4738 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

(3) If you claim that any or all of the

data or other information in your PBN

is confidential, FDA will evaluate your

claim. FDA will disclose the data or

information in your PBN, unless FDA

determines that your claim

demonstrates that the criteria for

exemption from disclosure in § 20.61 of

this chapter are satisfied.

(4) If FDA determines that any or all

of the data or other information in your

PBN is confidential as of the date that

we file it, those data or information

would be available for public

disclosure, in accordance with 20.61 of

this chapter, when the criteria for

exemption from disclosure in § 20.61 of

this chapter are no longer satisfied.

(5) As long as the existence of your

PBN is confidential, then the data or

other information in your PBN would

not be available for public disclosure.

(d) How could the public obtain

disclosable data and information in my

PBN? Under the FOIA, the public could

obtain the disclosable data or other

information in your PBN or an

amendment to your PBN, or that you

incorporate by reference into your PBN,

by looking for these data and

information in FDA’s electronic reading

room or by asking FDA to send them a

copy of these data and information.

(e) Would the agency’s evaluation of

my PBN be available to the public?

FDA will make the following

information easily accessible to the

public (e.g., by placing the information

on the Internet or in a paper or

electronic file that is available at FDA

for public review and copying):

(1) The text of any letter issued by the

agency under § 192.30(c) of this chapter.

(2) The text of the agency’s completed

evaluation of any notice submitted

under this part.

Dated: September 22, 2000.

Jane E. Henney,

Commissioner of Food and Drugs.

Donna E. Shalala,

Secretary of Health and Human Services.

[FR Doc. 01–1046 Filed 1–17–01; 8:45 am]

BILLING CODE 4160–01–F

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG–107047–00]

RIN 1545–AY02

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 http://www.irs.gov/taxlregs/

regslist.html. 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

Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules 4739

grants the Secretary the authority to

provide regulations to address the

treatment of nonidentified or

improperly identified hedging

transactions, and hedging transactions

involving related parties (sections

1221(b)(2)(B) and (b)(3), respectively).

The statutory hedging provisions are

effective for transactions entered into on

or after December 17, 1999.

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, 106th Cong., 1st Sess. 24

(1999). These proposed regulations

conform the Treasury regulations to

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 Treasury

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, 106th 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, 106th Cong., 1st

Sess. 24 (1999). The Senate 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.

Nonetheless, 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

4740 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

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 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 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 nonidentification, 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.

Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules 4741

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

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

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 to section

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 10th Street entrance, located

between 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

4742 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

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 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

Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules 4743

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

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 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 treated as the

risk of the other members as if all of the

members of the group were divisions of

a single corporation. For example, if any

member of a consolidated group hedges

the risk of another member of the group

by entering into a transaction with a

third party, that transaction may

potentially qualify as a hedging

transaction. Conversely, intercompany

transactions are not hedging

transactions because, when considered

as transactions between divisions of a

single corporation, they do not manage

the risk of that single corporation.

(2) Separate-entity election. In lieu of

the single-entity approach specified in

paragraph (d)(1) of this section, a

consolidated group may elect separateentity 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–

4744 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

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 separateentity 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, 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 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

Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules 4745

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 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. 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 nonidentification—(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

transaction is 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:

4746 Federal Register / Vol. 66, No. 12 / Thursday, January 18, 2001 / Proposed Rules

§ 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.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 01–491 Filed 1–17–01; 8:45 am]

BILLING CODE 4830–01–P

DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 1

[REG–105801–00]

RIN 1545–AX92

Capitalization of Interest and Carrying

Charges Properly Allocable to

Straddles

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Notice of proposed rulemaking

and notice of public hearing.

SUMMARY: This document contains

proposed regulations that clarify the

application of the straddle rules to a

variety of financial instruments. The

proposed regulations clarify what

constitutes interest and carrying charges

and when interest and carrying charges

are properly allocable to personal

property that is part of a straddle. The

proposed regulations also clarify that a

taxpayer’s obligation under a debt

instrument can be a position in personal

property that is part of a straddle. The

proposed regulations provide guidance

to taxpayers that enter into straddle

transactions. This document provides

notice of a public hearing on these

proposed regulations.

DATES: Written and electronic comments

and requests to appear and outlines of

topics to be discussed at the public

hearing scheduled for May 22, 2001, at

10 a.m., must be submitted by May 1,

2001.

ADDRESSES: Send submissions to:

CC:M&SP:RU (REG–105801–00), 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–

105801–00), Courier’s Desk, Internal

Revenue Service, 1111 Constitution

Avenue NW., Washington, DC.

Alternatively, taxpayers may submit

comments electronically via the Internet

by submitting comments directly to the

IRS Internet site at http://www.irs.gov/

taxlregs/regslist.html. The public

hearing will be held in the Auditorium,

Internal Revenue Building, 1111

Constitution Avenue, NW., Washington,

DC.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations,

Kenneth Christman (202) 622–3950;

concerning submission and delivery of

comments and the public hearing,

Treena Garrett, (202) 622–7180 (not tollfree numbers).

SUPPLEMENTARY INFORMATION:

Background

Sections 501 and 502 of the Economic

Recovery Tax Act of 1981 (Pub. L. 97–

34, 95 Stat. 172) added sections 1092

and 263(g), respectively, to the Internal

Revenue Code to address certain

deferral and conversion strategies

involving economically offsetting

positions in actively traded personal

property. These economically offsetting

positions are called straddles. Section

1092(c)(1).

In general, under section 1092, a

taxpayer that realizes a loss on a

position in actively traded personal

property must defer the recognition of

the loss to the extent the taxpayer has

unrecognized gain on an economically

offsetting position in the property. This

deferral rule matches the recognition of

loss with the recognition of the

economically offsetting income. Section

263(g) addresses interest and carrying

charges properly allocable to personal

property that is part of a straddle. Under

this section, these otherwise deductible

expenses are not currently deductible.

Instead, they must be capitalized into

the basis of the property. By requiring

capitalization, section 263(g) prevents:

(1) A taxpayer from gaining a timing

advantage by accruing deductions

associated with carrying the straddle

transaction before recognizing income

from a position in personal property

that is part of the straddle; and (2) the

deductions from having a character

different from that of the income.

These proposed regulations provide

certain rules with respect to the

application of section 263(g) and section

1092.

Explanation of Provisions

The proposed regulations consist of

§ 1.263(g)–1, which provides a general

introduction, and §§ 1.263(g)–2,

1.263(g)–3, 1.263(g)–4, and 1.263(g)–5,

described below. The proposed

regulations also include a new

paragraph 1.1092(d)–1(d).

The proposed regulations generally

address four issues: (1) The definition of

personal property as such term is used

in section 263(g) (in § 1.263(g)–2); (2)

the type of payments that are subject to

the capitalization rules of section 263(g)

(in § 1.263(g)–3); (3) the operation of the

capitalization rules of section 263(g) (in

§ 1.263(g)–4); and (4) the circumstances

under which an issuer’s obligation

under a debt instrument can be a

position in actively traded personal

property and, therefore, part of a

straddle (in § 1.1092(d)–1(d)). These

issues are discussed in more detail

below.

Definition of the Term Personal Property

for Purposes of Section 263(g)

Section 263(g)(1) requires

capitalization of interest and carrying

charges properly allocable to personal

property that is part of a straddle (as

defined in section 1092(c)). Section

1092(d)(1) defines personal property for

purposes of section 1092, as personal

property of a type that is actively traded.

Commentators have suggested that

because sections 263(g) and 1092 were

enacted at the same time, the term

personal property as used in section

263(g) should be given the same

definition under section 1092(d)(1).

This would limit the definition of

personal property in section 263(g) to

personal property of a type that is

actively traded.

Despite this suggestion, the proposed

regulations provide that personal

property has its common law meaning

in section 263(g) for two reasons. First,

the definition in section 1092(d)(1) by

its terms applies only for purposes of

section 1092. Second, the broader,

common law interpretation of personal

property more closely accords with the

purposes of section 263(g). Application

of the limited definition in section