[Federal Register Volume 66, Number 12 (Thursday, January 18, 2001)]
[Proposed Rules]
[Pages 4738-4746]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-491]


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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.

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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/tax__regs/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. (Sec. 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. Sec. 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

[[Page 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 Sec. 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 Sec. 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 Sec. 1.482-8 will address risk management 
activities in the context of a global dealing operation. Thus, except 
to the extent provided in Secs. 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 Secs. 1.882-5 and 1.884-1 also refer to 
hedging under Sec. 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 Sec. 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

[[Page 4740]]

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 (Sec. 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 non-
identification, respectively, are generally unchanged from the 
corresponding rules in the Treasury regulations. This is because 
Congress generally intended to codify the approach to hedging 
transactions that was taken in the Treasury regulations. S.

[[Page 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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

[[Page 4742]]

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 Sec. 1.1221 to read as follows:

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


Sec. 1.1221-2  Hedging transactions.

    (a) Treatment of hedging transactions--(1) In general. This section 
governs the treatment of hedging transactions under section 1221(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 
Secs. 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 
Sec. 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

[[Page 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 separate-entity treatment of its hedging transactions. If a group 
makes this separate-entity election, the following rules apply.
    (i) Risk of one member not risk of other members. Notwithstanding 
paragraph (d)(1) of this section, the risk of one member is not treated 
as the risk of other members.
    (ii) Intercompany transactions. An intercompany transaction is a 
hedging transaction (an intercompany hedging transaction) with respect 
to a member of a consolidated group if and only if it meets the 
following requirements--
    (A) The position of the member in the intercompany transaction 
would qualify as a hedging transaction with respect to the member 
(taking into account paragraph (d)(2)(i) of this section) if the member 
had entered into the transaction with an unrelated party; and
    (B) The position of the other member (the marking member) in the 
transaction is marked to market under the marking member's method of 
accounting.
    (iii) Treatment of intercompany hedging transactions. An 
intercompany hedging transaction (that is, a transaction that meets the 
requirements of paragraphs (d)(2)(ii)(A) and (B) of this section) is 
subject to the following rules--
    (A) The character and timing rules of Sec. 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-

[[Page 4744]]

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 
Sec. 1.446-4. The intercompany transaction B-C is not a hedging 
transaction and is taken into account under Sec. 1.1502-13.
    (ii) Identification. D must be identified as a hedging 
transaction under paragraph (e)(1) of this section, and A must be 
identified as the hedged item under paragraph (e)(2) of this 
section. Under paragraph (e)(5) of this section, the identification 
of A as the hedged item can be accomplished by identifying the 
positions in the intercompany transaction as hedges or hedged items, 
as appropriate. Thus, substantially contemporaneous with entering 
into D, H may identify C as the hedged item and O may identify B as 
a hedge and A as the hedged item.
    Example 2. Separate-entity election; counterparty that does not 
mark to market. In addition to the General Facts stated above, 
assume that the group makes a separate-entity election under 
paragraph (d)(2) of this section. If H does not mark C to market 
under its method of accounting, then B is not a hedging transaction, 
and the B-C intercompany transaction is taken into account under the 
rules of section 1502. D is not a hedging transaction with respect 
to A, but D may be a hedging transaction with respect to C if C is 
ordinary property or an ordinary obligation and if the other 
requirements of paragraph (b) of this section are met. If D is not 
part of a hedging transaction, then D may be part of a straddle for 
purposes of section 1092.
    Example 3. Separate-entity election; counterparty that marks to 
market. The facts are the same as in Example 2 above, except that H 
marks C to market under its method of accounting. Also assume that B 
would be a hedging transaction with respect to risk A if O had 
entered into that transaction with an unrelated party. Thus, for O, 
the B-C transaction is an intercompany hedging transaction with 
respect to O's risk A, the character and timing rules of 
Sec. 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 Sec. 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

[[Page 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 non-identification--(1) 
Transactions identified--(i) In general. If a taxpayer identifies a 
transaction as a hedging transaction for purposes of paragraph 
(e)(1) of this section, the identification is binding with respect 
to gain, whether or not all of the requirements of paragraph (e) are 
satisfied. Thus, gain from that transaction is ordinary income. If 
the transaction is not in fact a hedging transaction described in 
paragraph (b) of this section, however, paragraphs (a)(1) and (2) of 
this section do not apply and the character of loss is determined 
without reference to whether the transaction is a surrogate for a 
noncapital asset, serves as insurance against a business risk, 
serves a hedging function, or serves a similar function or purpose. 
Thus, the taxpayer's identification of the transaction as a hedging 
transaction does not itself make loss from the transaction ordinary.
    (ii) Inadvertent identification. Notwithstanding paragraph 
(f)(1)(i) of this section, if the taxpayer identifies a transaction 
as a hedging transaction for purposes of paragraph (e) of this 
section, the character of the gain is determined as if the 
transaction had not been identified as a hedging transaction if--
    (A) The transaction is not a hedging transaction (as defined in 
paragraph (b) of this section);
    (B) The identification of the transaction as a hedging 
transaction was due to inadvertent error; and
    (C) All of the taxpayer's transactions in all open years are 
being treated on either original or, if necessary, amended returns 
in a manner consistent with the principles of this section.
    (2) Transactions not identified--(i) In general. Except as 
provided in paragraphs (f)(2)(ii) and (iii) of this section, the 
absence of an identification that satisfies the requirements of 
paragraph (e)(1) of this section is binding and establishes that a 
transaction is not a hedging transaction. Thus, subject to the 
exceptions, the rules of paragraphs (a)(1) and (2) of this section 
do not apply, and the character of gain or loss is determined 
without reference to whether the transaction is a surrogate for a 
noncapital asset, serves as insurance against a business risk, 
serves a hedging function, or serves a similar function or purpose.
    (ii) Inadvertent error. If a taxpayer does not make an 
identification that satisfies the requirements of paragraph (e) of 
this section, the taxpayer may treat gain or loss from the 
transaction as ordinary income or loss under paragraph (a)(1) or (2) 
of this section if--
    (A) The transaction is a hedging transaction (as defined in 
paragraph (b) of this section);
    (B) The failure to identify the transaction was due to 
inadvertent error; and
    (C) All of the taxpayer's hedging transactions in all open years 
are being treated on either original or, if necessary, amended 
returns as provided in paragraphs (a)(1) and (2) of this section.
    (iii) Anti-abuse rule. If a taxpayer does not make an 
identification that satisfies all the requirements of paragraph (e) 
of this section but the taxpayer has no reasonable grounds for 
treating the transaction as other than a hedging transaction, then 
gain from the transaction is ordinary. The reasonableness of the 
taxpayer's failure to identify a transaction is determined by taking 
into consideration not only the requirements of paragraph (b) of 
this section but also the taxpayer's treatment of the transaction 
for financial accounting or other purposes and the taxpayer's 
identification of similar transactions as hedging transactions.
    (3) Transactions by members of a consolidated group--(i) Single-
entity approach. If a consolidated group is under the general rule 
of paragraph (d)(1) of this section (the single-entity approach), 
the rules of this paragraph (f) apply only to transactions that are 
not intercompany transactions.
    (ii) Separate-entity election. If a consolidated group has made 
the election under paragraph (d)(2) of this section, then, in 
addition to the rules of paragraphs (f)(1) and (2) of this section, 
the following rules apply:
    (A) If an intercompany transaction is identified as a hedging 
transaction but does not meet the requirements of paragraphs 
(d)(2)(ii)(A) and (B) of this section, then, notwithstanding any 
contrary provision in Sec. 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 Sec. 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:

[[Page 4746]]

Sec. 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 Sec. 1.1221-2(e)(1). Solely for purposes of section 
1256(f)(1), however, an identification that does not satisfy all of the 
requirements of Sec. 1.1221-2(e)(1) is nevertheless treated as an 
identification under section 1256(e)(2).
    (c) Consistency with Sec. 1.1221-2. Any identification for purposes 
of Sec. 1.1221-2(e)(1) is also an identification for purposes of this 
section. If a taxpayer satisfies the requirements of Sec. 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