Hedging Transactions

DEPARTMENT OF THE TREASURY 
Internal Revenue Service 26 CFR Part 1 [REG-107047-00] RIN 1545-AY02

TITLE: Hedging Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

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

SUMMARY: This document contains proposed regulations relating to the
character of hedging transactions. These proposed regulations
reflect changes to the law made by the Ticket to Work and Work
Incentives Improvement Act of 1999. The proposed regulations affect
businesses entering into hedging transactions. This document also
provides notice of a public hearing on these proposed regulations.

DATES: Written or electronically generated comments must be received
by April 25, 2001. Requests to speak (with outlines of oral comments
to be discussed) at the public hearing scheduled for May 16, 2001,
at 10 a.m., must be submitted by April 25, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG-107047-00), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG-107047-00), Courier's
Desk, Internal Revenue Service, 1111 Constitution Avenue NW.,
Washington, DC. Alternatively, taxpayers may submit comments
electronically via the Internet by selecting the "Tax Regs" option
on the IRS Home Page, or by submitting comments directly to the IRS
internet site. At The public hearing will be held in the IRS
auditorium, 1111 Constitution Ave., NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jo Lynn
Ricks, (202) 622-3920; concerning submissions of comments, the
hearing, and/or to be placed on the building access list to attend
the hearing, contact Lanita Vandyke, (202) 622-7180 (not toll-free
numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed
rulemaking has 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 numbers 1545-1403 and
1545-1480.

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.

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 proposed 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 most business hedges. The regulations
generally apply to hedges that reduce risk with respect to ordinary
property, ordinary obligations, and borrowings of the taxpayer and
that meet certain identification requirements. (§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. The
final regulations published in 1994 and 1996 are collectively
referred to as the Treasury regulations in this preamble.

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 generally to include 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. §1221(b)(2)(A)(i)
and (ii). The statutory 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 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.

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. The legislative history to the hedging provisions states that
Congress intended that the approach taken in the Treasury
regulations with respect to the character of hedging transactions
generally should be codified as an appropriate interpretation of
present law. S. Rep. No. 201, 106 Cong., 1 Sess. 24 (1999). These
proposed regulations conform the Treasury regulations to th st these
statutory provisions.

Explanation of Provisions

Paragraph (a) of the proposed regulations provides basic rules for
the treatment of hedging transactions. The substance of these rules
is the same as the rules under §1.1221-2(a). Accordingly,
paragraph (a)(1) of the proposed regulations generally provides that
property that is part of a hedging transaction, as defined in
section 1221(b) (2)(A) and paragraph (b) of the proposed
regulations, is not a capital asset. Paragraph (a)(2) of the
proposed regulations 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. 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. As under
the.reasury regulations, Congress intended that the hedging rules be
the exclusive means through which the gains and losses on hedging
transactions are treated as ordinary. S. Rep. No. 201, Cong., 1st
Sess. 25 (1999).

The provisions of the proposed regulations 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) of the proposed regulations, however, provides that
section 988 transactions are excluded from these regulations because
gain or loss on those transactions is ordinary under section 988(a)
(1). Paragraph (a)(4) of the proposed regulations also provides that
the definition of a hedging transaction under §1.1221-2(b) of
the proposed regulations 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).

Regulations under §1.482-8 will address risk management
activities in the context of a global dealing operation. Thus,
except to the extent provided in §§1.475(g)-2, 1.482-8,
and 1.863-3(h), these regulations do not apply in determining the
allocation and source of income for a participant in a global
dealing operation or whether a risk management function related to
the activities of a regular dealer in securities has been conducted.

Proposed regulations under §§1.882-5 and 1.884-1 also
refer to hedging under §1.1221-2 for purposes of determining
assets and liabilities of a foreign corporation for interest
allocation and branch tax purposes. The IRS and Treasury are
evaluating the appropriate requirements necessary to implement
cross-border and worldwide hedging rules for these purposes and seek
comments in this regard. Therefore, paragraph (a)(4) of the proposed
regulations provides that the definition of hedging transaction in
paragraph (b) of the proposed regulations is inapplicable in
determining the hedging requirements under sections 882(c) and 884,
except to the extent provided in regulations under those sections.

Paragraph (b) of the proposed regulations restates the definition of
hedging transaction in section 1221(b)(2)(A). Under this rule, a
hedging transaction is generally a transaction that a taxpayer
enters into in the normal course of its business primarily to manage
the risk of interest rate or price changes or currency fluctuations
with respect to ordinary property, ordinary obligations, or
borrowings of the taxpayer.

Paragraph (c) of the proposed regulations provides rules of
application designed to ensure that the definition of hedging
transaction is applied reasonably to include most common types of
business hedges. Congress intended that the approach taken in the
Treasury regulations with respect to the character of hedging
transactions generally should be codified as an appropriate
interpretation of present law. S. Rep. No. 201, 106 Cong., 1 Sess.
24 (1999). The Senate th st Finance Committee believed that the
Treasury regulations interpret risk reduction flexibly to provide
hedging transaction treatment for fixed to floating hedges, certain
written call options, dynamic hedges, partial hedges, recycled
hedges, and hedges of aggregate risk (see §1.1221-2(c)). Id. at
n.12. The Committee believed that (depending on the facts) the
treatment of those transactions as hedging transactions is
appropriate and that it is also appropriate to modernize the
definition of hedging transaction by providing risk management as
the standard. Id. These proposed regulations revise the Treasury
regulations to reflect the risk management standard. Paragraph (c)
(1) of the proposed regulations deals with the meaning of risk
management. It provides that, except as otherwise provided in
paragraph (c), a transaction satisfies the risk management standard
if it reduces risk. 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 But a hedge of a
single asset or liability, or pool of assets or liabilities, will be
respected as managing risk 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) of the proposed regulations also recognizes that
fixed to floating hedges and certain types of written options may
manage risk and may be hedging transactions in appropriate
situations. For example, a covered call with respect to assets held
or a written put option with respect to assets to be acquired may be
a hedging transaction. In addition, paragraph (c)(1) of the proposed
regulations provides that a hedging transaction includes a
transaction that reverses or counteracts a hedging transaction. This
rule recognizes that some transactions are used to eliminate some or
all of the risk reduction accomplished through another 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) of the proposed regulations
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
proposed regulations also provide that the fact that a taxpayer
frequently enters into and terminates hedging positions is not
relevant to whether transactions are hedging transactions.

Except as otherwise provided in paragraph (c) of the proposed
regulations, 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 output and enters into a long futures contract with
respect to the same product, is not a hedging transaction. In this
example, the long futures contact could be viewed as a surrogate for
the storage of the commodity. The net proceeds from the sale of the
production output and the gain or loss on the long futures contract
simulates the price at which the production output would have sold
if it had been physically stored and sold at a later time. However,
because the production output to which the futures contract relates
has been sold, there is no underlying position (with respect to
ordinary property held or to be held) that exposes the taxpayer to
price risk. Thus, the long position does not reduce risk. Moreover,
gain or loss on the contract is not treated as ordinary on the
grounds that it is a surrogate for inventory.

Paragraph (c)(2) of the proposed regulations 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) of the proposed regulations provides that the
acquisition of certain assets, such as investments, may not be a
hedging transaction. Even though acquisition of these assets may
involve some risk reduction, they typically are not acquired
primarily to manage 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
proposed regulations provide that 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 manage risk. The IRS and
Treasury request comments on the circumstances in which the
acquisition of debt instruments or borrowings are made primarily to
manage 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) of the proposed regulations provides 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. The special
rule in the Treasury regulations for noninventory supplies
(§1.1221-2(c)(5)(ii)), however, is not contained in these
proposed regulations. Under the noninventory supply 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, that
noninventory supply is treated as ordinary property. This rule is
not being proposed because section 1221(a)(8) generally provides
ordinary gain or loss treatment for consumable supplies held or
acquired on or after December 17, 1999.

Paragraph (c)(6) of the proposed regulations 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 so long as the transaction is entered into in furtherance
of the taxpayer's trade or business. The Service 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) of the proposed regulations provides 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, or 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 with
respect to ordinary property, ordinary obligations, or borrowings.
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.

Paragraph (c)(8) of the proposed regulations provides that a hedging
transaction does not include a transaction entered into to manage
risks other than interest rate or price changes, or currency
fluctuations, unless a regulation, revenue ruling, or revenue
procedure provides otherwise. Thus, until such guidance is
published, a hedge of volume or revenue fluctuations is not a
hedging transaction. One example of this type of hedge is a weather
derivative used by an energy producer to hedge against the decrease
in volume of sales from variations in weather patterns.

The IRS is considering whether to expand the definition of hedging
transaction 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. The Service solicits comments on the types of risks
that should be covered, including specific examples of derivative
transactions that may be incorporated into future guidance.

The status of so-called "gap" hedges is not separately addressed in
paragraph (c) of the proposed regulations. 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 assets. Whether a gap. 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 rules in paragraphs (d), (e) and (f) of the proposed
regulations, covering consolidated group hedging, identification and
recordkeeping rules, and the effect of identification and non-
identification, respectively, are generally unchanged from the
corresponding rules in the Treasury regulations. This is because
Congress generally intended to codify the approach to hedging
transactions that was taken in the Treasury regulations. S. Rep. No.
201, 106th Cong., 1st Sess. 24 (1999).

Paragraph (d) of the proposed regulations provides rules applicable
to hedging by members of a consolidated group. The proposed
regulations retain the single-entity approach of the Treasury
regulations. That is, they treat the risk of one member of the group
as the risk of the other members, as if all the members were
divisions of a single corporation. Thus, a member of a consolidated
group that hedges the risk of another member by entering into a
transaction with a third party may receive ordinary gain or loss
treatment on that transaction if the transaction otherwise qualifies
as a hedging transaction.

Under this single-entity approach, intercompany transactions are
neither hedging transactions nor hedged items. Because they are
treated as transactions between divisions of a single corporation,
intercompany transactions do not manage the risk of that single
corporation and, therefore, fail to qualify as hedging transactions.
The proposed regulations also retain the separate-entity election of
the Treasury regulations, permitting a consolidated group to treat
its members as separate entities when applying the hedging rules.
The election is made by attaching a statement to the group's federal
income tax return.

For a group that elects separate-entity treatment, an intercompany
transaction is treated as a hedging transaction if and only if: (1)
it would qualify as a hedging transaction if entered into with an
unrelated party; and (2) it is entered into with a member that,
under its method of accounting, marks its position in the
intercompany transaction to market. If these requirements are
satisfied, the member with respect to which it is an intercompany
hedging transaction must account for its position in the transaction
under §1.446-4, and, if that member properly identifies the
transaction as a hedging transaction, each member treats the gain or
loss from its position in the transaction as ordinary.

The proposed regulations provide that, even when these two
requirements are met, these regulations supplant only the character
and timing rules of §1.1502-13. Other aspects of the
transaction, such as the source of the gain or loss, are unaffected
by these regulations and thus may be governed by other portions of
§1.1502-13.

Pursuant to section 1221(a)(7), paragraph (e)(1) of the proposed
regulations provides that hedging transactions must be identified
before the close of the day on which they are entered into.

Paragraph (e)(2) of the proposed regulations 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.

Paragraph (e)(3) of the proposed regulations contains a series of
special rules for identifying certain types of hedging transactions.
In the case of inventory, the identification must 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 date and the amount 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 there is a system for
identifying transactions as 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) of the proposed regulations provides rules 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) of the proposed regulations deals with the required
identification where the taxpayer is a member of a consolidated
group, and paragraph (e)(6) of the proposed regulations provides
that an identification for purposes of section 1256(e)(2) is also an
identification for purposes of §1.1221-2(e)(1). Pursuant to
section 1221(b)(2)(B), paragraph (f) of the proposed regulations
deals with the effect of identification and non-identification. The
rules in this paragraph are the same as the rules in paragraph (f)
of the Treasury regulations. The proposed regulations under section
1256 generally restate the rules of §1.1256(e)-1 that
coordinate the identification of hedges for purposes of section
1256(e). The citations tosection 1256(e)(2)(C) in the Treasury
regulations have been replaced with citations to section 1256(e)(2)
in the proposed regulations.

Proposed Effective Date

The proposed regulations are proposed to be effective for
transactions entered into on or after January 18, 2001. However, the
IRS will not challenge any transaction entered into on or after
December 17, 1999, and before January 18, 2001 that satisfies the
provisions of these proposed regulations.

Special Analyses

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 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 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 electronic or written comments (a
signed original and eight (8) copies of written comments) that are
submitted timely (in the manner described in "ADDRESSES") to the
IRS. The IRS and Treasury request comments on the clarity of the
proposed rules and how they may be made easier to understand. All
comments will be available for public inspection and copying. A
public hearing has been scheduled for May 16, 2001, beginning at 10
a.m., in the IRS auditorium, Internal Revenue Building, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the 10 Street entrance, located
between th Constitution and Pennsylvania Avenues, NW. 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 15 minutes
before the hearing starts. For information about having your name
placed on the building access list to attend the hearing, see "FOR
FURTHER INFORMATION CONTACT."

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 written
comments and an outline of topics to be discussed and the time to be
devoted to each topic (signed original and eight (8) copies) by
April 25, 2001. A period of 10 minutes will be allotted to each
person 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 author of these regulations is Jo Lynn Ricks, 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.

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 is amended by
revising the entry for 1.1221- 2 to read as follows:

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

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

Par. 2. Section 1.1221-2 is revised to read as follows:

§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 (f)(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 (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 any
qualified fund as defined in section 988(c)(1)(E)(iii).

(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 sections 864(e) and 954(c).

(iii) Global dealing operation. Except as otherwise provided in
§§1.475(g)-2, 1.482-8, and 1.863-3(h), the rules of
application for purposes of the definition of a hedging transaction
in paragraph (c) of this section do not apply in determining the
allocation and source of income with respect to a participant in a
global dealing operation or in determining whether a risk management
function related to the activities of a regular dealer in securities
has been conducted. See §1.482- 8(a) for the definitions of
global dealing operation, regular dealer in securities, and
participant.

(iv) Sections 882(c) and 884. Except as otherwise provided in
regulations issued under sections 882(c) and 884, the definition of
hedging transaction in paragraph (b) of this section does not apply
for purposes of those sections.

(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)(5) 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 (c)(8) of this section).

(c) Rules of application. The rules of this paragraph (c) apply for
purposes of the definition of the term hedging transaction in
section 1221(b)(2)(A) and 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 section 1221(b)(2)(A) and this
section.

(1) Managing risk--

(i) Transactions that manage risk. 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. 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 were entered into
primarily to manage 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 managing 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 rate or price to a floating
rate or price may manage 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 manage 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 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.

(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 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 associatedwith 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 manage risk. A transaction that is
not entered into to reduce a taxpayer's risk does not manage risk.
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, and is not otherwise
treated as a hedging transaction in this paragraph (c), 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 as a hedge of another asset or liability
(recycling).

(3) No investments as hedging transactions. If an asset (such as an
investment) is not acquired primarily to manage 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 manage 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 managed relates to the expansion of an
existing business or the acquisition of a new trade or business.

(5) 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 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.

(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 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.

(8) Hedges of other risks. Except as otherwise determined in a
regulation, revenue ruling, or revenue procedure, a hedging
transaction does not include a transaction entered into to manage
risks other than interest rate or price changes, or currency
fluctuations.

(d) 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 treatedas
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 (d)(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 (d)(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 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 (d)(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 (d)(2)(ii)(A) and (B) of this
section) is subject to the following rules--

(A) The character and timing rules of §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 (f)(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 (d)
(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(d)(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. The following examples illustrate this paragraph (d):

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.

Example 1. Single-entity treatment--

(i) General rule. Under paragraph (d)(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 §1.446-4. The intercompany transaction B-C is not a
hedging transaction and is taken into account under §1.1502-13.

(ii) Identification. D must be identified as a hedging transaction
under paragraph (e)(1) of this section, and A must be identified as
the hedged item under paragraph (e)(2) of this section. Under
paragraph (e)(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 (d)
(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.

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
§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 §1.1502- 13. D is a hedging transaction with respect to C
if it meets the requirements of paragraph (b) of this section.

(e) 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, thetransaction 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 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)(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 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.

(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 of identification must be unambiguous. The presence 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) 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 (e) 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 (e)(1)
of this section. Under paragraph (e)(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 (e)(2) of this section may be met by
identifying the intercompany transactions, and the risks hedged by
the intercompany transactions, as 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
byparagraph (e)(2) of this section. For example, if a member
transfers risk in an intercompany transaction, it may identify under
the rules of this paragraph (e) 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 (e) both its position with the third party
and its position in the intercompany transaction. Paragraph (d)(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 (d)(2) of this section, each member of the group
must satisfy the requirements of this paragraph (e) 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 (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) 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 (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 (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 (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. 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 (d)(1) of this section (the single-entity
approach), the rules of this paragraph (f) apply only to
transactions that are not intercompany transactions.

(ii) Separate-entity election. If a consolidated group has made the
election under paragraph (d)(2) of this section, then, in addition
to the rules of paragraphs (f) (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 (d)(2)
(ii)(A) and (B) of this section, then, notwithstanding any contrary
provision in §1.1502-13, each party to the transaction is
subject to the rules of paragraph (f)(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 (d)(2)(ii)
(A) and (B) of this section but the transaction is not identified as
a hedging transaction, each party to the transactionis subject to
the rules of paragraph (f)(2) of this section. (Because the
transaction is an intercompany hedging transaction, the character
and timing rules of §1.1502-13 do not apply. See paragraph (d)
(2) (iii)(A) of this section.) (g) Effective date. The rules of this
section apply to transactions entered into on or after January 18,
2001.

Par. 2. Section 1.1256(e)-1 is revised to read as follows:

§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 §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 §1.1221-2(e)(1) is nevertheless treated as
an identification under section 1256(e)(2).

(c) Consistency with §1.1221-2. Any identification for purposes
of §1.1221-2(e)(1) is also an identification for purposes of
this section. If a taxpayer satisfies the requirements of
§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. This section applies to transactions entered
into on or after January 18, 2001.

Deputy Commissioner of Internal Revenue

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