday 
between the hours of 8 a.m. and 5 p.m. to: CC:ITA:RU REG-154920-01, 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit comments 
electronically directly to the IRS Internet site at: www.irs.gov/regs. 
The public hearing will be held in room 4718, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Kenneth Christman or Ted Setzer at (202) 622-3870; concerning 
submission and delivery of comments and the public hearing, Treena 
Garrett, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 954(c)(1)(C) of the Internal Revenue Code provides that 
foreign personal holding company income of a controlled foreign 
corporation (a CFC) generally includes the excess of gains over losses 
from transactions in commodities. An exception to this treatment is 
provided, however, for gains and losses that arise out of ``bona fide 
hedging transactions'' entered into by a producer, processor, merchant 
or handler of commodities. Section 954(c)(1)(C)(i). On September 7, 
1995, final regulations were published in the Federal Register (60 FR 
46500, as corrected at 60 FR 62024) under section 954 governing the 
definition of a CFC and the definitions of foreign base company income 
and foreign personal holding company income of a CFC. These regulations 
address, among other matters, the circumstances in which income from 
transactions in commodities will be treated as foreign personal holding 
company income. In particular, the regulations provide that income from 
a ``qualified hedging transaction'' is excluded from the definition of 
foreign personal holding company income. Sec. 1.954-2(f)(1)(ii). A 
qualified hedging transaction is defined in the regulations generally 
as a bona fide hedging transaction with respect to a sale of 
commodities in the active conduct of a commodities business by a CFC if 
substantially all of the CFC's business is as an active producer, 
processor, merchant or handler of commodities. Secs. 1.954-2(f)(2)(iii) 
and (iv).
    Following the publication of the final regulations, some taxpayers 
have commented that the regulations inappropriately characterize as 
foreign personal holding company income any gain arising from hedging 
transactions entered into by a manufacturer to protect itself from 
fluctuations in the prices of commodities associated with the products 
that it manufactures. Because the manufacturer would not be considered 
to be selling the commodities in the active conduct of a commodities 
business, transactions entered into by the manufacturer could not 
qualify for the ``qualified hedging transaction'' exception under the 
regulations.

[[Page 31996]]

    The regulations also address the treatment of currency gain or loss 
for purposes of subpart F. Although the regulations provide that 
foreign personal holding company income generally includes the excess 
of foreign currency gains over foreign currency losses, an exception is 
provided for foreign currency gain or loss ``directly related to the 
business needs of the controlled foreign corporation.'' Sec. 1.954-
2(g)(2)(ii). Notwithstanding this ``business needs'' exception, the 
regulations provide that currency gain or loss arising from an 
interest-bearing liability must be allocated and apportioned between 
subpart F and non-subpart F income in the same manner that interest 
expense associated with the liability is allocated and apportioned 
between subpart F and non-subpart F income under Secs. 1.861-9T and 
1.861-12T. Sec. 1.954-2(g)(2)(iii).
    Some taxpayers have commented that the final regulations 
inappropriately characterize a portion of foreign currency gain on 
certain interest-bearing liabilities as foreign personal holding 
company income. In particular, these taxpayers have noted that 
securities dealers commonly utilize a technique known as ``match 
funding'' to manage currency exposures associated with their dealer 
assets. Rather than borrowing in their functional currency to meet 
their business needs, dealers who utilize this technique attempt to 
manage their exposure to foreign currencies on their dealer assets by 
borrowing the funds needed for their business in the currency in which 
the dealer assets are denominated. As a result, the foreign currency 
exposure on the dealer assets is offset economically by the foreign 
currency exposure on the interest-bearing liabilities incurred by the 
dealer. Under the regulations, foreign currency gain on the dealer 
assets would qualify for the ``business needs'' exception and therefore 
would not be classified as foreign personal holding company income. If 
the foreign currency gain arose on the offsetting interest-bearing 
liabilities, however, a portion of the foreign currency gain likely 
would be treated as subpart F income under the regulations.

Explanation of Provisions

    The proposed regulations address each of these issues by refining 
the relevant exceptions to foreign personal holding company income.

Commodities Hedging Transactions

    Section 1.954-2(f)(2)(v), as proposed, would provide that a hedging 
transaction entered into by a CFC with respect to its business as a 
producer, processor, merchant or handler of commodities may be a 
qualified hedging transaction although the hedging transaction is not a 
hedge with respect to a sale of commodities in the active conduct of a 
commodities business by a CFC substantially all of whose business is as 
an active producer, processor, merchant or handler of commodities. The 
proposed regulation also provides that, for purposes of satisfying the 
qualified hedging transaction requirements, a producer, processor, 
merchant or handler of commodities includes (but is not limited to) a 
CFC that regularly uses commodities in a manufacturing, construction, 
utilities, or transportation business. Similar to the regulations 
currently in effect, the proposed regulations provide that a 
corporation is not a producer, processor, merchant or handler of 
commodities (and therefore cannot satisfy the qualified hedging 
transaction requirements) if its business is primarily financial.

Foreign Currency Gain or Loss on Interest-Bearing Liabilities

    Section 1.954-2(g)(2)(ii)(C)(2), as proposed, would provide that 
interest-bearing liabilities of a CFC will be treated as dealer 
property if the liabilities are denominated in a currency so as to 
manage the CFC's currency risk with respect to dealer property held by 
the CFC. This provision would apply only to interest-bearing 
liabilities identified on the date the liability is incurred. The 
result of the proposed rule would be to exclude currency gain or loss 
on interest-bearing liabilities that manage the CFC's currency risk 
with respect to dealer property from the computation of foreign 
personal holding company income.

Proposed Effective Dates

    Section 1.954-2(f)(2)(v) is proposed to apply to gain or loss 
realized by a CFC with respect to a qualified hedging transaction 
entered into on or after the date proposed Sec. 1.954-2(f)(2)(v) is 
published as a final regulation in the Federal Register. Section 1.954-
2(g)(2)(ii)(C)(2) is proposed to apply to gain or loss from an 
interest-bearing liability entered into by a CFC on or after the date 
proposed Sec. 1.954-2(g)(2)(ii)(C)(2) is published as a final 
regulation in the Federal Register.

Special Analysis

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations and, because 
these regulations do not impose on small entities a collection of 
information requirement, the Regulatory Flexibility Act (5 U.S.C. 
chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis 
is not required. Pursuant to section 7805(f) of the Internal Revenue 
Code, this notice of proposed rulemaking will be submitted to the Chief 
Counsel for Advocacy of the Small Business Administration for comment 
on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and Treasury Department specifically request 
comments on the clarity of the proposed regulations and how they can be 
made easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for September 11, 2002, at 10 
a.m. in room 4718, Internal Revenue Building, 1111 Constitution Avenue, 
NW., Washington, DC. Due to building security procedures, visitors must 
enter at the Constitution Avenue entrance. In addition, all visitors 
must present photo identification to enter the building. Because of 
access restrictions, visitors will not be admitted beyond the immediate 
entrance area more than 30 minutes before the hearing starts. For 
information about having your name placed on the building access list 
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section 
of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by August 21, 2002. A period of 10 minutes will be allotted to each 
person for making comments. An agenda showing the scheduling of the 
speakers will be prepared after the deadline for receiving outlines has 
passed. Copies of the agenda will be available free of charge at the 
hearing.

Drafting Information

    The principal authors of these regulations are Kenneth Christman 
and Ted Setzer of the Office of the Associate

[[Page 31997]]

Chief Counsel (International). However, other personnel from the IRS 
and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

    Par. 2. In Sec. 1.954-0, paragraph (b) is amended by:
    1. Removing the entry for Sec. 1.954-2(f)(2)(iii)(E).
    2. Revising the entry for Sec. 1.954-2(f)(2)(iv).
    3. Adding entries for Sec. 1.954-2(f)(2)(iv)(C), (f)(2)(v) and 
(f)(2)(vi).
    4. Revising the entry for Sec. 1.954-2(g)(2)(ii)(C).
    The additions and revisions read as follows::


Sec. 1.954-0  Introduction.

* * * * *
    (b) * * *


Sec. 1.954-2  Foreign personal holding company income.

* * * * *
    (f) * * *
    (2) * * *
    (iv) Qualified hedging transaction entered into prior to the date 
Sec. 1.954-2(f)(2)(v) is published as a final regulation in the Federal 
Register.
* * * * *
    (C) Effective date.
    (v) Qualified hedging transaction entered into on or after the date 
Sec. 1.954-2(f)(2)(v) is published as a final regulation in the Federal 
Register.
    (A) In general.
    (B) Exception.
    (C) Examples.
    (D) Effective date.
    (vi) Financial institutions not a producer, etc.
    (g) * * *
    (2) * * *
    (ii) * * *
    (C) Regular dealers.
    (1) General rule.
    (2) Certain interest-bearing liabilities treated as dealer 
property.
    (i) In general.
    (ii) Failure to identify certain liabilities.
    (iii) Effective date.
* * * * *
    Par. 3. Section 1.954-2 is amended by:
    1. Removing paragraph (f)(2)(iii)(E).
    2. Revising the heading of paragraph (f)(2)(iv).
    3. Adding paragraphs (f)(2)(iv)(C), (f)(2)(v), and (f)(2)(vi).
    4. Revising paragraph (g)(2)(ii)(C) and (g)(2)(iii).
    The revisions and additions read as follows:


Sec. 1.954-2  Foreign personal holding company income.

* * * * *
    (f) * * *
    (2) * * *
    (iv) Qualified hedging transaction entered into prior to the date 
Sec. 1.954-2(f)(2)(v) is published as a final regulations in the 
Federal Register.
* * * * *
    (C) Effective date. This paragraph (f)(2)(iv) applies to gain or 
loss realized by a controlled foreign corporation with respect to a 
qualified hedging transaction entered into prior to the date 
Sec. 1.954-2(f)(2)(v) is published as a final regulation in the Federal 
Register.
    (v) Qualified hedging transaction entered into on or after the date 
Sec. 1.954-2(f)(2)(v) is published as a final regulation in the Federal 
Register--(A) In general. The term qualified hedging transaction means 
a bona fide hedging transaction, as defined in paragraph (a)(4)(ii) of 
this section, with respect to one or more commodities transactions 
reasonably necessary to the conduct of any business by a producer, 
processor, merchant or handler of commodities in a manner in which such 
business is customarily and usually conducted by others. For purposes 
of this paragraph (f)(2)(v), a producer, processor, merchant or handler 
of commodities includes a controlled foreign corporation that regularly 
uses commodities in a manufacturing, construction, utilities, or 
transportation business.
    (B) Exception. The term qualified hedging transaction does not 
include a transaction described in section 988(c)(1) (without regard to 
section 988(c)(1)(D)(i)).
    (C) Examples. The following examples illustrate the provisions of 
this paragraph (f)(2)(v):

    Example 1. CFC1 is a controlled foreign corporation located in 
country A. CFC1 manufactures and sells machinery in country B using 
aluminum and component parts purchased from third parties that 
contain significant amounts of aluminum. CFC1 conducts its 
manufacturing business in a manner in which such business is 
customarily and usually conducted by others. To protect itself 
against increases in the price of aluminum used in the machinery it 
manufactures, CFC1 enters into futures purchase contracts for the 
delivery of aluminum. These futures purchase contracts are bona fide 
hedging transactions. As CFC1 purchases aluminum and component parts 
containing significant amounts of aluminum in the spot market for 
use in its business, it closes out an equivalent amount of aluminum 
futures purchase contracts by entering into offsetting aluminum 
futures sales contracts. The aluminum futures purchase contracts are 
qualified hedging transactions as defined in paragraph (f)(2)(v)(A) 
of this section. Accordingly, any gain or loss on such aluminum 
futures purchase contracts is excluded from the computation of 
foreign personal holding company income.
    Example 2. CFC2 is a controlled foreign corporation located in 
country B. CFC2 operates an airline business within country B in a 
manner in which such business is customarily and usually conducted 
by others. To protect itself against increases in the price of 
aviation fuel, CFC2 enters into forward contracts for the purchase 
of aviation fuel. These forward purchase contracts are bona fide 
hedging transactions. As CFC2 purchases aviation fuel in the spot 
market for use in its business, it closes out an equivalent amount 
of its forward purchase contracts for cash pursuant to a contractual 
provision that permits CFC2 to terminate the contract and make or 
receive a one-time payment representing the contract's fair market 
value. The aviation fuel forward purchase contracts are qualified 
hedging transactions as defined in paragraph (f)(2)(v)(A) of this 
section. Accordingly, any gain or loss on such aviation fuel forward 
purchase contracts is excluded from the computation of foreign 
personal holding company income.

    (D) Effective date. This paragraph (f)(2)(v) applies to gain or 
loss realized by a controlled foreign corporation with respect to a 
qualified hedging transaction entered into on or after the date 
Sec. 1.954-2(f)(2)(v) is published as a final regulation in the Federal 
Register.
    (vi) Financial institutions not a producer, etc. For purposes of 
this paragraph (f), a corporation is not a producer, processor, 
merchant or handler of commodities if its business is primarily 
financial. For example, the business of a controlled foreign 
corporation is primarily financial if its principal business is making 
a market in notional principal contracts based on a commodities index.
* * * * *
    (g) * * *
    (2) * * *
    (ii) * * *
    (C) Regular dealers--(1) General rule. Transactions in dealer 
property (as defined in paragraph (a)(4)(v) of this section) described 
in section 988(c)(1)(B) or (C) that are entered into by a controlled 
foreign corporation that is a regular dealer (as defined in paragraph 
(a)(4)(iv) of this section) in

[[Page 31998]]

such property in its capacity as a dealer will be treated as directly 
related to the business needs of the controlled foreign corporation 
under paragraph (g)(2)(ii)(A) of this section.
    (2) Certain interest-bearing liabilities treated as dealer 
property--(i) In general. For purposes of this paragraph (g)(2)(ii)(C), 
an interest-bearing liability incurred by a controlled foreign 
corporation that is denominated in (or determined by reference to) a 
non-functional currency shall be treated as dealer property if the 
liability, by being denominated in such currency, reduces the 
controlled foreign corporation's currency risk with respect to dealer 
property, and the liability is identified on the controlled foreign 
corporation's records as a liability treated as dealer property before 
the close of the day on which the liability is incurred.
    (ii) Failure to identify certain liabilities. If a controlled 
foreign corporation identifies certain interest-bearing liabilities as 
liabilities treated as dealer property under the previous paragraph but 
fails to so identify other interest-bearing liabilities that manage its 
currency risk with respect to assets held that constitute dealer 
property, the Commissioner may treat such other liabilities as dealer 
property if the Commissioner determines that the failure to identify 
such other liabilities had as one of its principal purposes the 
avoidance of federal income tax.
    (iii) Effective date. This paragraph (g)(2)(ii)(C)(2) applies only 
to gain or loss from an interest-bearing liability entered into by a 
controlled foreign corporation on or after the date Sec. 1.954-
2(g)(2)(ii)(C)(2) is published as a final regulation in the Federal 
Register.
* * * * *
    (iii) Special rule for foreign currency gain or loss from an 
interest-bearing liability. Except as provided in paragraph 
(g)(2)(ii)(C)(2) or (g)(5)(iv) of this section, foreign currency gain 
or loss arising from an interest-bearing liability is characterized as 
subpart F income and non-subpart F income in the same manner that 
interest expense associated with the liability would be allocated and 
apportioned between subpart F income and non-subpart F income under 
''1.861-9T and 1.861-12T.
* * * * *

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.
[FR Doc. 02-11891 Filed 5-10-02; 8:45 am]
BILLING CODE 4830-01-P