Temporary Regs Provide Ordinary Gain and Loss Treatment for Business Hedges

 [4830-01-u]

 ACTION: Temporary regulations.

 SUMMARY: This document contains temporary regulations clarifying the character of gain or loss from business hedges. The temporary regulations address questions that have arisen as a result of the decision of the United States Supreme Court in Arkansas Best. The temporary regulations provide guidance to taxpayers entering into hedging transactions and serve as a basis for resolving pending cases involving gains and losses from hedging. The text of the temporary regulations set forth in this document also serves as the text of the proposed regulations cross-referenced in the notice of proposed rulemaking in the Proposed Rules section of this issue of the Federal Register.

 DATES: These temporary regulations are effective October 20, 1993.

 For dates of applicability of these temporary 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, N.W., Washington D.C. 20224 (Attn: CC:DOM:FI&P). Telephone 202-622-3920 (not a toll- free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

This regulation is being issued without prior notice and public procedure pursuant to the Administrative Procedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and, pending receipt and evaluation of public comments, approved by the Office of Management and Budget under control number 1545-1403. The estimated annual burden per recordkeeper varies from .10 to 10.00 hours, depending on individual circumstances, with an estimated average of .50 hour.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on such information as is available to the Internal Revenue Service. Individual recordkeepers may require greater or less time, depending on their particular circumstances.

 For further information concerning this collection of information, and where to submit comments on this collection of information, the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble to the cross-referencing notice of proposed rulemaking published in the Proposed Rules section of this issue of the Federal Register.

BACKGROUND

 This document contains temporary 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. The tax treatment of the gain or loss generally depends upon whether property used as a hedge is characterized as a capital asset.

 In Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988) (Arkansas Best), the Supreme Court held that the taxpayer realized a capital loss on a sale of stock even though the stock was purchased with a business motive rather than an investment motive. In so holding, the Court rejected the business motive test (the Corn Products doctrine) that had developed following the Court's decision in Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955) (Corn Products). The Court reaffirmed its holding in Corn Products on the grounds that the futures contracts at issue in that case came within the inventory exception of section 1221(1) of the Code.

 Arkansas Best has caused uncertainty with respect to the tax treatment of business hedging generally. Prior to Corn Products, it had been widely recognized that gain or loss realized on a hedge of a non-capital asset was treated as ordinary income or loss. After Corn Products, however, virtually all hedging transactions were thought to be within the business motive test of the Corn Products doctrine. Thus, there was little new authority on the subject of hedging during the 30 years preceding the Arkansas Best decision.

 Arkansas Best itself did not involve a business hedging transaction, and the Court did not directly address the tax treatment of hedging. Nonetheless, based on the Court's narrow interpretation of its earlier decision in Corn Products, the Service, in individual cases, has treated various types of business hedging transactions as giving rise to capital gain or loss. Issues with respect to business hedging are present in many cases at an administrative level, and several cases involving these issues are pending in the courts.

 In Federal National Mortgage Association v. Commissioner, 100 T.C. No. 36 (June 17, 1993) (FNMA), the Tax Court rejected the Service's position and held that the taxpayer's business hedges gave rise to ordinary gain or loss. In that case, the taxpayer used short positions in futures contracts, put options, and short sales of Treasury securities to hedge the spread between the rate of interest on mortgages that it held or had committed to buy and the rate of interest on indebtedness to be incurred to carry the mortgages. The court found that the mortgages were not capital assets and that the hedges were so integrally related to the mortgages that they also were entitled to ordinary treatment. The court cited with favor the pre-Corn Products cases involving business hedges and expressed a willingness to extend ordinary treatment to "short" hedges as well as "long" hedges and to liability hedges as well as asset hedges.

 Although the Service may disagree with some aspects of the FNMA opinion, the court clearly found Arkansas Best not to be an impediment to treating gains and losses on business hedging transactions as ordinary rather than capital.

 The result reached by the court avoids the character mismatches that result from treating business hedges as capital. Moreover, it comports with substantial evidence that Congress has long assumed that business hedges give rise to ordinary gain or loss. The legislative history of the 1954 Code, for example, expressly notes that hedges were ordinary under then-current law and that Congress intended to continue that treatment. H.R. Rep. No. 1337, 83d Cong., 2d Sess. A278 (1954). In addition, a number of statutory provisions that provide special treatment to taxpayers that engage in hedging transactions are premised on Congress' understanding that business hedges receive ordinary treatment. See, e.g., sections 1256(e), 1092(e), 263(g)(3), and 1233(g) of the Code.

 In light of the above, the Service has decided to abandon the position it has taken with respect to the character of many common business hedges and to resolve that issue with these regulations. Cases pending at the administrative level and in the courts will be disposed of in a manner consistent with the regulations. On a prospective basis, the regulations provide an identification and record-keeping requirement that is necessary for the Service to locate and evaluate transactions that taxpayers believe should qualify for hedge treatment.

NEED FOR TEMPORARY REGULATIONS

 Immediate guidance is needed with respect to gains and losses on business hedging transactions. This Treasury decision will enable Service personnel to resolve in a fair and consistent manner the many cases pending either at the administrative level or in the courts. Moreover, the clarification is needed because the uncertainty caused by Arkansas Best regarding the tax treatment of business hedges may be influencing business decisions as to whether and how to hedge business risks. Therefore, good cause is found to dispense with the public notice requirement of 5 U.S.C. 553(b) and the delayed effective date requirement of 5 U.S.C. 553(d).

EXPLANATION OF PROVISIONS

 Paragraph (a)(1) of section 1.1221-2T provides that property that is part of a hedging transaction, as defined in the regulations, is not a capital asset. This rule is effective for all open years.

 Paragraph (a)(2) of section 1.1221-2T 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. Although the character of gain or loss on a short sale or option generally is determined under sections 1233 and 1234 rather than section 1221, the rule for short sales and options has been included here to provide a unified set of rules for determining the character of gain or loss on hedging transactions. New temporary regulations under sections 1233 and 1234 provide that section 1.1221-2T governs the character of gain or loss on short sales and options that are part of hedging transactions.

 Under paragraph (a)(3) of section 1.1221-2T, the fact that property, a short sale, or an option serves a hedging function makes gain or loss on the property, short sale, or option ordinary only if the property, short sale, or option is part of a hedging transaction as defined in the regulations. For example, 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 or that the transaction serves as "insurance" against a business risk.

 Paragraph (a)(4) of section 1.1221-2T describes the relationship between section 1.1221-2T and certain other sections. Section 988 transactions are excluded from these regulations because gain or loss on those transactions is ordinary under section 988(a)(1). The regulations do apply, however, to transactions that predate the effective date of section 988. Paragraph (a)(4) of section 1.1221-2T also makes clear that the definition of a hedging transaction under section 1.1221-2T(b) does not apply for purposes of certain hedging exceptions to the subpart F rules of section 954 and certain hedge identification rules in the interest allocation regulations under section 864(e).

 In defining the term hedging transaction, paragraph (b)(1) of section 1.1221-2T adopts the concept of hedging in section 1256(e)(2)(A) of the Code. A hedging transaction generally is a transaction that a taxpayer enters into in the normal course of the taxpayer's business primarily to reduce the risk of interest rate or price changes or currency fluctuations. Thus, the regulations do not provide ordinary treatment for gain or loss from the disposition of stock where, for example, the stock was acquired to protect the goodwill or business reputation of the acquirer or to ensure the availability of goods.

 The definition of a hedging transaction covers most, but not all, common business hedges. 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, because a hedging transaction must reduce the taxpayer's risk, the regulation does not apply where a taxpayer hedges the risk of a related party. The Service welcomes comments on the scope of the definition and on the treatment of transactions between related parties.

 A second element of the definition of a hedging transaction is that the risk being reduced must relate to ordinary property or obligations or to the taxpayer's borrowings. Paragraph (b)(2) of section 1.1221-2T defines the terms ordinary property and ordinary obligations. Property is ordinary property if a sale or exchange of the property could never produce capital gain or loss. An obligation is an ordinary obligation if performing or terminating the obligation could never produce capital gain or loss. For example, a taxpayer's obligation with respect to a short sale of a capital asset is not an ordinary obligation.

 Hedges of property within the exceptions to section 1221 and property that produces ordinary gain or loss under, for example, section 582(c) generally come within the definition of the term "hedging transaction." The Service believes that it is inappropriate, however, to have a loss on a hedge treated as ordinary when gain on the item or items being hedged could be treated as capital gain. Thus, a hedge of a section 1231 asset or a hedge of the ordinary income produced by a capital asset is excluded from the definition. Hedges of non-inventory supplies are also excluded because they are capital assets, notwithstanding the fact that they give rise to ordinary deductions when they are consumed in the taxpayer's business.

 Paragraph (b)(3) of section 1.1221-2T clarifies that a transaction that hedges an aggregate risk qualifies for ordinary treatment under the regulations only if all of the risk, or all but a de minimis amount of the risk, being hedged is related to ordinary property and liabilities. Thus, a bank could hedge the aggregate interest rate exposure on a large pool of its assets and treat any gain or loss from the hedge as ordinary gain or loss, even if a de minimis amount of the aggregate interest rate risk is related to capital assets. All of the risk being hedged, however, must be interest rate, price, or currency risk. Thus, the regulations do not permit ordinary treatment where a taxpayer hedges the overall profitability of one or more business units.

 Paragraphs (c)(1) and (c)(3) of section 1.1221-2T impose a same- day identification and record-keeping requirement with respect to hedging transactions entered into on or after January 1, 1994. In the case of transactions that were entered into before January 1, 1994, and that remain in existence on March 31, 1994, the same requirement applies except that the identification may be made until March 31, 1994. These requirements, authorized by sections 6001 and 7805, are designed to aid the Internal Revenue Service in administering the law and to prevent manipulation, such as recharacterization of transactions in view of later developments. In all cases, a taxpayer must identify a hedging transaction unambiguously. The identification is to be made on, and retained as part of, the taxpayer's books and records and must specify both the hedging position and the item, items, or aggregate risk that is being hedged.

 The Service is considering what requirements should be met in order for an identification to satisfy section 1.1221-2T(c). The proposed regulations that cross reference the text of this Treasury decision also contain proposed special identification requirements for specific types of hedging transactions. An additional matter to be decided is what transaction-by-transaction records are required. For example, some taxpayers today make identifications for purposes of section 1256(e) by checking a workpaper box that refers explicitly to that statutory provision. The Service solicits comments on this point and on how a taxpayer should identify a global or other aggregate hedge. Pending more specific guidance, the Service will accept any reasonable method of identifying the item, items, or aggregate risk being hedged.

 The taxpayer's identification of a transaction as a hedging transaction is binding on the taxpayer. Thus, a taxpayer who identifies a transaction as a hedging transaction must treat any gain from the transaction as ordinary gain, even if the transaction does not meet the definition of a hedging transaction. Misidentifying a nonhedging transaction as a hedge, however, does not transform a capital loss from the transaction into an ordinary loss. A taxpayer may not use the identification procedure to obtain a benefit to which the taxpayer is not entitled under the substantive rule. This rule is similar to the rule in section 1256(f)(1) of the Code.

 Similarly, the absence of identification generally is binding on a taxpayer and establishes that a transaction is not a hedging transaction. A taxpayer who does not identify a transaction may not claim the benefit of the regulations and must treat a loss from the transaction as a capital loss unless ordinary loss treatment is available without reference to whether the transaction serves a hedging function. An exception to this rule is provided where the taxpayer can show that the transaction in question was a hedging transaction and that the failure to identify the transaction was due to inadvertent error. Finally, if a hedging transaction was not identified and the taxpayer had no reasonable basis for treating the transaction as other than a hedging transaction, gain from the transaction is ordinary.

DATES OF APPLICABILITY

 These temporary regulations generally apply to all open taxable years. The identification requirements of paragraphs (c)(1) and (c)(3) of section 1.1221-2T apply to transactions entered into on or after January 1, 1994, and to transactions that were entered into before January 1, 1994, and that remain in existence on March 31, 1994.

SPECIAL ANALYSES

 It has been determined that these regulations are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also 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, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their 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), Internal Revenue Service. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR part 1

 Income taxes, Reporting and recordkeeping requirements.

26 CFR part 602

 Reporting and recordkeeping requirements.

ADOPTION OF AMENDMENTS TO THE REGULATIONS

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

Paragraph 1. The authority citation for part 1 is amended by adding a citation in numerical order to read as follows:

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

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

Par. 2. Section 1.1221-2T is added to read as follows:

SECTION 1.1221-2T HEDGING TRANSACTIONS (TEMPORARY).

(a) TREATMENT OF HEDGING TRANSACTIONS -- (1) IN GENERAL. This section governs the treatment of hedging transactions under section 1221. Except as provided in paragraph (d)(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 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 1.1233-2T and 1.1234-4T. Except as provided in paragraph (d)(2) of this section, gain or loss on a short sale or option that is part of a hedging transaction defined in paragraph (b) of this section is ordinary income or loss.

(3) EXCLUSIVITY. Gain or loss on property, a short sale, or an option is ordinary on the grounds that the property, short sale, or option serves a hedging function only if the property, short sale, or option is part of a hedging transaction as defined in paragraph (b) of this section.

(4) COORDINATION WITH OTHER SECTIONS -- (i) SECTION 988. This section does not apply to gain or loss realized on a section 988 transaction as defined in section 988(c)(1) or to any 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 954(c) AND 864(e). The definition of a hedging transaction in paragraph (b) of this section does not apply for purposes of section 954(c)(1)(C), section 954(c)(1)(D), and section 1.861-9T(b)(6)(iv)(C).

(b) HEDGING TRANSACTION -- (1) IN GENERAL. A hedging transaction is a transaction that a taxpayer enters into in the normal course of the taxpayer's trade or business primarily --

(i) To reduce risk of price changes or currency fluctuations with respect to ordinary property (as defined in paragraph (b)(2) of this section) that is held or to be held by the taxpayer; or

(ii) 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.

(2) ORDINARY PROPERTY AND OBLIGATIONS. Property is ordinary property 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 the 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.

(3) 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.

(c) IDENTIFICATION AND RECORD-KEEPING REQUIREMENTS -- (1) IN GENERAL. 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. The identification must be made on, and retained as part of, the taxpayer's books and records and must specify both the hedging transaction and the item, items, or aggregate risk that is being hedged.

(2) ADDITIONAL IDENTIFICATION REQUIREMENTS FOR CERTAIN HEDGING TRANSACTIONS. [RESERVED]

(3) PRESENCE OR ABSENCE OF IDENTIFICATION MUST BE UNAMBIGUOUS. The presence or absence of an identification for purposes of this paragraph (c) 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.

(4) CONSISTENCY WITH SECTION 1256(e)(2)(C). [RESERVED]

(5) EFFECTIVE DATE -- (i) IN GENERAL. Paragraphs (c)(1) and (c)(3) of this section apply 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) SPECIAL RULE FOR PARAGRAPHS (c)(2) AND (c)(4). [RESERVED]

(6) TRANSITION RULE. In the case of hedging transactions described in paragraph (c)(5)(i)(B) of this section, an identification is timely if it is made before the close of business on March 31, 1994.

(d) EFFECT OF IDENTIFICATION AND NON-IDENTIFICATION -- (1) TRANSACTIONS IDENTIFIED. If the taxpayer identifies a transaction as a hedging transaction for purposes of paragraph (c) of this section, the identification is binding with respect to gain, whether or not all of the requirements of that paragraph 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 serves a hedging function. Thus, the taxpayer's identification of the transaction as a hedging transaction does not itself make loss from the transaction ordinary.

(2) TRANSACTIONS NOT IDENTIFIED -- (i) IN GENERAL. Except as provided in paragraphs (d)(2)(ii) and (d)(2)(iii) of this section, the absence of an identification that satisfies the requirements of paragraph (c) 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 (a)(2) of this section do not apply and the character of gain or loss is determined without reference to whether the transaction serves a hedging function.

(ii) INADVERTENT ERROR. If a taxpayer does not make an identification that satisfies the requirements of paragraph (c) 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 only 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 the requirements of paragraph (c) of this section, but the taxpayer has no reasonable basis for treating the transaction as other than a hedging transaction, 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.

Par. 3. Section 1.1233-2T is added to read as follows:

SECTION 1.1233-2T HEDGING TRANSACTIONS (TEMPORARY).

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

Par. 4. Section 1.1234-4T is added to read as follows:

SECTION 1.1234-4T HEDGING TRANSACTIONS (TEMPORARY).

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

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

Par. 5. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 6. 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.

 (c) * * *