Td 8985

Section 846.—Discounted
Unpaid Losses Defined
The adjusted applicable federal short-term, midterm, and long-term rates are set forth for the month
of April 2002. See Rev. Rul. 2002–17, page 716.

The regulations reflect changes to the law
made by the Ticket to Work and Work
Incentives Improvement Act of 1999. The
regulations affect businesses entering into
hedging transactions.
DATES: Effective Date: These regulations are effective March 20, 2002.

Section 856.—Definition of
Real Estate Investment Trust
26 CFR 1.856–1: Definition of real estate investment trust.
Under what conditions will the Internal Revenue
Service consider a request for a ruling that an undivided interest in rental real property (other than a
mineral property as defined in § 614) is not an interest in a business entity within the meaning of
§ 301.7701–3 of the Procedure and Administration
Regulations? See Rev. Proc. 2002–22, page 733.

Applicability Dates: 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: Elizabeth Handler, (202) 622–
3930 or Viva Hammer at (202) 622–0869
(not toll-free numbers).
SUPPLEMENTARY INFORMATION:

Section 1031.—Exchange of
Property Held For Productive
Use or Investment
26 CFR 1.1031(a)–1: Property held for productive
use in trade or business or for investment.
Under what conditions will the Internal Revenue
Service consider a request for a ruling that an undivided interest in rental real property (other than a
mineral property as defined in § 614) is not an interest in a business entity within the meaning of
§ 301.7701–3 of the Procedure and Administration
Regulations? See Rev. Proc. 2002–22, page 733.

Section 1221.—Capital Asset
Defined
26 CFR 1.1221–2: Hedging transactions.

T.D. 8985
DEPARTMENT OF THE
TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Hedging Transactions
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations relating to the character
of gain or loss from hedging transactions.

April 8, 2002

Paperwork Reduction Act
The collections of information contained in these final regulations have been
reviewed and approved by the Office of
Management and Budget in accordance
with the Paperwork Reduction Act of
1995 (44 U.S.C. 3507(d)) under control
number 1545–1480. Some responses to
these collections of information are mandatory, and others are required to obtain
the benefit of the separate-entity election.
An agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information
unless it displays a valid control number
assigned by the Office of Management
and Budget.
The estimated annual burden per
respondent or recordkeeper varies from .1
to 40 hours, depending on individual circumstances, with an estimated average of
5.9 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, W:CAR:
MP:FP:S, 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.
Books or records relating to a collection of information must be retained as
long as their contents may become mate-

707

rial in the administration of any Internal
Revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. 6103.
Background
This document contains amendments
to 26 CFR Part 1 under section 1221 of
the Internal Revenue Code (Code). Prior
to amendment in 1999, section 1221 generally defined a capital asset as property
held by the taxpayer other than: (1) Stock
in trade or other types of assets includible
in inventory; (2) property used in a trade
or business that is real property or property subject to depreciation; (3) certain
copyrights (or similar property); (4)
accounts or notes receivable acquired in
the ordinary course of a trade or business;
and (5) U.S. government publications.
In 1994, the IRS published in the Federal Register (T.D. 8555, 1994–2 C.B.
180 [59 FR 36360]) final Treasury regulations under section 1221 providing for
ordinary character treatment for certain
business hedges. The regulations generally apply to transactions that reduce risk
with respect to ordinary property, ordinary obligations, and borrowings of the
taxpayer and that meet certain identification requirements. (§ 1.1221–2). In 1996,
the IRS published in the Federal Register (T.D. 8653, 1996–1 C.B. 67 [61 FR
517]) final regulations on the character
and timing of gain or loss from hedging
transactions entered into by members of a
consolidated group. In this preamble, the
final regulations published in 1994 and
1996 are referred to collectively as the
Treasury regulations.
On December 17, 1999, section 1221
was amended by section 532 of the Ticket
to Work and Work Incentives Improvement Act of 1999 (113 Stat 1860) to provide ordinary gain or loss treatment for
hedging transactions and consumable
supplies. Section 1221(a)(7) provides
ordinary treatment for hedging transactions that are clearly identified as such
before the close of the day on which they
were acquired, originated, or entered into.
The statute defines a hedging transaction as a transaction entered into by the
taxpayer in the normal course of business
primarily to manage risk of interest rate,
price changes, or currency fluctuations
with respect to ordinary property, ordinary obligations, or borrowings of the

2002–14 I.R.B.

taxpayer. Sections 1221(b)(2)(A)(i) and
(ii). The statutory definition of hedging
transaction also includes transactions to
manage such other risks as the Secretary
may prescribe in regulations. Section
1221(b)(2)(A)(iii). Further, the statute
grants the Secretary the authority to provide regulations to address the treatment
of nonidentified or improperly identified
hedging transactions, and hedging transactions involving related parties (sections
1221(b)(2)(B) and (b)(3), respectively).
The statutory hedging provisions are
effective for transactions entered into on
or after December 17, 1999. Congress
intended that the hedging rules be the
exclusive means through which the gains
and losses from hedging transactions are
treated as ordinary. S. Rep. No. 201,
106th Cong., 1st Sess. 25 (1999).
Section 1221(a)(8) provides that supplies of a type regularly consumed by the
taxpayer in the ordinary course of a taxpayer’s trade or business are not capital
assets. That provision is effective for supplies held or acquired on or after December 17, 1999.
A notice of proposed rulemaking
(REG–107047–00, 2001–14 I.R.B. 1002)
was published in the Federal Register
(66 FR 4738) on January 18, 2001. On
May 16, 2001, the IRS held a public hearing on the proposed regulations. Written
comments responding to the notice of
proposed rulemaking were also received.
In response to these comments, the proposed regulations were modified and as
so modified are adopted as final regulations. The principal changes to the proposed regulations are discussed below.
Explanation of Provisions
Coordination with International
Provisions of the Code
The provisions of these regulations
generally apply to determine the character
of gain or loss from transactions that are
also subject to various international provisions of the Code. Paragraph (a)(4) of
the regulations, however, provides that
the character of gain or loss on section
988 transactions is not determined under
these regulations because gain or loss on
those transactions is ordinary under section 988(a)(1). In addition, no implication
is intended as to what constitutes “risk
management” or “managing risk” for pur-

2002–14 I.R.B.

poses of proposed or final regulations
under section 482.
Paragraph (a)(4) of the proposed regulations provided that the definition of a
hedging transaction under § 1.1221–2(b)
of the proposed regulations would apply
for purposes of certain other international
provisions of the Code only to the extent
provided in regulations issued under
those provisions. Technical changes have
been made in the final regulations to
eliminate references to proposed regulations as well as Code sections for which
the relevant regulations have not been
issued in final form. Subsequent regulations will specify the extent to which the
rules relating to hedging transactions that
are contained in § 1.1221–2 will be applicable for purposes of those other regulations and related Code sections.
Risk Management Standard
Several commentators noted that the
proposed regulations used risk reduction
as the operating standard to implement
the risk management definition of hedging introduced by section 1221(b)(2)(A).
These commentators found that risk
reduction is too narrow a standard to
encompass the intent of Congress which
defined hedges to include transactions
that manage risk of interest rate, price
changes or currency fluctuations. They
urged the IRS and Treasury to adopt a
broader definition of hedging to reflect
Congress’ intent. With one exception, the
commentators did not suggest a definition
of risk management.
In response to these comments, the
final regulations have been restructured to
implement the risk management standard.
No definition of risk management is provided, but instead, the rules characterize a
variety of classes of transactions as hedging transactions because they manage
risk. Risk reducing transactions still
qualify as one class of hedging transactions, but there are also others. In addition, specific provision is made for the
recognition of additional types of qualifying risk management transactions through
published guidance or private letter rulings. Under the final regulations, as under
the proposed regulations, transactions
entered into for speculative purposes will
not qualify as hedging transactions. See
S. Rep. No. 201, 106th Cong., 1st Sess.
24 (1999).

708

Application on the Basis of Separate
Business Units
The proposed regulations provided
that a taxpayer has risk of a particular
type only if it is at risk when all of its
operations are considered. That is, risk
must exist on a “macro” basis. For this
purpose, under the proposed regulations,
a taxpayer has to show that hedges of particular assets or liabilities, or groups of
assets or liabilities, are reasonably
expected to reduce the overall risk of the
taxpayer’s operations.
Commentators pointed out that this
entity-based approach to hedging is no
longer uniform business practice. Instead,
businesses often conduct risk management on a business unit by business unit
basis. In response to these comments, the
final regulations permit the determination
of whether a transaction manages risk to
be made on a business unit basis provided
that the business unit is within a single
entity or consolidated return group that
adopts the single-entity approach. An
example was added to the final regulations in which for one taxpayer, the determination of whether hedging activities
reduce risk is made at the business unit
level. In the example, the conduct of risk
management activities within separate
business units is undertaken as part of a
program to reduce the overall risk of the
taxpayer’s operations.
Fixed-to-floating Interest Rate Hedges
Paragraph (c)(1) of the proposed regulations recognized that a transaction that
economically converts an interest rate or
price from a fixed rate or price to a floating rate or price may manage risk. Commentators suggested that the rule in the
proposed regulations provides insufficient
guidance in that it states only that fixedto-floating interest rate or price hedges
may be hedging transactions. In response
to these comments, the regulations have
been restructured to separately address
interest rate hedges and price hedges.
Commentators suggested that in the
case of interest rate conversions, a taxpayer may choose to convert from a floating to a fixed rate to fix the amount payable on the obligation. However, a
taxpayer could also elect to convert from
a fixed to a floating rate to insure that the
value of the liability remained relatively

April 8, 2002

constant. In response to these comments,
the final regulations provide that a transaction that converts an interest rate from
a fixed rate to a floating rate or from a
floating rate to a fixed rate manages risk.
With respect to fixed-to-floating price
hedges, the final regulations adopt the
proposed rules without change.

entered into primarily to manage risk. An
example has been added to the final regulations to illustrate that an investment in
mutual fund shares in the case described
in the preceding paragraph does not
qualify as a hedging transaction. A similar
example is added with respect to an
investment in an annuity contract.

Transactions Not Entered into Primarily
to Manage Risk

Hedging Risks Other Than Interest Rate
or Price Changes, or Currency
Fluctuations

Paragraph (c)(3) of the proposed regulations provided that the purchase or sale
of certain assets will not qualify as a
hedging transaction if the assets are not
acquired primarily to manage risk. This
rule was illustrated by the example of a
taxpayer that has an interest rate risk from
a floating rate borrowing and that
acquires debt instruments bearing a comparable floating interest rate. Although
the taxpayer’s interest rate risk from the
floating rate borrowing may be reduced
by the purchase of the floating rate debt
instruments, the proposed regulations provided that the acquisition of the debt
instruments is not made primarily to
reduce risk and, therefore, is not a hedging transaction.
The IRS and Treasury understand that
some employers may invest in assets
(such as shares of a mutual fund) that are
used as a reference investment for purposes of computing their liability to
employees under a nonqualified deferred
compensation plan. A question may arise
whether such an investment may constitute a hedging transaction and, if so,
whether income from the investment may
be deferred by the employer until payments of deferred compensation are made
to employees. See § 1.446–4(b); but compare Albertson’s, Inc. v. Commissioner, 42
F.3d 537 (9th Cir. 1994).
The rule in the proposed regulations is
based on § 1.1221–2(c)(1)(vii). The rule
has been restated in the final regulations
to refer specifically to investments in debt
instruments, equity securities, and annuity
contracts so as to provide greater certainty in its application. For this purpose
certain transactions in instruments that
are not themselves debt instruments may
include a debt investment. See, e.g.,
§ 1.446–3(g)(4). Further, the final regulations provide that the IRS may identify by
future published guidance specified transactions that are determined not to be

April 8, 2002

Paragraph (c)(8) of the proposed regulations provided that the Commissioner
may, by published guidance, provide that
hedging transactions include transactions
entered into to manage risks other than
interest rate or price changes, or currency
fluctuations.
The notice of proposed rulemaking
solicited comments regarding the expansion of the definition of hedging transactions to include transactions that manage
risks other than interest rate or price
changes, or currency fluctuations with
respect to ordinary property, ordinary
obligations or borrowings of the taxpayer.
Some comments were received in
response to that request. Because the
comments described hedging transactions
that related to the general operating
results of a business (such as gross sales)
rather than specific ordinary property,
ordinary obligations or borrowings of the
taxpayer, the implementation of rules
respecting such hedges would present a
number of issues not easily dealt with by
the rules contained in the final regulations. Thus, the expansion of the scope of
operation of the hedging rules is not
being proposed at this time, so as not to
delay the publication of guidance on the
matters that are covered by the final regulations. However, the IRS is continuing to
consider whether to expand the definition
of hedging transactions to cover hedges
of such other risks. The IRS and Treasury
invite comments on the types of risks that
should be covered, including specific
examples of derivative transactions that
may be incorporated into future guidance,
as well as the appropriate timing of inclusion of gains and losses with respect to
such transactions. Send submissions to:
CC:ITA:RU (REG–107047–00), room
5226, Internal Revenue Service, POB
7604, Ben Franklin Station, Washington,
DC 20044.

709

“Gap” Hedges
The status of so-called gap hedges was
not separately addressed in the proposed
regulations and is not covered in the final
regulations. Insurance companies, for
example, sometimes hedge the gap
between their liabilities and the assets that
fund them. Under the final regulations, a
hedge of those assets would not qualify as
a hedging transaction if the assets are
capital assets. Whether a gap hedge qualifies as a liability hedge is a question of
fact and depends on whether it is more
closely associated with the liabilities than
with the assets.
Identification Requirement
A rule has been added specifying additional information that must be provided
for a transaction that counteracts a hedging transaction.
Dates of Applicability
The regulations generally apply to all
transactions entered into on or after
March 20, 2002. However, the IRS will
not challenge any transaction entered into
on or after December 17, 1999, and
before March 20, 2002, that satisfies the
provisions of either § 1.1221–2 of REG–
107047–00 (2001–14 I.R.B. 1002), published in the Federal Register (66 FR
4738) on January 18, 2001, or the provisions of this final regulation.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It is hereby certified
that the collection of information in these
regulations will not have a significant
economic impact on a substantial number
of small entities. This certification is
based upon the fact that very few small
businesses enter into hedging transactions
due to their cost and complexity. Further,
those small businesses that hedge enter
into very few hedging transactions
because hedging transactions are costly,
complex, and require constant monitoring
and a sophisticated understanding of the
capital markets. Therefore, a Regulatory
Flexibility Analysis under the Regulatory

2002–14 I.R.B.

Flexibility Act (5 U.S.C. chapter 6) is not
required. Pursuant to section 7805(f) of
the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy
of the Small Business Administration for
comment on its impact on small business.
Drafting Information
The principal author of these regulations is Elizabeth Handler, Office of the
Associate Chief Counsel (Financial Insti-

tutions and Products). However, other
personnel from the IRS and Treasury
Department participated in their development.
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES

Paragraph 1. The authority citation for
part 1 is amended by revising the entry
for §1.1221–2 to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1221–2 also issued under 26
U.S.C. 1221(b)(2)(A)(iii), (b)(2)(B), and
(b)(3); 1502 and 6001. * * *
Par. 2. In the list below, for each location indicated in the left column, remove
the language in the middle column from
that section, and add the language in the
right column.

Affected section
1.446–4(d)(2), first sentence
1.446–4(d)(2), last sentence
1.446–4(d)(3), first sentence

Remove
1.1221–2(e)
1.1221–2(e)(2)
1.1221–2(e)

Add
1.1221–2(f)
1.1221–2(f)(2)
1.1221–2(f)

1.446–4(d)(3), last sentence
1.446–4(e)(7), first sentence

1.1221–2(a)(4)(i)
1.1221–2(c)(2)

1.1221–2(a)(4)
1.1221–2(d)(4)

1.446–4(e)(9)(ii), first sentence
1.446–4(e)(9)(ii), last sentence
1.475(b)–1(d)(2)
1.954–2(a)(4)(ii)(A), first sentence
1.954–2(a)(4)(ii)(B), first sentence

1.1221–2(d)(2)
1.1221–2(d)(2)(ii)
1.1221–2(e)
1.1221–2(a) through (c)
1.1221–2(e)

1.1221–2(e)(2)
1.1221–2(e)(2)(ii)
1.1221–2(f)
1.1221–2(a) through (d)
1.1221–2(f)

1.954–2(g)(2)(ii)(B)(2), last sentence
1.954–2(g)(3)(i)(B), last sentence

1.1221–2(c)(7)
1.1221–2(c)(7)

1.1221–2(c)(3)
1.1221–2(c)(3)

1.1256(e)–1(b), first and last sentences
1.1256(e)–1(c), first sentence
1.1256(e)–1(c), last sentence

1.1221–2(e)(1)
1.1221–2(e)(1)
paragraph (f)(1)(ii) of § 1.1221–2

1.1221–2(f)(1)
1.1221–2(f)(1)
1.1221–2(g)(1)(ii)

Par. 3. Section 1.1221–2 is revised to
read as follows:
§ 1.1221–2 Hedging transactions.
(a) Treatment of hedging transactions—(1) In general. This section governs the treatment of hedging transactions
under section 1221(a)(7). Except as provided in paragraph (g)(2) of this section,
the term capital asset does not include
property that is part of a hedging transaction (as defined in paragraph (b) of this
section).
(2) Short sales and options. This section also governs the character of gain or
loss from a short sale or option that is
part of a hedging transaction. Except as
provided in paragraph (g)(2) of this section, gain or loss on a short sale or option
that is part of a hedging transaction (as

2002–14 I.R.B.

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 section 988.
This section does not apply to determine
the character of gain or loss realized on a
section 988 transaction as defined in section 988(c)(1) or realized with respect to
any qualified fund as defined in section
988(c)(1)(E)(iii).
(b) Hedging transaction defined. Section 1221(b)(2)(A) provides that a hedg-

710

ing transaction is any transaction that a
taxpayer enters into in the normal course
of the taxpayer’s trade or business
primarily—
(1) To manage risk of price changes or
currency fluctuations with respect to ordinary property (as defined in paragraph
(c)(2) of this section) that is held or to be
held by the taxpayer;
(2) To manage risk of interest rate or
price changes or currency fluctuations
with respect to borrowings made or to be
made, or ordinary obligations incurred or
to be incurred, by the taxpayer; or
(3) To manage such other risks as the
Secretary may prescribe in regulations
(see paragraph (d)(6) of this section).
(c) General rules—(1) 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

April 8, 2002

in the normal course of the taxpayer’s
trade or business. This rule includes managing risks relating to the expansion of an
existing business or the acquisition of a
new trade or business.
(2) Ordinary property and obligations.
Property is ordinary property to a taxpayer only if a sale or exchange of the
property by the taxpayer could not produce capital gain or loss under any circumstances. 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 this paragraph (c)(2), the term
termination has the same meaning as it
does in section 1234A.
(3) Hedging an aggregate risk. The
term hedging transaction includes a transaction that manages an aggregate risk of
interest rate changes, price changes,
and/or currency fluctuations only if all of
the risk, or all but a de minimis amount of
the risk, is with respect to ordinary property, ordinary obligations, or borrowings.
(4) Managing risk—(i) In general.
Whether a transaction manages a taxpayer’s risk is determined based on all of the
facts and circumstances surrounding the
taxpayer’s business and the transaction.
Whether a transaction manages a taxpayer’s risk may be determined on a business
unit by business unit basis (for example
by treating particular groups of activities,
including the assets and liabilities attributable to those activities, as separate business units), provided that the business
unit is within a single entity or consolidated return group that adopts the singleentity approach. A taxpayer’s hedging
strategies and policies as reflected in the
taxpayer’s minutes or other records are
evidence of whether particular transactions were entered into primarily to manage the taxpayer’s risk.
(ii) Limitation of risk management
transactions
to
those
specifically
described. Except as otherwise determined by published guidance or by private letter ruling, a transaction that is not
treated as a hedging transaction under
paragraph (d) does not manage risk.
Moreover, a transaction undertaken for

April 8, 2002

speculative purposes will not be treated as
a hedging transaction.
(d) Transactions that manage risk—
(1) Risk reduction transactions—(i) In
general. A transaction that is entered into
to reduce a taxpayer’s risk, manages a
taxpayer’s risk.
(ii) Micro and macro hedges—(A) In
general. A taxpayer generally 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) Example. The following example
illustrates the rules stated in paragraph
(d)(1)(ii)(A) of this section:
Example. Corporation X manages its business
operations by treating particular groups of activities,
including the assets and liabilities attributable to
those assets, as separate business units. A separate
set of books and records is maintained with respect
to the activities, assets and liabilities of separate
business unit y. As part of a risk management program that Corporation X reasonably expects to
reduce the overall risks of its business operations,
Corporation X enters into hedges to reduce the risks
of separate business unit y. Corporation X may demonstrate that the hedges reduce risk by taking into
account only the activities, assets and liabilities of
business unit y.

(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 (d)(3) of this section.
(iv) Fixed-to-floating price hedges.
Under the principles of paragraph
(d)(1)(ii)(A) of this section, a transaction
that economically converts a price from a
fixed price to a floating price may reduce
risk. For example, 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, for
such a taxpayer a transaction that con-

711

verts its fixed price to a floating price
may be a hedging transaction.
(2) Interest rate conversions. A transaction that economically converts an
interest rate from a fixed rate to a floating
rate or that converts an interest rate from
a floating rate to a fixed rate manages
risk.
(3) Transactions that counteract hedging transactions. If a transaction is
entered into primarily to offset all or any
part of the risk management effected by
one or more hedging transactions, the
transaction is a hedging transaction. For
example, if a written option is used to
reduce or eliminate the risk reduction
obtained from another position such as a
purchased option, then it may be a hedging transaction.
(4) Recycling. A taxpayer may enter
into a hedging transaction by using a
position that was a hedge of one asset or
liability as a hedge of another asset or
liability (recycling).
(5) Transactions not entered into primarily to manage risk—(i) Rule. Except
as otherwise determined in published
guidance or private letter ruling, the purchase or sale of a debt instrument, an
equity security, or an annuity contract is
not a hedging transaction even if the
transaction limits or reduces the taxpayer’s risk with respect to ordinary property,
borrowings, or ordinary obligations. In
addition, the Commissioner may determine in published guidance that other
transactions are not hedging transactions.
(ii) Examples. The following examples
illustrate the rule stated in paragraph
(d)(5)(i) of this section:
Example 1. Taxpayer borrows money and agrees
to pay a floating rate of interest. Taxpayer purchases
debt instruments that bear a comparable floating
rate. Although taxpayer’s interest rate risk from the
floating rate borrowing may be reduced by the purchase of the debt instruments, the acquisition of the
debt instruments is not a hedging transaction,
because the transaction is not entered into primarily
to manage the taxpayer’s risk.
Example 2. Taxpayer undertakes obligations to
pay compensation in the future. The amount of the
future compensation payments is adjusted as if
amounts were invested in a specified mutual fund
and were increased or decreased by the earnings,
gains and losses that would result from such an
investment. Taxpayer invests funds in the shares of
the mutual fund. Although the investment in shares
of the mutual fund reduces the taxpayer’s risk of
fluctuation in the amount of its obligation to
employees, the investment was not made primarily
to manage the taxpayer’s risk. Accordingly, the
transaction is not a hedging transaction.

2002–14 I.R.B.

Example 3. Taxpayer provides a nonqualified
retirement plan for employees that is structured like
a defined contribution plan. Based on a schedule
that takes into account an employee’s monthly salary and years of service with the taxpayer, the taxpayer makes monthly credits to an account for each
employee. Each employee may designate that the
account will be treated as if it were used to pay premiums on a variable annuity contract issued by the
M insurance company with a value that reflects a
specified investment option. M offers a number of
investment options for its variable annuity contracts.
Taxpayer invests funds in M company variable
annuity contracts that parallel the investment
options selected by the employees. The investment
is not made primarily to manage the taxpayer’s risk
and is not a hedging transaction.

(6) Hedges of other risks. The Commissioner may, by published guidance,
determine that hedging transactions
include transactions entered into to manage risks other than interest rate or price
changes, or currency fluctuations.
(7) Miscellaneous provision—(i) Extent of risk management. A taxpayer may
hedge all or any portion of its risk for all
or any part of the period during which it
is exposed to the risk.
(ii) 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.
(e) Hedging by members of a consolidated group—(1) General rule: singleentity approach. For purposes of this section, the risk of one member of a
consolidated group is treated as the risk
of the other members as if all of the
members of the group were divisions of a
single corporation. For example, if any
member of a consolidated group hedges
the risk of another member of the group
by entering into a transaction with a third
party, that transaction may potentially
qualify as a hedging transaction. Conversely, intercompany transactions are not
hedging transactions because, when con-

2002–14 I.R.B.

sidered as transactions between divisions
of a single corporation, they do not manage the risk of that single corporation.
(2) Separate-entity election. In lieu of
the single-entity approach specified in
paragraph (e)(1) of this section, a consolidated group may elect separate-entity
treatment of its hedging transactions. If a
group makes this separate-entity election,
the following rules apply:
(i) Risk of one member not risk of
other members. Notwithstanding paragraph (e)(1) of this section, the risk of
one member is not treated as the risk of
other members.
(ii) Intercompany transactions. An
intercompany transaction is a hedging
transaction (an intercompany hedging
transaction) with respect to a member of
a consolidated group if and only if it
meets the following requirements—
(A) The position of the member in the
intercompany transaction would qualify
as a hedging transaction with respect to
the member (taking into account paragraph (e)(2)(i) of this section) if the member had entered into the transaction with
an unrelated party; and
(B) The position of the other member
(the marking member) in the transaction
is marked to market under the marking
member’s method of accounting.
(iii) Treatment of intercompany hedging transactions. An intercompany hedging transaction (that is, a transaction that
meets the requirements of paragraphs
(e)(2)(ii)(A) and (B) of this section) is
subject to the following rules—
(A) The character and timing rules of
§ 1.1502–13 do not apply to the income,
deduction, gain, or loss from the intercompany hedging transaction; and
(B) Except as provided in paragraph
(g)(3) of this section, the character of the
marking member’s gain or loss from the
transaction is ordinary.
(iv) Making and revoking the election.
Unless the Commissioner otherwise prescribes, the election described in this
paragraph (e)(2) must be made in a separate statement saying “[Insert Name and
Employer Identification Number of Common Parent] HEREBY ELECTS THE
APPLICATION OF SECTION 1.1221–
2(e)(2) (THE SEPARATE-ENTITY
APPROACH).” The statement must also
indicate the date as of which the election

712

is to be effective. The election must be
signed by the common parent and filed
with the group’s Federal income tax
return for the taxable year that includes
the first date for which the election is to
apply. The election applies to all transactions entered into on or after the date so
indicated. The election may be revoked
only with the consent of the Commissioner.
(3) Definitions. For definitions of consolidated group, divisions of a single corporation, group, intercompany transactions, and member, see section 1502 and
the regulations thereunder.
(4) Examples. General Facts. In these examples,
O and H are members of the same consolidated
group. O’s business operations give rise to interest
rate risk “A,” which O wishes to hedge. O enters
into an intercompany transaction with H that transfers the risk to H. O’s position in the intercompany
transaction is “B,” and H’s position in the transaction is “C.” H enters into position “D” with a third
party to reduce the interest rate risk it has with
respect to its position C. D would be a hedging
transaction with respect to risk A if O’s risk A were
H’s risk. The following examples illustrate this paragraph (e):
Example 1. Single-entity treatment—(i) General
rule. Under paragraph (e)(1) of this section, O’s risk
A is treated as H’s risk, and therefore D is a hedging
transaction with respect to risk A. Thus, the character of D is determined under the rules of this section,
and the income, deduction, gain, or loss from D
must be accounted for under a method of accounting that satisfies § 1.446–4. The intercompany transaction B-C is not a hedging transaction and is taken
into account under § 1.1502–13.
(ii) Identification. D must be identified as a
hedging transaction under paragraph (f)(1) of this
section, and A must be identified as the hedged item
under paragraph (f)(2) of this section. Under paragraph (f)(5) of this section, the identification of A as
the hedged item can be accomplished by identifying
the positions in the intercompany transaction as
hedges or hedged items, as appropriate. Thus, substantially contemporaneous with entering into D, H
may identify C as the hedged item and O may identify B as a hedge and A as the hedged item.
Example 2. Separate-entity election; counterparty that does not mark to market. In addition to
the General Facts stated above, assume that the
group makes a separate-entity election under paragraph (e)(2) of this section. If H does not mark C to
market under its method of accounting, then B is not
a hedging transaction, and the B-C intercompany
transaction is taken into account under the rules of
section 1502. D is not a hedging transaction with
respect to A, but D may be a hedging transaction
with respect to C if C is ordinary property or an
ordinary obligation and if the other requirements of
paragraph (b) of this section are met. If D is not part
of a hedging transaction, then D may be part of a
straddle for purposes of section 1092.

April 8, 2002

Example 3. Separate-entity election; counterparty that marks to market. The facts are the same
as in Example 2 above, except that H marks C to
market under its method of accounting. Also assume
that B would be a hedging transaction with respect
to risk A if O had entered into that transaction with
an unrelated party. Thus, for O, the B-C transaction
is an intercompany hedging transaction with respect
to O’s risk A, the character and timing rules of
§ 1.1502–13 do not apply to the B-C transaction,
and H’s income, deduction, gain, or loss from C is
ordinary. However, other attributes of the items
from the B-C transaction are determined under
§ 1.1502–13. D is a hedging transaction with respect
to C if it meets the requirements of paragraph (b) of
this section.

(f) Identification and recordkeeping—
(1) Same-day identification of hedging
transactions. Under section 1221(a)(7), a
taxpayer that enters into a hedging transaction (including recycling an existing
hedging transaction) must clearly identify
it as a hedging transaction before the
close of the day on which the taxpayer
acquired, originated, or entered into the
transaction (or recycled the existing hedging transaction).
(2) Substantially contemporaneous
identification of hedged item—(i) Content
of the identification. A taxpayer that
enters into a hedging transaction must
identify the item, items, or aggregate risk
being hedged. Identification of an item
being hedged generally involves identifying a transaction that creates risk, and the
type of risk that the transaction creates.
For example, if a taxpayer is hedging the
price risk with respect to its June purchases of corn inventory, the transaction
being hedged is the June purchase of corn
and the risk is price movements in the
market where the taxpayer buys its corn.
For additional rules concerning the content of this identification, see paragraph
(f)(3) of this section.
(ii) Timing of the identification. The
identification required by this paragraph
(f)(2) must be made substantially contem-

April 8, 2002

poraneously 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 (f)(3), the identification under
paragraph (f)(2) of this section must
include the information specified.
(i) Anticipatory asset hedges. If the
hedging transaction relates to the anticipated acquisition of assets by the taxpayer, the identification must include the
expected date or dates of acquisition and
the amounts expected to be acquired.
(ii) Inventory hedges. If the hedging
transaction relates to the purchase or sale
of inventory by the taxpayer, the identification is made by specifying the type or
class of inventory to which the transaction relates. If the hedging transaction
relates to specific purchases or sales, the
identification must also include the
expected dates of the purchases or sales
and the amounts to be purchased or sold.
(iii) Hedges of debt of the taxpayer—
(A) Existing debt. If the hedging transaction relates to accruals or payments under
an issue of existing debt of the taxpayer,
the identification must specify the issue
and, if the hedge is for less than the full
issue price or the full term of the debt, the
amount of the issue price and the term
covered by the hedge.
(B) Debt to be issued. If the hedging
transaction relates to the expected issuance of debt by the taxpayer or to accruals or payments under debt that is
expected to be issued by the taxpayer, the
identification must specify the following
information: the expected date of issuance of the debt; the expected maturity or
maturities; the total expected issue price;

713

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)(3) of this section, the identification under paragraph (f)(2) of this
section must include a description of the
risk being hedged and of the hedging program under which the hedging transaction
was entered. This requirement may be
met by placing in the taxpayer’s records a
description of the hedging program and
by establishing a system under which
individual transactions can be identified
as being entered into pursuant to the program.
(B) Description of hedging program. A
description of a hedging program must
include an identification of the type of
risk being hedged, a description of the
type of items giving rise to the risk being
aggregated, and sufficient additional
information to demonstrate that the program is designed to reduce aggregate risk
of the type identified. If the program contains controls on speculation (for
example, position limits), the description
of the hedging program must also explain
how the controls are established, communicated, and implemented.

2002–14 I.R.B.

(v) Transactions that counteract hedging transactions. If the hedging transaction is described in paragraph (d)(3) of
this section, the description of the hedging transaction must include an identification of the risk management transaction
that is being offset and the original underlying hedged item.
(4) Manner of identification and
records to be retained—(i) Inclusion of
identification in tax records. The identification required by this paragraph (f) must
be made on, and retained as part of, the
taxpayer’s books and records.
(ii) Presence of identification must be
unambiguous. The presence of an identification for purposes of this paragraph (f)
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 (f)(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) Principles of paragraph (f)(4)(iii)
of this section illustrated. Paragraphs
(f)(4)(iv)(A) through (C) of this section
illustrate the principles of paragraph
(f)(4)(iii) of this section and assume that
the other requirements of this paragraph
(f) 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).

2002–14 I.R.B.

(B) A taxpayer can make an identification by including and retaining in its
books and records a statement that designates all future transactions in a specified
derivative product as hedges of a specified item, items, or aggregate risk.
(C) A taxpayer can make an identification by designating a certain mark, a certain form, or a certain legend as meaning
that a transaction is a hedge of a specified
item (or of specified items or a specified
aggregate risk). Identification can be
made by placing the designated mark on
a record of the transaction (for example,
trading ticket, purchase order, or trade
confirmation) or by using the designated
form or a record that contains the designated legend.
(5) Identification of hedges involving
members of the same consolidated
group—(i) General rule: single-entity
approach. A member of a consolidated
group must satisfy the requirements of
this paragraph (f) 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 (f)(1) of this section.
Under paragraph (f)(2) of this section,
that member must also identify the item,
items, or aggregate risk that is being
hedged, even if the item, items, or aggregate risk relates primarily or entirely to
other members of the group. If the members of a group use intercompany transactions to transfer risk within the group, the
requirements of paragraph (f)(2) of this
section may be met by identifying the
intercompany transactions, and the risks
hedged by the intercompany transactions,
as hedges or hedged items, as appropriate.
Because identification of the intercompany transaction as a hedge serves solely
to identify the hedged item, the identification is timely if made within the period
required by paragraph (f)(2) of this section. For example, if a member transfers
risk in an intercompany transaction, it
may identify under the rules of this paragraph (f) 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 (f) both
its position with the third party and its
position in the intercompany transaction.

714

Paragraph (e)(4) Example 1 of this section illustrates this identification.
(ii) Rule for consolidated groups making the separate-entity election. If a consolidated group makes the separate-entity
election under paragraph (e)(2) of this
section, each member of the group must
satisfy the requirements of this paragraph
(f) as though it were not a member of a
consolidated group.
(6)
Consistency
with
section
1256(e)(2). Any identification for purposes of section 1256(e)(2) is also an
identification for purposes of paragraph
(f)(1) of this section.
(g) Effect of identification and nonidentification—(1) Transactions identified—(i) In general. If a taxpayer identifies a transaction as a hedging transaction
for purposes of paragraph (f)(1) of this
section, the identification is binding with
respect to gain, whether or not all of the
requirements of paragraph (f) 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
(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 (g)(1)(i) of this
section, if the taxpayer identifies a transaction as a hedging transaction for purposes of paragraph (f) 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.

April 8, 2002

(2) Transactions not identified—(i) In
general. Except as provided in paragraphs
(g)(2)(ii) and (iii) of this section, the
absence of an identification that satisfies
the requirements of paragraph (f)(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 (f) of
this section, the taxpayer may treat gain
or loss from the transaction as ordinary
income or loss under paragraph (a)(1) or
(2) of this section if—
(A) The transaction is a hedging transaction (as defined in paragraph (b) of this
section);
(B) The failure to identify the transaction was due to inadvertent error; and
(C) All of the taxpayer’s hedging
transactions in all open years are being
treated on either original or, if necessary,
amended returns as provided in paragraphs (a)(1) and (2) of this section.
(iii) Anti-abuse rule. If a taxpayer does
not make an identification that satisfies
all the requirements of paragraph (f) of
this section but the taxpayer has no reasonable grounds for treating the transaction as other than a hedging transaction,
then gain from the transaction is ordinary.
The reasonableness of the taxpayer’s failure to identify a transaction is determined
by taking into consideration not only the
requirements of paragraph (b) of this section but also the taxpayer’s treatment of
the transaction for financial accounting or

other purposes and the taxpayer’s identification of similar transactions as hedging
transactions.
(3) Transactions by members of a consolidated group—(i) Single-entity approach. If a consolidated group is under
the general rule of paragraph (e)(1) of this
section (the single-entity approach), the
rules of this paragraph (g) apply only to
transactions that are not intercompany
transactions.
(ii) Separate-entity election. If a consolidated group has made the election
under paragraph (e)(2) of this section,
then, in addition to the rules of paragraphs (g)(1) and (2) of this section, the
following rules apply:
(A) If an intercompany transaction is
identified as a hedging transaction but
does not meet the requirements of paragraphs (e)(2)(ii)(A) and (B) of this section, then, notwithstanding any contrary
provision in § 1.1502–13, each party to
the transaction is subject to the rules of
paragraph (g)(1) of this section with
respect to the transaction as though it had
incorrectly identified its position in the
transaction as a hedging transaction.
(B) If a transaction meets the requirements of paragraphs (e)(2)(ii)(A) and (B)
of this section but the transaction is not
identified as a hedging transaction, each
party to the transaction is subject to the
rules of paragraph (g)(2) of this section.
(Because the transaction is an intercompany hedging transaction, the character
and timing rules of § 1.1502–13 do not
apply. See paragraph (e)(2)(iii)(A) of this
section.)
(h) Effective date. The rules of this
section apply to transactions entered into
on or after March 20, 2002.
Par. 4. Section 1.1256(e)–1 is revised
to read as follows:
§ 1.1256(e)–1 Identification of hedging
transactions.

(a) Identification and recordkeeping
requirements. Under section 1256(e)(2), a
taxpayer that enters into a hedging transaction must identify the transaction as a
hedging transaction before the close of
the day on which the taxpayer enters into
the transaction.
(b) Requirements for identification.
The identification of a hedging transaction for purposes of section 1256(e)(2)
must satisfy the requirements of
§ 1.1221–2(f)(1). Solely for purposes of
section 1256(f)(1), however, an identification that does not satisfy all of the
requirements of § 1.1221–2(f)(1) is nevertheless treated as an identification under
section 1256(e)(2).
(c) Consistency with § 1.1221–2. Any
identification for purposes of § 1.1221–
2(f)(1) is also an identification for purposes of this section. If a taxpayer satisfies the requirements of § 1.1221–
2(f)(1)(ii), the transaction is treated as if
it were not identified as a hedging transaction for purposes of section 1256(e)(2).
(d) Effective date. The rules of this
section apply to transactions entered into
on or after March 20, 2002.
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. In § 602.101, paragraph (b) is
amended by removing the entries for
“1.1221–2,” “1.1221–2(d)(2)(iv),”
“1.1221–2(e)(5),” “1.1221–2(g)(5)(ii),”
“1.1221–2(g)(6)(ii),”
“1.1221–
2(g)(6)(iii),” and “1.1221–2T(c)” and
adding an entry in numerical order to the
table to read as follows:
§ 602.101 OMB Control numbers.
*****
(b) * * *

CFR part or section where
identified and described

Current OMB
control No.

*****
1.1221–2...................................................................................................................................................................

1545–1480

*****

April 8, 2002

715

2002–14 I.R.B.

Robert E. Wenzel,
Deputy Commissioner of
Internal Revenue.
Approved March 14, 2002.
Mark Weinberger,
Assistant Secretary of the Treasury.
(Filed by the Office of the Federal Register on
March 15, 2002, 8:54 a.m., and published in the
issue of the Federal Register for March 20, 2002, 67
F.R. 12863)

Section 1274.—Determination of Issue Price in the
Case of Certain Debt
Instruments Issued for
Property

Federal rates; adjusted federal
rates; adjusted federal long-term rate
and the long-term exempt rate. For purposes of sections 382, 1274, 1288, and
other sections of the Code, tables set forth
the rates for April 2002.

Rev. Rul. 2002–17
This revenue ruling provides various
prescribed rates for federal income tax
purposes for April 2002 (the current
month). Table 1 contains the short-term,
mid-term, and long-term applicable federal rates (AFR) for the current month for
purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the
short-term, mid-term, and long-term
adjusted applicable federal rates (adjusted
AFR) for the current month for purposes

of section 1288(b). Table 3 sets forth the
adjusted federal long-term rate and the
long-term tax-exempt rate described in
section 382(f). Table 4 contains the
appropriate percentages for determining
the low-income housing credit described
in section 42(b)(2) for buildings placed in
service during the current month. Finally,
Table 5 contains the federal rate for determining the present value of an annuity, an
interest for life or for a term of years, or
a remainder or a reversionary interest for
purposes of section 7520.

(Also sections 42, 280G, 382, 412, 467, 468, 482,
483, 642, 807, 846, 1288, 7520, 7872.)

REV. RUL. 2002–17 TABLE 1
Applicable Federal Rates (AFR) for April 2002
Period for Compounding
Annual

Semiannual

Quarterly

Monthly

Short-Term
AFR

2.88%

2.86%

2.85%

2.84%

110% AFR
120% AFR
130% AFR

3.17%
3.46%
3.75%

3.15%
3.43%
3.72%

3.14%
3.42%
3.70%

3.13%
3.41%
3.69%

Mid-Term
AFR
110% AFR

4.65%
5.12%

4.60%
5.06%

4.57%
5.03%

4.56%
5.01%

120% AFR
130% AFR
150% AFR
175% AFR

5.60%
6.07%
7.02%
8.21%

5.52%
5.98%
6.90%
8.05%

5.48%
5.94%
6.84%
7.97%

5.46%
5.91%
6.80%
7.92%

Long-Term
AFR

5.62%

5.54%

5.50%

5.48%

110% AFR
120% AFR

6.18%
6.76%

6.09%
6.65%

6.04%
6.60%

6.01%
6.56%

130% AFR

7.33%

7.20%

7.14%

7.09%

2002–14 I.R.B.

716

April 8, 2002