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:
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(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.
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(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.
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(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).
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(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.