[Federal Register Volume 59, Number 136 (Monday, July 18, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-16869]
[[Page Unknown]]
[Federal Register: July 18, 1994]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[FI-34-94]
RIN 1545-AS75
Hedging Transactions by Members of a Consolidated Group
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains proposed regulations relating to the
character and timing of gain or loss from certain hedging transactions
entered into by members of a consolidated group. These proposed
regulations apply when one member of the group hedges the risk of
another member or enters into a hedge with another member. The
regulations are needed because related-party hedging is a common
business practice and existing regulations treat as hedging
transactions only hedges entered into by a taxpayer to reduce its own
risk. This document also provides notice of a public hearing on these
proposed regulations.
DATES: Written comments must be received by September 26, 1994.
Requests to speak (with outlines of oral comments) at a public hearing
scheduled for October 18, 1994, must be received by September 26, 1994.
ADDRESSES: Send submissions to: CC:DOM:CORP:T:R (FI-34-94) room 5228,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. In the alternative, submissions may be hand delivered between
the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:T:R (FI-34-94),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW,
Washington, DC. The public hearing has been scheduled to be held in
room 3718, 1111 Constitution Avenue, NW, Washington, DC 20224.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jo Lynn
Ricks of the Office of the Assistant Chief Counsel (Financial
Institutions and Products), (202) 622-3920 (not a toll-free number);
concerning submissions and the hearing, Carol Savage, (202) 622-8452
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act (44 U.S.C.
3504(h)). Comments on the collections of information should be sent to
the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, PC:FP, Washington, DC
20224.
The collections of information are in Secs. 1.1221-2(d)(2)(iv) and
1.1221-2(e)(5). This information is required by the IRS to aid it in
administering the law and to prevent manipulation, such as
recharacterization of transactions in view of later developments. This
information will be used to determine whether the taxpayer has elected
separate-entity treatment under Sec. 1.1221-2(d)(2) and to verify that
the taxpayer is properly reporting its business hedging transactions.
The likely respondents and recordkeepers are businesses or other for-
profit institutions.
Estimated total annual reporting and recordkeeping burden: 75,000
hrs.
The estimated annual burden per respondent or recordkeeper varies
from 1.0 to 40.0 hours, depending on individual circumstances, with an
estimated average of 5 hours.
Estimated number of respondents and recordkeepers: 15,000.
Estimated frequency of responses: once in the existence of each
respondent.
Background
Final regulations under section 1221, published elsewhere in this
issue of the Federal Register, generally provide for ordinary gain or
loss from hedging transactions. To qualify as a hedging transaction, a
transaction must be entered into in the normal course of business to
reduce certain specified risks of the taxpayer. Final regulations under
section 446, published elsewhere in this issue of the Federal Register,
require taxpayers to account for hedging transactions in a manner that
clearly reflects income by reasonably matching the timing of income,
deduction, gain, or loss from the hedge with the timing of the income,
deduction, gain, or loss from the item being hedged.
Because a hedging transaction must reduce the taxpayer's own risk,
the regulations do not apply where a taxpayer hedges the risk of
another taxpayer, even if that other taxpayer is a related party. In
the preamble to TD 8493, which was published on October 20, 1993 (58 FR
54037), the IRS requested comments on the treatment of transactions
involving related parties.
Several commentators suggested extending the definition of hedging
transaction to the hedging of a related party's risk. Many businesses
that are conducted through separate but related entities centralize
their hedging operations in a single entity or a small number of
entities that hedge the risks of the entire business. Centralizing the
hedging function creates economies of scale and allows the risks of the
business to be netted or offset against each other, with the hedging
entity entering into hedges with unrelated parties only for the
remaining net risk. Thus, various commentators suggested that the term
hedging transaction should include hedges of the risk of other members
of the same consolidated group, of affiliated corporations filing
separate returns, of controlled but unaffiliated corporations, and of
controlled partnerships.
Explanation of Provisions
As a general rule, the proposed regulations adopt a single-entity
approach to consolidated groups, applying the hedging rules to a
member's transactions that hedge the risk of other members of the same
consolidated group. Proposed Sec. 1.1221-2(d)(1) provides that the risk
of one member of a consolidated group is treated for purposes of the
hedging rules as the risk of the other members of the group as if all
of the members of the group were divisions of a single corporation.
Thus, if a transaction entered into by a centralized hedging member
reduces the risk of the group as a whole and the other requirements of
Sec. 1.1221-2 are met, the transaction qualifies as a hedging
transaction.
Many consolidated groups that centralize their hedging operations
execute contracts or enter into other transactions between the members
to transfer risk from the operating members to the hedging member. For
example, an operating member that assumes a floating rate liability may
enter into an interest rate swap with the hedging member pursuant to
which the operating member will pay fixed and receive floating. The
hedging member nets this risk with its other interest rate risk and, if
it has a net risk, may enter into an interest rate swap with a third
party to offset this net risk.
Under the single-entity approach of the proposed regulations,
transactions between members of a consolidated group are not hedging
transactions because they do not reduce the risk of the group. Instead,
these transactions are subject to the rules of section 1502 and the
regulations thereunder, which govern the timing and character of income
on intercompany transactions and obligations. Thus, only a transaction
with a third party can qualify as a hedging transaction.
Several commentators on the proposed character and timing
regulations requested that the IRS adopt a separate-entity regime for
related-party hedges. They expressed concern that, under a single-
entity regime, a hedging member may not have the information necessary
to comply with the identification requirements imposed on hedging
transactions. That is, the hedging member may not have information with
respect to the transaction that gave rise to the risk that was
transferred to it in the intercompany transaction.
Under a separate-entity approach, an intercompany transaction that
met the definition in Sec. 1.1221-2(b) would be respected as a hedging
transaction and accounted for as such, and the transaction would not be
subject to the intercompany transaction regime. In other words, if a
member of a consolidated group enters into a transaction to transfer
risk to another member, the transaction would be treated as if it had
been entered into with an unrelated party.
The IRS and Treasury recognize that, where a consolidated group
uses intercompany transactions to transfer risk within the group, the
separate-entity approach may facilitate the identification of hedging
transactions and simplify the accounting for those transactions. A
generally applicable separate-entity approach, however, frequently
would not clearly reflect the income of the consolidated group and
might be subject to manipulation. Moreover, a general separate-entity
approach for hedges would be contrary to the single-entity approach of
recently proposed Sec. 1.1502-13, and it would be difficult to
coordinate the treatment of intercompany hedging transactions with the
treatment of other intercompany transactions.
Despite the concern with a general separate-entity approach, the
IRS and Treasury believe that there is less opportunity for
manipulation or distortion if a member of a group enters into a hedging
transaction with another member that is using mark-to-market accounting
for tax purposes. Thus, when a group contains a hedging member that
accounts for the transaction on a mark-to-market method of accounting,
a limited separate-entity approach may be acceptable.
Therefore, the proposed regulations allow a consolidated group to
make a separate-entity election. The election is made by the group for
all of its hedging activities and may not be revoked without the
consent of the Commissioner. If a group makes the election, the risk of
one member is not treated as risk of the other members. Thus, a member
can hedge only its own risk, and an intercompany transaction must be
used if one member of the group wishes to transfer risk to another
member.
In an electing group, certain intercompany transactions are
recognized as hedging transactions for purposes of Sec. 1.1221-2. An
intercompany transaction is treated as a hedging transaction if it
would be a hedging transaction if entered into with an unrelated party,
and if it is entered into with another member that, under its method of
accounting, marks the position to market. Thus, for example, an
operating member could enter into a hedging transaction with a hedging
member that marks the position obtained to market under section 475. As
a result of the separate-entity election, the hedging transaction is
not treated as an intercompany transaction or obligation for purposes
of section 1502 and the regulations thereunder, and any gain or loss to
the member marking to market the position obtained is ordinary.
This special treatment is provided only for intercompany
transactions entered into with a member that marks its position to
market. If an identical transaction is entered into with a member of
the group that does not mark to market the position obtained, the
transaction is subject to the intercompany transaction rules under
section 1502. Thus, the separate-entity election is likely to be made
only by a group whose intercompany hedging activity is done with a
member that uses a mark-to-market method of accounting.
The proposed regulations provide identification rules that conform
to the treatment of hedging transactions described above. If a
consolidated group is under the general rule of the regulations (the
single-entity approach), identification is done as if the members of
the group were divisions of a single corporation. The member engaging
in a hedging transaction with an unrelated party identifies the
transaction and the item, items, or aggregate risk being hedged, even
if the item, items, or aggregate risk is that of another member.
If a group is under the general rule but uses intercompany
transactions to transfer risk within the group, it may satisfy the
identification requirement by identifying the item, items, or aggregate
risk being hedged, its intercompany transactions, and its hedging
transactions with unrelated parties. Although the intercompany
transactions are not respected as hedging transactions, their
identification should enable the group to associate hedging
transactions with the item, items, or aggregate risk being hedged.
If a group makes the separate-entity election, each member must
identify its hedging transactions with unrelated parties, its
intercompany transactions that are treated as hedging transactions
under these regulations, and the item, items, or aggregate risk being
hedged, as appropriate.
The proposed regulations also provide rules with respect to the
effects of identification and nonidentification. If a group is under
the general rule, the rules of Sec. 1.1221-2(f) apply to a hedging
transaction, but not to intercompany transactions. If a group makes the
separate-entity election, the rules of Sec. 1.1221- 2(f) are extended
to intercompany transactions that are treated as hedging transactions
under these regulations.
Finally, the proposed regulations provide new rules with respect to
timing under Sec. 1.446-4. If a group is under the general rule, it
accounts for hedging transactions as if the members of the group were
divisions of a single corporation. The income, deduction, gain, or loss
on a hedging transaction is matched with the income, deduction, gain,
or loss on the item, items, or aggregate risk being hedged and not with
an intercompany transaction. If a group makes the separate-entity
election, the rules of Sec. 1.446-4 apply on a member-by-member basis
to hedging transactions with unrelated parties and to intercompany
transactions that are treated as hedging transactions under these
regulations.
It is anticipated that these regulations will apply to transactions
entered into on or after the date that is 60 days after the publication
of final regulations on this subject in the Federal Register.
All of the rules described above apply only in the case of a
consolidated group. Thus, the proposed regulations do not treat as a
hedging transaction the hedging of the risk of a related party that is
not a member of the same consolidated group. The IRS is concerned that
the single-entity approach is generally not appropriate where the
parties are not members of the same consolidated group.
Outside the context of a consolidated group, taxpayers with
ordinary business risk sometimes enter into transactions to transfer
risk to a related party. Commentators have requested that these
transactions be treated as hedging transactions and that the entities
to which risk is transferred be treated as realizing ordinary gain or
loss on their positions in these transactions. The IRS is concerned,
however, about whether these transactions reduce risk, whether the
requested ordinary treatment to the entities receiving risk is
authorized under the Internal Revenue Code (Code), and whether the
approach would create opportunities for manipulation. Therefore, the
proposed regulations do not include the requested rule.
The IRS intends to issue guidance under section 475 of the Code to
coordinate the hedging exception of section 475(b)(1)(C) with these
rules. In particular, if a consolidated group has not made a separate-
entity election, the IRS is considering whether the identification of a
hedging transaction by a member subject to section 475 should generally
be sufficient to identify the transaction as a hedge under section
475(b)(1)(C), provided the hedged item or items are not securities
subject to section 475(a). In this case, gain or loss on the hedging
transaction would generally be subject to the timing rules of
Sec. 1.446-4 rather than to mark-to-market treatment under section 475.
Comments are requested on this matter.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866. Therefore,
a regulatory assessment is not required. It also has been determined
that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do
not apply to these regulations, and, therefore, a Regulatory
Flexibility Analysis is not required. Pursuant to section 7805(f) of
the Internal Revenue Code, this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) that are submitted timely to the IRS. All
comments will be available for public inspection and copying.
A public hearing has been scheduled for Tuesday, October 18, 1994,
at 10:00 a.m. in room 3718, 1111 Constitution Avenue, NW., Washington,
DC, 20224. Because of access restrictions, visitors will not be
admitted beyond the Internal Revenue Building lobby more than 15
minutes before the hearing starts.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons that wish to present oral comments at the hearing must
submit written comments by September 26, 1994, and submit an outline of
the topics to be discussed and the time to be devoted to each topic
(signed original and eight (8) copies) by September 26, 1994.
A period of 10 minutes will be allotted to each person for making
comments.
An agenda showing the scheduling of the speakers will be prepared
after the deadline for receiving outlines has passed. Copies of the
agenda will be available free of charge at the hearing.
Drafting Information
The principal author of these regulations is Jo Lynn Ricks, Office
of Assistant Chief Counsel (Financial Institutions and Products).
However, other personnel from the IRS and Treasury Department
participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 is amended by
removing the entry for Sec. 1.1221-2 and by adding entries in numerical
order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.446-4 also issued under 26 U.S.C. 1502. * * *
Section 1.1221-2 also issued under 26 U.S.C. 1502 and 6001. * * *
Par. 2. Section 1.446-4 is amended by adding the text of paragraph
(e)(9) to read as follows:
Sec. 1.446-4 Hedging transactions.
* * * * *
(e) * * *
(9) Hedging by members of a consolidated group--(i) General rule.
In general, a member of a consolidated group that hedges the risk of
another member must account for its hedging transactions as if all of
the members were separate divisions of a single corporation. Thus, the
timing of the income, deduction, gain, or loss on a hedging transaction
must be matched with the timing of income, deduction, gain, or loss
from the item or items being hedged rather than with an intercompany
transaction.
(ii) Separate-entity election. If a consolidated group makes an
election under Sec. 1.1221-2(d)(2), each member of the consolidated
group must account for its hedging transactions (including its
intercompany transactions that are treated as hedging transactions) in
a manner that meets the requirements of paragraph (b) of this section.
Thus, each member of the group must comply with this section for its
hedging transactions without regard to the fact that the taxpayer is a
member of a consolidated group.
(iii) Definitions. For definitions of consolidated group, member of
a consolidated group, and intercompany transaction, see section 1502
and the regulations thereunder.
(iv) Effective date. This paragraph (e)(9) applies to transactions
entered into on or after the date 60 days after publication of final
regulations on this subject in the Federal Register.
Par. 3. Section 1221-2 is amended by adding the text of paragraphs
(d), (e)(5), (f)(3), and (g)(4) to read as follows:
Sec. 1.1221-2 Hedging transactions.
* * * * *
(d) Hedging by members of a consolidated group--(1) General rule.
For purposes of this section, the risk of one member of a consolidated
group is treated as the risk of the other members as if all of the
members of the group were divisions of a single corporation. For
example, if any member of a consolidated group hedges the risk of
another member of the group by entering into a transaction with an
unrelated person, that transaction may potentially qualify as a hedging
transaction. Under this rule, intercompany transactions are not hedging
transactions because they are treated as transactions between divisions
of a single corporation and thus do not reduce the risk of the group.
(2) Separate-entity election. In lieu of the treatment specified in
paragraph (d)(1) of this section, a consolidated group may elect
separate-entity treatment of its hedges. If a group makes this
separate-entity election, the following rules apply.
(i) Risk of one member not risk of other members. Notwithstanding
paragraph (d)(1) of this section, the risk of one member is not treated
as the risk of other members.
(ii) Intercompany transactions. An intercompany transaction or
obligation is a hedging transaction with respect to a member of a
consolidated group if and only if it meets the following requirements--
(A) The position of the member in the intercompany transaction or
obligation would qualify as a hedging transaction with respect to that
member if that member entered into the transaction with an unrelated
party; and
(B) The position of the other member (the marking member) in the
transaction is marked to market under the marking member's method of
accounting.
(iii) Treatment of intercompany hedging transactions. An
intercompany transaction or obligation that is a hedging transaction
(because it meets the requirements of paragraphs (d)(2)(ii) (A) and (B)
of this section) is treated as follows--
(A) Neither the hedging transaction nor any intercompany obligation
with respect to that transaction is treated as an intercompany
transaction or obligation for purposes of section 1502 and the
regulations thereunder; and
(B) Except as provided in paragraph (f)(3) of this section, the
character of the marking member's gain or loss from the transaction is
ordinary.
(iv) Making and revoking the election. The election described in
this paragraph (d)(2) must be made in a separate statement that is
filed with the group's consolidated return for the taxable year that
includes the first date for which the election is to apply. The
statement must specify that the election is being made and must
indicate the date that the election is to be effective. The election
applies to all transactions entered into on or after the date so
indicated. In no event, however, does the election apply to
transactions entered into before the date 60 days after final
regulations on this subject are published in the Federal Register. The
election cannot be revoked without the consent of the Commissioner.
(3) Definitions. For definitions of consolidated group, member of a
consolidated group, intercompany transaction, and intercompany
obligation, see section 1502 and the regulations thereunder.
(4) Examples. These examples illustrate this paragraph (d). In
these examples, O and H are members of the same consolidated group. O's
business operations give rise to interest rate risk ``A,'' which O
wishes to hedge. O enters into an intercompany transaction with H that
transfers the risk to H. O's position in the intercompany transaction
is ``B,'' and H's position in the contract is ``C.'' H enters into
position ``D'' with a third party to reduce the interest rate risk it
has with respect to its position C. D would be a hedging transaction
with respect to risk A if O's risk A were H's risk.
Example 1. Single-entity treatment--(i) General rule. Under
paragraph (d)(1) of this section, O's risk A is treated as H's risk,
and therefore D is a hedging transaction with respect to risk A.
Thus, the character of D is determined under the rules of this
section, and D must be accounted for under a method of accounting
that satisfies Sec. 1.446-4. The intercompany transaction B-C is not
a hedging transaction, and the B-C transaction is accounted for
according to the regulations under section 1502.
(ii) Identification. D must be identified as a hedging
transaction under paragraph (e)(1) of this section, and A must be
identified as the hedged item under paragraph (e)(2) of this
section. Under paragraph (e)(5) of this section, the identification
of A as the hedged item can be accomplished by identifying the
positions in the intercompany transaction as hedges or hedged items,
as appropriate. Thus, substantially contemporaneously with entering
into D, H may identify C as the hedged item and O may identify B as
a hedge and A as the hedged item.
Example 2. Separate-entity election; no marking. In addition to
the facts stated above, assume that the group makes a separate-
entity election under paragraph (d)(2) of this section. If H does
not mark C to market under its method of accounting, then B is not a
hedging transaction, and the B-C intercompany transaction is
accounted for under the rules of section 1502. D is not a hedging
transaction with respect to A, but D may be a hedging transaction
with respect to C if the requirements of paragraph (b) of this
section are met. If D is not part of a hedging transaction, then D
may be part of a straddle for purposes of section 1092.
Example 3. Separate-entity election; marking. The facts are the
same as in Example 2 above. If H marks C to market under its method
of accounting and B would be a hedging transaction with respect to O
if O had entered into that transaction with an unrelated party, then
the B-C transaction is a hedging transaction with respect to O.
Thus, O's position B is a hedging transaction with respect to its
risk A, the B-C transaction is not treated as an intercompany
transaction or obligation, and H's income, deduction, gain or loss
on C is ordinary. D is a hedge of C if it meets the requirements of
paragraph (b) of this section.
(e) * * *
(5) Identification of hedges involving members of the same
consolidated group--(i) General rule. If one member of a consolidated
group hedges the risk of another member under the general rule of
paragraph (d)(1) of this section, then the identification requirements
of this paragraph (e) must be met as if all of the members of the group
were divisions of a single corporation. Thus, the member entering into
the hedging transaction with a third party must identify the hedging
transaction under paragraph (e)(1) of this section. Under paragraph
(e)(2) of this section, that member must also identify the item, items,
or aggregate risk that is being hedged, even if the item, items, or
aggregate risk relates primarily or entirely to other members of the
group. If the members of a group use intercompany transactions or
obligations to transfer risk within the group, the requirements of
paragraph (e)(2) of this section may be met by identifying the
intercompany transactions or obligations as hedges or hedged items, as
appropriate. Because identification of the intercompany transaction as
a hedge serves solely to identify the hedged item, the identification
is timely if made within the period required by paragraph (e)(2) of
this section. For example, if a member transfers risk in an
intercompany transaction, it may identify under the rules of this
paragraph (e) both its position in that transaction and the item,
items, or aggregate risk being hedged. The member that hedges the risk
outside the group may identify under the rules of this paragraph (e)
both its position with the third party and its position in the
intercompany transaction. See paragraph (d)(4) of this section for an
example of this identification.
(ii) Rule for taxpayers making the separate-entity election. If a
consolidated group makes the separate-entity election under paragraph
(d)(2) of this section, each member of the group must satisfy the
requirements of this paragraph (e) as though it were not a member of a
consolidated group.
* * * * *
(f) * * *
(3) Transactions by members of a consolidated group--(i) General
rule. If a consolidated group is under the general rule of paragraph
(d)(1) of this section, the rules of this paragraph (f) apply only to
hedging transactions and not to intercompany transactions.
(ii) Separate-entity election. If a consolidated group has made the
election under paragraph (d)(2) of this section, then, in addition to
the rules of paragraphs (f)(1) and (f)(2) of this section, the
following rules apply.
(A) If an intercompany transaction is identified as a hedging
transaction but does not meet the requirements of paragraphs (d)(2)(ii)
(A) and (B) of this section, then both parties to the transaction are
subject to the rules of paragraph (f)(1) of this section with respect
to the transaction as though both had identified their positions in the
transaction as hedging transactions, notwithstanding the regulations
under section 1502.
(B) If a transaction that meets the requirements of paragraphs
(d)(2)(ii) (A) and (B) is not identified as a hedging transaction, then
both parties to the transaction are subject to the rules of paragraph
(f)(2).
(g) * * *
(4) Effective date for hedges by members of a consolidated group.
Paragraphs (d), (e)(5), and (f)(3) of this section apply to
transactions entered into on or after the date that is 60 days after
publication of final regulations in the Federal Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 94-16869 Filed 7-13-94; 9:10 am]
BILLING CODE 4830-01-U
