Final Regs Provide Rules for Tax Treatment of Hedging Gains and Losses

 DEPARTMENT OF THE TREASURY

 ACTION: Final regulations.

 SUMMARY: This document contains final regulations clarifying the character of gain or loss from business hedges. In general, the regulations treat gain or loss on most hedging transactions as ordinary rather than capital. The regulations are needed to provide guidance to businesses entering into hedging transactions and to serve as a basis for resolving pending cases involving gains and losses from hedging.

 DATES: These regulations are effective July 12, 1994, except that the amendments relating to the removal of section 1.1221-2T are effective October 1, 1994.

 For dates of applicability of these regulations, see the discussion in the Dates of Applicability paragraph in the Supplementary Information portion of the preamble.

 FOR FURTHER INFORMATION CONTACT: Jo Lynn Ricks of the Office of the Assistant Chief Counsel (Financial Institutions and Products), Internal Revenue Service, 1111 Constitution Avenue, NW, Washington DC 20224 (Attn: CC:DOM:FI&P). Telephone 202-622-3920 (not a toll-free call).

 SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3504(h)) under control number 1545-1403. The estimated annual burden per recordkeeper varies from .1 to 10 hours, depending on individual circumstances, with an estimated average of .9 hours.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC 20224, and to the Office of Management and Budget, Attn: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

BACKGROUND

 This document contains final regulations amending the Income Tax Regulations (26 CFR part 1) under section 1221 of the Internal Revenue Code (Code) (relating to the definition of capital asset). The provisions affected relate to the determination of the character of gain or loss from hedging transactions.

 On October 20, 1993, temporary regulations (TD 8493) providing that gain or loss on most common business hedges is ordinary rather than capital were published in the Federal Register (58 FR 54037). A notice of proposed rulemaking (FI-46-93) cross-referencing the temporary regulations was published in the Federal Register for the same day (58 FR 54075). The regulations were intended to resolve questions that had arisen with respect to the tax treatment of business hedging following the decision of the United States Supreme Court in Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988).

 Many comments were received on the proposed regulations, and a public hearing was held on January 19, 1994. Most commentators supported the general approach of the proposed regulations, but a number suggested specific revisions to the proposed rules or the addition of rules to resolve remaining issues.

EXPLANATION OF PROVISIONS

 Paragraph (a) of section 1.1221-2 provides basic rules for the treatment of hedging transactions. Only minor, clarifying changes have been made to the proposed regulations.

 Paragraph (a)(1) provides that property that is part of a hedging transaction, as defined in the regulations, is not a capital asset. Paragraph (a)(2) provides a similar rule for short sales and options. Where a short sale or option is part of a hedging transaction, as defined, any gain or loss on the short sale or option is ordinary. Final regulations under sections 1233 and 1234 provide that section 1.1221-2 governs the character of gain or loss on short sales and options that are part of hedging transactions.

 Under paragraph (a)(3), if a transaction falls outside the regulations, gain or loss from the transaction is not made ordinary by the fact that property is a surrogate for a non-capital asset, that the transaction serves as insurance against a business risk, that the transaction serves a hedging function, or that the transaction serves a similar function or purpose.

 The provisions of this section generally apply to determine the character of gain or loss from transactions that also are subject to various international provisions of the Code. Paragraph (a)(4), however, provides that section 988 transactions are excluded from the character provisions of these regulations because gain or loss on those transactions is ordinary under section 988(a)(1). The regulations do apply to transactions that predate the effective date of section 988. Paragraph (a)(4) also provides that the definition of a hedging transaction under section 1.1221-2(b) does not apply for purposes of the hedging exceptions to the subpart F rules of section 954(c) and certain hedging rules in the interest allocation regulations under section 864(e). The IRS and Treasury are considering the possibility of using the definition of hedging transaction and other provisions of these regulations for purposes of various international tax provisions, except where a modification of the provisions is necessary to carry out the purposes of those international provisions. Comments on this subject are welcomed.

 In defining the term hedging transaction, paragraph (b) of section 1.1221-2 retains the rule of the proposed regulations and adopts the concept of hedging in section 1256(e)(2)(A) of the Code. Under this rule, a hedging transaction generally is a transaction that a taxpayer enters into in the normal course of its business primarily to reduce the risk of interest rate or price changes or currency fluctuations.

 A number of commentators suggested that the IRS abandon the rule of the proposed regulations and adopt a definition of hedging that looks to risk management rather than risk reduction. This comment was not adopted because the IRS and Treasury believe that the definition in section 1256 represents the best indication of congressional intent with respect to business hedges. Although the risk reduction standard has been retained, the final regulations provide rules of application designed to ensure that the definition of hedging transaction is applied reasonably to include most common types of hedging transactions.

 Paragraph (c)(1) deals with the meaning of risk reduction. To enter into a hedging transaction, the taxpayer must have risk when all of its operations are considered -- that is, there must be risk on a "macro" basis. Nonetheless, a hedge of a single asset or liability, or pool of assets or liabilities, will be respected if the hedge reduces the risk attributable to the item or items being hedged and if the hedge is reasonably calculated to reduce the overall risk of the taxpayer's operations. In addition, if a taxpayer hedges a particular asset or liability, or a pool of assets or liabilities, and the hedge is undertaken as part of a program to reduce the overall risk of the taxpayer's operations, the taxpayer need not show that the hedge reduces its overall risk.

 Paragraph (c)(1) also recognizes that fixed to floating hedges and certain types of written options may be risk reducing and may be used in hedging transactions. For example, a covered call with respect to assets held or a written put option with respect to assets to be acquired may reduce risk.

 In addition, paragraph (c)(1) provides that a hedging transaction includes a transaction that is entered into primarily to reverse or counteract a hedging transaction. This rule recognizes that some transactions are used to eliminate some or all of the risk reduction accomplished through a hedging transaction. Although the transactions are not risk reducing if viewed independently, they are considered to be part of the larger hedging transaction.

 Paragraph (c)(1) further provides that a taxpayer may hedge any part or all of its risk for any part of the period during which it has risk. The regulations also provide that the frequent entering into and termination of hedging positions is not relevant to whether transactions are hedging transactions.

 Finally, paragraph (c)(1) provides that a transaction that is not entered into primarily to reduce risk is not a hedging transaction. For example, the so-called "store-on-the-board" transaction, in which a taxpayer disposes of its production and enters into a long futures or forward contract, is not a hedging transaction because the long position does not reduce risk. Moreover, gain or loss on the contract is not made ordinary on the grounds that it is a surrogate for inventory.

 The IRS and Treasury understand that there are situations in which a taxpayer engages in a store-on-the-board transaction as a hedge of an expected payment under an agricultural price support program. In this situation, a long futures or forward contract may qualify as a hedging transaction with respect to the expected payment.

 Paragraph (c)(2) provides that a hedging transaction may be entered into by using a position that was a hedge of one asset or liability to hedge another asset or liability.

 Paragraph (c)(3) provides that the acquisition of certain assets, such as investments, may not be a hedging transaction. Even though these assets may reduce risk, they typically are not acquired primarily to reduce risk. For example, a taxpayer's interest rate risk from a floating rate borrowing may be reduced by the purchase of debt instruments that bear a comparable floating rate. The acquisition of the debt instruments, however, is not made primarily to reduce risk and, therefore, is not a hedging transaction. Similarly, borrowings generally are not made primarily to reduce risk.

 Paragraph (c)(4) defines the normal course requirement of paragraph (b) to include any transaction entered into in furtherance of a taxpayer's trade or business. Thus, for example, a liability hedge meets this requirement regardless of whether the liability is undertaken to fund current operations, an acquisition, or an expansion of a taxpayer's business. This definition does not apply to other uses of the term "normal course" in the Code or regulations.

 Paragraph (c)(5) retains the rule in the proposed regulations that a hedge of property or of an obligation is a hedging transaction only if a sale or exchange of the property, or performance or termination of the obligation, could not produce capital gain or loss. In response to the many comments received, however, a special rule has been added for noninventory supplies. Under this rule, if a taxpayer sells only a negligible amount of a noninventory supply, then, only for purposes of determining whether a hedge of the purchase of that noninventory supply is a hedging transaction, the noninventory supply is treated as ordinary property. In this case, the Service and Treasury believe that the theoretical possibility of ordinary loss on a hedge and capital gain on the sale of supplies should not prevent the transactions from qualifying as hedging transactions. The Service intends to issue guidance on the negligible amount standard. The comments received indicate that most taxpayers sell none of their supplies or a very small amount. Further comments are requested.

 For prior years, a transition rule provides a substantially more generous standard for noninventory supplies. If, in each prior year that is open for assessment on September 1, 1994, a taxpayer sold no more than 15 percent of the greater of the total amount of a supply held at the beginning of the year or the total amount of the supply acquired in that year and meets certain other requirements, hedges of purchases of that supply are hedging transactions.

 The final regulations do not provide a negligible sales rule for hedges of section 1231 assets. Sales of these assets are less predictable than sales of supplies and may occur many years after the transaction that hedges their purchase. The IRS and Treasury believe that it is inappropriate to provide ordinary treatment for the hedges when it is not known whether the assets will produce capital gains. Nonetheless, the regulations provide a special transition rule applicable to certain hedges of section 1231 assets entered into in prior years.

 Paragraph (c)(6) provides that the status of liability hedges as hedging transactions is determined without regard to the use that is made of the proceeds of a borrowing. The IRS and Treasury believe that a liability hedge should not fail to qualify as a hedging transaction because the proceeds of the borrowing being hedged are used to purchase a capital asset.

 Paragraph (c)(7) retains the rule in the proposed regulations that, in the case of hedges of aggregate risk, all but a de minimis amount of the risk being hedged must be attributable to ordinary property, ordinary obligations, and borrowings.

 Although the purpose of the rules in paragraph (c) is to ensure that the definition of hedging transaction will be interpreted reasonably to cover most common business hedges, not all hedges are intended to be covered. For example, the regulations do not apply where a taxpayer hedges a dividend stream, the overall profitability of a business unit, or other business risks that do not relate directly to interest rate or price changes or currency fluctuations. Moreover, the regulations do not provide ordinary treatment for gain or loss from the disposition of stock where, for example, the stock is acquired to protect the goodwill or business reputation of the acquirer or to ensure the availability of goods.

 The status of so-called "gap" hedges is not separately addressed in paragraph (c). Insurance companies, for example, sometimes hedge the "gap" between their liabilities and the assets that fund them. Under the proposed regulations, a hedge of those assets does not qualify as a hedging transaction if the assets are capital. Commentators, therefore, suggested that the final regulations provide a rule that deems all gap hedges to be hedges of the liabilities rather than of the assets. The IRS and Treasury, however, are concerned that, where this type of hedge is more closely associated with the assets than the liabilities, there is a significant possibility of mismatch if the hedges are given ordinary treatment and the assets can be sold for capital gains. Thus, the final regulations do not include the suggested rule.

 Whether a gap hedge qualifies as a liability hedge is a question of fact and depends on whether it is more closely associated with the liabilities than with the assets. For example, a contract to purchase assets is generally not a liability hedge even if the assets are being purchased to fund the liability. Other gap hedges may be appropriately treated as liability hedges and, therefore, may qualify as hedging transactions.

 The IRS and Treasury understand that the most significant consequence of the failure of gap hedges to qualify as hedging transactions may be that they are then subject to the straddle rules of section 1092. Comments are requested on whether it would be appropriate to exempt these transactions from section 1092 and apply the hedge accounting rules of section 1.446-4 even though the transactions are not hedging transactions and their character is not determined under section 1.1221-2. The IRS and Treasury also note that there may be different considerations for determining whether income or loss from a gap hedge should be treated as an interest equivalent for purposes of international tax provisions, such as section 864(e). Comments are also requested on this point.

 Paragraph (d) is reserved in the final regulations to allow development of rules applicable to hedging by members of a consolidated group. Proposed regulations on this subject are published in the Proposed Rules section of this issue of the Federal Register.

 Paragraph (e)(1) retains the requirement of the proposed regulations that hedging transactions must be identified before the close of the day on which they are entered into. Paragraph (e)(2), however, relaxes the rule of the proposed regulations and requires that the item, items, or aggregate risk being hedged be identified substantially contemporaneously with entering into the hedging transaction. The identification must be made no more than 35 days after entering into the hedging transaction. This time period should make it possible for taxpayers to identify the hedged item, items, or aggregate risk at the time they prepare monthly reports for nontax purposes.

 Some commentators suggested eliminating entirely the requirement of identifying the item being hedged. The Service and Treasury believe, however, that this identification is needed to establish that the definition of hedging transaction is satisfied. Moreover, because special identification rules have been provided for hedges of aggregate risk and certain inventory hedges, the requirement of identifying the items being hedged should not be overly burdensome.

 A transition rule is provided to extend the time period for identifying a transaction that is a hedging transaction under the final regulations and that the taxpayer reasonably treated as other than a hedging transaction under the proposed regulations. If such a transaction was entered into before October 1, 1994, and remains in existence on that date, the identification and recordkeeping requirements of paragraph (e) apply, except that the identification of both the hedging transaction and the hedged item are timely if made before the close of business on October 1, 1994. However, if the transaction was entered into before October 1, 1994, and does not remain in existence on that date, the identification and recordkeeping requirements of paragraph (e) do not apply.

 Paragraph (e)(3) contains a series of special rules for identifying certain types of hedging transactions. In the case of inventory, the identification must specify the type or class of inventory to which the hedge relates. If particular inventory purchases or sales transactions are being hedged, the taxpayer must also identify the expected dates and the amounts to be acquired or sold. In the case of hedges of aggregate risk, the identification requirement is satisfied if a taxpayer's records contain a description of the hedging program and if the taxpayer establishes a system under which transactions are identified as being entered into as part of that program. The intent underlying this rule is to provide verifiable information with respect to the item being hedged without requiring the taxpayer to identify individually the many items that give rise to the aggregate risk being hedged.

 Paragraph (e)(4) generally retains and expands the rules of the proposed regulations with respect to how an identification is made. It must be clear that the identification is being made for tax purposes. In lieu of separately identifying each transaction, however, a taxpayer may establish a system in which identification is indicated by the type of transaction or the manner in which the transaction is consummated or recorded.

 Paragraph (e)(5) is reserved to deal with the required identification where the taxpayer is a member of a consolidated group, and paragraph (e)(6) provides that an identification for purposes of section 1256(e)(2)(c) is also an identification for purposes of section 1.1221-2(e)(1).

 Paragraph (f) deals with the effect of identification and non- identification and provides rules that generally are unchanged from the proposed regulations. The only significant change is the addition of a rule that allows correction of an inadvertent identification in some circumstances. If the correction is allowed, the transaction is not subject to the ordinary-gain, capital-loss rule that generally applies to transactions that are incorrectly identified as hedging transactions.

 Final regulations under section 1256 retain the rules of the proposed regulations that coordinate the identification of hedges for purposes of section 1256(e). In addition, the regulations provide that, if a taxpayer inadvertently identifies a transaction as a hedging transaction and corrects it in accordance with paragraph (f)(1)(ii) of section 1.1221-2, the transaction is treated as if it were not identified as a hedging transaction for purposes of section 1256(e)(2)(c). Thus, section 1256(f)(1) does not impose ordinary- gain, capital-loss treatment on the transaction.

DATES OF APPLICABILITY

 Except for the identification rules of paragraph (e), which apply to transactions that were entered into on or after January 1, 1994, or were entered into before that date and remained in existence on March 31, 1994, these final regulations generally apply to all open taxable years. Taxpayers may, however, rely on any paragraph in section 1.1221-2T (26 CFR part 1 revised as of April 1, 1994), for transactions entered into prior to October 1, 1994, provided that the taxpayer applies the paragraph reasonably and consistently.

SPECIAL ANALYSES

 It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Jo Lynn Ricks, Office of Assistant Chief Counsel (Financial Institutions and Products). However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR Part 1

 Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

 Reporting and recordkeeping requirements.

Treasury Decision 8555

ADOPTION OF AMENDMENTS TO THE REGULATIONS

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

PART 1 -- INCOME TAXES

Paragraph 1. Effective July 12, 1994, the authority citation for part 1 is amended by adding an entry in numerical order to read as follows:

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

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

Par. 2. Effective October 1, 1994, the authority citation for Part 1 is further amended by removing the entry for section 1.1221-2T.

Par. 3. Effective July 12, 1994, section 1.1221-2 is added to read as follows:

SECTION 1.122l-2 HEDGING TRANSACTIONS.

(a) TREATMENT OF HEDGING TRANSACTIONS -- (1) IN GENERAL. This section governs the treatment of hedging transactions under section 1221. Except as provided in paragraph (f)(2) of this section (and notwithstanding the provisions of section 1.1221-1(a)), the term capital asset does not include property that is part of a hedging transaction (as defined in paragraph (b) of this section).

(2) SHORT SALES AND OPTIONS. This section also governs the character of gain or loss from a short sale or option that is part of a hedging transaction. See sections 1.1233-2 and 1.1234-4. Except as provided in paragraph (f)(2) of this section, gain or loss on a short sale or option that is part of a hedging transaction (as defined in paragraph (b) of this section) is ordinary income or loss.

(3) EXCLUSIVITY. If a transaction is not a hedging transaction as defined in paragraph (b) of this section, gain or loss from the transaction is not made ordinary on the grounds that property involved in the transaction is a surrogate for a noncapital asset, that the transaction serves as insurance against a business risk, that the transaction serves a hedging function, or that the transaction serves a similar function or purpose.

(4) COORDINATION WITH OTHER SECTIONS -- (i) SECTION 988. This section does not apply to determine the character of gain or loss realized on a section 988 transaction as defined in section 988(c)(1) or realized with respect to a qualified fund as defined in section 988(c)(1)(E)(iii). This section does apply, however, to transactions or payments that would be subject to section 988 but for the date that the transactions were entered into or the date that the payments were made.

(ii) SECTIONS 864(e) AND 954(c). Except as otherwise provided in regulations issued pursuant to sections 864(e) and 954(c), the definition of hedging transaction in paragraph (b) of this section does not apply for purposes of section 864(e) and 954(c).

(b) HEDGING TRANSACTION DEFINED. A hedging transaction is a transaction that a taxpayer enters into in the normal course of the taxpayer's trade or business primarily --

(1) To reduce risk of price changes or currency fluctuations with respect to ordinary property (as defined in paragraph (c)(5) of this section) that is held or to be held by the taxpayer; or

(2) To reduce risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer.

(c) RULES OF APPLICATION. The rules of this paragraph (c) apply for purposes of the definition of the term hedging transaction in paragraph (b) of this section. These rules must be interpreted reasonably and consistently with the purposes of this section. Where no specific rules of application control, the definition of hedging transaction must be interpreted reasonably and consistently with the purposes of this section.

(1) REDUCING RISK -- (i) TRANSACTIONS THAT REDUCE RISK. Whether a transaction reduces a taxpayer's risk is determined based on all of the facts and circumstances surrounding the taxpayer's business and the transaction. In general, a taxpayer's hedging strategies and policies as reflected in the taxpayer's minutes or other records are evidence of whether particular transactions reduce the taxpayer's risk.

(ii) MICRO AND MACRO HEDGES -- (A) IN GENERAL. A taxpayer has risk of a particular type only if it is at risk when all of its operations are considered. Nonetheless, a hedge of a particular asset or liability generally will be respected as reducing risk if it reduces the risk attributable to the asset or liability and if it is reasonably expected to reduce the overall risk of the taxpayer's operations. If a taxpayer hedges particular assets or liabilities, or groups of assets or liabilities, and the hedges are undertaken as part of a program that, as a whole, is reasonably expected to reduce the overall risk of the taxpayer's operations, the taxpayer generally does not have to demonstrate that each hedge that was entered into pursuant to the program reduces its overall risk.

(B) FIXED-TO-FLOATING HEDGES. Under the principles of paragraph (c)(1)(ii)(A) of his section, a transaction that economically converts an interest rate or price from a fixed price or rate to a floating price or rate may reduce risk. For example, if a taxpayer's income varies with interest rates, the taxpayer may be at risk if it has a fixed rate liability. Similarly, a taxpayer with a fixed cost for its inventory may be at risk if the price at which the inventory can be sold varies with a particular factor. Thus, a transaction that converts an interest rate or price from fixed to floating may be a hedging transaction.

(iii) WRITTEN OPTIONS. A written option may reduce risk. For example, in appropriate circumstances, a written call option with respect to assets held by a taxpayer or a written put option with respect to assets to be acquired by a taxpayer may be a hedging transaction. See also paragraph (c)(1)(v) of this section.

(iv) EXTENT OF RISK REDUCTION. A taxpayer may hedge all or any portion of its risk for all or any part of the period during which it is exposed to the risk.

(v) TRANSACTIONS THAT COUNTERACT HEDGING TRANSACTIONS. If a transaction is entered into primarily to counteract all or any part of the risk reduction effected by one or more hedging transactions, the transaction is a hedging transaction. For example, if a written option is used to reduce or eliminate the risk reduction obtained from another position such as a purchased option, then it may be part of a hedging transaction.

(vi) NUMBER OF TRANSACTIONS. The fact that a taxpayer frequently enters into and terminates positions (even if done on a daily or more frequent basis) is not relevant to whether these transactions are hedging transactions. Thus, for example, a taxpayer hedging the risk associated with an asset or liability may frequently establish and terminate positions that hedge that risk, depending on the extent the taxpayer wishes to be hedged. Similarly, if a taxpayer maintains its level of risk exposure by entering into and terminating a large number of transactions in a single day, its transactions may nonetheless qualify as hedging transactions.

(vii) TRANSACTIONS THAT DO NOT REDUCE RISK. A transaction that is not entered into to reduce a taxpayer's risk is not a hedging transaction. For example, assume that a taxpayer produces a commodity for sale, sells the commodity, and enters into a long futures or forward contract in that commodity in the hope that the price will increase. Because the long position does not reduce risk, the transaction is not a hedging transaction. Moreover, gain or loss on the contract is not made ordinary on the grounds that it is a surrogate for inventory. See paragraph (a)(3) of this section.

(2) ENTERING INTO A HEDGING TRANSACTION. A taxpayer may enter into a hedging transaction by using a position that was a hedge of one asset or liability to hedge another asset or liability (recycling).

(3) NO INVESTMENTS AS HEDGING TRANSACTIONS. If an asset (such as an investment) is not acquired primarily to reduce risk, the purchase or sale of that asset is not a hedging transaction even if the terms of the asset limit or reduce the taxpayer's risk with respect to other assets or liabilities. For example, a taxpayer's interest rate risk from a floating rate borrowing may be reduced by the purchase of debt instruments that bear a comparable floating rate. The acquisition of the debt instruments, however, is not a hedging transaction because the transaction is not entered into primarily to reduce the taxpayer's risk. Similarly, borrowings generally are not made primarily to reduce risk.

(4) NORMAL COURSE. Solely for purposes of paragraph (b) of this section, if a transaction is entered into in furtherance of a taxpayer's trade or business, the transaction is entered into in the normal course of the taxpayer's trade or business. This rule applies even if the risk to be reduced relates to the expansion of an existing business or the acquisition of a new trade or business.

(5) ORDINARY PROPERTY AND OBLIGATIONS -- (i) IN GENERAL. Except as provided in paragraph (g)(3) of this section (which contains transition rules), property is ordinary property to a taxpayer only if a sale or exchange of the property by the taxpayer could not produce capital gain or loss regardless of the taxpayer's holding period when the sale or exchange occurs. Thus, for example, property used in a trade or business within the meaning of section 1231(b) (determined without regard to the holding period specified in that section) is not ordinary property. An obligation is an ordinary obligation if performance or termination of the obligation by the taxpayer could not produce capital gain or loss. For purposes of the preceding sentence, termination has the same meaning as in section 1234A.

(ii) HEDGES OF NONINVENTORY SUPPLIES. Notwithstanding paragraph (c)(5)(i) of this section, if a taxpayer sells only a negligible amount of a noninventory supply, then, only for purposes of determining whether a transaction to hedge the purchase of that noninventory supply is a hedging transaction, the supply is treated as ordinary property. A noninventory supply is a supply that a taxpayer purchases for consumption in its trade or business and that is not an asset described in sections 1221(1) through (5).

(6) BORROWINGS. Whether hedges of a taxpayer's debt issuances (borrowings) are hedging transactions is determined without regard to the use of the proceeds of the borrowing.

(7) HEDGING AN AGGREGATE RISK. The term hedging transaction includes a transaction that reduces an aggregate risk of interest rate changes, price changes, and/or currency fluctuations only if all of the risk, or all but a de minimis amount of the risk, is with respect to ordinary property, ordinary obligations, and borrowings.

(d) HEDGING BY MEMBERS OF A CONSOLIDATED GROUP. [Reserved].

(e) IDENTIFICATION AND RECORDKEEPING -- (1) SAME-DAY IDENTIFICATION OF HEDGING TRANSACTIONS. A taxpayer that enters into a hedging transaction (including recycling an existing hedge) must identify it as a hedging transaction. This identification must be made before the close of the day on which the taxpayer enters into the transaction.

(2) SUBSTANTIALLY CONTEMPORANEOUS IDENTIFICATION OF HEDGED ITEM -- (i) CONTENT OF THE IDENTIFICATION. A taxpayer that enters into a hedging transaction must identify the item, items, or aggregate risk being hedged. Identification of an item being hedged generally involves identifying a transaction that creates risk, and the type of risk that the transaction creates. For example, if a taxpayer is hedging the price risk with respect to its June purchases of corn inventory, the transaction being hedged is the June purchase of corn and the risk is price movements in the market where the taxpayer buys its corn. For additional rules concerning the content of this identification, see paragraph (e)(3) of this section.

(ii) TIMING OF THE IDENTIFICATION. The identification required by this paragraph (e)(2) must be made substantially contemporaneously with entering into the hedging transaction. An identification is not substantially contemporaneous if it is made more than 35 days after entering into the hedging transaction.

(3) IDENTIFICATION REQUIREMENTS FOR CERTAIN HEDGING TRANSACTIONS. In the case of the hedging transactions described in this paragraph (e)(3), the identification under paragraph (e)(2) of this section must include the information specified.

(i) ANTICIPATORY ASSET HEDGES. If the hedging transaction relates to the anticipated acquisition of assets by the taxpayer, the identification must include the expected date or dates of acquisition and the amounts expected to be acquired.

(ii) INVENTORY HEDGES. If the hedging transaction relates to the purchase or sale of inventory by the taxpayer, the identification is made by specifying the type or class of inventory to which the transaction relates. If the hedging transaction relates to specific purchases or sales, the identification must also include the expected dates of the purchases or sales and the amounts to be purchased or sold.

(iii) HEDGES OF DEBT OF THE TAXPAYER -- (A) EXISTING DEBT. If the hedging transaction relates to accruals or payments under an issue of existing debt of the taxpayer, the identification must specify the issue and, if the hedge is for less than the full adjusted issue price or the full term of the debt, the amount and the term covered by the hedge.

(B) DEBT TO BE ISSUED. If the hedging transaction relates to the expected issuance of debt by the taxpayer or to accruals or payments under debt that is expected to be issued by the taxpayer, the identification must specify the following information: the expected date of issuance of the debt; the expected maturity or maturities; the total expected issue price of the issue; and the expected interest provisions. If the hedge is for less than the entire expected issue price of the debt or the full expected term of the debt, the identification must also include the amount or the term being hedged. The identification may indicate a range of dates, terms, and amounts, rather than specific dates, terms, or amounts. For example, a taxpayer might identify a transaction as hedging the yield on an anticipated issuance of fixed rate debt during the second half of its fiscal year, with the anticipated amount of the debt between $75 million and $125 million, and an anticipated term of approximately 20 to 30 years.

(iv) HEDGES OF AGGREGATE RISK -- (A) REQUIRED IDENTIFICATION. If a transaction hedges aggregate risk as described in paragraph (c)(7) of this section, the identification under paragraph (e)(2) of this section must include a description of the risk being hedged and of the hedging program under which the hedging transaction was entered. This requirement may be met by placing in the taxpayer's records a description of the hedging program and by establishing a system under which individual transactions are identified as being entered into pursuant to the program.

(B) DESCRIPTION OF HEDGING PROGRAM. A description of a hedging program must include an identification of the type of risk being hedged, a description of the type of items giving rise to the risk being aggregated, and sufficient additional information to demonstrate that the program is designed to reduce aggregate risk of the type identified. If the program contains controls on speculation (for example, position limits), the description of the hedging program must also explain how the controls are established, communicated, and implemented.

(4) MANNER OF IDENTIFICATION AND RECORDS TO BE RETAINED -- (i) INCLUSION OF IDENTIFICATION IN TAX RECORDS. The identification required by this paragraph (e) must be made on, and retained as part of, the taxpayer's books and records.

(ii) PRESENCE OR ABSENCE OF IDENTIFICATION MUST BE UNAMBIGUOUS. The presence or absence of an identification for purposes of this paragraph (e) must be unambiguous. The identification of a hedging transaction for financial accounting or regulatory purposes does not satisfy this requirement unless the taxpayer's books and records indicate that the identification is also being made for tax purposes. The taxpayer may indicate that individual hedging transactions, or a class or classes of hedging transactions, that are identified for financial accounting or regulatory purposes are also being identified as hedging transactions for purposes of this section.

(iii) MANNER OF IDENTIFICATION. The taxpayer may separately and explicitly make each identification, or, so long as paragraph (e)(4)(ii) of this section is satisfied, the taxpayer may establish a system pursuant to which the identification is indicated by the type of transaction or by the manner in which the transaction is consummated or recorded. An identification under this system is made at the later of the time that the system is established or the time that the transaction satisfies the terms of the system by being entered, or by being consummated or recorded, in the designated fashion.

(iv) EXAMPLES. The following examples illustrate the principles of paragraph (e)(4)(iii) of this section and assume that the other requirements of paragraph (e) of this section are satisfied.

(A) A taxpayer can make an identification by designating a hedging transaction for (or placing it in) an account that has been identified as containing only hedges of a specified item (or of specified items or specified aggregate risk).

(B) A taxpayer can make an identification by including and retaining in its books and records a statement that designates all future transactions in a specified derivative product as hedges of a specified item, items, or aggregate risk.

(C) A taxpayer can make an identification by placing a designated mark on a record of the transaction (for example, trading ticket, purchase order, or trade confirmation) or by using a designated form or a record that contains a designated legend.

(5) IDENTIFICATION OF HEDGES INVOLVING MEMBERS OF THE SAME CONSOLIDATED GROUP. [Reserved].

(6) CONSISTENCY WITH SECTION 1256(e)(2)(C). Any identification for purposes of section 1256(e)(2)(C) is also an identification for purposes of paragraph (e)(1) of this section.

(f) EFFECT OF IDENTIFICATION AND NON-IDENTIFICATION -- (1) TRANSACTIONS IDENTIFIED -- (i) IN GENERAL. If a taxpayer identifies a transaction as a hedging transaction for purposes of paragraph (e)(1) of this section, the identification is binding with respect to gain, whether or not all of the requirements of paragraph (e) of this section are satisfied. Thus, gain from that transaction is ordinary income. If the transaction is not in fact a hedging transaction described in paragraph (b) of this section, however, paragraphs (a)(1) and (a)(2) of this section do not apply and the character of loss is determined without reference to whether the transaction is a surrogate for a noncapital asset, serves as insurance against a business risk, serves a hedging function, or serves a similar function or purpose. Thus, the taxpayer's identification of the transaction as a hedging transaction does not itself make loss from the transaction ordinary.

(ii) INADVERTENT IDENTIFICATION. Notwithstanding paragraph (f)(1)(i) of this section, if the taxpayer identifies a transaction as a hedging transaction for purposes of paragraph (e) of this section, the character of the gain is determined as if the transaction had not been identified as a hedging transaction if --

(A) The transaction is not a hedging transaction (as defined in paragraph (b) of this section);

(B) The identification of the transaction as a hedging transaction was due to inadvertent error; and

(C) All of the taxpayer's transactions in all open years are being treated on either original or, if necessary, amended returns in a manner consistent with the principles of this section.

(2) TRANSACTIONS NOT IDENTIFIED -- (i) IN GENERAL. Except as provided in paragraphs (f)(2)(ii) and (iii) of this section, the absence of an identification that satisfies the requirements of paragraph (e)(1) of this section is binding and establishes that a transaction is not a hedging transaction. Thus, subject to the exceptions, the rules of paragraphs (a)(1) and (2) of this section do not apply, and the character of gain or loss is determined without reference to whether the transaction is a surrogate for a noncapital asset, serves as insurance against a business risk, serves a hedging function, or serves a similar function or purpose.

(ii) INADVERTENT ERROR. If a taxpayer does not make an identification that satisfies the requirements of paragraph (e) of this section, the taxpayer may treat gain or loss from the transaction as ordinary income or loss under paragraph (a)(1) or (a)(2) of this section if --

(A) The transaction is a hedging transaction (as defined in paragraph (b) of this section);

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

(C) All of the taxpayer's hedging transactions in all open years are being treated on either original or, if necessary, amended returns as provided in paragraphs (a)(1) and (a)(2) of this section.

(iii) ANTI-ABUSE RULE. If a taxpayer does not make an identification that satisfies all the requirements of paragraph (e) of this section but the taxpayer has no reasonable grounds for treating the transaction as other than a hedging transaction, then gain from the transaction is ordinary. Thus, a taxpayer may not elect to treat gain or loss from a hedging transaction as capital gain or loss. The reasonableness of the taxpayer's failure to identify a transaction is determined by taking into consideration not only the requirements of paragraph (b) of this section but also the taxpayer's treatment of the transaction for financial accounting or other purposes and the taxpayer's identification of similar transactions as hedging transactions.

(3) TRANSACTIONS BY MEMBERS OF A CONSOLIDATED GROUP. [Reserved].

(g) EFFECTIVE DATES AND TRANSITION RULES -- (1) EFFECTIVE DATE FOR IDENTIFICATION REQUIREMENTS -- (i) IN GENERAL. Paragraph (e) of this section applies to transactions that --

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

(B) Are entered into before that date and remain in existence on March 31, 1994.

(ii) TRANSITION RULE. In the case of a hedging transaction that is entered into before January 1, 1994, and remains in existence on March 31, 1994, an identification is timely if it is made before the close of business on March 31, 1994.

(iii) SPECIAL RULES FOR HEDGING TRANSACTIONS NOT DESCRIBED IN SECTION 1.1221-2T(b). In the case of a transaction that is entered into before October 1, 1994, that is a hedging transaction within the meaning of paragraph (b) of this section (or is treated as a hedging transaction under paragraph (g)(3) of this section), and that the taxpayer reasonably treated as not being a hedging transaction within the meaning of paragraph (b) of section 1.1221-2T (26 CFR part 1 revised as of April 1, 1994) --

(A) If the transaction does not remain in existence on October 1, 1994, paragraph (e) of this section does not apply; and

(B) If the transaction remains in existence on October 1, 1994, paragraph (e) of this section applies, and an identification is timely if it is made before the close of business on October 1, 1994.

(2) RELIANCE ON SECTION 1.1221-2T -- (i) GENERAL RULE. A taxpayer may rely on any paragraph in section 1.1221-IT (26 CFR part 1 revised as of April 1, 1994), for transactions entered into prior to October 1, 1994, provided that the taxpayer applies the paragraph reasonably and consistently.

(ii) IDENTIFICATION. In the case of a transaction entered into before October 1, 1994, an identification is deemed to satisfy paragraph (e) of this section if it satisfies section 1.1221-2T(c) (26 CFR part 1 revised as of April 1, 1994). For this purpose, identification of the hedged item is timely if it is made within the period specified in paragraph (e)(2)(ii) of this section.

(3) TRANSITION RULES FOR HEDGES OF CERTAIN PROPERTY -- (i) TRANSITION RULE FOR SECTION 1231 ASSETS. For all taxable years that ended prior to [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER] and that, as of September 1, 1994, were still open for assessment under section 6501, a taxpayer may treat as hedging transactions all transactions that were entered into during those years and that hedge property used in the trade or business within the meaning of section 1231(b) (a section 1231 asset) if the taxpayer can establish that, during those years --

(A) Sales of section 1231 assets did not give rise to net gain treated as capital gain (after application of section 1231(c));

(B) All of the hedges of section 1231 assets would be hedging transactions under paragraph (b) of this section if section 1231 assets were ordinary property; and

(C) On original or amended returns, the taxpayer consistently treats all of the hedges of section 1231 assets as hedging transactions.

(ii) TRANSITION RULE FOR NONINVENTORY SUPPLIES. For all taxable years that ended prior to [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER] and that, as of September 1, 1994, were still open for assessment under section 6501, a taxpayer may treat as hedging transactions all hedges of purchases of noninventory supplies (as defined in paragraph (c)(5)(ii) of this section) that would not otherwise qualify as hedging transactions and that were entered into during those years if the taxpayer can establish that, during those years --

(A) The taxpayer did not sell in any of those years more than 15 percent of the greater of the total amount of the supply held at the beginning of the year or the total amount of the supply acquired during that year;

(B) All of the hedges would be hedging transactions under paragraph (b) of this section if noninventory supplies were ordinary property; and

(C) On original or amended returns, the taxpayer consistently treats all of the hedges of noninventory supplies as hedging transactions.

(4) EFFECTIVE DATE FOR HEDGES BY MEMBERS OF A CONSOLIDATED GROUP. [Reserved].

SECTION 1.1221-2T [REMOVED]

Par. 4. Effective October 1, 1994, section 1.1221-2T is removed.

Par. 5. Effective [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER] section 1.1233-2T is redesignated section 1.1233-2 and is revised to read as follows:

SECTION 1.1233-2 HEDGING TRANSACTIONS.

The character of gain or loss on a short sale that is (or is identified as being) part of a hedging transaction is determined under the rules of section 1.1221-2.

Par. 6. Effective [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER] Section 1.1234-4T is redesignated section 1.1234-4 and is revised to read as follows:

SECTION 1.1234-4 HEDGING TRANSACTIONS.

The character of gain or loss on an acquired or a written option that is (or is identified as being) part of a hedging transaction is determined under the rules of section 1.1221-2.

Par. 7. Effective [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER] section 1.1256(e)-1 is added to read as follows:

SECTION 1.1256(e)-1 IDENTIFICATION OF HEDGING TRANSACTIONS.

(a) IDENTIFICATION AND RECORDKEEPING REQUIREMENTS. Under section 1256(e)(2)(C), a taxpayer that enters into a hedging transaction must identify the transaction as a hedging transaction before the close of the day on which the taxpayer enters into the transaction.

(b) REQUIREMENTS FOR IDENTIFICATION. The identification of a hedging transaction for purposes of section 1256(e)(2)(C) must satisfy the requirements of section 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 section 1.1221-2(e)(1) is nevertheless treated as an identification under section 1256(e)(2)(C).

(c) CONSISTENCY WITH SECTION 1.1221-2. Any identification for purposes of section 1.1221-2(e)(1) is also an identification for purposes of this section. If a taxpayer satisfies the requirements of paragraph (f)(1)(ii) of section 1.1221-2, the transaction is treated as if it were not identified as a hedging transaction for purposes of section 1256(e)(2)(C).

(d) EFFECTIVE DATE. This section applies to transactions entered into on or after October 1, 1994.

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

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

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

Par. 9. Effective [INSERT DATE OF PUBLICATION OF THIS DOCUMENT IN THE FEDERAL REGISTER] Section 602.101(c) is amended by adding an entry in numerical order to the table to read as follows:

SECTION 602.101 OMB CONTROL NUMBERS.

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