Hedging Transactions by Members of a Consolidated Group

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[FI-34-94]

RIN 1545-AS75

Hedging Transactions by Members of a Consolidated Group

AGENCY: Internal Revenue Service (IRS), Treasury.

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

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SUMMARY: This document contains proposed regulations relating to the

character and timing of gain or loss from certain hedging transactions

entered into by members of a consolidated group. These proposed

regulations apply when one member of the group hedges the risk of

another member or enters into a hedge with another member. The

regulations are needed because related-party hedging is a common

business practice and existing regulations treat as hedging

transactions only hedges entered into by a taxpayer to reduce its own

risk. This document also provides notice of a public hearing on these

proposed regulations.

DATES: Written comments must be received by September 26, 1994.

Requests to speak (with outlines of oral comments) at a public hearing

scheduled for October 18, 1994, must be received by September 26, 1994.

ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-34-94) room 5228,

Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,

DC 20044. In the alternative, submissions may be hand delivered between

the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-34-94),

Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW,

Washington, DC. The public hearing has been scheduled to be held in

room 3718, 1111 Constitution Avenue, NW, Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jo Lynn

Ricks of the Office of the Assistant Chief Counsel (Financial

Institutions and Products), (202) 622-3920 (not a toll-free number);

concerning submissions and the hearing, Carol Savage, (202) 622-8452

(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in this notice of proposed

rulemaking have been submitted to the Office of Management and Budget

for review in accordance with the Paperwork Reduction Act (44 U.S.C.

3504(h)). Comments on the collections of information should be sent 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, with copies to the Internal Revenue

Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC

20224.

The collections of information are in Secs. 1.1221-2(d)(2)(iv) and

1.1221-2(e)(5). This information is required by the IRS to aid it in

administering the law and to prevent manipulation, such as

recharacterization of transactions in view of later developments. This

information will be used to determine whether the taxpayer has elected

separate-entity treatment under Sec. 1.1221-2(d)(2) and to verify that

the taxpayer is properly reporting its business hedging transactions.

The likely respondents and recordkeepers are businesses or other for-

profit institutions.

Estimated total annual reporting and recordkeeping burden: 75,000

hrs.

The estimated annual burden per respondent or recordkeeper varies

from 1.0 to 40.0 hours, depending on individual circumstances, with an

estimated average of 5 hours.

Estimated number of respondents and recordkeepers: 15,000.

Estimated frequency of responses: once in the existence of each

respondent.

Background

Final regulations under section 1221, published elsewhere in this

issue of the Federal Register, generally provide for ordinary gain or

loss from hedging transactions. To qualify as a hedging transaction, a

transaction must be entered into in the normal course of business to

reduce certain specified risks of the taxpayer. Final regulations under

section 446, published elsewhere in this issue of the Federal Register,

require taxpayers to account for hedging transactions in a manner that

clearly reflects income by reasonably matching the timing of income,

deduction, gain, or loss from the hedge with the timing of the income,

deduction, gain, or loss from the item being hedged.

Because a hedging transaction must reduce the taxpayer's own risk,

the regulations do not apply where a taxpayer hedges the risk of

another taxpayer, even if that other taxpayer is a related party. In

the preamble to TD 8493, which was published on October 20, 1993 (58 FR

54037), the IRS requested comments on the treatment of transactions

involving related parties.

Several commentators suggested extending the definition of hedging

transaction to the hedging of a related party's risk. Many businesses

that are conducted through separate but related entities centralize

their hedging operations in a single entity or a small number of

entities that hedge the risks of the entire business. Centralizing the

hedging function creates economies of scale and allows the risks of the

business to be netted or offset against each other, with the hedging

entity entering into hedges with unrelated parties only for the

remaining net risk. Thus, various commentators suggested that the term

hedging transaction should include hedges of the risk of other members

of the same consolidated group, of affiliated corporations filing

separate returns, of controlled but unaffiliated corporations, and of

controlled partnerships.

Explanation of Provisions

As a general rule, the proposed regulations adopt a single-entity

approach to consolidated groups, applying the hedging rules to a

member's transactions that hedge the risk of other members of the same

consolidated group. Proposed Sec. 1.1221-2(d)(1) provides that the risk

of one member of a consolidated group is treated for purposes of the

hedging rules as the risk of the other members of the group as if all

of the members of the group were divisions of a single corporation.

Thus, if a transaction entered into by a centralized hedging member

reduces the risk of the group as a whole and the other requirements of

Sec. 1.1221-2 are met, the transaction qualifies as a hedging

transaction.

Many consolidated groups that centralize their hedging operations

execute contracts or enter into other transactions between the members

to transfer risk from the operating members to the hedging member. For

example, an operating member that assumes a floating rate liability may

enter into an interest rate swap with the hedging member pursuant to

which the operating member will pay fixed and receive floating. The

hedging member nets this risk with its other interest rate risk and, if

it has a net risk, may enter into an interest rate swap with a third

party to offset this net risk.

Under the single-entity approach of the proposed regulations,

transactions between members of a consolidated group are not hedging

transactions because they do not reduce the risk of the group. Instead,

these transactions are subject to the rules of section 1502 and the

regulations thereunder, which govern the timing and character of income

on intercompany transactions and obligations. Thus, only a transaction

with a third party can qualify as a hedging transaction.

Several commentators on the proposed character and timing

regulations requested that the IRS adopt a separate-entity regime for

related-party hedges. They expressed concern that, under a single-

entity regime, a hedging member may not have the information necessary

to comply with the identification requirements imposed on hedging

transactions. That is, the hedging member may not have information with

respect to the transaction that gave rise to the risk that was

transferred to it in the intercompany transaction.

Under a separate-entity approach, an intercompany transaction that

met the definition in Sec. 1.1221-2(b) would be respected as a hedging

transaction and accounted for as such, and the transaction would not be

subject to the intercompany transaction regime. In other words, if a

member of a consolidated group enters into a transaction to transfer

risk to another member, the transaction would be treated as if it had

been entered into with an unrelated party.

The IRS and Treasury recognize that, where a consolidated group

uses intercompany transactions to transfer risk within the group, the

separate-entity approach may facilitate the identification of hedging

transactions and simplify the accounting for those transactions. A

generally applicable separate-entity approach, however, frequently

would not clearly reflect the income of the consolidated group and

might be subject to manipulation. Moreover, a general separate-entity

approach for hedges would be contrary to the single-entity approach of

recently proposed Sec. 1.1502-13, and it would be difficult to

coordinate the treatment of intercompany hedging transactions with the

treatment of other intercompany transactions.

Despite the concern with a general separate-entity approach, the

IRS and Treasury believe that there is less opportunity for

manipulation or distortion if a member of a group enters into a hedging

transaction with another member that is using mark-to-market accounting

for tax purposes. Thus, when a group contains a hedging member that

accounts for the transaction on a mark-to-market method of accounting,

a limited separate-entity approach may be acceptable.

Therefore, the proposed regulations allow a consolidated group to

make a separate-entity election. The election is made by the group for

all of its hedging activities and may not be revoked without the

consent of the Commissioner. If a group makes the election, the risk of

one member is not treated as risk of the other members. Thus, a member

can hedge only its own risk, and an intercompany transaction must be

used if one member of the group wishes to transfer risk to another

member.

In an electing group, certain intercompany transactions are

recognized as hedging transactions for purposes of Sec. 1.1221-2. An

intercompany transaction is treated as a hedging transaction if it

would be a hedging transaction if entered into with an unrelated party,

and if it is entered into with another member that, under its method of

accounting, marks the position to market. Thus, for example, an

operating member could enter into a hedging transaction with a hedging

member that marks the position obtained to market under section 475. As

a result of the separate-entity election, the hedging transaction is

not treated as an intercompany transaction or obligation for purposes

of section 1502 and the regulations thereunder, and any gain or loss to

the member marking to market the position obtained is ordinary.

This special treatment is provided only for intercompany

transactions entered into with a member that marks its position to

market. If an identical transaction is entered into with a member of

the group that does not mark to market the position obtained, the

transaction is subject to the intercompany transaction rules under

section 1502. Thus, the separate-entity election is likely to be made

only by a group whose intercompany hedging activity is done with a

member that uses a mark-to-market method of accounting.

The proposed regulations provide identification rules that conform

to the treatment of hedging transactions described above. If a

consolidated group is under the general rule of the regulations (the

single-entity approach), identification is done as if the members of

the group were divisions of a single corporation. The member engaging

in a hedging transaction with an unrelated party identifies the

transaction and the item, items, or aggregate risk being hedged, even

if the item, items, or aggregate risk is that of another member.

If a group is under the general rule but uses intercompany

transactions to transfer risk within the group, it may satisfy the

identification requirement by identifying the item, items, or aggregate

risk being hedged, its intercompany transactions, and its hedging

transactions with unrelated parties. Although the intercompany

transactions are not respected as hedging transactions, their

identification should enable the group to associate hedging

transactions with the item, items, or aggregate risk being hedged.

If a group makes the separate-entity election, each member must

identify its hedging transactions with unrelated parties, its

intercompany transactions that are treated as hedging transactions

under these regulations, and the item, items, or aggregate risk being

hedged, as appropriate.

The proposed regulations also provide rules with respect to the

effects of identification and nonidentification. If a group is under

the general rule, the rules of Sec. 1.1221-2(f) apply to a hedging

transaction, but not to intercompany transactions. If a group makes the

separate-entity election, the rules of Sec. 1.1221- 2(f) are extended

to intercompany transactions that are treated as hedging transactions

under these regulations.

Finally, the proposed regulations provide new rules with respect to

timing under Sec. 1.446-4. If a group is under the general rule, it

accounts for hedging transactions as if the members of the group were

divisions of a single corporation. The income, deduction, gain, or loss

on a hedging transaction is matched with the income, deduction, gain,

or loss on the item, items, or aggregate risk being hedged and not with

an intercompany transaction. If a group makes the separate-entity

election, the rules of Sec. 1.446-4 apply on a member-by-member basis

to hedging transactions with unrelated parties and to intercompany

transactions that are treated as hedging transactions under these

regulations.

It is anticipated that these regulations will apply to transactions

entered into on or after the date that is 60 days after the publication

of final regulations on this subject in the Federal Register.

All of the rules described above apply only in the case of a

consolidated group. Thus, the proposed regulations do not treat as a

hedging transaction the hedging of the risk of a related party that is

not a member of the same consolidated group. The IRS is concerned that

the single-entity approach is generally not appropriate where the

parties are not members of the same consolidated group.

Outside the context of a consolidated group, taxpayers with

ordinary business risk sometimes enter into transactions to transfer

risk to a related party. Commentators have requested that these

transactions be treated as hedging transactions and that the entities

to which risk is transferred be treated as realizing ordinary gain or

loss on their positions in these transactions. The IRS is concerned,

however, about whether these transactions reduce risk, whether the

requested ordinary treatment to the entities receiving risk is

authorized under the Internal Revenue Code (Code), and whether the

approach would create opportunities for manipulation. Therefore, the

proposed regulations do not include the requested rule.

The IRS intends to issue guidance under section 475 of the Code to

coordinate the hedging exception of section 475(b)(1)(C) with these

rules. In particular, if a consolidated group has not made a separate-

entity election, the IRS is considering whether the identification of a

hedging transaction by a member subject to section 475 should generally

be sufficient to identify the transaction as a hedge under section

475(b)(1)(C), provided the hedged item or items are not securities

subject to section 475(a). In this case, gain or loss on the hedging

transaction would generally be subject to the timing rules of

Sec. 1.446-4 rather than to mark-to-market treatment under section 475.

Comments are requested on this matter.

Special Analyses

It has been determined that this notice of proposed rulemaking 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, this notice of proposed rulemaking will be

submitted to the Chief Counsel for Advocacy of the Small Business

Administration for comment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. All

comments will be available for public inspection and copying.

A public hearing has been scheduled for Tuesday, October 18, 1994,

at 10:00 a.m. in room 3718, 1111 Constitution Avenue, NW., Washington,

DC, 20224. Because of access restrictions, visitors will not be

admitted beyond the Internal Revenue Building lobby more than 15

minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons that wish to present oral comments at the hearing must

submit written comments by September 26, 1994, and submit an outline of

the topics to be discussed and the time to be devoted to each topic

(signed original and eight (8) copies) by September 26, 1994.

A period of 10 minutes will be allotted to each person for making

comments.

An agenda showing the scheduling of the speakers will be prepared

after the deadline for receiving outlines has passed. Copies of the

agenda will be available free of charge at the hearing.

Drafting Information

The principal 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 in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by

removing the entry for Sec. 1.1221-2 and by adding entries in numerical

order to read as follows:

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

Section 1.446-4 also issued under 26 U.S.C. 1502. * * *

Section 1.1221-2 also issued under 26 U.S.C. 1502 and 6001. * * *

Par. 2. Section 1.446-4 is amended by adding the text of paragraph

(e)(9) to read as follows:

Sec. 1.446-4 Hedging transactions.

* * * * *

(e) * * *

(9) Hedging by members of a consolidated group--(i) General rule.

In general, a member of a consolidated group that hedges the risk of

another member must account for its hedging transactions as if all of

the members were separate divisions of a single corporation. Thus, the

timing of the income, deduction, gain, or loss on a hedging transaction

must be matched with the timing of income, deduction, gain, or loss

from the item or items being hedged rather than with an intercompany

transaction.

(ii) Separate-entity election. If a consolidated group makes an

election under Sec. 1.1221-2(d)(2), each member of the consolidated

group must account for its hedging transactions (including its

intercompany transactions that are treated as hedging transactions) in

a manner that meets the requirements of paragraph (b) of this section.

Thus, each member of the group must comply with this section for its

hedging transactions without regard to the fact that the taxpayer is a

member of a consolidated group.

(iii) Definitions. For definitions of consolidated group, member of

a consolidated group, and intercompany transaction, see section 1502

and the regulations thereunder.

(iv) Effective date. This paragraph (e)(9) applies to transactions

entered into on or after the date 60 days after publication of final

regulations on this subject in the Federal Register.

Par. 3. Section 1221-2 is amended by adding the text of paragraphs

(d), (e)(5), (f)(3), and (g)(4) to read as follows:

Sec. 1.1221-2 Hedging transactions.

* * * * *

(d) Hedging by members of a consolidated group--(1) General rule.

For purposes of this section, the risk of one member of a consolidated

group is treated as the risk of the other members as if all of the

members of the group were divisions of a single corporation. For

example, if any member of a consolidated group hedges the risk of

another member of the group by entering into a transaction with an

unrelated person, that transaction may potentially qualify as a hedging

transaction. Under this rule, intercompany transactions are not hedging

transactions because they are treated as transactions between divisions

of a single corporation and thus do not reduce the risk of the group.

(2) Separate-entity election. In lieu of the treatment specified in

paragraph (d)(1) of this section, a consolidated group may elect

separate-entity treatment of its hedges. 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 or

obligation is a 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 or

obligation would qualify as a hedging transaction with respect to that

member if that member 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 transaction or obligation that is a hedging transaction

(because it meets the requirements of paragraphs (d)(2)(ii) (A) and (B)

of this section) is treated as follows--

(A) Neither the hedging transaction nor any intercompany obligation

with respect to that transaction is treated as an intercompany

transaction or obligation for purposes of section 1502 and the

regulations thereunder; 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. The election described in

this paragraph (d)(2) must be made in a separate statement that is

filed with the group's consolidated return for the taxable year that

includes the first date for which the election is to apply. The

statement must specify that the election is being made and must

indicate the date that the election is to be effective. The election

applies to all transactions entered into on or after the date so

indicated. In no event, however, does the election apply to

transactions entered into before the date 60 days after final

regulations on this subject are published in the Federal Register. The

election cannot be revoked without the consent of the Commissioner.

(3) Definitions. For definitions of consolidated group, member of a

consolidated group, intercompany transaction, and intercompany

obligation, see section 1502 and the regulations thereunder.

(4) Examples. These examples illustrate this paragraph (d). 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 contract 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 D must be accounted for under a method of accounting

that satisfies Sec. 1.446-4. The intercompany transaction B-C is not

a hedging transaction, and the B-C transaction is accounted for

according to the regulations under section 1502.

(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 contemporaneously 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; no marking. In addition to

the 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

accounted for 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 the 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; marking. The facts are the

same as in Example 2 above. If H marks C to market under its method

of accounting and B would be a hedging transaction with respect to O

if O had entered into that transaction with an unrelated party, then

the B-C transaction is a hedging transaction with respect to O.

Thus, O's position B is a hedging transaction with respect to its

risk A, the B-C transaction is not treated as an intercompany

transaction or obligation, and H's income, deduction, gain or loss

on C is ordinary. D is a hedge of C if it meets the requirements of

paragraph (b) of this section.

(e) * * *

(5) Identification of hedges involving members of the same

consolidated group--(i) General rule. If one member of a consolidated

group hedges the risk of another member under the general rule of

paragraph (d)(1) of this section, then the identification requirements

of this paragraph (e) must be met 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 or

obligations to transfer risk within the group, the requirements of

paragraph (e)(2) of this section may be met by identifying the

intercompany transactions or obligations 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 by paragraph (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. See paragraph (d)(4) of this section for an

example of this identification.

(ii) Rule for taxpayers 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.

* * * * *

(f) * * *

(3) Transactions by members of a consolidated group--(i) General

rule. If a consolidated group is under the general rule of paragraph

(d)(1) of this section, the rules of this paragraph (f) apply only to

hedging transactions and not to 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 (f)(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 both parties to the transaction are

subject to the rules of paragraph (f)(1) of this section with respect

to the transaction as though both had identified their positions in the

transaction as hedging transactions, notwithstanding the regulations

under section 1502.

(B) If a transaction that meets the requirements of paragraphs

(d)(2)(ii) (A) and (B) is not identified as a hedging transaction, then

both parties to the transaction are subject to the rules of paragraph

(f)(2).

(g) * * *

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

Paragraphs (d), (e)(5), and (f)(3) of this section apply to

transactions entered into on or after the date that is 60 days after

publication of final regulations in the Federal Register.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

[FR Doc. 94-16869 Filed 7-13-94; 9:10 am]

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