Part IV. Items — Internal Revenue Bulletin 2001-14

are submitted timely (preferably a signed original and eight copies) to the IRS. All comments will be available for public inspection and copying.

A public hearing has been scheduled for July 24, 2001, at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Because of access restrictions, visitors will not be admitted beyond the lobby more than 15 minutes before the hearing starts.

The rules of 26 CFR 601.601(a)(3) apply to the hearing.

Persons who wish to present oral comments at the hearing must submit written comments by July 18, 2001, and submit an outline of the topics to be discussed and the time to be devoted to each topic by July 3, 2001.

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 authors of these regulations are Bruce M. Serchuk, and Rose M. Weber, Office of Chief Counsel (Tax Exempt and Government Entities), Internal Revenue Service, and Stephen J. Watson, Office of Tax Legislative Counsel, Department of the Treasury. However, other personnel from the IRS and Treasury Department participated in their development.

Partial Withdrawal of Notice of Proposed Rulemaking

Under the authority of 26 U.S.C. 7805, §§1.141–7, 1.141–8 and 1.141–15(f) through (i) in the notice of proposed rulemaking that was published on January 22, 1998 (63 FR 3256) are withdrawn.

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 continues to read in part as follows:

Partial Withdrawal of Notice of Proposed Rulemaking; Notice of Proposed Rulemaking by Cross- Reference to Temporary Regulations; and Notice of Public Hearing

Obligations of States and Political Subdivisions

REG–114998–99

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Partial withdrawal of notice of proposed rulemaking; notice of proposed rulemaking by cross-reference to temporary regulations; and notice of public hearing.

SUMMARY: This document withdraws portions of the notice of proposed rulemaking published in the Federal Register on January 22, 1998. In T.D. 8941 on page 977 of this Bulletin, the IRS is issuing temporary regulations that provide guidance to state and local governments that issue bonds for output facilities. The text of those temporary regulations also serves as the text of these proposed regulations. This document provides a notice of public hearing on these proposed regulations.

DATES: Written comments must be received by July 18, 2001. Outlines of topics to be discussed at the public hearing scheduled for July 24, 2001, at 10 a.m. must be received by July 3, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–114998–99), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG–114998– 99), courier’s desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.gov/tax_regs/ regslist.html. The public hearing will be held in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Rose M. Weber, (202) 622-3980; concerning submissions and the hearing, Treena Garrett, (202) 622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Proposed regulations (REG–110965–97, 1998–1 C.B. 793) §§1.141–7, 1.141–8 and 1.141–15(f) through (i), published on January 22, 1998 (63 FR 3296), addressed the application of the private activity bond tests of section 141(b) (1) and (2) to output contracts for output facilities and the application of the $15 million limitation under section 141(b)(4) to output facility financings. These proposed sections are withdrawn.

Sections 1.141–7T, 1.141–8T and 1.141–15T published in T.D. 8941 are issued to provide guidance on certain aspects of the private activity bond restrictions under section 141 of the Internal Revenue Code.

The text of the temporary regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations explains the temporary regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 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 that

April 2, 2001 992 2001–14 I.R.B.

Authority: 26 U.S.C. 7805 * * * Par. 2. Sections 1.141–7 and 1.141–8 are added to read as follows:

§1.141–7 Special rules for output facilities.

[The text of this proposed section is the same as the text of §1.141–7T published in T.D. 8941.]

§1.141–8 $15 million limitation for output facilities.

[The text of this proposed section is the same as the text of §1.141–8T published in T.D. 8941.]

Par. 3. Section 1.141–15 is amended by adding paragraphs (f) through (i) to read as follows:

§1.141–15 Effective dates.

(f) through (i) [The text of proposed paragraphs (f) through (i) is the same as the text of §1.141–15T(f) through (i) published in T.D. 8941.]

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on January 17, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 18, 2001, 66 F.R. 4754)

Notice of Proposed Rulemaking and Notice of Public Hearing

Equity Options with Flexible Terms; Qualified Covered Call Treatment

REG–115560–99

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations providing guidance on the application of the rules governing qualified covered calls. The new rules address concerns that were created by the introduction of new financial instruments several years after the enactment of the qualified covered call rules. The proposed regulations would provide guidance to taxpayers writing equity call op

tions. This document also provides notice of public hearing on these proposed regulations.

DATES: Written and electronic comments and requests to appear and outlines of topics to be discussed at the public hearing scheduled for May 9, 2001, at 10 a.m., must be submitted by April 18, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–115560–99), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG–115560– 99), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option of the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.gov/tax_regs/ regslist.html. The public hearing will be held in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Pamela Lew, (202) 622-3950; concerning submissions and the hearing, Guy Traynor, (202) 622-7180, (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On June 25, 1998, the IRS published in the Federal Register proposed regulations (REG–104641–97, 1998–2 C.B. 75

[63 FR 34616]) addressing whether strike prices available for equity options with flexible terms affect the definition of a qualified covered call (QCC) under section 1092(c)(4) for equity options with standardized terms. No requests to speak at a public hearing were received, and no public hearing was held.

The proposed regulations provided that strike prices available for equity options with flexible terms do not affect the bench marks used to determine whether equity options with standardized terms are eligible for QCC treatment. That provision was adopted as §1.1092(c)–1 of the final regulations (T.D. 8866, 2000-6 I.R.B.

495), published in the Federal Register for January 25, 2000 (65 F.R. 3812).

The regulatory text of REG–104641– 97 did not address whether an equity option with flexible terms is itself eligible for QCC treatment. The preamble to the proposed regulations, however, did request comments about whether equity options with flexible terms should be eligible for QCC treatment and, if eligible, what bench marks should apply. In light of the comments received, consideration was also given to the treatment of overthe-counter options and standardized options with terms of more than one year. After consideration of the written comments, this NPRM proposes regulations addressing the eligibility for QCC treatment of equity options with flexible terms, over-the-counter options and standardized options with terms longer than one year.

QCC Treatment

Section 1092(c) defines a straddle as offsetting positions with respect to personal property. Under section 1092(d)(3)(B)(i)(I), stock is personal property if the stock is part of a straddle that involves an option on that stock or substantially identical stock or securities. Under section 1092(c)(4), however, writing a QCC option and owning the optioned stock is not treated as a straddle under section 1092 if certain conditions are satisfied.

The legislative history of section 1092 indicates that QCCs were excepted from the loss deferral rule for straddles because “they are undertaken primarily to enhance the taxpayer’s investment return on the stock and not to reduce the taxpayer’s risk of loss on the stock.” H.R. Rep. No. 432, 98th Cong., 2d Sess. at 1266-68 (1983). To qualify as a QCC, a covered call must, among other things, be exchange traded and not be deep in the money. An option is exchange traded if the option is traded on a national securities exchange that is registered with the Securities and Exchange Commission or on some other market that the Secretary determines has rules adequate to carry out the purposes of the QCC provisions. An option is deep in the money if the strike price of the option is lower than the lowest qualified bench mark for the stock at the time the option is written.

2001–14 I.R.B. 993 April 2, 2001

Section 1092(c)(4)(H) grants the Secretary of the Treasury the authority to prescribe regulations to carry out the purposes of the QCC exception, including regulations modifying the provisions of the exception as appropriate to take account of changes in the practices of options exchanges.

The introduction of exchange-traded equity options with flexible terms is one such change. Unlike equity options with standardized terms, equity options with flexible terms can have strike prices at other than fixed intervals and have other than standardized expiration dates. Options exchanges have also introduced standardized options with longer terms.

In response to the request for comments, two comments were received. One commentator argued that equity options with flexible terms should not be eligible for QCC treatment. This commentator noted that in 1984, when section 1092(c)(4) was enacted, only equity options with standardized terms were traded on the national exchanges and that it is likely that Congress did not intend to include customizable options within the definition of a QCC. This commentator also pointed out that equity options with flexible terms were developed to compete with over-the-counter (OTC) options, which are not eligible for QCC treatment. The commentator suggested that excluding equity options with flexible terms from QCC treatment would avoid a competitive imbalance from different tax treatment for competing products.

The second commentator stated that, as a matter of statutory analysis, equity options with flexible terms are already eligible for QCC treatment. This commentator argued that QCC treatment is appropriate if the taxpayer is using the option to increase the yield on its stock investment and not to reduce the risk of loss on its stock. In support of this point, the commentator noted that nothing in the applicable legislative history suggests that Congress intended to limit the QCC option exception to standardized options. Alternatively, this commentator argued that because equity options with flexible terms were designed to compete with OTC options, regulations should be promulgated allowing OTC options to qualify for QCC treatment on the same terms

as exchange-traded equity options with flexible terms.

Explanation of Provisions

Equity Options with Flexible Terms and Qualifying OTC Options

After consideration of the comments received, the proposed regulations provide that equity options with flexible terms may be QCC options as long as they satisfy the general rules for QCC treatment described in section 1092(c)(4), are not for a term of longer than one year, and meet other specified requirements. In addition, an equity option with standardized terms must be outstanding for the underlying equity. For purposes of applying the general rules, the bench marks will be the same as those for an equity option with standardized terms on the same stock having the same applicable stock price.

The proposed regulations also provide that certain OTC options may be QCC options so that OTC options that are economically similar to equity options with flexible terms may enjoy the same tax benefits as equity options with flexible terms. Specifically, the proposed regulations provide that an OTC option is eligible for QCC treatment if it is entered into with a person registered with the Securities and Exchange Commission as a broker-dealer or alternative trading system and meets the same requirements for QCC treatment that apply to equity options with flexible terms.

QCC Status for Equity Options with Standardized Terms

In the process of considering the proper treatment for equity options with flexible terms, the IRS examined QCC status in general. At the time that Congress enacted section 1092(c)(4), options available on the national securities exchanges had a term of nine months or less. Congress did not include in the legislative history any guidance on the effect of the time value of money upon the strike price.

Subsequent to the enactment of section 1092(c)(4), the national securities exchanges began offering certain standardized options with expiration dates that are 12 or more months after the date entered into. The longer term of these options may reduce the taxpayer’s risk of loss on its stock position because of the time pe

riod involved.

Increased risk reduction through the use of long term options applies equally to equity options with flexible terms, OTC options, and equity options with standardized terms. The proposed regulations therefore provide that a one-year term limit also applies to equity options with standardized terms. Comments are requested on this issue, including a discussion of time limitations in general, as well as the appropriateness of a one-year cutoff.

If QCC treatment should apply to longer-term options, it may be appropriate to change the deep-in-the-money standard to prevent the increase in risk reduction. A comment recommending a time limitation greater than one year or recommending that there be no time limitation should also provide detailed, comprehensive descriptions of possible solutions to the problem of increased risk reduction. Comments should also address the administrability of any proposed solutions.

Proposed Effective Date

These regulations would apply to options entered into on or after 30 days after the date that the Treasury decision adopting these rules as final regulations is published in the Federal Register .

Regulations concerning time limitations for equity options with standardized terms would be prospective in nature and would apply to transactions entered into on or after 90 days from the date of publication of the final regulation promulgating such rules.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It is hereby certified that these regulations will not have a significant economic impact on a substantial number of small entities. This certification is based upon the fact that these regulations do not impose any recordkeeping or reporting requirements and therefore impose minimal compliance costs, if any, upon any small entities that may be affected. Because equity options with standardized terms will not be eligible for QCC treatment if such options have a duration of more than 1 year, some

April 2, 2001 994 2001–14 I.R.B.

taxpayers may lose substantive tax benefits. This certification is further based upon the understanding that such taxpayers will not include a substantial number of small entities. Comments are specifically requested on the question of whether a substantial number of small entities (as opposed to large entities or individual investors) will suffer a significant economic impact under these regulations. Therefore, a Regulatory Flexibility Analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) 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 or electronic comments (a signed original and eight (8) copies, if written) that are submitted timely (in the manner described in the ADDRESSES portion of this preamble) to the IRS. The IRS and Treasury request comments on the clarity of the proposed regulations and how they may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for May 9, 2001, at 10 a.m., in the IRS Auditorium, Internal Revenue Building, 1111 Constitution Avenue NW, Washington DC. Due to building security procedures, visitors must enter at the 10th Street entrance located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identifications to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written comments and an outline of the topics to be discussed and the time to be devoted to each topic

(signed original and eight (8) copies) by April 18, 2001. 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 Pamela Lew, Office of Associate Chief Counsel (Financial Institutions and Products). However, other personnel from the IRS and Treasury Department participated in their development.

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 adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * * Section 1.1092(c)–2 also issued under 26 U.S.C.1092(c)(4)(H) Section 1.1092(c)–3 also issued under 26 U.S.C. 1092(c)(4)(H).* * * Par. 2. Section 1.1092(c)–1 is amended as follows:

Paragraphs (b) and (d)(1)(ii) introductory text are revised.
Paragraphs (c) and (d)(3) are added.
Paragraph (e) is revised. The revisions and addition read as follows:

§1.1092(c)–1 Equity options with flexible terms.

(b) No effect on lowest qualified bench mark for standardized options . The availability of strike prices for equity options with flexible terms does not affect the determination of the lowest qualified bench mark, as defined in section 1092(c)(4)(D), for an equity option with standardized terms.

(c) Qualified covered call option status —(1) Requirements . An equity option with flexible terms is a qualified covered call option only if—

(i) The option meets the requirements of section 1092(c)(4)(B) (taking into account paragraph (c)(2) of this section);

(ii) The only payments permitted with respect to the option are a single fixed premium paid not later than 5 business days after the day on which the option is granted, and a single fixed strike price stated as a dollar amount that is payable entirely at (or within 5 business days of) exercise;

(iii) The option is granted not more than 1 year before the day on which the option expires; and

(iv) An equity option with standardized terms is outstanding for the underlying equity.

(2) Lowest qualified bench mark —(i) In general . For purposes of determining whether an equity option with flexible terms is deep in the money within the meaning of section 1092(c)(4)(C), the lowest qualified bench mark under section 1092(c)(4)(D) is the same for an equity option with flexible terms as the lowest qualified bench mark for an equity option with standardized terms on the same stock having the same applicable stock price.

(ii) Example . The following example illustrates the rules set out in paragraph (c)(2)(i) of this section:

Example . Taxpayer owns stock in Corporation X. Taxpayer writes an equity call option with flexible terms on Corporation X stock through a national securities exchange. The applicable stock price for Corporation X stock is $73.75. Using the bench marks for an equity option with standardized terms with an applicable stock price of $73.75, the highest available bench mark less than the applicable stock price is $70, and the second highest bench mark is $65. Therefore, an equity call option with flexible terms on Corporation X with a term of 90 days or less will not be deep in the money if the strike price is not less than $70. If the term is greater than 90 days, an equity call option with flexible terms on Corporation X will not be deep in the money if the strike price is not less than $65.

(d) * * * (1) * * * (ii) That is traded on any national securities exchange which is registered with the Securities and Exchange Commission (other than those described in the SEC Releases set forth in paragraph (d)(1)(i) of this section) and is—

(3) Equity option with standardized terms means an equity option that is traded on a national securities exchange registered with the Securities and Ex

2001–14 I.R.B. 995 April 2, 2001

change Commission and that is not an equity option with flexible terms.

(e) Effective date —(1) In general . Except as provided in paragraph (e)(2) of this section, this section applies to equity options with flexible terms entered into on or after January 25, 2000.

(2) Special effective date for paragraph (c) . Paragraph (c) of this section applies to equity options with flexible terms entered into on or after 30 days after the date that the Treasury decision adopting these regulations is published in the Federal Register .

Par. 3. Section 1.1092(c)–2 is added to read as follows:

§1.1092(c)–2 Equity options with standardized terms.

(a) One-year limitation . An equity option with standardized terms (as defined in §1.1092(c)–1(d)(3)) is a qualified covered call only if—

(1) The option meets the requirements of section 1092(c)(4)(B); and

(2) The option is granted not more than 1 year before the day on which the option expires.

(b) Effective date . This section applies to equity options with standardized terms entered into on or after 90 days after the date that the Treasury decision adopting these regulations is published in the Fed- eral Register .

Par. 4. Section 1.1092(c)–3 is added.

§1.1092(c)–3 Qualifying over-the- counter options.

(a) In general . Under section 1092(c)(4)(B)(i), an equity option is not a qualified covered call option unless it is traded on a national securities exchange which is registered with the Securities and Exchange Commission or other market which the Secretary determines has rules adequate to carry out the purposes of section 1092(c)(4). In accordance with section 1092(c)(4)(H), this requirement is modified as provided in paragraph (b) of this section.

(b) Qualified covered call option status . A qualifying over-the-counter option is a qualified covered call option if it meets the requirements of §1.1092(c)–1(c) after substituting “qualifying over-the-counter option” for “equity option with flexible terms”. For the purposes of this paragraph (b), a qualifying over the counter option is deemed to satisfy the requirements of sec

tion 1092(c)(4)(B)(i).

(c) Qualifying over-the-counter option . For the purposes of this section, qualify- ing over-the-counter option means an equity option that—

(1) Is not traded on a national securities exchange registered with the Securities and Exchange Commission; and

(2) Is entered into with a person registered with the Securities and Exchange Commission as—

(i) A broker-dealer under section 15 of the Securities Act of 1934 and the regulations thereunder; or

(ii) An alternative trading system under 17 CFR 242.300 et seq . (d) Effective date . This section applies to qualifying over-the-counter options entered into on or after 30 days after the date that the Treasury decision adopting these regulations is published in the Federal Register .

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

document provides notice of a public hearing on the proposed regulations.

DATES: Written comments and outline of topics to be discussed at the public hearing scheduled for May 16, 2001, must be received by April 25, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–101739–00), room 5226, 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:M&SP:RU (REG–101739–00), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option of the IRS Home Page, or by submitting comments directly to the IRS Internet site at: http://www.irs.gov/tax_regs/ regslist.html . The public hearing will be held in room 6718, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Camille B. Evans, (202) 622-3860 (not a toll-free number); concerning submissions and the hearing, Sonya M. Cruse, (202) 622-7180 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background and Purpose

On December 18, 1996, the IRS and the Treasury Department published the elective regime under section 7701 known as the check-the-box regulations (T.D. 8697, 1997–1 C.B. 215 [61 FR 66584]). Generally, the check-the-box regulations allow any business entity to elect to be treated for Federal tax purposes as a corporation, a partnership (if it has two or more members), or a disregarded entity (if it has a single owner). This document proposes to amend the current Procedure and Administration Regulations (26 CFR Part 301) to address the treatment of an entity wholly owned by a foreign government (as defined in §1.892–2T) and a nonbank entity wholly owned by a foreign bank.

This document also proposes to provide that a partnership can be a controlled commercial entity under section 892.

(Filed by the Office of the Federal Register on January 17, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 18, 2001, 66 F.R. 4751)

Notice of Proposed Rulemaking and Notice of Public Hearing

Clarification of Entity Classification Rules

REG–101739–00

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document proposes regulations under section 7701 that address the Federal tax classification of a business entity wholly owned by a foreign government and provide that a nonbank entity that is wholly owned by a foreign bank cannot be disregarded as an entity separate from its owner (disregarded entity) for purposes of applying the special rules of the Internal Revenue Code applicable to banks. This document also proposes regulations under section 892 that provide that a partnership can be a controlled commercial entity for purposes of section 892(a)(2)(B). In addition, this

April 2, 2001 996 2001–14 I.R.B.

tion 7805(f) of the Code, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (preferably a signed original and eight (8) copies) that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for May 16, 2001, beginning at 10 a.m., in room 6718, Internal Revenue Building, 1111 Constitution Avenue NW., Washington, DC. Because of access restrictions, visitors will not be admitted beyond the Internal Revenue Building lobby more than fifteen (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 timely written comments and an outline of the topics to be discussed and the time to be devoted to each topic (preferably a signed original and eight (8) copies) by April 25, 2001.

A period of ten (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 Camille B. Evans of the Office of Associate Chief Counsel (International). However, other personnel from the IRS and Treasury Department participated in their development.

Proposed Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 301 are proposed to be amended as follows:

Explanation of Provisions

A. §301.7701–2

Section 301.7701–2(b) of the checkthe-box regulations specifies that certain business entities are classified as per se corporations for Federal tax purposes (i.e., those business entities that are not permitted to elect a noncorporate Federal tax classification). Section 301.7701– 2(b)(6) classifies a business entity wholly owned by a State or any of its political subdivisions as a per se corporation. However, the regulations do not specify that the phrase State or any political sub- division thereof includes a foreign government.

The IRS and Treasury believe that it is appropriate to treat a foreign government similarly to a State in this context. Thus, to achieve parallel tax treatment under the check-the-box regulations of a business entity wholly owned by a State or any of its political subdivisions and a business entity wholly owned by a foreign government, these proposed regulations provide that a business entity wholly owned by a foreign government cannot elect to be treated as a disregarded entity.

The check-the-box regulations also provide a special rule for the treatment of nonbank entities that are wholly owned by banks. In particular, §301.7701– 2(c)(2)(ii) provides that a bank cannot treat a wholly owned nonbank entity as a disregarded entity for purposes of applying the special rules of the Internal Revenue Code (Code) applicable to banks. The term bank for this purpose is defined in section 581 to include only domestic entities. Section 301.7701–2(c)(2)(ii) does not explicitly restrict foreign banks from treating their wholly owned nonbank entities as disregarded entities for all tax purposes (because foreign banks are not defined as banks under section 581).

As with the rule described for foreign governments, the IRS and Treasury believe that nonbank entities wholly owned by domestic banks and foreign banks should be treated similarly in this context. These regulations incorporate a reference to section 585(a)(2)(B) (which includes certain foreign banks that are engaged in a U.S. trade or business in the definition of the term bank) in §301.7701–2(c)(2)(ii). As a result, neither domestic banks nor foreign banks engaged in a U.S. trade or

business can treat wholly owned nonbank entities as disregarded entities for purposes of applying the special rules of the Code applicable to banks.

B. §1.892–5(a)

Section 1.892–5T(a) currently provides that for purposes of defining the term con- trolled commercial entity, the term entity encompasses corporations and trusts (including pension trusts described in §1.892–2T(c)) and estates. To ensure that investments in the United States by a foreign government through separate juridical entities are treated similarly, these proposed regulations under §1.892–5(a) provide that, for purposes of section 892(a)(2)(B), the term entity also includes a partnership.

Proposed Effective Dates

The regulations that address the Federal tax classification of business entities wholly owned by a foreign government under §301.7701–2 are proposed to apply on or after the earlier of January 14, 2002, or the date these regulations are published as final regulations in the FEDERAL REGISTER to such business entities regardless of any prior entity classification, and the regulations that address the definition of the term entity for purposes of section 892(a)(2)(B) are proposed to apply on or after the earlier of January 14, 2002, or the date these regulations are published as final regulations in the FED- ERAL REGISTER . The regulations relating to a nonbank entity that is wholly owned by a foreign bank are proposed to apply to taxable years beginning after January 12, 2001.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 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) does not apply to these regulations, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Therefore, a Regulatory Flexibility Analysis is not required. Pursuant to sec

2001–14 I.R.B. 997 April 2, 2001

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by removing the entry for “Sections 1.892–1T through 1.892–7T” and adding the following entries in numerical order:

Authority: 26 U.S.C. 7805 * * * Section 1.892–1T also issued under 26 U.S.C. 892(c).

Section 1.892–2T also issued under 26 U.S.C. 892(c).

Section 1.892–3T also issued under 26 U.S.C. 892(c).

Section 1.892–4T also issued under 26 U.S.C. 892(c).

Section 1.892–5 also issued under 26 U.S.C. 892(c).

Section 1.892–5T also issued under 26 U.S.C. 892(c).

Section 1.892–6T also issued under 26 U.S.C. 892(c).

Section 1.892–7T also issued under 26 U.S.C. 892(c). * * *

Par. 2. Section 1.892–5 is added to read as follows:

§1.892–5 Controlled commercial entity.

PART 301—PROCEDURE AND ADMINISTRATION

Notice of Proposed Rulemaking and Notice of Public Hearing

Taxable Years of Partner and Partnership; Foreign Partners

REG–104876–00

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations on the taxable year of a partnership with foreign partners. The proposed regulations affect partnerships and their partners. This document also contains a notice of public hearing on these proposed regulations.

DATES: Written comments must be received by April 17, 2001. Requests to speak (with outlines of oral comments) at the public hearing scheduled for June 6, 2001, at 10 a.m., must be submitted by May 16, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–104876–00), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG–104876– 00), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option of the IRS Home Page or by submitting comments directly to the IRS Internet site at http://www.irs.ustreas.gov/ tax_regs/regslist.html . The public hearing will be held in room 4718, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Dan Carmody, (202) 622-3080; concerning specific international issues, Ronald M. Gootzeit, (202) 622-3860; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, LaNita VanDyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

This document proposes to amend section 706 of the Income Tax Regulations

(a) through (a)(2) [Reserved]. For further information, see §1.892–5T(a) through (a)(2).

(3) For purposes of section 892(a)(2)(B), the term entity means and includes a corporation, a partnership, a trust (including a pension trust described in §1.892–2T(c)) and an estate.

(4) Effective date . This section applies on or after the earlier of January 14, 2002, or the date these regulations are published as final regulations in the FEDERAL REGISTER .

(b) through (d) [Reserved]. For further information, see §§1.892–5T(b) through (d).

Par. 3. Section 1.892–5T is amended by:

Removing the flush language immediately following paragraph (a)(2).
Adding paragraph (a)(3). The addition reads as follows:

§1.892–5T Controlled commercial entity (temporary regulations).

(a) * * * (3) [Reserved]. For further information, see §1.892–5(a)(3).

Par. 4. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 5. Section 301.7701–2 is amended by:

Revising paragraphs (b)(6) and (c)(2)(ii).
Revising the first sentence of paragraph (e).

The revisions read as follows:

§301.7701–2 Business entities; definitions.

(b) * * * (6) A business entity wholly owned by a State or any political subdivision thereof, or a business entity wholly owned by a foreign government (as defined in §1.892–2T);

(c) * * * (2) * * * (ii) Special rule for certain business en- tities . If the single owner of a business entity is a bank (as defined in section 581, or, in the case of a foreign bank, as defined in section 585(a)(2)(B) without regard to the second sentence thereof), then the special rules of the Internal Revenue Code applicable to banks will continue to apply to the single owner as if the wholly owned entity were a separate entity.

(e) Effective date . Except as otherwise provided in this paragraph (e), the rules of this section apply as of January 1, 1997, except that paragraph (b)(6) applies on or after the earlier of January 14, 2002, or the date these regulations are published as final regulations in the FEDERAL REG- ISTER to a business entity wholly owned by a foreign government regardless of any prior entity classification, and paragraph (c)(2)(ii) of this section applies to taxable years beginning after January 12, 2001.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on January 11, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 12, 2001, 66 F.R. 2854)

April 2, 2001 998 2001–14 I.R.B.

(26 CFR part 1) regarding partnership taxable years.

Background

Section 706 governs the taxable years for a partnership and its partners. The partners and the partnership each have their own taxable years, which may or may not coincide. Under section 706(a), for a partner’s taxable year, the partner must include in taxable income the partner’s share of any income, gain, loss, deduction, or credit of the partnership for the partnership’s taxable year that ends within or with the partner’s taxable year. Section 706(b) provides rules for determining a partnership’s taxable year.

Prior to the Tax Reform Act of 1986, it was possible for partners to create income deferral opportunities through arranging divergent taxable years for a partnership and its partners. For example, under certain circumstances, a partnership could elect a June 30 taxable year while its partners were calendar year taxpayers. Under such an arrangement, the partners would include partnership income earned from July 1, Year 1, to June 30, Year 2, in Year 2, when the partnership’s taxable year ended, even though six months of income was generated during Year 1. To prevent this potential for income deferral, Congress amended section 706(b). See generally Staff of the Joint Committee on Taxation, General Explanation of the Tax Re- form Act of 1986, 533-39 (1986) .

Section 706(b) provides that, unless the partnership establishes a business purpose for a different taxable year, a partnership cannot have a taxable year other than: (i) the majority interest taxable year; (ii) if there is no majority interest taxable year, the taxable year of all the principal partners of the partnership; or (iii) if there is no taxable year described in (i) or (ii), the calendar year unless the Secretary by regulation prescribes another period. Section 1.706–1T(a)(1) and (2) provides that if neither (i) nor (ii) is applicable, the partnership’s taxable year will be the taxable year that results in the least aggregate deferral of partnership income. Additionally, §1.706–3T(a) provides that under certain circumstances, a tax-exempt partner will be disregarded for purposes of section 706(b).

Explanation of Provisions

I. Treatment of Foreign Partners

Currently, foreign partners are taken into consideration when determining a partnership’s taxable year under section 706(b). In some circumstances, this could allow the taxable year of a partnership to be determined for Federal tax purposes by reference to the taxable year of one or more partners who may not be subject to U.S. taxation on income earned through the partnership. For instance, assume that a foreign partner owns a majority interest in a partnership that generates only foreign source income that is not effectively connected with a trade or business conducted within the United States. The minority partners are domestic persons subject to tax in the United States on income earned through the partnership. If the taxable year or years of the domestic partners are different from that of the majority partner, the majority partner’s taxable year would determine the partnership’s taxable year, which would affect the timing of the domestic partners’ inclusion of partnership income. Thus, by conforming the partnership’s taxable year to the taxable year of foreign partners, the mechanical application of section 706(b) can create deferral for those partners who are subject to tax in the United States on income earned through the partnership, while having no impact on the majority foreign partners who are not subject to tax in the United States on such income. The IRS and the Treasury do not believe that such a result is consistent with the intent of the statute.

A. Disregard certain foreign partners

The proposed regulations generally require foreign partners who are not subject to U.S. taxation on a net basis on income earned through the partnership to be disregarded for purposes of applying section 706(b). For these purposes a foreign partner will be considered subject to Federal income tax only if the partner is allocated gross income of the partnership that is effectively connected (or treated as effectively connected) with the conduct of a trade or business within the United States (effectively connected income or ECI). In the case of a foreign partner claiming benefits under a U.S. income tax treaty, a foreign partner will be disregarded unless it

is allocated gross income that is attributable to a permanent establishment in the United States.

A foreign partner also may be subject to U.S. Federal income tax on its distributive share of fixed or determinable annual or periodic income (FDAP income) from U.S. sources. In certain circumstances, the timing for imposing United States withholding tax on FDAP income earned through a partnership may be affected by the partnership’s taxable year. See, e.g., §1.1441–5(b)(2)(i) (providing the timing for withholding under section 1441 in the case of a domestic partnership that has received, but not distributed, FDAP income that is includible in the distributive share of a foreign partner). The IRS and Treasury believe that the withholding provisions of section 1441 provide a more appropriate mechanism than section 706 for addressing timing issues for these partners. Additionally, the IRS and Treasury are concerned that the ability of a partnership to earn small amounts of FDAP income, and thereby alter the determination of its taxable year, may permit inappropriate manipulation of the rule under section 706(b) for the domestic partners. Accordingly, under these proposed regulations, the taxable year of a foreign partner would be disregarded for purposes of section 706(b) if that partner is subject to Federal income tax solely due to the presence of U.S. source income earned through the partnership that is not ECI. In addition, it is irrelevant, for purposes of the proposed regulations, whether the foreign partner is subject to tax in the United States with respect to income other than income earned by the partnership.

The rule for foreign partners provided in these proposed regulations generally is consistent with the present rule under §1.706–3T for the treatment of partners that are exempt from taxation under section 501(a). The taxable years of tax-exempt partners are not considered for purposes of section 706(b) unless those partners are subject to tax on income from the partnership. One difference between the rules for foreign partners and the rules for tax-exempt partners is that foreign partners will be included in determining a partnership’s taxable year where the foreign partner is allocated gross income that is effectively connected with a U.S. trade or business, but actually has a net loss

2001–14 I.R.B. 999 April 2, 2001

from the partnership for the taxable year (i.e., the foreign partners are not actually subject to tax on their allocable portion of the partnership’s income). By contrast, a tax-exempt partner is disregarded where its allocable share of the partnership’s tax items produces a net loss for the taxable year even though, if the foreign partner were allocated net income for the taxable year, the tax-exempt entity would have been subject to tax on such income. The IRS and Treasury are considering modifying the tax-exempt rule to conform with the proposed rule for foreign partners and request comments in this regard.

Finally, for purposes of these rules, the proposed regulations generally define a foreign partner as a partner that is not a U.S. person (as defined in section 7701(a)(30)), but provide that controlled foreign corporations (CFCs) and foreign personal holding companies (FPHCs) are not treated as foreign partners. These entities are not treated as foreign for purposes of determining a partnership’s taxable year under section 706 because the U.S. owners of such entities may be subject to Federal income taxation on a current basis with respect to income earned by the entities.

The IRS and Treasury also considered, but did not include, a similar rule for passive foreign investment companies (PFICs). The proposed regulations do not include a similar rule for PFICs because, unlike the rules for CFCs and FPHCs, which require that a majority of the ownership be concentrated in a small group of U.S. persons, the PFIC rules apply without regard to the level of ownership of the individual, or of all U.S. owners in the aggregate. Additionally, in most instances where a PFIC does have substantial U.S. ownership, it will also be a CFC or a FPHC.

B. Minority interest rule

The IRS and Treasury recognize that requiring a partnership taxable year to be determined without regard to certain foreign partners may present difficulties for minority partners in some cases. If the taxable years of certain foreign partners are disregarded for purposes of section 706(b), it is possible that the taxable year of a partnership may be determined solely by reference to the taxable year of one or more small minority domestic partners.

This could create significant administrative burdens for minority partners if the partnership maintains its books and records on a taxable year selected by significant foreign partners that is different from the taxable year of the minority partner or partners.

In order to provide relief in this situation, the proposed regulations contain an exception providing that foreign partners will not be disregarded for purposes of section 706(b) if the partnership’s taxable year would be determined by reference to partners that individually hold less than a 10-percent interest, and in the aggregate hold less than a 20-percent interest, in the capital and profits of the partnership. For purposes of this rule, a partner’s interest will include interests held directly and interests held by related partners. In determining whether the minority interest rule applies, the proposed regulations take into account the ownership of tax-exempt entities that are disregarded under §1.706–3T(a).

Where a domestic tax-exempt entity (or entities) owns a relatively small interest in the partnership, but enough to cause the minority interest rule not to apply, the result may be anomalous, given that the taxexempt entity has no real interest in a particular taxable year and thus has no incentive to convince significant foreign partners to cause the partnership to determine its taxable year by reference to the domestic partners. However, where such a tax-exempt entity (or entities) owns a majority interest in the partnership, the result may be more appropriate because the domestic partners are more likely to have significant bargaining power regarding the taxable year vis-a-vis the foreign partners. An appropriate solution may be to exclude tax-exempt entities from both the numerator and denominator in applying the de minimis rule. The IRS and Treasury request comments regarding how tax-exempt entities should be treated for purposes of the minority interest rule.

C. Transitional relief

Under current law, a partnership may have adopted a taxable year that creates deferral by reference to the taxable year of a foreign partner not subject to U.S. net income taxation. In such instances, compliance with these regulations could result in a change in the partnership taxable year

which would cause a “bunching” of more than 12 months of partnership income into a single taxable year of the partners subject to Federal income tax.

For example, consider a partnership that has a June 30 taxable year because of the presence of a 60-percent foreign partner that is not subject to U.S. net income taxation on income earned through the partnership. This taxable year creates six months of deferral for the 40-percent domestic partner, who is on the calendar year. In the year that these proposed regulations become effective, two partnership taxable years (the taxable year concluding on June 30 and the initial short calendar year concluding December 31) would close during the domestic partner’s taxable year. Thus, section 706(a) would require the domestic partner to recognize its distributive share of 18 months of partnership income during a single taxable year. While the historic taxable year of the partnership in this example is inconsistent with the intent of section 706(b), the IRS and Treasury recognize that the potential bunching of income caused by changing to an appropriate taxable year might present an undue hardship for some taxpayers.

In order to alleviate such a hardship, the proposed regulations would permit adversely affected taxpayers to apply the four-year spread provisions of §1.702–3T. This transitional rule will have limited application; it is intended only to provide relief for bunching of income that occurs in the first taxable year beginning on or after the effective date of these proposed regulations.

II. Application of §1.701–2

The mechanical rules of section 706(b) operate to limit partners’ opportunities to defer the recognition of partnership income. Where partners have different taxable years, eliminating or limiting deferral for one partner may result in increasing deferral for another partner. Such deferral is an anticipated result of section 706(b). However, an application of the mechanical rules of section 706(b) and these proposed regulations remains subject to the antiabuse rule of §1.701–2.

For example, assume that these proposed regulations would disregard the taxable year of a 76-percent foreign partner and require the partnership (which only has for

April 2, 2001 1000 2001–14 I.R.B.

eign operations, and therefore does not earn ECI) to adopt the taxable year of the 24percent domestic partner. Conceivably the partners could attempt to avoid this result by forming a tiered structure where the foreign partner would own a 95-percent interest in an upper-tier domestic partnership that would hold, as its only asset, an 80 percent interest in the lower-tier operating partnership (the domestic partner would own the remaining 5 percent of the uppertier partnership and the remaining 20 percent of the lower-tier partnership). In substance, this is the same arrangement as the single partnership except that the minority interest rule would generally require the upper-tier partnership to adopt the taxable year of the foreign partner (because the domestic partner owns less than a 10-percent interest in the upper-tier partnership). The upper-tier domestic partnership’s taxable year would then be considered the majority interest taxable year of the lower-tier partnership under section 706(b)(1)(B)(i). In these circumstances, the Commissioner may determine that in order to achieve a tax result that is consistent with the intent of section 706, §1.701–2 should apply. In such event, the Commissioner may disregard the upper-tier partnership and treat the assets thereof (in this case, the interest in the lower-tier partnership) as being owned directly by its partners, with the result that the foreign partner would be disregarded in determining the taxable year of the lowertier partnership under section 706(b) and these proposed regulations.

III. Finalization of Prior Proposed

Regulations

The current temporary regulations under section 706 are the product of three separate Treasury decisions. The text of these Treasury decisions, T.D. 7991 (1985–1 C.B. 71) (adopted November 29, 1984), T.D. 8169 (1988–1 C.B. 259) (adopted December 23, 1987), and T.D. 8205 (1988–1 C.B. 156) (adopted May 24, 1988), were also contemporaneously promulgated as proposed regulations, LR–183–84 (1985–1 C.B. 653) (published in the Federal Regis- ter on November 30, 1984), LR–101–86 (1988–1 C.B. 924) (published in the Fed- eral Register on December 29, 1987), and LR–53–88 (1988–1 C.B. 935) (published in the Federal Register on May 27, 1988). These proposed regulations have not been withdrawn, and it is likely that they will be

finalized in conjunction with the finalization of the regulations proposed by this document. The IRS and Treasury expect that the finalization of these previously proposed regulations will be accompanied by the withdrawal of the existing temporary regulations. Comments previously received in connection with the prior proposed regulations will be considered as well as new or additional comments with respect to such regulations.

IV. Effective Date

These regulations are proposed to apply to partnership taxable years beginning on or after the date final regulations are published in the Federal Register . For example, if the final regulations were published on November 1, 2001, a partnership that historically has determined its taxable year by reference to a 75-percent foreign partner with a March 31 taxable year end rather than by reference to a 25-percent domestic partner that uses the calendar year would be required to change to the calendar year as of April 1, 2002 (the partnership year beginning after the date final regulations were published). This would result in a short taxable year from April 1, 2002, to December 31, 2002.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 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) does not apply to these regulations, and because these regulations do not impose on small entities a collection of information requirement, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. 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, considera

tion will be given to any written comments (preferably a signed original and eight (8) copies) that are submitted timely to the IRS. The IRS and Treasury specifically request comments on the clarity of the proposed regulations and how they may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for June 6, 2001, beginning at 10 a.m., in room 4718, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington, DC. Due to building security procedures, visitors must enter at the 10th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

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 timely written comments and must submit an outline of the topics to be discussed and the time to be devoted to each topic (preferably a signed original and eight (8) copies) by May 16, 2001.

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 Dan Carmody, Office of Chief Counsel (Passthroughs and Special Industries). However, other personnel from the IRS and Treasury Department participated in their development.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

2001–14 I.R.B. 1001 April 2, 2001

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.706–4 is added to read as follows:

§1.706–4 Certain foreign partners disregarded

(a) General rule —(1) Foreign part- ners not claiming benefits under a U.S. income tax treaty . In determining the taxable year (the current taxable year) of a partnership under section 706(b) and the regulations thereunder, a foreign partner shall be disregarded unless such partner is allocated any gross income of the partnership that was effectively connected (or treated as effectively connected) with the conduct of a trade or business within the United States during the partnership’s taxable year immediately preceding the current taxable year. However, if a foreign partner was not a partner during the partnership’s immediately preceding taxable year, such partner will be disregarded for the current taxable year if the partnership reasonably believes that the partner will not be allocated any gross income generated by the partnership during the current taxable year that is effectively connected with the conduct of a trade or business within the United States.

(2) Foreign partners claiming benefits under a U.S. income tax treaty . In the case of a foreign partner claiming benefits under an income tax treaty between the United States and another jurisdiction, a foreign partner will be disregarded under this paragraph (a) unless such partner was allocated any gross income that was attributable to a permanent establishment in the United States during the partnership’s taxable year immediately preceding the current taxable year (or, if such partner was not a partner during the immediately preceding taxable year, the partnership reasonably believes that such partner will be allocated such income during the current taxable year).

(b) Minority interest rule . If the partners that are not disregarded by paragraph (a) of this section (absent the application of this paragraph (b)) individually hold less than a 10-percent interest, and in the aggregate hold less than a 20-percent in

terest, in the capital and profits of the partnership, paragraph (a) of this section will not apply. For purposes of determining ownership in the partnership after application of paragraph (a) of this section, the constructive ownership rules of section 318 shall apply, and the attribution rules of section 267(c) also shall apply to the extent they attribute ownership to persons to whom section 318 does not attribute ownership. However, “10 percent” shall be substituted for “50 percent” in section 318(a)(2)(C) and (3)(C). For purposes of determining if partners hold less than a 20-percent interest in the aggregate, the same interests will not be considered as being owned by more than one partner.

(c) Definition of foreign partner . For purposes of this section, a foreign partner is any partner that is not a U.S. person (as defined in section 7701(a)(30)), except that a partner that is a controlled foreign corporation (as defined in section 957(a)) or a foreign personal holding company (as defined in section 552) shall not be treated as a foreign partner.

(d) Example . The provisions of this section may be illustrated by the following example:

Example . Partnership B is owned by two partners, F, a foreign corporation that owns a 95-percent interest in the capital and profits of partnership B, and D, a domestic corporation that owns the remaining 5-percent interest in the capital and profits of partnership B. Partnership B is not engaged in the conduct of a trade or business within the United States, and, accordingly, partnership B does not earn any income that is effectively connected with a U.S. trade or business. F uses a March 31 fiscal year, and causes partnership B to maintain its books and records on a March 31 fiscal year as well. D is a calendar year taxpayer. Under paragraph (a) of this section, F would be disregarded and partnership B’s taxable year would be determined by reference to D. However, because D owns less than a 10-percent interest in the capital and profits of partnership B, the minority interest rule of paragraph (b) of this section applies, and partnership B must adopt the March 31 fiscal year.

(e) Effective date —(1) Generally . The provisions of this section are applicable for partnership taxable years that begin on or after the date final regulations are published in the Federal Register .

(2) Transition rule . Partners of a partnership that is required to change its taxable year as of the beginning of its first taxable year after the date final regulations are published in the Federal Regis- ter may apply the provisions of

§1.702–3T if the change in taxable year occurs in the first taxable year following the date final regulations are published in the Federal Register .

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on January 16, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 17, 2001, 66 F.R. 3920)

Notice of Proposed Rulemaking and Notice of Public Hearing

Hedging Transactions

REG–107047–00

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document contains proposed regulations relating to the character of hedging transactions. These proposed regulations reflect changes to the law made by the Ticket to Work and Work Incentives Improvement Act of 1999. The proposed regulations affect businesses entering into hedging transactions. This document also provides notice of a public hearing on these proposed regulations.

DATES: Written or electronically generated comments must be received by April 25, 2001. Requests to speak (with outlines of oral comments to be discussed) at the public hearing scheduled for May 16, 2001, at 10 a.m., must be submitted by April 25, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–107047–00), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG–107047– 00), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option on the IRS Home Page, or by sub

April 2, 2001 1002 2001–14 I.R.B.

regulations with respect to the character of hedging transactions generally should be codified as an appropriate interpretation of present law. S. Rep. No. 201, 106th Cong., 1st Sess. 24 (1999). These proposed regulations conform the Treasury regulations to these statutory provisions.

Explanation of Provisions

Paragraph (a) of the proposed regulations provides basic rules for the treatment of hedging transactions. The substance of these rules is the same as the rules under §1.1221–2(a).

Accordingly, paragraph (a)(1) of the proposed regulations generally provides that property that is part of a hedging transaction, as defined in section 1221(b)(2)(A) and paragraph (b) of the proposed regulations, is not a capital asset. Paragraph (a)(2) of the proposed regulations provides a similar rule for short sales and options. Where a short sale or option is part of a hedging transaction, as defined, any gain or loss on the short sale or option is ordinary. Under paragraph (a)(3), if a transaction falls outside the regulations, gain or loss from the transaction is not made ordinary by the fact that property is a surrogate for a 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. As under the Treasury regulations, Congress intended that the hedging rules be the exclusive means through which the gains and losses on hedging transactions are treated as ordinary. S. Rep. No. 201, 106th Cong., 1st Sess. 25 (1999).

The provisions of the proposed regulations generally apply to determine the character of gain or loss from transactions that also are subject to various international provisions of the Code. Paragraph (a)(4) of the proposed regulations, however, provides that section 988 transactions are excluded from these regulations because gain or loss on those transactions is ordinary under section 988(a)(1). Paragraph (a)(4) of the proposed regulations also provides that the definition of a hedging transaction under §1.1221–2(b) of the proposed regulations does not apply for purposes of the hedging exceptions to the subpart F rules of section 954(c) and cer

mitting comments directly to the IRS internet site at http://www.irs.gov/tax_regs/ regslist.html. The public hearing will be held in the IRS auditorium, 1111 Constitution Ave., NW, Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Jo Lynn Ricks, (202) 622-3920; concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, contact Lanita Vandyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information contained in this notice of proposed rulemaking has 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 numbers 1545-1403 and 1545-1480. 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.

Books or records relating to a collection of information must be retained as long as their contents may become material 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 proposed 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 Fed- eral Register (59 FR 36360) final Treasury regulations under section 1221 pro

viding for ordinary character treatment for most business hedges. The regulations generally apply to hedges 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 (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. The final regulations published in 1994 and 1996 are collectively referred to as the Treasury regulations in this preamble.

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 generally to include 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 taxpayer. §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.

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.

The legislative history to the hedging provisions states that Congress intended that the approach taken in the Treasury

2001–14 I.R.B. 1003 April 2, 2001

tain hedging rules in the interest allocation regulations under section 864(e).

Regulations under §1.482–8 will address risk management activities in the context of a global dealing operation. Thus, except to the extent provided in §§1.475(g)–2, 1.482–8, and 1.863–3(h), these regulations do not apply in determining the allocation and source of income for a participant in a global dealing operation or whether a risk management function related to the activities of a regular dealer in securities has been conducted.

Proposed regulations under §§1.882–5 and 1.884–1 also refer to hedging under §1.1221–2 for purposes of determining assets and liabilities of a foreign corporation for interest allocation and branch tax purposes. The IRS and Treasury are evaluating the appropriate requirements necessary to implement cross-border and worldwide hedging rules for these purposes and seek comments in this regard. Therefore, paragraph (a)(4) of the proposed regulations provides that the definition of hedging transaction in paragraph (b) of the proposed regulations is inapplicable in determining the hedging requirements under sections 882(c) and 884, except to the extent provided in regulations under those sections.

Paragraph (b) of the proposed regulations restates the definition of hedging transaction in section 1221(b)(2)(A). Under this rule, a hedging transaction is generally a transaction that a taxpayer enters into in the normal course of its business primarily to manage the risk of interest rate or price changes or currency fluctuations with respect to ordinary property, ordinary obligations, or borrowings of the taxpayer.

Paragraph (c) of the proposed regulations provides rules of application designed to ensure that the definition of hedging transaction is applied reasonably to include most common types of business hedges. Congress intended that the approach taken in the Treasury regulations with respect to the character of hedging transactions generally should be codified as an appropriate interpretation of present law. S. Rep. No. 201, 106th Cong., 1st Sess. 24 (1999). The Senate Finance Committee believed that the Treasury regulations interpret risk reduction flexibly to provide hedging transac

tion treatment for fixed to floating hedges, certain written call options, dynamic hedges, partial hedges, recycled hedges, and hedges of aggregate risk (see §1.1221–2(c)). Id . at n.12. The Committee believed that (depending on the facts) the treatment of those transactions as hedging transactions is appropriate and that it is also appropriate to modernize the definition of hedging transaction by providing risk management as the standard. Id . These proposed regulations revise the Treasury regulations to reflect the risk management standard.

Paragraph (c)(1) of the proposed regulations deals with the meaning of risk management. It provides that, except as otherwise provided in paragraph (c), a transaction satisfies the risk management standard if it reduces risk. To enter into a hedging transaction, the taxpayer must have risk when all of its operations are considered — that is, there must be risk on a “macro” basis. Nonetheless, a hedge of a single asset or liability, or pool of assets or liabilities, will be respected as managing risk if the hedge reduces the risk attributable to the item or items being hedged and if the hedge is reasonably calculated to reduce the overall risk of the taxpayer’s operations. In addition, if a taxpayer hedges a particular asset or liability, or a pool of assets or liabilities, and the hedge is undertaken as part of a program to reduce the overall risk of the taxpayer’s operations, the taxpayer need not show that the hedge reduces its overall risk.

Paragraph (c)(1) of the proposed regulations also recognizes that fixed to floating hedges and certain types of written options may manage risk and may be hedging transactions in appropriate situations. For example, a covered call with respect to assets held or a written put option with respect to assets to be acquired may be a hedging transaction.

In addition, paragraph (c)(1) of the proposed regulations provides that a hedging transaction includes a transaction that reverses or counteracts a hedging transaction. This rule recognizes that some transactions are used to eliminate some or all of the risk reduction accomplished through another hedging transaction. Although the transactions are not risk reducing if viewed independently, they are considered to be part of the larger hedging transaction.

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

Except as otherwise provided in paragraph (c) of the proposed regulations, a transaction that is not entered into primarily to reduce risk is not a hedging transaction. For example, the so-called “storeon-the-board” transaction, in which a taxpayer disposes of its production output and enters into a long futures contract with respect to the same product, is not a hedging transaction. In this example, the long futures contact could be viewed as a surrogate for the storage of the commodity. The net proceeds from the sale of the production output and the gain or loss on the long futures contract simulates the price at which the production output would have sold if it had been physically stored and sold at a later time. However, because the production output to which the futures contract relates has been sold, there is no underlying position (with respect to ordinary property held or to be held) that exposes the taxpayer to price risk. Thus, the long position does not reduce risk. Moreover, gain or loss on the contract is not treated as ordinary on the grounds that it is a surrogate for inventory.

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

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

April 2, 2001 1004 2001–14 I.R.B.

made primarily to manage risk. The IRS and Treasury request comments on the circumstances in which the acquisition of debt instruments or borrowings are made primarily to manage risk.

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

Paragraph (c)(5) of the proposed regulations provides that a hedge of property or of an obligation is a hedging transaction only if a sale or exchange of the property, or performance or termination of the obligation, could not produce capital gain or loss. The special rule in the Treasury regulations for noninventory supplies (§1.1221–2(c)(5)(ii)), however, is not contained in these proposed regulations. Under the noninventory supply rule, if a taxpayer sells only a negligible amount of a noninventory supply, then, only for purposes of determining whether a hedge of the purchase of that noninventory supply is a hedging transaction, that noninventory supply is treated as ordinary property. This rule is not being proposed because section 1221(a)(8) generally provides ordinary gain or loss treatment for consumable supplies held or acquired on or after December 17, 1999.

Paragraph (c)(6) of the proposed regulations provides that the status of liability hedges as hedging transactions is determined without regard to the use that is made of the proceeds of a borrowing so long as the transaction is entered into in furtherance of the taxpayer’s trade or business. The Service and Treasury believe that a liability hedge should not fail to qualify as a hedging transaction because the proceeds of the borrowing being hedged are used to purchase a capital asset.

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

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

Paragraph (c)(8) of the proposed regulations provides that a hedging transaction does not include a transaction entered into to manage risks other than interest rate or price changes, or currency fluctuations, unless a regulation, revenue ruling, or revenue procedure provides otherwise. Thus, until such guidance is published, a hedge of volume or revenue fluctuations is not a hedging transaction. One example of this type of hedge is a weather derivative used by an energy producer to hedge against the decrease in volume of sales from variations in weather patterns.

The IRS is considering whether to expand the definition of hedging transaction 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. The Service solicits comments on the types of risks that should be covered, including specific examples of derivative transactions that may be incorporated into future guidance.

The status of so-called “gap” hedges is not separately addressed in paragraph (c) of the proposed regulations. Insurance companies, for example, sometimes hedge the “gap” between their liabilities and the assets that fund them. Under the proposed regulations, a hedge of those assets does not qualify as a hedging transaction if the assets are capital 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.

For example, a contract to purchase assets is generally not a liability hedge even if the assets are being purchased to fund the liability. Other gap hedges may be appropriately treated as liability hedges and, therefore, may qualify as hedging transactions.

The rules in paragraphs (d), (e) and (f) of the proposed regulations, covering consolidated group hedging, identification and recordkeeping rules, and the effect of identification and non-identification, respectively, are generally unchanged from the corresponding rules in the Treasury regulations. This is because Congress generally intended to codify the approach to hedging transactions that was taken in the Treasury regulations. S. Rep. No. 201, 106th Cong., 1st Sess. 24 (1999). Paragraph (d) of the proposed regulations provides rules applicable to hedging by members of a consolidated group. The proposed regulations retain the single-entity approach of the Treasury regulations. That is, they treat the risk of one member of the group as the risk of the other members, as if all the members were divisions of a single corporation. Thus, a member of a consolidated group that hedges the risk of another member by entering into a transaction with a third party may receive ordinary gain or loss treatment on that transaction if the transaction otherwise qualifies as a hedging transaction.

Under this single-entity approach, intercompany transactions are neither hedging transactions nor hedged items. Because they are treated as transactions between divisions of a single corporation, intercompany transactions do not manage the risk of that single corporation and, therefore, fail to qualify as hedging transactions.

The proposed regulations also retain the separate-entity election of the Treasury regulations, permitting a consolidated group to treat its members as separate entities when applying the hedging rules. The election is made by attaching a statement to the group’s federal income tax return.

For a group that elects separate-entity treatment, an intercompany transaction is treated as a hedging transaction if and only if: (1) it would qualify as a hedging transaction if entered into with an unrelated party; and (2) it is entered into with

2001–14 I.R.B. 1005 April 2, 2001

quire constant monitoring and a sophisticated understanding of the capital markets. Therefore, a Regulatory Flexibility analysis under the Regulatory Flexibility Act (5 U.S.C. chapter 6) 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 electronic or written comments (a signed original and eight (8) copies of written comments) that are submitted timely (in the manner described in “ADDRESSES”) to the IRS. The IRS and Treasury request comments on the clarity of the proposed rules and how they may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing has been scheduled for May 16, 2001, beginning at 10 a.m., in the IRS auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. Due to building security procedures, visitors must enter at the 10 ^th Street entrance, located between Constitution and Pennsylvania Avenues, NW. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 15 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see “FOR FURTHER INFORMATION CONTACT.”

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written comments and an outline of topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by April 25, 2001. A period of 10 minutes will be allotted to each person 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.

a member that, under its method of accounting, marks its position in the intercompany transaction to market. If these requirements are satisfied, the member with respect to which it is an intercompany hedging transaction must account for its position in the transaction under §1.446–4, and, if that member properly identifies the transaction as a hedging transaction, each member treats the gain or loss from its position in the transaction as ordinary.

The proposed regulations provide that, even when these two requirements are met, these regulations supplant only the character and timing rules of §1.1502–13. Other aspects of the transaction, such as the source of the gain or loss, are unaffected by these regulations and thus may be governed by other portions of §1.1502–13.

Pursuant to section 1221(a)(7), paragraph (e)(1) of the proposed regulations provides that hedging transactions must be identified before the close of the day on which they are entered into. Paragraph (e)(2) of the proposed regulations requires that the item, items, or aggregate risk being hedged be identified substantially contemporaneously with entering into the hedging transaction. The identification must be made no more than 35 days after entering into the hedging transaction.

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

Paragraph (e)(4) of the proposed regulations provides rules with respect to how an identification is made. It must be clear

that the identification is being made for tax purposes. In lieu of separately identifying each transaction, however, a taxpayer may establish a system in which identification is indicated by the type of transaction or the manner in which the transaction is consummated or recorded.

Paragraph (e)(5) of the proposed regulations deals with the required identification where the taxpayer is a member of a consolidated group, and paragraph (e)(6) of the proposed regulations provides that an identification for purposes of section 1256(e)(2) is also an identification for purposes of §1.1221–2(e)(1).

Pursuant to section 1221(b)(2)(B), paragraph (f) of the proposed regulations deals with the effect of identification and non-identification. The rules in this paragraph are the same as the rules in paragraph (f) of the Treasury regulations.

The proposed regulations under section 1256 generally restate the rules of §1.1256(e)–1 that coordinate the identification of hedges for purposes of section 1256(e). The citations to section 1256(e)(2)(C) in the Treasury regulations have been replaced with citations to section 1256(e)(2) in the proposed regulations.

Proposed Effective Date

The proposed regulations are proposed to be effective for transactions entered into on or after January 18, 2001. However, the IRS will not challenge any transaction entered into on or after December 17, 1999, and before January 18, 2001, that satisfies the provisions of these proposed regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking 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 re

April 2, 2001 1006 2001–14 I.R.B.

control, the definition of hedging transaction must be interpreted reasonably and consistently with the purposes of section 1221(b)(2)(A) and this section. (1) Managing risk —(i) Transactions that manage risk . 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. In general, a taxpayer’s hedging strategies and policies as reflected in the taxpayer’s minutes or other records are evidence of whether particular transactions were entered into primarily to manage the taxpayer’s risk.

(ii) Micro and macro hedges —(A) In general . A taxpayer has risk of a particular type only if it is at risk when all of its operations are considered. Nonetheless, a hedge of a particular asset or liability generally will be respected as managing risk if it reduces the risk attributable to the asset or liability and if it is reasonably expected to reduce the overall risk of the taxpayer’s operations. If a taxpayer hedges particular assets or liabilities, or groups of assets or liabilities, and the hedges are undertaken as part of a program that, as a whole, is reasonably expected to reduce the overall risk of the taxpayer’s operations, the taxpayer generally does not have to demonstrate that each hedge that was entered into pursuant to the program reduces its overall risk.

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

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

Drafting Information

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

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 revising the entry for §1.1221–2 to read as follows:

Authority: 26 U.S.C. 7805 * * * §1.1221–2 also issued under 26 U.S.C. 1221(b)(2)(A)(iii), (b)(2)(B), and (b)(3).*** Par. 2. 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 (f)(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 (f)(2) of this section, gain or loss on a short sale or option that is part of a hedging transaction (as defined in paragraph (b) of this section) is ordinary income or loss.

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

(4) Coordination with other sections (i) Section 988 . This section does not apply to determine the character of gain

or loss realized on a section 988 transaction as defined in section 988(c)(1) or realized with respect to any qualified fund as defined in section 988(c)(1)(E)(iii).

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

(iii) Global dealing operation . Except as otherwise provided in §§1.475(g)–2, 1.482–8, and 1.863–3(h), the rules of application for purposes of the definition of a hedging transaction in paragraph (c) of this section do not apply in determining the allocation and source of income with respect to a participant in a global dealing operation or in determining whether a risk management function related to the activities of a regular dealer in securities has been conducted. See §1.482–8(a) for the definitions of global dealing operation, regular dealer in securities, and participant.

(iv) Sections 882(c) and 884 . Except as otherwise provided in regulations issued under sections 882(c) and 884, the definition of hedging transaction in paragraph (b) of this section does not apply for purposes of those sections.

(b) Hedging transaction defined . Section 1221(b)(2)(A) provides that a hedging 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)(5) 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 (c)(8) of this section).

(c) Rules of application . The rules of this paragraph (c) apply for purposes of the definition of the term hedging transaction in section 1221(b)(2)(A) and paragraph (b) of this section. These rules must be interpreted reasonably and consistently with the purposes of this section. Where no specific rules of application

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(iv) 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.

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

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

(vii) Transactions that do not manage risk . A transaction that is not entered into to reduce a taxpayer’s risk does not manage risk. For example, assume that a taxpayer produces a commodity for sale, sells the commodity, and enters into a long futures or forward contract in that commodity in the hope that the price will increase. Because the long position does not reduce risk, and is not otherwise treated as a hedging transaction in this paragraph (c), the transaction is not a hedging transaction. Moreover, gain or loss on the contract is not made ordinary on the grounds that it is a surrogate for inventory. See paragraph (a)(3) of this section.

(2) Entering into a hedging transaction . A taxpayer may enter into a hedging transaction by using a position that was a hedge of one asset or liability as a hedge of another asset or liability (recycling).

(3) No investments as hedging transac- tions . If an asset (such as an investment) is not acquired primarily to manage risk, the purchase or sale of that asset is not a

hedging transaction even if the terms of the asset limit or reduce the taxpayer’s risk with respect to other assets or liabilities. For example, a taxpayer’s interest rate risk from a floating rate borrowing may be reduced by the purchase of debt instruments that bear a comparable floating rate. The acquisition of the debt instruments, however, is not a hedging transaction because the transaction is not entered into primarily to reduce the taxpayer’s risk. Similarly, borrowings generally are not made primarily to manage risk.

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

(5) 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 regardless of the taxpayer’s holding period when the sale or exchange occurs. Thus, for example, property used in a trade or business within the meaning of section 1231(b) (determined without regard to the holding period specified in that section) is not ordinary property. An obligation is an ordinary obligation if performance or termination of the obligation by the taxpayer could not produce capital gain or loss. For purposes of the preceding sentence, termination has the same meaning as in section 1234A.

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

(7) Hedging an aggregate risk . The term hedging transaction includes a transaction that 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.

(8) Hedges of other risks . Except as otherwise determined in a regulation, revenue ruling, or revenue procedure, a

hedging transaction does not include a transaction entered into to manage risks other than interest rate or price changes, or currency fluctuations.

(d) Hedging by members of a consoli- dated group —(1) General rule: single- entity 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 considered 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 (d)(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 (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 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 (d)(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 hedg- ing transactions . An intercompany hedging transaction (that is, a transaction that meets the requirements of paragraphs (d)(2)(ii)(A) and (B) of this section) is subject to the following rules—

April 2, 2001 1008 2001–14 I.R.B.

(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 (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 . Unless the Commissioner otherwise prescribes, the election described in this paragraph (d)(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(d)(2) (THE SEPARATE-ENTITY APPROACH).” The statement must also indicate the date as of which the election 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 . The following examples illustrate this paragraph (d):

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.

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 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 (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 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; counter- party 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 (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 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.

Example 3. Separate-entity election; counter- party 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.

(e) 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 con

tent of this identification, see paragraph (e)(3) of this section.

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

(3) Identification requirements for cer- tain hedging transactions . In the case of the hedging transactions described in this paragraph (e)(3), the identification under paragraph (e)(2) of this section must include the information specified.

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

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

(iii) Hedges of debt of the taxpayer (A) Existing debt . If the hedging transaction relates to accruals or payments under an issue of existing debt of the taxpayer, the identification must specify the issue and, if the hedge is for less than the full 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; 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,

2001–14 I.R.B. 1009 April 2, 2001

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) Re- quired identification . If a transaction hedges aggregate risk as described in paragraph (c)(7) of this section, the identification under paragraph (e)(2) of this section must include a description of the risk being hedged and of the hedging program under which the hedging transaction was entered. This requirement may be met by placing in the taxpayer’s records a description of the hedging program and by establishing a system under which individual transactions 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.

(4) Manner of identification and records to be retained —(i) Inclusion of identification in tax records . The identification required by this paragraph (e) must be made on, and retained as part of, the taxpayer’s books and records.

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

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

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

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

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

(C) A taxpayer can make an identification by 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 ap- proach . A member of a consolidated group must satisfy the requirements of this paragraph (e) 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 to transfer risk within the group, the requirements of paragraph (e)(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 (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. Paragraph (d)(4) Example 1 of this section illustrates this identification.

(ii) Rule for consolidated groups mak- ing 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.

(6) Consistency with section 1256(e)(2) . Any identification for purposes of section 1256(e)(2) is also an identification for purposes of paragraph (e)(1) of this section.

(f) Effect of identification and non-iden- tification —(1) Transactions identified —(i) In general . If a taxpayer identifies a transaction as a hedging transaction for purposes of paragraph (e)(1) of this section, the identification is binding with respect to gain, whether or not all of the requirements of paragraph (e) 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

April 2, 2001 1010 2001–14 I.R.B.

purpose. Thus, the taxpayer’s identification of the transaction as a hedging transaction does not itself make loss from the transaction ordinary.

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

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

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

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

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

(ii) Inadvertent error . If a taxpayer does not make an identification that satisfies the requirements of paragraph (e) of this section, the taxpayer may treat gain or loss from the transaction as ordinary income or loss under paragraph (a)(1) or (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 (e) of this section but the taxpayer has no reasonable grounds for treating the transaction as other than a hedging transaction, then gain from the transaction is ordinary. 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 con- solidated group —(i) Single-entity ap- proach . If a consolidated group is under the general rule of paragraph (d)(1) of this section (the single-entity approach), the rules of this paragraph (f) apply only to transactions that are not 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 (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, notwithstanding any contrary provision in §1.1502–13, each party to the transaction is subject to the rules of paragraph (f)(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 (d)(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 (f)(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 (d)(2)(iii)(A) of this section.)

(g) Effective date . The rules of this section apply to transactions entered into on or after January 18, 2001.

Par. 2. Section 1.1256(e)–1 is revised to read as follows:

§1.1256(e)–1 Identification of hedging transactions.

(a) Identification and recordkeeping re- quirements . 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(e)(1). Solely for purposes of section 1256(f)(1), however, an identification that does not satisfy all of the requirements of §1.1221–2(e)(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(e)(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 . This section applies to transactions entered into on or after January 18, 2001.

(Filed by the Office of the Federal Register on January 17, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 18, 2001, 66 F.R. 4738)

Notice of Proposed Rulemaking

Notice to Interested Parties

REG–129608–00

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

SUMMARY: This document contains proposed regulations relating to the notice to interested parties. Before the IRS can issue an advance determination regarding the qualification of a retirement plan, a plan sponsor must provide evidence that it has notified all persons who qualify as interested parties that an application for an advance determination will be filed.

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

2001–14 I.R.B. 1011 April 2, 2001

These proposed regulations set forth standards by which a plan sponsor may satisfy the notice to interested parties requirement. The proposed regulations affect retirement plan sponsors, plan participants and other interested parties with respect to an application for a determination letter, and certain representatives of interested parties.

DATES: Written or electronic comments and requests for a public hearing must be received by April 17, 2001.

ADDRESSES: Send submissions to: CC:M&SP:RU (REG–129608–00), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 5 p.m. to: CC:M&SP:RU (REG–129608–00), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by selecting the “Tax Regs” option on the IRS Home Page, or by submitting comments directly to the IRS Internet site at http://www.irs.gov/tax_regs/ reglist.html .

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, contact Pamela R. Kinard, (202) 622-6060; concerning the submission of comments, contact LaNita VanDyke, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax Regulations (26 CFR Parts 1 and 601) under section 7476 of the Internal Revenue Code of 1986 (Code). Section 7476(b)(2) provides that, with respect to a pleading filed by a petitioner for a request for a determination on the qualified status of a retirement plan under section 7476(a), the Tax Court may find the pleading to be premature unless the petitioner establishes to the satisfaction of the court that he has complied with the requirements prescribed by the regulations of the Secretary regarding the notice to interested parties.

On May 21, 1976, Final Income Tax Regulations (T.D. 7421, 1976–1 C.B. 405)

under section 7476 were published in the Federal Register (41 FR 20874). The final regulations provide guidance on the nature and method of giving notice to interested parties. Existing §1.7476– 1(a)(1) provides that in order to receive a determination on the qualified status of a retirement plan, the applicant must provide evidence that individuals who qualified as interested parties received notification of the determination letter application. In general, interested parties are defined in §1.7476–1(b)(1) as all present employees of the employer eligible to participate in the plan, and all other present employees whose principal place of employment is the same as the principal place of employment of the employees eligible to participate. For plan terminations, §1.7476–1(b)(5) defines interested parties as all present employees with accrued benefits, all former employees with vested benefits, and all beneficiaries of deceased former employees currently receiving benefits under the plan.

Existing §1.7476–2(b) provides that the notice must be given in writing, must contain the information in §601.201(o)(3) (Statement of Procedural Rules) and must be given in the manner prescribed in §1.7476–2(c). For present employees, §1.7476–2(c)(1) provides that the notice must be given in person, by mailing, by posting, or by printing it in a publication of the employer or an employee organization that is reasonably available to employees. For interested parties who are in a unit of employees covered by a collective-bargaining agreement, the notice must also be given in person or by mail to the collective-bargaining representative of the interested parties. For former employees and beneficiaries who qualify as interested parties, §1.7476–2(c)(2)(i) provides that notice shall be given in person or by mail to the last known address of the interested party.

On February 8, 2000, the IRS and Treasury published Final Income Tax Regulations (T.D. 8873, 2000–9 I.R.B. 713) in the Federal Register (65 FR 6001) that provide safe harbor methods for plan sponsors and administrators using electronic media to transmit notices and consents required under sections 402(f), 411(a)(11), or 3405(e)(10)(B). Notice 99–1 (1999–1 C.B. 269) and Announcement 99–6 (1999–1 C.B. 352) also pro

vide guidance on the use of electronic media by retirement plans.

In order to continue to advance the goal of permitting plan sponsors to use electronic media in administering their retirement plans, this amendment to the regulations eliminates the writing requirement for the notice to interested parties. Instead, the proposed regulations set forth new standards for satisfying the notice requirement that would ensure that interested parties will receive timely and adequate notice.

Explanation of Provisions

This notice of proposed rulemaking would amend §§1.7476–2 and 601.201 regarding the nature and method of giving notices to interested parties. The proposed regulations do not change the information that the notice must contain or the time period in which the notice must be given. These regulations continue to provide that the notice to interested parties must contain the information and be given within the time period prescribed in §601.201(o)(3) (Statement of Procedural Rules). The proposed regulations would set forth new standards for providing the notice to interested parties. These new standards permit greater flexibility in the manner in which the notice may be provided.

The proposed regulations provide that, in the case of a present employee, former employee, or beneficiary who is an interested party, the notice may be provided by any method that reasonably ensures that all interested parties will receive the notice. The method used must be reasonably calculated to provide timely and adequate notice to all interested parties. In addition, the proposed regulations provide that if an interested party who is a present employee is in a unit of employees covered by a collective-bargaining agreement between employee representatives and one or more employers, notice shall also be given to the collective-bargaining representative of such interested party by any method that reasonably ensures that the collective-bargaining representative will receive the notice. The proposed regulations also provide if the notice to interested parties is delivered using an electronic medium under a system that satisfies the requirements of Q&A-5 of §1.402(f)–1, the notice will be deemed to be provided in a

April 2, 2001 1012 2001–14 I.R.B.

manner that satisfies the notice to interested parties requirement.

The proposed regulations provide that whether the notice to interested parties is given in a manner that satisfies the requirements under these regulations will be determined on the basis of all the facts and circumstances. These regulations further provide that since the facts and circumstances will differ depending on the interested party, it is possible that more than one method of delivery (including nonelectronic writing) must be used in order to ensure timely and adequate notice to all interested parties.

The proposed regulations also revise §601.201 (Statement of Procedural Rules) to conform to the changes in §1.7476–2.

Proposed Effective Date

These regulations are proposed to be effective with respect to applications made on or after the date they are published in the Federal Register as final regulations. Plan sponsors may rely on these proposed regulations for guidance pending the issuance of final regulations. If, and to the extent, future guidance is more restrictive than the guidance in these proposed regulations, the future guidance will be applied without retroactive effect.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 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) does not apply to these regulations, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Comments and Requests for a 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) or electronic comments that are submitted timely to the IRS. The IRS and Treasury specifically request comments on the clarity of the proposed rule and how it may be made easier to understand. All comments will be available for public inspection and copying.

A public hearing may be scheduled if requested in writing by a person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register .

Drafting Information

The principal author of these regulations is Pamela R. Kinard of the Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities), IRS. However, other personnel from the IRS and Treasury Department participated in their development.

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 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.7476–2 is amended as follows:

Paragraphs (b) and (c) are revised.
Paragraph (d) is redesignated as paragraph (e) and a new paragraph (d) is added.
Paragraph (e)(1) is revised. The revisions and additions read as follows:

§1.7476–2 Notice to interested parties.

(b) Nature of notice . The notice required by this section shall —

(1) Contain the information and be given within the time period prescribed in §601.201(o)(3) of this chapter (Statement of Procedural Rules); and,

(2) Be given in a manner prescribed in paragraph (c) of this section.

ested party, the notice may be provided by any method that reasonably ensures that all interested parties will receive timely and adequate notice. If an interested party who is a present employee is in a unit of employees covered by a collective-bargaining agreement between employee representatives and one or more employers, notice shall also be given to the collective-bargaining representative of such interested party by any method that satisfies this paragraph. Whether the notice is provided in a manner that satisfies the requirements of this paragraph will be determined on the basis of all the facts and circumstances. Because the facts and circumstances will differ depending on the interested party, it is possible that more than one method of delivery must be used in order to ensure timely and adequate notice to all interested parties.

(2) If the notice to interested parties is delivered using an electronic medium under a system that satisfies the requirements of Q&A-5 of §1.402(f)–1, the notice will be deemed to be provided in a manner that satisfies the requirements of paragraph (c)(1) of this section.

(d) Examples . The principles of this section are illustrated by the following examples:

Example 1 . (i) Employer A is amending Plan C and applying for a determination letter. Plan C is not maintained pursuant to one or more collective-bargaining agreements and is not being terminated. As part of the determination letter application process, Employer A provides the notice required under this section to interested parties. For present employees, Employer A provides the notice by posting the notice at those locations within the principal places of employment of the interested parties which are customarily used for employer notices to employees with regard to labor-management relations matters.

(ii) In this Example 1, Employer A satisfies the notice to interested parties requirement described in this section.

Example 2 . (i) Employer B is amending Plan D and applying for a determination letter. As part of the determination letter application process, Employer B provides the notice required under this section to interested parties.

(ii) Employer B has multiple worksites. Employer B’s employees located at worksites 1 through 4 have access to computers at their workplace. However, Employer B’s employees located at worksite 5 do not have access to computers.

(iii) For present employees with access to computers (worksites 1 through 4), Employer B provides the notice by posting the notice on Employer B’s web site (Internet or intranet). Employer B customarily posts employer notices to employees at worksites 1 through 4 with regard to labor-management relations matters on its web site. For present employees without access to computers (worksite 5),

2001–14 I.R.B. 1013 April 2, 2001

Employer B provides the notice by posting the notice at worksite 5 in a location that is customarily used for employer notices to employees with regard to labor-management relations matters.

(iv) Employer B also sends the notice by e-mail to each collective-bargaining representative of interested parties who are present employees of Employer B covered by a collective-bargaining agreement between employee representatives and Employer B, using the e-mail address previously provided to Employer B by such collective-bargaining representative.

(v) In this Example 2, Employer B satisfies the notice to interested parties requirement described in this section.

Example 3 . (i) Employer C is terminating Plan E and applying for a determination letter as to whether the plan termination affects the continuing qualification of Plan E. As part of the determination letter application process, Employer C provides the notice required under this section to interested parties.

(ii) All of Employer C’s employees have access to computers. Each employee has an e-mail address where he or she can receive messages from Employer C. Employer C has set up kiosks for employees’ use. The kiosks are located within the principal places of employment of the employees and are customarily used for employer notices to employees with regard to labor-management relations matters.

(iii) For present employees, Employer C provides the notice by sending the notice by e-mail.

(iv) Employer C also sends the notice by e-mail to each collective-bargaining representative of interested parties who are present employees of Employer C covered by a collective-bargaining agreement between employee representatives and Employer C, using the e-mail address previously provided to Employer C by such collective-bargaining representative.

(v) In addition, Employer C sends the notice by e-mail to each interested party who is a former employee or beneficiary, using the e-mail address previously provided to Employer C by such interested party. For any former employee or beneficiary who did not provide an e-mail address, Employer C sends the notice by regular mail to the last known address of such former employee or beneficiary.

(vi) In this Example 3, Employer C satisfies the notice to interested parties requirement described in this section.

(e) Effective date . (1) The provisions of this section shall apply to applications referred to in paragraph (a) of §1.7476–1 made on or after the date the regulations are published in the Federal Register as final regulations.

PART 601 — STATEMENT OF PROCEDURAL RULES

Paragraph 1. The authority citation for part 601 continues to read, in part, as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 601.201 is amended as follows:

In paragraph (o)(3)(xv), the first sentence is replaced by two new sentences.
In paragraph (o)(3)(xvi), introductory text is revised.

The revisions read as follows:

§601.201 Rulings and determination letters.

(o) * * * (3) * * * (xv) When the notice referred to in paragraph (o)(3)(xiv) of this section is given in the manner set forth in §1.7476–2(c), the following time limitations for providing the notice apply. When the notice is given other than by mailing, it should be given not less than 7 days nor more than 21 days prior to the date that the application for a determination is made. * * *

(xvi) The notice referred to in paragraph (o)(3)(xiv) of this section shall be given in the manner prescribed in §1.7476–2 and shall contain the following information:

Robert E. Wenzel, Deputy Commissioner

of Internal Revenue.

(Filed by the Office of the Federal Register on January 16, 2001, 8:45 a.m., and published in the issue of the Federal Register for January 17, 2001, 66 F.R. 3954)

Supplemental Information on Treasury Bills for Publication 1212

Announcement 2001–29

Banks, brokers, and other middlemen who report discount on Treasury bill redemptions on Form 1099-INT must use the owner’s purchase price, where available, to determine the amount of discount to report. This information can usually be obtained from the owner’s or middleman’s records. However, if the owner’s purchase price is not available from existing records, the middleman must report the discount as if the holder had purchased the Treasury bill at its original issue price. In this case, the middleman must use as the original issue price the noncompetitive issue price for the longest-maturity Treasury bill maturing on that date.

For Treasury bill redemptions when the owner’s purchase price cannot be determined, the following list gives the noncompetitive issue prices and corresponding amounts of discount to be reported on Form 1099-INT for Treasury bills maturing May through July 2001. This list, which should also help middlemen determine any amounts subject to backup withholding, supplements the list that appears in the 2000 edition of Publication 1212, List of Original Issue Discount Instru- ments .

April 2, 2001 1014 2001–14 I.R.B.

SHORT-TERM UNITED STATES TREASURY BILLS Issued at a discount and maturing May 2001 - July 2001

Noncompetitive Dollar Amount of OID CUSIP Maturity Issue Issue Price (% of to be reported (per Number Date Date Principal Amount) $1,000 of Maturity Value)

	912795GE5	05/03/01	11/02/00	96.929	30.71
	912795GF2	05/10/01	11/09/00	96.914	30.86
	912795GG0	05/17/01	11/16/00	96.931	30.69
	912795GH8	05/24/01	11/24/00	96.958	30.42
*	912795GJ4	05/31/01	06/01/00	93.933	60.67
	912795GK1	06/07/01	12/07/00	97.048	29.52
	912795GL9	06/14/01	12/14/00	97.073	29.27
	912795GM7	06/21/01	12/21/00	97.139	28.61
	912795GN5	06/28/01	12/28/00	97.219	27.81
	912795HA2	07/05/01	01/04/01	97.290	27.10
	912795HC8	07/12/01	01/11/01	97.561	24.39
	912795GP0	07/19/01	01/18/01	97.444	25.56
	912795HD6	07/26/01	01/25/01	97.513	24.87

*52-Week Bill

2001–14 I.R.B. 1015 April 2, 2001