[Code of Federal Regulations]
[Title 26, Volume 6]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.446-4]

[Page 75-79]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.446-4  Hedging transactions.

    (a) In general. Except as provided in this paragraph (a), a hedging 
transaction as defined in Sec. 1.1221-2(b) (whether or not the 
character of gain or loss from the transaction is determined under Sec. 
1.1221-2) must be accounted for under the rules of this section. To the 
extent that provisions of any other regulations governing the timing of 
income, deductions, gain, or loss are inconsistent with the rules of 
this section, the rules of this section control.
    (1) Trades or businesses excepted. A taxpayer is not required to 
account for hedging transactions under the rules of this section for any 
trade or business in which the cash receipts and disbursements method of 
accounting is used or in which Sec. 1.471-6 is used for inventory 
valuations if, for all prior taxable years ending on or after September 
30, 1993, the taxpayer met the $5,000,000 gross receipts test of section 
448(c) (or would have met that test if the taxpayer were a corporation 
or partnership). A taxpayer not required to use the rules of this 
section may nonetheless use a method of accounting that is consistent 
with these rules.
    (2) Coordination with other sections. This section does not apply 
to--
    (i) Any position to which section 475(a) applies;
    (ii) An integrated transaction subject to Sec. 1.1275-6;
    (iii) Any section 988 hedging transaction if the transaction is 
integrated under Sec. 1.988-5 or if other regulations issued under 
section 988(d) (or an advance ruling described in 1.988-5(e)) govern 
when gain or loss from the transaction is taken into account; or
    (iv) The determination of the issuer's yield on an issue of tax-
exempt bonds for purposes of the arbitrage restrictions to which Sec. 
1.148-4(h) applies.
    (b) Clear reflection of income. The method of accounting used by a 
taxpayer for a hedging transaction must clearly reflect income. To 
clearly reflect income, the method used must reasonably match the timing 
of income, deduction, gain, or loss from the hedging transaction with 
the timing of income, deduction, gain, or loss from the item or items 
being hedged. Taking gains and losses into account in the period in 
which they are realized may clearly reflect income in the case of 
certain hedging transactions. For example, where a hedge and the item 
being hedged are disposed of in the same taxable year, taking realized 
gain or loss into account on both items in that taxable year may clearly 
reflect income. In the case of many hedging transactions, however, 
taking gains and losses into account as they are realized does not 
result in the matching required by this section.
    (c) Choice of method and consistency. For any given type of hedging 
transaction, there may be more than one method of accounting that 
satisfies the clear reflection requirement of paragraph (b) of this 
section. A taxpayer is generally permitted to adopt a method of 
accounting for a particular type of hedging transaction that clearly 
reflects the taxpayer's income from that type of transaction. See 
paragraph (e) of this section for requirements and limitations on the 
taxpayer's choice of method. Different methods of accounting may be used 
for different types of hedging transactions and for transactions that 
hedge different types of items. Once a taxpayer adopts a method of 
accounting, however, that method must be applied consistently and

[[Page 76]]

can only be changed with the consent of the Commissioner, as provided by 
section 446(e) and the regulations and procedures thereunder.
    (d) Recordkeeping requirements--(1) In general. The books and 
records maintained by a taxpayer must contain a description of the 
accounting method used for each type of hedging transaction. The 
description of the method or methods used must be sufficient to show how 
the clear reflection requirement of paragraph (b) of this section is 
satisfied.
    (2) Additional identification. In addition to the identification 
required by Sec. 1.1221-2(f), the books and records maintained by a 
taxpayer must contain whatever more specific identification with respect 
to a transaction is necessary to verify the application of the method of 
accounting used by the taxpayer for the transaction. This additional 
identification may relate to the hedging transaction or to the item, 
items, or aggregate risk being hedged. The additional identification 
must be made at the time specified in Sec. 1.1221-2(f)(2) and must be 
made on, and retained as part of, the taxpayer's books and records.
    (3) Transactions in which character of gain or loss is not 
determined under Sec. 1.1221-2. A section 988 transaction, as defined 
in section 988(c)(1), or a qualified fund, as defined in section 
988(c)(1)(E)(iii), is subject to the identification and recordkeeping 
requirements of Sec. 1.1221-2(f). See Sec. 1.1221-2(a)(4).
    (e) Requirements and limitations with respect to hedges of certain 
assets and liabilities. In the case of certain hedging transactions, 
this paragraph (e) provides guidance in determining whether a taxpayer's 
method of accounting satisfies the clear reflection requirement of 
paragraph (b) of this section. Even if these rules are satisfied, 
however, the taxpayer's method, as actually applied to the taxpayer's 
hedging transactions, must clearly reflect income by meeting the 
matching requirement of paragraph (b) of this section.
    (1) Hedges of aggregate risk--(i) In general. The method of 
accounting used for hedges of aggregate risk must comply with the 
matching requirements of paragraph (b) of this section. Even though a 
taxpayer may not be able to associate the hedging transaction with any 
particular item being hedged, the timing of income, deduction, gain, or 
loss from the hedging transaction must be matched with the timing of the 
aggregate income, deduction, gain, or loss from the items being hedged. 
For example, if a notional principal contract hedges a taxpayer's 
aggregate risk, taking into account income, deduction, gain, or loss 
under the provisions of Sec. 1.446-3 may clearly reflect income. See 
paragraph (e)(5) of this section.
    (ii) Mark-and-spread method. The following method may be appropriate 
for taking into account income, deduction, gain, or loss from hedges of 
aggregate risk:
    (A) The hedging transactions are marked to market at regular 
intervals for which the taxpayer has the necessary data, but no less 
frequently than quarterly; and
    (B) The income, deduction, gain, or loss attributable to the 
realization or periodic marking to market of hedging transactions is 
taken into account over the period for which the hedging transactions 
are intended to reduce risk. Although the period over which the hedging 
transactions are intended to reduce risk may change, the period must be 
reasonable and consistent with the taxpayer's hedging policies and 
strategies.
    (2) Hedges of items marked to market. In the case of a transaction 
that hedges an item that is marked to market under the taxpayer's method 
of accounting, marking the hedge to market clearly reflects income.
    (3) Hedges of inventory--(i) In general. If a hedging transaction 
hedges purchases of inventory, gain or loss on the hedging transaction 
may be taken into account in the same period that it would be taken into 
account if the gain or loss were treated as an element of the cost of 
inventory. Similarly, if a hedging transaction hedges sales of 
inventory, gain or loss on the hedging transaction may be taken into 
account in the same period that it would be taken into account if the 
gain or loss were treated as an element of sales proceeds. If a hedge is 
associated with a particular purchase or sales transaction, the gain or 
loss on the hedge may be taken into account when it

[[Page 77]]

would be taken into account if it were an element of cost incurred in, 
or sales proceeds from, that transaction. As with hedges of aggregate 
risk, however, a taxpayer may not be able to associate hedges of 
inventory purchases or sales with particular purchase or sales 
transactions. In order to match the timing of income, deduction, gain, 
or loss from the hedge with the timing of aggregate income, deduction, 
gain, or loss from the hedged purchases or sales, it may be appropriate 
for a taxpayer to account for its hedging transactions in the manner 
described in paragraph (e)(1)(ii) of this section, except that the gain 
or loss that is spread to each period is taken into account when it 
would be if it were an element of cost incurred (purchase hedges), or an 
element of proceeds from sales made (sales hedges), during that period.
    (ii) Alternative methods for certain inventory hedges. In lieu of 
the method described in paragraph (e)(3)(i) of this section, other 
simpler, less precise methods may be used in appropriate cases where the 
clear reflection requirement of paragraph (b) of this section is 
satisfied. For example:
    (A) Taking into account realized gains and losses on both hedges of 
inventory purchases and hedges of inventory sales when they would be 
taken into account if the gains and losses were elements of inventory 
cost in the period realized may clearly reflect income in some 
situations, but does not clearly reflect income for a taxpayer that uses 
the last-in, first-out method of accounting for the inventory; and
    (B) Marking hedging transactions to market with resulting gain or 
loss taken into account immediately may clearly reflect income even 
though the inventory that is being hedged is not marked to market, but 
only if the inventory is not accounted for under either the last-in, 
first-out method or the lower-of-cost-or-market method and only if items 
are held in inventory for short periods of time.
    (4) Hedges of debt instruments. Gain or loss from a transaction that 
hedges a debt instrument issued or to be issued by a taxpayer, or a debt 
instrument held or to be held by a taxpayer, must be accounted for by 
reference to the terms of the debt instrument and the period or periods 
to which the hedge relates. A hedge of an instrument that provides for 
interest to be paid at a fixed rate or a qualified floating rate, for 
example, generally is accounted for using constant yield principles. 
Thus, assuming that a fixed rate or qualified floating rate instrument 
remains outstanding, hedging gain or loss is taken into account in the 
same periods in which it would be taken into account if it adjusted the 
yield of the instrument over the term to which the hedge relates. For 
example, gain or loss realized on a transaction that hedged an 
anticipated fixed rate borrowing for its entire term is accounted for, 
solely for purposes of this section, as if it decreased or increased the 
issue price of the debt instrument. Similarly, gain or loss realized on 
a transaction that hedges a contingent payment on a debt instrument 
subject to Sec. 1.1275-4(c) (a contingent payment debt instrument 
issued for nonpublicly traded property) is taken into account when the 
contingent payment is taken into account under Sec. 1.1275-4(c).
    (5) Notional principal contracts. The rules of Sec. 1.446-3 govern 
the timing of income and deductions with respect to a notional principal 
contract unless, because the notional principal contract is part of a 
hedging transaction, the application of those rules would not result in 
the matching that is needed to satisfy the clear reflection requirement 
of paragraph (b) and, as applicable, (e)(4) of this section. For 
example, if a notional principal contract hedges a debt instrument, the 
method of accounting for periodic payments described in Sec. 1.446-3(e) 
and the methods of accounting for nonperiodic payments described in 
Sec. 1.446-3(f)(2)(iii) and (v) generally clearly reflect the 
taxpayer's income. The methods described in Sec. 1.446-3(f)(2)(ii) and 
(iv), however, generally do not clearly reflect the taxpayer's income in 
that situation.
    (6) Disposition of hedged asset or liability. If a taxpayer hedges 
an item and disposes of, or terminates its interest in, the item but 
does not dispose of or terminate the hedging transaction, the taxpayer 
must appropriately match the built-in gain or loss on the hedging 
transaction to the gain or loss on the

[[Page 78]]

disposed item. To meet this requirement, the taxpayer may mark the hedge 
to market on the date it disposes of the hedged item. If the taxpayer 
intends to dispose of the hedging transaction within a reasonable 
period, however, it may be appropriate to match the realized gain or 
loss on the hedging transaction with the gain or loss on the disposed 
item. If the taxpayer intends to dispose of the hedging transaction 
within a reasonable period and the hedging transaction is not actually 
disposed of within that period, the taxpayer must match the gain or loss 
on the hedge at the end of the reasonable period with the gain or loss 
on the disposed item. For purposes of this paragraph (e)(6), a 
reasonable period is generally 7 days.
    (7) Recycled hedges. If a taxpayer enters into a hedging transaction 
by recycling a hedge of a particular hedged item to serve as a hedge of 
a different item, as described in Sec. 1.1221-2(d)(4), the taxpayer 
must match the built-in gain or loss at the time of the recycling to the 
gain or loss on the original hedged item, items, or aggregate risk. 
Income, deduction, gain, or loss attributable to the period after the 
recycling must be matched to the new hedged item, items, or aggregate 
risk under the principles of paragraph (b) of this section.
    (8) Unfulfilled anticipatory transactions--(i) In general. If a 
taxpayer enters into a hedging transaction to reduce risk with respect 
to an anticipated asset acquisition, debt issuance, or obligation, and 
the anticipated transaction is not consummated, any income, deduction, 
gain, or loss from the hedging transaction is taken into account when 
realized.
    (ii) Consummation of anticipated transaction. A taxpayer consummates 
a transaction for purposes of paragraph (e)(8)(i) of this section upon 
the occurrence (within a reasonable interval around the expected time of 
the anticipated transaction) of either the anticipated transaction or a 
different but similar transaction for which the hedge serves to 
reasonably reduce risk.
    (9) Hedging by members of a consolidated group--(i) General rule: 
single-entity approach. In general, a member of a consolidated group 
must account for its hedging transactions as if all of the members were 
separate divisions of a single corporation. Thus, the timing of the 
income, deduction, gain, or loss on a hedging transaction must match the 
timing of income, deduction, gain, or loss from the item or items being 
hedged. Because all of the members are treated as if they were divisions 
of a single corporation, intercompany transactions are neither hedging 
transactions nor hedged items for these purposes.
    (ii) Separate-entity election. If a consolidated group makes an 
election under Sec. 1.1221-2(e)(2), then paragraph (e)(9)(i) of this 
section does not apply. Thus, in that case, each member of the 
consolidated group must account for its hedging transactions in a manner 
that meets the requirements of paragraph (b) of this section. For 
example, the income, deduction, gain, or loss from intercompany hedging 
transactions (as defined in Sec. 1.1221-2(e)(2)(ii)) is taken into 
account under the timing rules of Sec. 1.446-4 rather than under the 
timing rules of Sec. 1.1502-13.
    (iii) Definitions. For definitions of consolidated group, divisions 
of a single corporation, intercompany transaction, and member, see 
section 1502 and the regulations thereunder.
    (iv) Effective date. This paragraph (e)(9) applies to transactions 
entered into on or after March 8, 1996.
    (f) Type or character of income and deduction. The rules of this 
section govern the timing of income, deduction, gain, or loss on hedging 
transactions but do not affect the type or character of income, 
deduction, gain, or loss produced by the transaction. Thus, for example, 
the rules of paragraph (e)(3) of this section do not affect the 
computation of cost of goods sold or sales proceeds for a taxpayer that 
hedges inventory purchases or sales. Similarly, the rules of paragraph 
(e)(4) of this section do not increase or decrease the interest income 
or expense of a taxpayer that hedges a debt instrument or a liability.
    (g) Effective date. This section applies to hedging transactions 
entered into on or after October 1, 1994.
    (h) Consent to change methods of accounting. The Commissioner grants 
consent for a taxpayer to change its methods of accounting for 
transactions

[[Page 79]]

that are entered into on or after October 1, 1994, and that are 
described in paragraph (a) of this section. This consent is granted only 
for changes for the taxable year containing October 1, 1994. The 
taxpayer must describe its new methods of accounting in a statement that 
is included in its Federal income tax return for that taxable year.

[T.D. 8554, 59 FR 36358, July 18, 1994, as amended by T.D. 8653, 61 FR 
519, Jan. 8, 1996; T.D. 8674, 61 FR 30138, June 14, 1996; T.D. 8985, 67 
FR 12865, Mar. 20, 2002; 67 FR 31955, May 13, 2002]