Hedging Transactions

DEPARTMENT OF THE TREASURY

26 CFR Parts 1 and 602

[TD 8555]

RIN 1545-AR73

Hedging Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations clarifying the

character of gain or loss from business hedges. In general, the

regulations treat gain or loss on most hedging transactions as ordinary

rather than capital. The regulations are needed to provide guidance to

businesses entering into hedging transactions and to serve as a basis

for resolving pending cases involving gains and losses from hedging.

DATES: These regulations are effective July 18, 1994, except that the

amendments relating to the removal of Sec. 1.1221-2T are effective

October 1, 1994.

For dates of applicability of these regulations, see the discussion

in the Dates of Applicability paragraph in the Supplementary

Information portion of the preamble.

FOR FURTHER INFORMATION CONTACT: Jo Lynn Ricks of the Office of the

Assistant Chief Counsel (Financial Institutions and Products), Internal

Revenue Service, 1111 Constitution Avenue, NW, Washington DC 20224

(Attn: CC:DOM:FI&P). Telephone 202-622-3920 (not a toll-free call).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in these final regulations

has been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h))

under control number 1545-1403. The estimated annual burden per

recordkeeper varies from .1 to 10 hours, depending on individual

circumstances, with an estimated average of .9 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, PC:FP,

Washington, DC 20224, and to the Office of Management and Budget, Attn:

Desk Officer for the Department of the Treasury, Office of Information

and Regulatory Affairs, Washington, DC 20503.

Background

This document contains final regulations amending the Income Tax

Regulations (26 CFR part 1) under section 1221 of the Internal Revenue

Code (Code) (relating to the definition of capital asset). The

provisions affected relate to the determination of the character of

gain or loss from hedging transactions.

On October 20, 1993, temporary regulations (TD 8493) providing that

gain or loss on most common business hedges is ordinary rather than

capital were published in the Federal Register (58 FR 54037). A notice

of proposed rulemaking (FI-46-93) cross-referencing the temporary

regulations was published in the Federal Register for the same day (58

FR 54075). The regulations were intended to resolve questions that had

arisen with respect to the tax treatment of business hedging following

the decision of the United States Supreme Court in Arkansas Best Corp.

v. Commissioner, 485 U.S. 212 (1988).

Many comments were received on the proposed regulations, and a

public hearing was held on January 19, 1994. Most commentators

supported the general approach of the proposed regulations, but a

number suggested specific revisions to the proposed rules or the

addition of rules to resolve remaining issues.

Explanation of Provisions

Paragraph (a) of Sec. 1.1221-2 provides basic rules for the

treatment of hedging transactions. Only minor, clarifying changes have

been made to the proposed regulations.

Paragraph (a)(1) provides that property that is part of a hedging

transaction, as defined in the regulations, is not a capital asset.

Paragraph (a)(2) provides a similar rule for short sales and options.

Where a short sale or option is part of a hedging transaction, as

defined, any gain or loss on the short sale or option is ordinary.

Final regulations under sections 1233 and 1234 provide that

Sec. 1.1221-2 governs the character of gain or loss on short sales and

options that are part of hedging transactions.

Under paragraph (a)(3), if a transaction falls outside the

regulations, gain or loss from the transaction is not made ordinary by

the fact that property is a surrogate for a non-capital asset, that the

transaction serves as insurance against a business risk, that the

transaction serves a hedging function, or that the transaction serves a

similar function or purpose.

The provisions of this section generally apply to determine the

character of gain or loss from transactions that also are subject to

various international provisions of the Code. Paragraph (a)(4),

however, provides that section 988 transactions are excluded from the

character provisions of these regulations because gain or loss on those

transactions is ordinary under section 988(a)(1). The regulations do

apply to transactions that predate the effective date of section 988.

Paragraph (a)(4) also provides that the definition of a hedging

transaction under Sec. 1.1221-2(b) does not apply for purposes of the

hedging exceptions to the subpart F rules of section 954(c) and certain

hedging rules in the interest allocation regulations under section

864(e). The IRS and Treasury are considering the possibility of using

the definition of hedging transaction and other provisions of these

regulations for purposes of various international tax provisions,

except where a modification of the provisions is necessary to carry out

the purposes of those international provisions. Comments on this

subject are welcomed.

In defining the term hedging transaction, paragraph (b) of

Sec. 1.1221-2 retains the rule of the proposed regulations and adopts

the concept of hedging in section 1256(e)(2)(A) of the Code. Under this

rule, a hedging transaction generally is a transaction that a taxpayer

enters into in the normal course of its business primarily to reduce

the risk of interest rate or price changes or currency fluctuations.

A number of commentators suggested that the IRS abandon the rule of

the proposed regulations and adopt a definition of hedging that looks

to risk management rather than risk reduction. This comment was not

adopted because the IRS and Treasury believe that the definition in

section 1256 represents the best indication of congressional intent

with respect to business hedges. Although the risk reduction standard

has been retained, the final regulations provide rules of application

designed to ensure that the definition of hedging transaction is

applied reasonably to include most common types of hedging

transactions.

Paragraph (c)(1) deals with the meaning of risk reduction. To enter

into a hedging transaction, the taxpayer must have risk when all of its

operations are considered--that is, there must be risk on a ``macro''

basis. Nonetheless, a hedge of a single asset or liability, or pool of

assets or liabilities, will be respected if the hedge reduces the risk

attributable to the item or items being hedged and if the hedge is

reasonably calculated to reduce the overall risk of the taxpayer's

operations. In addition, if a taxpayer hedges a particular asset or

liability, or a pool of assets or liabilities, and the hedge is

undertaken as part of a program to reduce the overall risk of the

taxpayer's operations, the taxpayer need not show that the hedge

reduces its overall risk.

Paragraph (c)(1) also recognizes that fixed to floating hedges and

certain types of written options may be risk reducing and may be used

in hedging transactions. For example, a covered call with respect to

assets held or a written put option with respect to assets to be

acquired may reduce risk.

In addition, paragraph (c)(1) provides that a hedging transaction

includes a transaction that is entered into primarily to reverse or

counteract a hedging transaction. This rule recognizes that some

transactions are used to eliminate some or all of the risk reduction

accomplished through a hedging transaction. Although the transactions

are not risk reducing if viewed independently, they are considered to

be part of the larger hedging transaction.

Paragraph (c)(1) further provides that a taxpayer may hedge any

part or all of its risk for any part of the period during which it has

risk. The regulations also provide that the frequent entering into and

termination of hedging positions is not relevant to whether

transactions are hedging transactions.

Finally, paragraph (c)(1) provides that a transaction that is not

entered into primarily to reduce risk is not a hedging transaction. For

example, the so-called ``store-on-the-board'' transaction, in which a

taxpayer disposes of its production and enters into a long futures or

forward contract, is not a hedging transaction because the long

position does not reduce risk. Moreover, gain or loss on the contract

is not made ordinary on the grounds that it is a surrogate for

inventory.

The IRS and Treasury understand that there are situations in which

a taxpayer engages in a store-on-the-board transaction as a hedge of an

expected payment under an agricultural price support program. In this

situation, a long futures or forward contract may qualify as a hedging

transaction with respect to the expected payment.

Paragraph (c)(2) provides that a hedging transaction may be entered

into by using a position that was a hedge of one asset or liability to

hedge another asset or liability.

Paragraph (c)(3) provides that the acquisition of certain assets,

such as investments, may not be a hedging transaction. Even though

these assets may reduce risk, they typically are not acquired primarily

to reduce risk. For example, a taxpayer's interest rate risk from a

floating rate borrowing may be reduced by the purchase of debt

instruments that bear a comparable floating rate. The acquisition of

the debt instruments, however, is not made primarily to reduce risk

and, therefore, is not a hedging transaction. Similarly, borrowings

generally are not made primarily to reduce risk.

Paragraph (c)(4) defines the normal course requirement of paragraph

(b) to include any transaction entered into in furtherance of a

taxpayer's trade or business. Thus, for example, a liability hedge

meets this requirement regardless of whether the liability is

undertaken to fund current operations, an acquisition, or an expansion

of a taxpayer's business. This definition does not apply to other uses

of the term ``normal course'' in the Code or regulations.

Paragraph (c)(5) retains the rule in the proposed regulations that

a hedge of property or of an obligation is a hedging transaction only

if a sale or exchange of the property, or performance or termination of

the obligation, could not produce capital gain or loss. In response to

the many comments received, however, a special rule has been added for

noninventory supplies. Under this rule, if a taxpayer sells only a

negligible amount of a noninventory supply, then, only for purposes of

determining whether a hedge of the purchase of that noninventory supply

is a hedging transaction, the noninventory supply is treated as

ordinary property. In this case, the Service and Treasury believe that

the theoretical possibility of ordinary loss on a hedge and capital

gain on the sale of supplies should not prevent the transactions from

qualifying as hedging transactions. The Service intends to issue

guidance on the negligible amount standard. The comments received

indicate that most taxpayers sell none of their supplies or a very

small amount. Further comments are requested.

For prior years, a transition rule provides a substantially more

generous standard for noninventory supplies. If, in each prior year

that is open for assessment on September 1, 1994, a taxpayer sold no

more than 15 percent of the greater of the total amount of a supply

held at the beginning of the year or the total amount of the supply

acquired in that year and meets certain other requirements, hedges of

purchases of that supply are hedging transactions.

The final regulations do not provide a negligible sales rule for

hedges of section 1231 assets. Sales of these assets are less

predictable than sales of supplies and may occur many years after the

transaction that hedges their purchase. The IRS and Treasury believe

that it is inappropriate to provide ordinary treatment for the hedges

when it is not known whether the assets will produce capital gains.

Nonetheless, the regulations provide a special transition rule

applicable to certain hedges of section 1231 assets entered into in

prior years.

Paragraph (c)(6) provides that the status of liability hedges as

hedging transactions is determined without regard to the use that is

made of the proceeds of a borrowing. The IRS and Treasury believe that

a liability hedge should not fail to qualify as a hedging transaction

because the proceeds of the borrowing being hedged are used to purchase

a capital asset.

Paragraph (c)(7) retains the rule in the proposed regulations that,

in the case of hedges of aggregate risk, all but a de minimis amount of

the risk being hedged must be attributable to ordinary property,

ordinary obligations, and borrowings.

Although the purpose of the rules in paragraph (c) is to ensure

that the definition of hedging transaction will be interpreted

reasonably to cover most common business hedges, not all hedges are

intended to be covered. For example, the regulations do not apply where

a taxpayer hedges a dividend stream, the overall profitability of a

business unit, or other business risks that do not relate directly to

interest rate or price changes or currency fluctuations. Moreover, the

regulations do not provide ordinary treatment for gain or loss from the

disposition of stock where, for example, the stock is acquired to

protect the goodwill or business reputation of the acquirer or to

ensure the availability of goods.

The status of so-called ``gap'' hedges is not separately addressed

in paragraph (c). Insurance companies, for example, sometimes hedge the

``gap'' between their liabilities and the assets that fund them. Under

the proposed regulations, a hedge of those assets does not qualify as a

hedging transaction if the assets are capital. Commentators, therefore,

suggested that the final regulations provide a rule that deems all gap

hedges to be hedges of the liabilities rather than of the assets. The

IRS and Treasury, however, are concerned that, where this type of hedge

is more closely associated with the assets than the liabilities, there

is a significant possibility of mismatch if the hedges are given

ordinary treatment and the assets can be sold for capital gains. Thus,

the final regulations do not include the suggested rule.

Whether a gap hedge qualifies as a liability hedge is a question of

fact and depends on whether it is more closely associated with the

liabilities than with the assets. For example, a contract to purchase

assets is generally not a liability hedge even if the assets are being

purchased to fund the liability. Other gap hedges may be appropriately

treated as liability hedges and, therefore, may qualify as hedging

transactions.

The IRS and Treasury understand that the most significant

consequence of the failure of gap hedges to qualify as hedging

transactions may be that they are then subject to the straddle rules of

section 1092. Comments are requested on whether it would be appropriate

to exempt these transactions from section 1092 and apply the hedge

accounting rules of Sec. 1.446-4 even though the transactions are not

hedging transactions and their character is not determined under

Sec. 1.1221-2. The IRS and Treasury also note that there may be

different considerations for determining whether income or loss from a

gap hedge should be treated as an interest equivalent for purposes of

international tax provisions, such as section 864(e). Comments are also

requested on this point.

Paragraph (d) is reserved in the final regulations to allow

development of rules applicable to hedging by members of a consolidated

group. Proposed regulations on this subject are published in the

Proposed Rules section of this issue of the Federal Register.

Paragraph (e)(1) retains the requirement of the proposed

regulations that hedging transactions must be identified before the

close of the day on which they are entered into. Paragraph (e)(2),

however, relaxes the rule of the proposed regulations and requires that

the item, items, or aggregate risk being hedged be identified

substantially contemporaneously with entering into the hedging

transaction. The identification must be made no more than 35 days after

entering into the hedging transaction. This time period should make it

possible for taxpayers to identify the hedged item, items, or aggregate

risk at the time they prepare monthly reports for nontax purposes.

Some commentators suggested eliminating entirely the requirement of

identifying the item being hedged. The Service and Treasury believe,

however, that this identification is needed to establish that the

definition of hedging transaction is satisfied. Moreover, because

special identification rules have been provided for hedges of aggregate

risk and certain inventory hedges, the requirement of identifying the

items being hedged should not be overly burdensome.

A transition rule is provided to extend the time period for

identifying a transaction that is a hedging transaction under the final

regulations and that the taxpayer reasonably treated as other than a

hedging transaction under the proposed regulations. If such a

transaction was entered into before October 1, 1994, and remains in

existence on that date, the identification and recordkeeping

requirements of paragraph (e) apply, except that the identification of

both the hedging transaction and the hedged item are timely if made

before the close of business on October 1, 1994. However, if the

transaction was entered into before October 1, 1994, and does not

remain in existence on that date, the identification and recordkeeping

requirements of paragraph (e) do not apply.

Paragraph (e)(3) contains a series of special rules for identifying

certain types of hedging transactions. In the case of inventory, the

identification must specify the type or class of inventory to which the

hedge relates. If particular inventory purchases or sales transactions

are being hedged, the taxpayer must also identify the expected dates

and the amounts to be acquired or sold. In the case of hedges of

aggregate risk, the identification requirement is satisfied if a

taxpayer's records contain a description of the hedging program and if

the taxpayer establishes a system under which transactions are

identified as being entered into as part of that program. The intent

underlying this rule is to provide verifiable information with respect

to the item being hedged without requiring the taxpayer to identify

individually the many items that give rise to the aggregate risk being

hedged.

Paragraph (e)(4) generally retains and expands the rules of the

proposed regulations with respect to how an identification is made. It

must be clear that the identification is being made for tax purposes.

In lieu of separately identifying each transaction, however, a taxpayer

may establish a system in which identification is indicated by the type

of transaction or the manner in which the transaction is consummated or

recorded.

Paragraph (e)(5) is reserved to deal with the required

identification where the taxpayer is a member of a consolidated group,

and paragraph (e)(6) provides that an identification for purposes of

section 1256(e)(2)(C) is also an identification for purposes of

Sec. 1.1221-2(e)(1).

Paragraph (f) deals with the effect of identification and non-

identification and provides rules that generally are unchanged from the

proposed regulations. The only significant change is the addition of a

rule that allows correction of an inadvertent identification in some

circumstances. If the correction is allowed, the transaction is not

subject to the ordinary-gain, capital-loss rule that generally applies

to transactions that are incorrectly identified as hedging

transactions.

Final regulations under section 1256 retain the rules of the

proposed regulations that coordinate the identification of hedges for

purposes of section 1256(e). In addition, the regulations provide that,

if a taxpayer inadvertently identifies a transaction as a hedging

transaction and corrects it in accordance with paragraph (f)(1)(ii) of

Sec. 1.1221-2, the transaction is treated as if it were not identified

as a hedging transaction for purposes of section 1256(e)(2)(C). Thus,

section 1256(f)(1) does not impose ordinary-gain, capital-loss

treatment on the transaction.

Dates of Applicability

Except for the identification rules of paragraph (e), which apply

to transactions that were entered into on or after January 1, 1994, or

were entered into before that date and remained in existence on March

31, 1994, these final regulations generally apply to all open taxable

years. Taxpayers may, however, rely on any paragraph in Sec. 1.1221-2T

(26 CFR part 1 revised as of April 1, 1994), for transactions entered

into prior to October 1, 1994, provided that the taxpayer applies the

paragraph reasonably and consistently.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

The principal author of these regulations is Jo Lynn Ricks, Office

of Assistant Chief Counsel (Financial Institutions and Products).

However, other personnel from the IRS and Treasury Department

participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. Effective July 18, 1884 the authority citation for

part 1 is amended by adding an entry in numerical order to read as

follows:

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

under 26 U.S.C. 6001. * * *

Par. 2. Effective October 1, 1994, the authority citation for part

1 is further amended by removing the entry for Sec. 1.1221-2T.

Par. 3. Effective July 18, 1994, Sec. 1.1221-2 is added to read as

follows:

Sec. 1.1221-2 Hedging transactions.

(a) Treatment of hedging transactions--(1) In general. This section

governs the treatment of hedging transactions under section 1221.

Except as provided in paragraph (f)(2) of this section (and

notwithstanding the provisions of Sec. 1.1221-1(a)), the term capital

asset does not include property that is part of a hedging transaction

(as defined in paragraph (b) of this section).

(2) Short sales and options. This section also governs the

character of gain or loss from a short sale or option that is part of a

hedging transaction. See Secs. 1.1233-2 and 1.1234-4. Except as

provided in paragraph (f)(2) of this section, gain or loss on a short

sale or option that is part of a hedging transaction (as defined in

paragraph (b) of this section) is ordinary income or loss.

(3) Exclusivity. If a transaction is not a hedging transaction as

defined in paragraph (b) of this section, gain or loss from the

transaction is not made ordinary on the grounds that property involved

in the transaction is a surrogate for a noncapital asset, that the

transaction serves as insurance against a business risk, that the

transaction serves a hedging function, or that the transaction serves a

similar function or purpose.

(4) Coordination with other sections--(i) Section 988. This section

does not apply to determine the character of gain or loss realized on a

section 988 transaction as defined in section 988(c)(1) or realized

with respect to a qualified fund as defined in section

988(c)(1)(E)(iii). This section does apply, however, to transactions or

payments that would be subject to section 988 but for the date that the

transactions were entered into or the date that the payments were made.

(ii) Sections 864(e) and 954(c). Except as otherwise provided in

regulations issued pursuant to sections 864(e) and 954(c), the

definition of hedging transaction in paragraph (b) of this section does

not apply for purposes of section 864(e) and 954(c).

(b) Hedging transaction defined. A hedging transaction is a

transaction that a taxpayer enters into in the normal course of the

taxpayer's trade or business primarily--

(1) To reduce risk of price changes or currency fluctuations with

respect to ordinary property (as defined in paragraph (c)(5) of this

section) that is held or to be held by the taxpayer; or

(2) To reduce risk of interest rate or price changes or currency

fluctuations with respect to borrowings made or to be made, or ordinary

obligations incurred or to be incurred, by the taxpayer.

(c) Rules of application. The rules of this paragraph (c) apply for

purposes of the definition of the term hedging transaction in paragraph

(b) of this section. These rules must be interpreted reasonably and

consistently with the purposes of this section. Where no specific rules

of application control, the definition of hedging transaction must be

interpreted reasonably and consistently with the purposes of this

section.

(1) Reducing risk--(i) Transactions that reduce risk. Whether a

transaction reduces a taxpayer's risk is determined based on all of the

facts and circumstances surrounding the taxpayer's business and the

transaction. In general, a taxpayer's hedging strategies and policies

as reflected in the taxpayer's minutes or other records are evidence of

whether particular transactions reduce the taxpayer's risk.

(ii) Micro and macro hedges--(A) In general. A taxpayer has risk of

a particular type only if it is at risk when all of its operations are

considered. Nonetheless, a hedge of a particular asset or liability

generally will be respected as reducing risk if it reduces the risk

attributable to the asset or liability and if it is reasonably expected

to reduce the overall risk of the taxpayer's operations. If a taxpayer

hedges particular assets or liabilities, or groups of assets or

liabilities, and the hedges are undertaken as part of a program that,

as a whole, is reasonably expected to reduce the overall risk of the

taxpayer's operations, the taxpayer generally does not have to

demonstrate that each hedge that was entered into pursuant to the

program reduces its overall risk.

(B) Fixed-to-floating hedges. Under the principles of paragraph

(c)(1)(ii)(A) of this section, a transaction that economically converts

an interest rate or price from a fixed price or rate to a floating

price or rate may reduce risk. For example, if a taxpayer's income

varies with interest rates, the taxpayer may be at risk if it has a

fixed rate liability. Similarly, a taxpayer with a fixed cost for its

inventory may be at risk if the price at which the inventory can be

sold varies with a particular factor. Thus, a transaction that converts

an interest rate or price from fixed to floating may be a hedging

transaction.

(iii) Written options. A written option may reduce risk. For

example, in appropriate circumstances, a written call option with

respect to assets held by a taxpayer or a written put option with

respect to assets to be acquired by a taxpayer may be a hedging

transaction. See also paragraph (c)(1)(v) of this section.

(iv) Extent of risk reduction. A taxpayer may hedge all or any

portion of its risk for all or any part of the period during which it

is exposed to the risk.

(v) Transactions that counteract hedging transactions. If a

transaction is entered into primarily to counteract all or any part of

the risk reduction effected by one or more hedging transactions, the

transaction is a hedging transaction. For example, if a written option

is used to reduce or eliminate the risk reduction obtained from another

position such as a purchased option, then it may be part of a hedging

transaction.

(vi) Number of transactions. The fact that a taxpayer frequently

enters into and terminates positions (even if done on a daily or more

frequent basis) is not relevant to whether these transactions are

hedging transactions. Thus, for example, a taxpayer hedging the risk

associated with an asset or liability may frequently establish and

terminate positions that hedge that risk, depending on the extent the

taxpayer wishes to be hedged. Similarly, if a taxpayer maintains its

level of risk exposure by entering into and terminating a large number

of transactions in a single day, its transactions may nonetheless

qualify as hedging transactions.

(vii) Transactions that do not reduce risk. A transaction that is

not entered into to reduce a taxpayer's risk is not a hedging

transaction. For example, assume that a taxpayer produces a commodity

for sale, sells the commodity, and enters into a long futures or

forward contract in that commodity in the hope that the price will

increase. Because the long position does not reduce risk, the

transaction is not a hedging transaction. Moreover, gain or loss on the

contract is not made ordinary on the grounds that it is a surrogate for

inventory. See paragraph (a)(3) of this section.

(2) Entering into a hedging transaction. A taxpayer may enter into

a hedging transaction by using a position that was a hedge of one asset

or liability to hedge another asset or liability (recycling).

(3) No investments as hedging transactions. If an asset (such as an

investment) is not acquired primarily to reduce risk, the purchase or

sale of that asset is not a hedging transaction even if the terms of

the asset limit or reduce the taxpayer's risk with respect to other

assets or liabilities. For example, a taxpayer's interest rate risk

from a floating rate borrowing may be reduced by the purchase of debt

instruments that bear a comparable floating rate. The acquisition of

the debt instruments, however, is not a hedging transaction because the

transaction is not entered into primarily to reduce the taxpayer's

risk. Similarly, borrowings generally are not made primarily to reduce

risk.

(4) Normal course. Solely for purposes of paragraph (b) of this

section, if a transaction is entered into in furtherance of a

taxpayer's trade or business, the transaction is entered into in the

normal course of the taxpayer's trade or business. This rule applies

even if the risk to be reduced relates to the expansion of an existing

business or the acquisition of a new trade or business.

(5) Ordinary property and obligations--(i) In general. Except as

provided in paragraph (g)(3) of this section (which contains transition

rules), property is ordinary property to a taxpayer only if a sale or

exchange of the property by the taxpayer could not produce capital gain

or loss regardless of the taxpayer's holding period when the sale or

exchange occurs. Thus, for example, property used in a trade or

business within the meaning of section 1231(b) (determined without

regard to the holding period specified in that section) is not ordinary

property. An obligation is an ordinary obligation if performance or

termination of the obligation by the taxpayer could not produce capital

gain or loss. For purposes of the preceding sentence, termination has

the same meaning as in section 1234A.

(ii) Hedges of noninventory supplies. Notwithstanding paragraph

(c)(5)(i) of this section, if a taxpayer sells only a negligible amount

of a noninventory supply, then, only for purposes of determining

whether a transaction to hedge the purchase of that noninventory supply

is a hedging transaction, the supply is treated as ordinary property. A

noninventory supply is a supply that a taxpayer purchases for

consumption in its trade or business and that is not an asset described

in sections 1221(1) through (5).

(6) Borrowings. Whether hedges of a taxpayer's debt issuances

(borrowings) are hedging transactions is determined without regard to

the use of the proceeds of the borrowing.

(7) Hedging an aggregate risk. The term hedging transaction

includes a transaction that reduces an aggregate risk of interest rate

changes, price changes, and/or currency fluctuations only if all of the

risk, or all but a de minimis amount of the risk, is with respect to

ordinary property, ordinary obligations, and borrowings.

(d) Hedging by members of a consolidated group. [Reserved].

(e) Identification and recordkeeping--(1) Same-day identification

of hedging transactions. A taxpayer that enters into a hedging

transaction (including recycling an existing hedge) must identify it as

a hedging transaction. This identification must be made before the

close of the day on which the taxpayer enters into the transaction.

(2) Substantially contemporaneous identification of hedged item--

(i) Content of the identification. A taxpayer that enters into a

hedging transaction must identify the item, items, or aggregate risk

being hedged. Identification of an item being hedged generally involves

identifying a transaction that creates risk, and the type of risk that

the transaction creates. For example, if a taxpayer is hedging the

price risk with respect to its June purchases of corn inventory, the

transaction being hedged is the June purchase of corn and the risk is

price movements in the market where the taxpayer buys its corn. For

additional rules concerning the content of this identification, see

paragraph (e)(3) of this section.

(ii) Timing of the identification. The identification required by

this paragraph (e)(2) must be made substantially contemporaneously with

entering into the hedging transaction. An identification is not

substantially contemporaneous if it is made more than 35 days after

entering into the hedging transaction.

(3) Identification requirements for certain hedging transactions.

In the case of the hedging transactions described in this paragraph

(e)(3), the identification under paragraph (e)(2) of this section must

include the information specified.

(i) Anticipatory asset hedges. If the hedging transaction relates

to the anticipated acquisition of assets by the taxpayer, the

identification must include the expected date or dates of acquisition

and the amounts expected to be acquired.

(ii) Inventory hedges. If the hedging transaction relates to the

purchase or sale of inventory by the taxpayer, the identification is

made by specifying the type or class of inventory to which the

transaction relates. If the hedging transaction relates to specific

purchases or sales, the identification must also include the expected

dates of the purchases or sales and the amounts to be purchased or

sold.

(iii) Hedges of debt of the taxpayer--(A) Existing debt. If the

hedging transaction relates to accruals or payments under an issue of

existing debt of the taxpayer, the identification must specify the

issue and, if the hedge is for less than the full adjusted issue price

or the full term of the debt, the amount and the term covered by the

hedge.

(B) Debt to be issued. If the hedging transaction relates to the

expected issuance of debt by the taxpayer or to accruals or payments

under debt that is expected to be issued by the taxpayer, the

identification must specify the following information: the expected

date of issuance of the debt; the expected maturity or maturities; the

total expected issue price of the issue; and the expected interest

provisions. If the hedge is for less than the entire expected issue

price of the debt or the full expected term of the debt, the

identification must also include the amount or the term being hedged.

The identification may indicate a range of dates, terms, and amounts,

rather than specific dates, terms, or amounts. For example, a taxpayer

might identify a transaction as hedging the yield on an anticipated

issuance of fixed rate debt during the second half of its fiscal year,

with the anticipated amount of the debt between $75 million and $125

million, and an anticipated term of approximately 20 to 30 years.

(iv) Hedges of aggregate risk--(A) Required identification. If a

transaction hedges aggregate risk as described in paragraph (c)(7) of

this section, the identification under paragraph (e)(2) of this section

must include a description of the risk being hedged and of the hedging

program under which the hedging transaction was entered. This

requirement may be met by placing in the taxpayer's records a

description of the hedging program and by establishing a system under

which individual transactions are identified as being entered into

pursuant to the program.

(B) Description of hedging program. A description of a hedging

program must include an identification of the type of risk being

hedged, a description of the type of items giving rise to the risk

being aggregated, and sufficient additional information to demonstrate

that the program is designed to reduce aggregate risk of the type

identified. If the program contains controls on speculation (for

example, position limits), the description of the hedging program must

also explain how the controls are established, communicated, and

implemented.

(4) Manner of identification and records to be retained--(i)

Inclusion of identification in tax records. The identification required

by this paragraph (e) must be made on, and retained as part of, the

taxpayer's books and records.

(ii) Presence or absence of identification must be unambiguous. The

presence or absence of an identification for purposes of this paragraph

(e) must be unambiguous. The identification of a hedging transaction

for financial accounting or regulatory purposes does not satisfy this

requirement unless the taxpayer's books and records indicate that the

identification is also being made for tax purposes. The taxpayer may

indicate that individual hedging transactions, or a class or classes of

hedging transactions, that are identified for financial accounting or

regulatory purposes are also being identified as hedging transactions

for purposes of this section.

(iii) Manner of identification. The taxpayer may separately and

explicitly make each identification, or, so long as paragraph

(e)(4)(ii) of this section is satisfied, the taxpayer may establish a

system pursuant to which the identification is indicated by the type of

transaction or by the manner in which the transaction is consummated or

recorded. An identification under this system is made at the later of

the time that the system is established or the time that the

transaction satisfies the terms of the system by being entered, or by

being consummated or recorded, in the designated fashion.

(iv) Examples. The following examples illustrate the principles of

paragraph (e)(4)(iii) of this section and assume that the other

requirements of paragraph (e) of this section are satisfied.

(A) A taxpayer can make an identification by designating a hedging

transaction for (or placing it in) an account that has been identified

as containing only hedges of a specified item (or of specified items or

specified aggregate risk).

(B) A taxpayer can make an identification by including and

retaining in its books and records a statement that designates all

future transactions in a specified derivative product as hedges of a

specified item, items, or aggregate risk.

(C) A taxpayer can make an identification by placing a designated

mark on a record of the transaction (for example, trading ticket,

purchase order, or trade confirmation) or by using a designated form or

a record that contains a designated legend.

(5) Identification of hedges involving members of the same

consolidated group. [Reserved].

(6) Consistency with section 1256(e)(2)(C). Any identification for

purposes of section 1256(e)(2)(C) is also an identification for

purposes of paragraph (e)(1) of this section.

(f) Effect of identification and non-identification--(1)

Transactions identified--(i) In general. If a taxpayer identifies a

transaction as a hedging transaction for purposes of paragraph (e)(1)

of this section, the identification is binding with respect to gain,

whether or not all of the requirements of paragraph (e) of this section

are satisfied. Thus, gain from that transaction is ordinary income. If

the transaction is not in fact a hedging transaction described in

paragraph (b) of this section, however, paragraphs (a)(1) and (a)(2) of

this section do not apply and the character of loss is determined

without reference to whether the transaction is a surrogate for a

noncapital asset, serves as insurance against a business risk, serves a

hedging function, or serves a similar function or purpose. Thus, the

taxpayer's identification of the transaction as a hedging transaction

does not itself make loss from the transaction ordinary.

(ii) Inadvertent identification. Notwithstanding paragraph

(f)(1)(i) of this section, if the taxpayer identifies a transaction as

a hedging transaction for purposes of paragraph (e) of this section,

the character of the gain is determined as if the transaction had not

been identified as a hedging transaction if--

(A) The transaction is not a hedging transaction (as defined in

paragraph (b) of this section);

(B) The identification of the transaction as a hedging transaction

was due to inadvertent error; and

(C) All of the taxpayer's transactions in all open years are being

treated on either original or, if necessary, amended returns in a

manner consistent with the principles of this section.

(2) Transactions not identified--(i) In general. Except as provided

in paragraphs (f)(2)(ii) and (iii) of this section, the absence of an

identification that satisfies the requirements of paragraph (e)(1) of

this section is binding and establishes that a transaction is not a

hedging transaction. Thus, subject to the exceptions, the rules of

paragraphs (a)(1) and (2) of this section do not apply, and the

character of gain or loss is determined without reference to whether

the transaction is a surrogate for a noncapital asset, serves as

insurance against a business risk, serves a hedging function, or serves

a similar function or purpose.

(ii) Inadvertent error. If a taxpayer does not make an

identification that satisfies the requirements of paragraph (e) of this

section, the taxpayer may treat gain or loss from the transaction as

ordinary income or loss under paragraph (a)(1) or (a)(2) of this

section if--

(A) The transaction is a hedging transaction (as defined in

paragraph (b) of this section);

(B) The failure to identify the transaction was due to inadvertent

error; and

(C) All of the taxpayer's hedging transactions in all open years

are being treated on either original or, if necessary, amended returns

as provided in paragraphs (a)(1) and (a)(2) of this section.

(iii) Anti-abuse rule. If a taxpayer does not make an

identification that satisfies all the requirements of paragraph (e) of

this section but the taxpayer has no reasonable grounds for treating

the transaction as other than a hedging transaction, then gain from the

transaction is ordinary. Thus, a taxpayer may not elect to treat gain

or loss from a hedging transaction as capital gain or loss. The

reasonableness of the taxpayer's failure to identify a transaction is

determined by taking into consideration not only the requirements of

paragraph (b) of this section but also the taxpayer's treatment of the

transaction for financial accounting or other purposes and the

taxpayer's identification of similar transactions as hedging

transactions.

(3) Transactions by members of a consolidated group. [Reserved].

(g) Effective dates and transition rules--(1) Effective date for

identification requirements--(i) In general. Paragraph (e) of this

section applies to transactions that--

(A) Are entered into on or after January 1, 1994; or

(B) Are entered into before that date and remain in existence on

March 31, 1994.

(ii) Transition rule. In the case of a hedging transaction that is

entered into before January 1, 1994, and remains in existence on March

31, 1994, an identification is timely if it is made before the close of

business on March 31, 1994.

(iii) Special rules for hedging transactions not described in

Sec. 1.1221-2T(b). In the case of a transaction that is entered into

before October 1, 1994, that is a hedging transaction within the

meaning of paragraph (b) of this section (or is treated as a hedging

transaction under paragraph (g)(3) of this section), and that the

taxpayer reasonably treated as not being a hedging transaction within

the meaning of paragraph (b) of Sec. 1.1221-2T (26 CFR part 1 revised

as of April 1, 1994)--

(A) If the transaction does not remain in existence on October 1,

1994, paragraph (e) of this section does not apply; and

(B) If the transaction remains in existence on October 1, 1994,

paragraph (e) of this section applies, and an identification is timely

if it is made before the close of business on October 1, 1994.

(2) Reliance on Sec. 1.1221-2T--(i) General rule. A taxpayer may

rely on any paragraph in Sec. 1.1221-2T (26 CFR part 1 revised as of

April 1, 1994), for transactions entered into prior to October 1, 1994,

provided that the taxpayer applies the paragraph reasonably and

consistently.

(ii) Identification. In the case of a transaction entered into

before October 1, 1994, an identification is deemed to satisfy

paragraph (e) of this section if it satisfies Sec. 1.1221-2T(c) (26 CFR

part 1 revised as of April 1, 1994). For this purpose, identification

of the hedged item is timely if it is made within the period specified

in paragraph (e)(2)(ii) of this section.

(3) Transition rules for hedges of certain property--(i) Transition

rule for section 1231 assets. For all taxable years that ended prior to

July 18, 1994 and that, as of September 1, 1994, were still open for

assessment under section 6501, a taxpayer may treat as hedging

transactions all transactions that were entered into during those years

and that hedge property used in the trade or business within the

meaning of section 1231(b) (a section 1231 asset) if the taxpayer can

establish that, during those years--

(A) Sales of section 1231 assets did not give rise to net gain

treated as capital gain (after application of section 1231(c));

(B) All of the hedges of section 1231 assets would be hedging

transactions under paragraph (b) of this section if section 1231 assets

were ordinary property; and

(C) On original or amended returns, the taxpayer consistently

treats all of the hedges of section 1231 assets as hedging

transactions.

(ii) Transition rule for noninventory supplies. For all taxable

years that ended prior to July 18, 1994 and that, as of September 1,

1994, were still open for assessment under section 6501, a taxpayer may

treat as hedging transactions all hedges of purchases of noninventory

supplies (as defined in paragraph (c)(5)(ii) of this section) that

would not otherwise qualify as hedging transactions and that were

entered into during those years if the taxpayer can establish that,

during those years--

(A) The taxpayer did not sell in any of those years more than 15

percent of the greater of the total amount of the supply held at the

beginning of the year or the total amount of the supply acquired during

that year;

(B) All of the hedges would be hedging transactions under paragraph

(b) of this section if noninventory supplies were ordinary property;

and

(C) On original or amended returns, the taxpayer consistently

treats all of the hedges of noninventory supplies as hedging

transactions.

(4) Effective date for hedges by members of a consolidated group.

[Reserved].

Sec. 1.1221-2T [Removed]

Par. 4. Effective October 1, 1994, Sec. 1.1221-2T is effectively

removed.

Par. 5. Effective July 18, 1994 Sec. 1.1233-2T is redesignated

Sec. 1.1233-2 and is revised to read as follows:

Sec. 1.1233-2 Hedging transactions.

The character of gain or loss on a short sale that is (or is

identified as being) part of a hedging transaction is determined under

the rules of Sec. 1.1221-2.

Par. 6. Effective July 18, 1994 Sec. 1.1234-4T is redesignated

Sec. 1.1234-4 and is revised to read as follows:

Sec. 1.1234-4 Hedging transactions.

The character of gain or loss on an acquired or a written option

that is (or is identified as being) part of a hedging transaction is

determined under the rules of Sec. 1.1221-2.

Par. 7. Effective July 18, 1994 Sec. 1.1256(e)-1 is added to read

as follows:

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

(a) Identification and recordkeeping requirements. Under section

1256(e)(2)(C), a taxpayer that enters into a hedging transaction must

identify the transaction as a hedging transaction before the close of

the day on which the taxpayer enters into the transaction.

(b) Requirements for identification. The identification of a

hedging transaction for purposes of section 1256(e)(2)(C) must satisfy

the requirements of Sec. 1.1221-2(e)(1). Solely for purposes of section

1256(f)(1), however, an identification that does not satisfy all of the

requirements of Sec. 1.1221-2(e)(1) is nevertheless treated as an

identification under section 1256(e)(2)(C).

(c) Consistency with Sec. 1.1221-2. Any identification for purposes

of Sec. 1.1221-2(e)(1) is also an identification for purposes of this

section. If a taxpayer satisfies the requirements of paragraph

(f)(1)(ii) of Sec. 1.1221-2, the transaction is treated as if it were

not identified as a hedging transaction for purposes of section

1256(e)(2)(C).

(d) Effective date. This section applies to transactions entered

into on or after October 1, 1994.

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

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

follows:

Authority: 26 U.S.C. 7805.

Par. 9. Effective July 18, 1994 Sec. 602.101(c) is amended by

adding an entry in numerical order to the table to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

------------------------------------------------------------------------

Current OMB

CFR part or section where identified and described control

number

------------------------------------------------------------------------

*****

1.1221-2................................................... 1545-1403

*****

------------------------------------------------------------------------

Par. 10. Effective October 1, 1994, in Sec. 602.101(c), the entry

for Sec. 1.1221-2T(c) is removed.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: June 3, 1994.

Samuel Y. Sessions,

Acting Assistant Secretary of the Treasury.

[FR Doc. 94-16867 Filed 7-13-94; 9:10 am]

BILLING CODE 4830-01-U