Final Regs Provide Rules on Nonfunctional Currency Transactions

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to the taxation of gain or loss from certain foreign currency transactions and applies to taxpayers engaging in such transactions. This action is necessary because of changes to the applicable tax law made by the Tax Reform Act of 1986.

 DATES: These regulations are effective for taxable years after December 31, 1986 with the following exceptions:

Section 1.267(f)-1, which is effective for transactions entered into after September 21, 1989;

 The removal of sections 1.988-1T through 1.988-5T are effective March 17, 1992.

 Section 1.988-1(a)(2)(iii), (a)(7)(ii), and (a)(8) which is effective for certain transactions entered into after October 21, 1988;

 Section 1.988-1(a)(7)(iii), which is effective with respect to certain tiered partnerships for taxable years after March 17, 1992;

 Section 1.988-2(a)(2)(v), which is effective for taxable years beginning after March 17, 1992;

 Section 1.988-2(b)(2)(iii)(B), which is effective for taxable years beginning after March 17, 1992;

 Section 1.988-2(b)(13), which is effective for exchanges of debt for stock effected after September 21, 1989;

 Section 1.988-2(d)(2)(ii)(B), which is effective for transactions creating an offset after September 21, 1989;

 Section 1.988-2(e)(3), which is effective for transactions entered into after September 21, 1989;

 Section 1.988-3(b), which is effective for taxable years beginning on or after September 21, 1989, except for section 1.988-3(b)(5), which is effective for transactions entered into after March 17, 1992;

 Section 1.988-3(c)(2) which is effective with respect to debt instruments acquired on or after June 24, 1987.

 Section 1.988-5 is effective for transactions entered into on or after September 21, 1989, with the following exceptions:

Section 1.988-5(a)(3)(i) which, in the case of a contingent payment debt instrument, is effective for transactions entered into after March 17, 1992;

 Section 1.988-5(a)(3)(ii), which is effective for transactions entered into after March 17, 1992;

 Section 1.988-5(a)(6)(i) which is effective for transactions that leg into integrated treatment after March 17, 1992;

 The second sentence of section 1.988-5(b)(2)(ii)(A) (which provides that a contract to buy or sell stock is considered an executory contract) is effective for contracts to buy or sell stock entered into on or after March 17, 1992.

 The amendments to part 602 are effective March 17, 1992.

 Taxpayers may rely on the temporary section 988 regulations for the period during which they were effective.

 FOR FURTHER INFORMATION CONTACT: Jeffrey L. Dorfman of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N. W., Washington, DC 20224 (Attention: CC:CORP:T:R (INTL-0485-89) (202-377-9059), not a toll-free call).

SUPPLEMENTARY INFORMATION:

PAPERWORK REDUCTION ACT

The collection of information contained in these regulations has been reviewed end approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act of 1980 (44 U.S.C. 3504(h)) under control number 1545-1131. The estimated average annual burden per respondent is 40 minutes.

 These estimates are an approximation of the average time expected to be necessary for a collection of information. They are based on information as is available to the Internal Revenue Service. Individual respondents/recordkeepers may require greater or less time, depending on their particular circumstances.

 Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be directed to the Internal Revenue Service, Attention: IRS Reports Clearance Officer T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

BACKGROUND On September 21, 1989, the Federal Register published proposed amendments (54 FR 38874) to the Income Tax Regulations (26 CFR parts 1 and 602) under sections 267 and 988 of the Internal Revenue Code. Pursuant to section 7805(f) of the Internal Revenue Code, the Small Business Administration was given an opportunity to comment on the proposed amendments. Comments from the public are discussed below. No public hearing was requested or held. Accordingly, the proposed amendments are adopted as modified by this Treasury Decision.

EXPLANATION OF PROVISIONS

SECTION 1.988-1 CERTAIN DEFINITIONS AND SPECIAL RULES.

SECTION 1.988-(1)(a)(2) DESCRIPTION OF TRANSACTIONS.

Section 1.988-1T(a)(2)(ii) of the temporary regulations provides that the accrual of a foreign tax liability is a section 988 transaction. The final regulations retain this rule except in the case of a dollar functional currency QBU branch of a domestic person that credits foreign taxes under section 901. A payable relating to accrued foreign taxes of that QBU branch is not treated as a section 988 transaction. This rule is necessary to insure that the taxpayer ultimately has a similar income inclusion and credit as a U.S. shareholder of a foreign corporation and a domestic person with a QBU branch that computes income under section 987. See, section 78 and Notice 89-74, 1989-1 C.B. 739.

 Section 1.988-1(a)(2)(iii)(A) provides that a forward contract, futures contract, option, warrant, or similar financial instrument is a section 988 transaction only if the underlying property to which the instrument ultimately relates is a nonfunctional currency or is otherwise described in paragraph (a)(1)(ii) of this section. Commentators suggest bifurcation of financial instruments that contain both currency and noncurrency elements. For example, contracts to buy wheat or a machine for deferred delivery in a nonfunctional currency would be bifurcated into a currency component (the movement of the exchange rates between the contract date and the payment date) and a noncurrency component (the movement in the market price of wheat or the machine). Bifurcation of transactions described in section 988(c)(1)(B)(iii) is prohibited by section 988(b)(3) which provides that any gain or loss from a transaction described in section 988(c)(1)(B)(iii) is treated as foreign currency gain or loss. Accordingly, this suggestion is rejected.

 The treatment under section 988 regarding certain nonfunctional currency denominated contingent payment bonds under section 1.1275-4(g) of the proposed regulations, dual currency bonds, and multi- currency bonds is reserved. However, see section 1.988-1(a)(3), (4), and (5) of the proposed regulations.

SECTION 1.988-1(a)(10) INTRA-TAXPAYER TRANSACTIONS.

Section 1.988-1(a)(10) has been amended to provide that in the case of a gain or loss incurred in a transaction described in that section which does not have a significant business purpose, the Commissioner, in his or her discretion, may defer such gain or loss. This provision was added, in part, to prevent taxpayers from engaging in intra-taxpayer transfers of section 988 transactions for the purpose of recognizing gains or losses on such transactions.

SECTION 1.988-1(d)(3) SPOT RATE CONVENTION.

In response to comments, section 1.988-1(d)(3) has been amended to allow the use of spot rate conventions computed on a quarterly basis and to clarify that use of a prior month's end convention is allowable.

SECTION 1.988-1(e) EXCHANGE GAIN OR LOSS.

Section 1.988-1(e) has been amended to clarify that generally the amount of exchange gain or loss from a section 988 transaction is separately computed for each section 988 transaction, and such amount is not integrated with gain or loss recognized on another transaction.

SECTION 1.988-1(g) FAIR MARKET VALUE.

Section 1.988-1(g) provides that the fair market value of an item shall, where relevant, reflect an appropriate premium or discount for the time value of money. In response to comments, this section has been amended to provide that if consistent with the taxpayer's method of financial accounting (and consistently applied from year to year), the rule described in the preceding sentence shall not apply to a financial instrument that matures within one year from the date of issuance or acquisition.

SECTION 1.988-2 RECOGNITION AND COMPUTATION OF EXCHANGE GAIN OR LOSS.

SECTION 1.988-2(a)(1) DISPOSITION OF NONFUNCTIONAL CURRENCY.

Commentators have recommended adoption of a rule that would exempt a de minimis amount of exchange gain or loss realized by individuals during a taxable year. The Service does not have authority to adopt such a rule in light of section 988 (e).

SECTION 1.988-2(a)(2) COMPUTATION OF EXCHANGE GAIN OR LOSS

Commentators have suggested that the rule of section 1.988-2(a)(2)(iv) regarding the purchase and sale of stock or securities traded on an established securities market by a cash basis taxpayer be extended to accrual basis taxpayers. This rule has been adopted on an elective basis in section 1.988-2(a)(2)(v).

SECTION 1.988-2(b) TRANSLATION OF NONFUNCTIONAL CURRENCY INTEREST INCOME OR EXPENSE

A commentator has suggested treating all exchange gain or loss on debt instruments as interest. This approach is being considered under section 1.861-9T for source of income and expense purposes. However, in order to simplify the translation of accrued interest income or expense with respect to a debt instrument subject to section 988, section 1.988-2(b)(2)(ii) and (iii)(B) allows a taxpayer on the accrual method of accounting for interest income or expense (including cash method taxpayers that accrue original issue discount) to elect to translate interest income and expense at the spot rate on the last day of the interest accrual period (and in the case of a partial accrual period, the spot rate on the last day of the taxable year). If the last day of the interest accrual period is within five business days of the date of receipt or payment, the taxpayer may translate interest income or expense at the spot rate on the date of receipt or payment. This elective spot rate convention eliminates the complexity of determining an average exchange rate and simplifies the computation of exchange gain or loss with respect to accrued interest.

 A commentator recommends using the historic exchange rate (the date the debt instrument was issued) to accrue interest income or expense rather than the average rate for the accrual period currently in the regulations. The rationale is to provide similar treatment between a discount bond and a synthetically created discount bond (composed of a par bond with the purchase of an annuity to defease the interest payments on the par bond). This approach has been rejected because excessive exchange gain or loss would result with respect to long term instruments. Further, compared to the elective spot rate convention, this approach would create greater computational complexity with respect to par bonds. Finally, a synthetically created discount bond is subject to the substance over form provision of section 1.988-2(f) which requires similar treatment of actual and synthetic discount bonds.

 Commentators have pointed out a technical problem with definition or "principal amount" in section 1.988-2T(b)(5) and (6) that results in double counting of a portion of the principal for purposes of computing exchange gain or loss in certain cases (e.g., in the case of a discount bond acquired at a market discount). Accordingly, the definition of principal amount has been amended.

 Rules regarding nonfunctional currency debt for debt exchanges have been proposed under section 1.988-2(b)(14) of the proposed regulations.

 Rules regarding exchange gain or loss with respect to debt instruments issued in hyperinflationary currencies have been proposed under section 1.988-2(b)(15) of the proposed regulations.

SECTION 1.988-2(c) ITEM OF EXPENSE OR GROSS INCOME OR RECEIPTS WHICH IS TO BE PAID OR RECEIVED AFTER THE DATE ACCRUED.

Certain commentators suggest that the current separate computation of exchange gain or loss on short term (60 days or less) payables and receivables be disregarded and treated as an adjustment to expense or income with respect to which the payables or receivables relate. In contrast, other commentators suggest allowing taxpayers to elect to mark to market such payables and receivables consistent with their method of financial accounting. It has been proposed to adopt the latter suggestion because it more clearly reflects gain or loss with respect to such transactions. See section 1.988-5(f) of the proposed regulations regarding election of a mark to market method of accounting for exchange gain or loss for nondealers.

SECTION 1.988-2(d) EXCHANGE GAIN OR LOSS WITH RESPECT TO FORWARD CONTRACTS, FUTURES CONTRACTS AND OPTION CONTRACTS.

A commentator suggests that the realization by offset rule of section 1.988-2(d)(2)(ii) be modified to allow realization of exchange gain or loss if a contract is offset by another contract with the same counterparty. This suggestion has been rejected because it results in a potential whipsaw to the government (i.e., taxpayers can lock in a gain without realization by entering into an offsetting contract with a different counterparty, but lock in and realize a loss by entering into an offsetting contract with the same counterparty even though they are not out of pocket any cash). A commentator suggests that taxpayers be allowed to make an election whereby all offsetting positions are treated as terminated. This suggestion has been rejected as unnecessary in most cases in light of section 1256 and in contravention of section 1092.

 A commentator suggests that the rule that recognizes the interest component in a historic rate rollover be limited to long term rollovers. This suggestion has been adopted in section 1.988-2(d)(2)(v), which provides that the amount attributable to the time value of any gain or loss recognized shall be treated as exchange gain or loss if the period beginning on the first date the contract is rolled over and ending on the date payment is ultimately made or received with respect to such contract does not exceed 183 days.

SECTION 1.988-2(e) CURRENCY SWAPS AND NOTIONAL PRINCIPAL CONTRACTS.

A commentator suggests clarification that all income and expense attributable to notional principal contracts described in section 1.988-2(e) is exchange gain or loss. With respect to currency swaps, it was clear under the temporary regulations that any income or loss is exchange gain or loss (except as provided in section 1.988-2(f) and section 1.988-5). With respect to notional principal contracts denominated in a single nonfunctional currency, a sentence has been added to section 1.988-2(e)(1) to clarify that such income or loss is exchange gain or loss (with certain exceptions). It should be noted, however, that section 1.861-9T may allocate and apportion exchange gain or loss like interest notwithstanding its character as exchange gain or loss.

SECTION 1.988-2(e)(1) HAS BEEN AMENDED TO BETTER COORDINATE WITH SECTION 446.

Commentators pointed out a flaw in the definition of a currency swap, which required that the periodic interim payments be exchanged at the swap exchange rate. This requirement unintentionally prevented cross currency interest rate swaps from qualifying as a currency swap. Accordingly the definition of a currency swap in section 1.988-2(e)(2)(ii) has been amended to delete this requirement.

 Commentators also suggest recognition of gain or loss on receipt or payment of swap principal, regardless of when such principal amounts are paid. Section 1.988-2(e)(2)(ii) requires that all of the swap principal amount be exchanged at maturity of the contract. If principal is prepaid on one side of the swap without a matching payment on the other side, taxpayers can generate gains and losses without economic substance. Accordingly, this suggestion was rejected. The definition of currency swap covers the overwhelming number of contracts marketed as currency swaps. Contracts that do not conform to the definition of currency swap but may nevertheless be notional principal contracts (such as a self-amortizing currency swap) are subject to rules under section 446.

SECTION 1.988-3 CHARACTER OF EXCHANGE GAIN OR LOSS.

 A commentator suggests that the identification and verification requirements for electing capital gain or loss characterization are unduly burdensome for traders in foreign currency contracts. In response to this comment, section 1.988-3(b)(5) has been added to allow taxpayers to make the capital gain or loss election with respect to contracts in certain designated accounts.

SECTION 1.988-4 SOURCE OF EXCHANGE GAIN OR LOSS REALIZED ON A SECTION 988 TRANSACTION.

 The Service is studying and solicits comments on the proper method of attributing liabilities and hedges to a U.S. branch of a foreign corporation. For example, the issue may arise where under section 1.882-5 the amount of U.S. connected liabilities is less than the amount of liabilities shown on the books of a U.S. trade or business.

SECTION 1.988-5 SECTION 988(d) HEDGING TRANSACTIONS.

(a)INTEGRATION OF A NONFUNCTIONAL CURRENCY DEBT INSTRUMENT AND A SECTION 1.988-5(A) HEDGE.

A commentator suggests that the integration rules be extended to partial hedges of debt instruments. The commentator proposes that with respect to any payment made under a nonfunctional currency denominated debt instrument that is hedged into functional currency, the functional currency amount be substituted for the nonfunctional currency amount. In other words, the yield to maturity of a nonfunctional currency denominated debt instrument will be determined in units of nonfunctional currency, notwithstanding that a majority of the payments may be hedged into functional currency effectively altering the yield. This suggestion is rejected because the yield of such an instrument cannot be determined under this approach. However, section 1.988-5(a)(3)(ii) has been added to allow proportional hedging of debt instruments where the integrated yield with respect to such proportion is determinable.

 In response to comments, the definition of qualifying debt instrument in section 1.988-5(a)(3)(i) has been amended retroactively to allow taxpayers to synthesize a functional currency borrowing into a nonfunctional currency borrowing consistent with Notice 87-11, 1987-1 C.B. 423. The prior exclusion was unintentional.

 The definition of qualifying debt instrument in section 1.988-5(a)(3)(1) has been amended prospectively to include contingent payment debt instruments. If all payments of a contingent payment obligation are hedged such that a yield to maturity can be determined in another currency, then assuming the requirements of section 1.988-2(a) are satisfied, the transaction can be Integrated. The term contingent payment debt obligation does not include dual currency or multi-currency debt instruments which were within the definition of qualifying debt instrument in section 1.988-5T(a)(3) and hence eligible for integration under the Temporary Regulations. The term contingent payment debt obligation does include reverse principal exchange rate linked securities such as the one described in Example 6 of section 1.988-5(a)(9)(iv) because the amount of principal paid upon maturity of the instrument is not determinable in any currency on the issue date (assuming, of course, that the instrument is unhedged).

 In response to comments, an option is included in the definition of section 1.988-5(a) hedge if, when integrated with the qualifying debt instrument, it permits the calculation of a yield to maturity (under principles of section 1272) in the currency in which the synthetic debt instrument is denominated.

 Commentators suggest liberalization of the rule in section 1.988-5(a)(5)(iii) that prohibits hedges with related persons. This suggestion was rejected because the integration rules are intended for transactions that in fact result in a hedged position. A hedge with a related person merely shifts the location for currency risk to that related person -- there is no guarantee that the related person will hedge the risk it has assumed with an unrelated person.

 A commentator asks for clarification that a self-amortizing currency swap may be used as a hedge. While not within the definition of currency swap set forth in section 1.988-2(e)(2)(ii), a self- amortizing currency swap may qualify as a hedge if, when integrated with the qualifying debt instrument, it permits the calculation of a yield to maturity (under principles of section 1272) in the currency in which the synthetic debt instrument is denominated. This was true under the Temporary Regulations and needs no clarification.

 A commentator suggests that taxpayers should be able to integrate a debt instrument (or executory contract) incurred by a taxpayer with a hedge entered into by a foreign affiliate. This suggestion is rejected because of the administrative difficulty of auditing such transactions and of determining the corporation on whose books the integrated transaction should be reflected.

 A commentator suggests deletion of the requirement that the hedge and the underlying transaction be recorded on the books of the same QBU. The rationale of the rule is to facilitate auditing integrated transactions by having the hedge and the underlying transaction recorded in one place. For administrative convenience, the rule is retained.

 Section 1.988-5(a)(6)(i) has been amended to eliminate the need to obtain valuations of debt instruments that are part of a qualified hedging transaction when the taxpayer is legging into integrated treatment. If a taxpayer legs into integrated treatment by entering into a hedge after the qualifying debt instrument is issued or acquired, section 1.988-5(a)(6)(i) provides that only gain or loss from movements in exchange rates up to the leg in date is realized (and deferred).

 Section 1.988-5(a)(6)(ii) contains an expanded definition of "legging out" to clarify ambiguities in the temporary regulations. "Legging out" of integrated treatment means that the taxpayer disposes of or otherwise terminates all or a part of the qualifying debt instrument or hedge prior to maturity of the qualified hedging transaction, or the taxpayer changes a material term of the qualifying debt instrument (e.g., exercises an option to change the interest rate or index, or the maturity date) or hedge (e.g., changes the interest or exchange rates underlying the hedge, or the expiration date) prior to maturity of the qualified hedging transaction. A taxpayer that disposes of or terminates a qualified hedging transaction (i.e., disposes of or terminates both the qualifying transaction and the hedge on the same day) shall be considered to have disposed of or otherwise terminated the synthetic debt instrument rather than as legging out.

 Section 1.988-5(a)(6)(ii)(D) and (E) provide anti-abuse rules for taxpayers that leg out of a qualified hedging transaction.

 A commentator requests that the identification requirements be expanded to allow the sponsor of a trust issuing synthetic instruments to satisfy the identification requirements on behalf of the investors. This rule has been adopted in section 1.988-5(a)(8)(ii).

 A commentator suggests that taxpayers be allowed to identify a hedged transaction in an electronic ledger, rather than a paper ledger. This suggestion has been adopted in section 1.988-5(a)(8)(i) and (b)(3)(i) which merely requires that a taxpayer establish a record with the pertinent information.

 The Service is considering whether to permit the rules of section 1.988-5 to be applied by treating consolidated group members as a single corporation. For example, if a domestic finance company enters into a transaction with an unrelated party that is intended to hedge a debt instrument issued by a domestic operating company that is a member of the same consolidated group, section 1.988-5 might be applied to treat the hedge as entered into by the domestic operating company.

 The Service therefore seeks comments and information on the following issues: (1) Which member(s) make the decision to hedge (or to leg out); (2) How and when the hedge is identified and documented; (3) Which member bears the cost of the hedge, i.e., whether, how and when the cost of the hedge is charged to the hedged member; (4) How payments made or received under the hedge are accounted for within the group; (5) How the intercompany transaction rules of section 1.1502-13 should apply to such a hedged transaction; and (6) What type of transactions should be permitted to be hedged on a consolidated basis.

(b) HEDGED EXECUTORY CONTRACTS

In response to comments that taxpayers frequently adjust hedges as contracts to purchase or sell goods and services change, the rule in section 1.988-5T(b)(2)(i)(C) which provided that the amount of an executory contract that is hedged cannot be decreased has been deleted.

 Commentators have suggested that allowing integration treatment with respect to assets used in the ordinary course of a taxpayer's trade or business but not for stock purchases discriminates unfairly between two acquisition techniques. In response to this comment, section 1.988-5(b)(2)(ii) prospectively provides that a contract to buy or sell stock is an executory contract eligible for integration treatment.

 A commentator suggests that options be included in the definition of hedge as defined in section 1.988-5(b)(2)(iii). We have responded to this comment by providing that the term hedge also includes an option contract described in section 1.988-1(a)(1)(ii) and (2)(iii), but only if the option contract's expiration date is on or before the accrual date. The premium paid for an option that lapses shall be integrated with the executory contract.

 Commentators suggest that the requirement in section 1.988-5T(b)(2)(iii) of keeping a separate bank account for each hedge involving cash is overly restrictive. They suggest the use of a single account for all hedging transactions, combined with a convention for determining the basis of cash withdrawn. This suggestion has been adopted in section 1.988-5(b)(2)(iii)(D).

 To address concerns of the Service regarding disposition of a hedge or an executory contract prior to the accrual date in a transaction between related persons (as defined in sections 267(b) and 707(b)), new section 1.988-5(b)(4)(iii)(C) has been added. This section provides that the Commissioner may redetermine the timing, source, and character of gain or loss from the hedge or the executory contract if he determines that a significant purpose for disposing of the hedge or terminating the executory contract prior to the accrual date was to affect the timing, source, or character of income, gain, expense, or loss for Federal income tax purposes.

(c) HEDGES OF PERIOD BETWEEN TRADE DATE AND SETTLEMENT DATE ON PURCHASE OR SALE OF PUBLICLY TRADED STOCK OR SECURITY IN THE CASE OF CASH BASIS TAXPAYERS.

A commentator suggests that the provisions of section 1.988-5T(c) be extended to accrual basis taxpayers. This suggestion has been adopted in section 1.988-2(c). See section 1.6045-1(d)(6)(iii) of the proposed regulations for changes to the broker reporting rules in certain cases.

(d) HEDGES OF CERTAIN NONFUNCTIONAL CURRENCY PAYMENTS.

This section is reserved in the final regulations. See, section 1.988-5(d) of the proposed regulations for integration rules regarding certain dividend, rent and royalty payments.

 Commentators have suggested that special timing rules be provided for hedges of the net investment of a U.S. corporation in a foreign corporation (hereafter referred to as "Hoover hedges" -- see Hoover Co., 72 T.C. 206 (1979)). Prior to the adoption of section 988, gains and losses realized with respect to Hoover hedges were characterized as capital gains and losses and the general timing rule of the Code applied. See Hoover Co., supra; Barnes Group, Inc. v. U.S., 697 F. Supp. 591 (D. Conn., 1988). Problems resulting from characterizing gains or losses realized on Hoover hedges as capital gains or losses are resolved under section 988(a)(1)(A) which characterizes such gains and losses as ordinary gains and losses (with a taxpayer election for capital gain or loss characterization). Some commentators have suggested, however, that special timing rules which parallel the financial accounting rules for Hoover hedges be adopted. See paragraphs 13 and 20(a) of the Statement of Financial Accounting Standards No. 52 which generally provide for deferral of gain or loss on a Hoover hedge until sale or liquidation of the foreign corporation. Other commentators have suggested complicated regimes for deferring gains and losses on Hoover hedges until dividends are paid to the U.S. corporation. Since the general timing rules of the Code as applied to Hoover hedges provide a reasonable timing result, complicated deferral regimes have been rejected.

(e) ADVANCE RULINGS REGARDING NET HEDGING AND ANTICIPATORY HEDGING SYSTEMS.

Several commentators have suggested adoption of special hedging rules applicable to hedges of net nonfunctional currency exposure (other than Hoover hedges) and anticipatory hedges of items of income or expense. Because corporations employ different systems for engaging in such hedging, adoption of specific rules is not practicable. However, section 1.988-5(e) provides that the Commissioner may issue an advance ruling addressing the income tax consequences of a taxpayer's system of hedging net nonfunctional currency exposure and anticipated nonfunctional currency exposure. The ruling may address the character, source, and timing of both the section 988 transaction(s) making up the hedge and the underlying transactions being hedged. The Commissioner will not issue a ruling regarding Hoover hedges. The Service anticipates publishing a revenue procedure addressing the procedural requirements for obtaining an advanced ruling.

(f) MARK TO MARKET METHOD OF ACCOUNTING FOR TAXPAYERS THAT ARE NOT ACTING IN THE CAPACITY OF A DEALER.

Provisions regarding a mark to market method of accounting for exchange gain or loss with respect to taxpayers that are not acting in the capacity of a dealer are reserved. See section 1.988-5(f) of the proposed regulations.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted without response to the Administrator of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal authors of these regulations are Jeffrey Dorfman and Charles T. Plambeck. Messrs. Dorfman and Plambeck are of the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and Treasury Department participated in developing the regulations.

LIST OF SUBJECTS

26 CFR sections 1.261-1 through 1.280H-1T

 Income Taxes, Reporting and recordkeeping requirements.

26 CFR sections 1.985-0 through 1.989(c)-1T

 Income Taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

 Reporting and Recordkeeping Requirements.

Treasury Decision 8400

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR parts 1 and 602 are amended to read as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 is amended by adding a new citation to read as follows:

Authority: Sec 7805, 68A Stat. 917 (26 U.S.C. 7805) * * * Sections 1.988-0 through 1.988-5 also issued under 26 U.S.C. 988. * * *

Par. 2. New section 1.267(f)-1 is added and section 1.267(f)- 1T(h) is redesignated as section 1.267(f)-1(h) and newly designated paragraphs (h)(2) and (h)(3) are revised to read as follows:

SECTION 1.267(f)-1 DEFERRAL OF CERTAIN LOSSES OF CONTROLLED GROUPS.

(a) through (g). [Reserved]

(h) * * *

(2) The loan is described in section 1.988-1(a)(2)(i);

(3) The loan is not in a hyperinflationary currency as defined in section 1.988-1(f); and

* * * *

Par. 3. Sections 1.988-1T, 1.988-2T, 1.988-3T, 1.988-4T, and 1.988-5T are deleted as of [DATE THIS DOCUMENT IS PUBLISHED IN THE FEDERAL REGISTER].

Par. 4. New sections 1.988-0 through 1.988-5 are added to read as follows:

SECTION 1.988-0 TAXATION OF GAIN OR LOSS FROM A SECTION 988 TRANSACTION; TABLE OF CONTENTS.

This section lists captioned paragraphs contained in sections 1.988-1 through 1.988-5.

SECTION 1.988-1 CERTAIN DEFINITIONS AND SPECIAL RULES.

 (a) Section 988 transaction.

(a) SECTION 988 TRANSACTION -- (1) IN GENERAL. The term "section 988 transaction" means any of the following transactions --

(i) A disposition of nonfunctional currency as defined in paragraph (c) of this section;

(ii) Any transaction described in paragraph (a)(2) of this section if any amount which the taxpayer is entitled to receive or is required to pay by reason of such transaction is denominated in terms of a nonfunctional currency or is determined by reference to the value of one or more nonfunctional currencies.

A transaction described in this paragraph (a) need not require or permit payment with a nonfunctional currency as long as any amount paid or received is determined by reference to the value of one or more nonfunctional currencies. The acquisition of nonfunctional currency is treated as a section 988 transaction for purposes of establishing the taxpayer's basis in such currency and determining exchange gain or loss thereon.

(2) DESCRIPTION OF TRANSACTIONS. The following transactions are described in this paragraph (a)(2).

(i) DEBT INSTRUMENTS. Acquiring a debt instrument or becoming an obligor under a debt instrument. The term "debt instrument" means a bond, debenture, note, certificate or other evidence of indebtedness.

(ii) PAYABLES, RECEIVABLES, ETC. Accruing, or otherwise taking into account, for purposes of subtitle A of the Internal Revenue Code, any item of expense or gross income or receipts which is to be paid or received after the date on which so accrued or taken into account. A payable relating to cost of goods sold, or a payable or receivable relating to a capital expenditure or receipt, is within the meaning of this paragraph (a)(2)(ii). Generally, a payable relating to foreign taxes (whether or not claimed as a credit under section 901) is within the meaning of this paragraph (a)(2)(ii). However, a payable of a domestic person relating to accrued foreign taxes of its qualified business unit (QBU branch) is not within the meaning of this paragraph (a)(2)(ii) if the QBU branch's functional currency is the U.S. dollar and the foreign taxes are claimed as a credit under section 901.

(iii) FORWARD CONTRACT, FUTURES CONTRACT, OPTION CONTRACT, OR SIMILAR FINANCIAL INSTRUMENT. Except as otherwise provided in this paragraph (a)(2)(iii) and paragraph (a)(4)(i) of this section, entering into or acquiring any forward contract, futures contract, option, warrant, or similar financial instrument.

(A) LIMITATION FOR CERTAIN DERIVATIVE INSTRUMENTS. A forward contract, futures contract, option, warrant, or similar financial instrument is within this paragraph (a)(2)(iii) only if the underlying property to which the instrument ultimately relates is a nonfunctional currency or is otherwise described in paragraph (a)(1)(ii) of this section. Thus, if the underlying property of an instrument is another financial instrument (e.g., an option on a futures contract), then the underlying property to which such other instrument (e.g., the futures contract) ultimately relates must be a nonfunctional currency. For example, a forward contract to purchase wheat denominated in a nonfunctional currency, an option to enter into a forward contract to purchase wheat denominated in a nonfunctional currency, or a warrant to purchase stock denominated in a nonfunctional currency is not described in this paragraph (a)(2)(iii). On the other hand, a forward contract to purchase a nonfunctional currency, an option to enter into a forward contract to purchase a nonfunctional currency, an option to purchase a bond denominated in or the payments of which are determined by reference to the value of a nonfunctional currency, or a warrant to purchase nonfunctional currency is described in this paragraph (a)(2)(iii).

(B) NONFUNCTIONAL CURRENCY NOTIONAL PRINCIPAL CONTRACTS -- (1) IN GENERAL. The term "similar financial instrument" includes a notional principal contract only if the payments required to be made or received under the contract are determined with reference to a nonfunctional currency.

(2) DEFINITION OF NOTIONAL PRINCIPAL CONTRACT. The term "notional principal contract" means a contract (e.g., a swap, cap, floor or collar) that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. For this purpose, a "notional principal contract" shall only include an instrument where the underlying property to which the instrument ultimately relates is money (e.g., functional currency), nonfunctional currency, or property the value of which is determined by reference to an interest rate. Thus, the term "notional principal contract" includes a currency swap as defined in section 1.988-2(e)(2)(ii), but does not include a swap referenced to a commodity or equity index.

(C) EFFECTIVE DATE WITH RESPECT TO CERTAIN CONTRACTS. This paragraph (a)(2)(iii) does not apply to any forward contract, futures contract, option, warrant, or similar financial instrument entered into or acquired on or before October 21, 1988, if such instrument would have been marked to market under section 1256 if held on the last day of the taxable year.

(3)-(5) [Reserved]

(6) EXAMPLES. The following examples illustrate the application of paragraph (a) of this section. The examples assume that X is a U.S. corporation on an accrual method with the calendar year as its taxable year. Because X is a U.S. corporation the U.S. dollar is its functional currency under section 985. The examples also assume that section 988(d) does not apply.

EXAMPLE 1. On January 1, 1989, X acquires 10,000 Canadian dollars. On January 15, 1989, X uses the 10,000 Canadian dollars to purchase inventory. The acquisition of the 10,000 Canadian dollars is a section 988 transaction for purposes of establishing X's basis in such Canadian dollars. The disposition of the 10,000 Canadian dollars is a section 988 transaction pursuant to paragraph (a)(1) of this section.

EXAMPLE 2. On January 1, 1989, X acquires 10,000 Canadian dollars. On January 15, 1989, X converts the 10,000 Canadian dollars to U.S. dollars. The acquisition of the 10,000 Canadian dollars is a section 988 transaction for purposes of establishing X's basis in such Canadian dollars. The conversion of the 10,000 Canadian dollars to U.S. dollars is a section 988 transaction pursuant to paragraph (a)(1) of this section.

EXAMPLE 3. On January 1, 1989, X borrows 100,000 British pounds (BP) for a period of 10 years and issues a note to the lender with a face amount of BP100,000. The note provides for payments of interest at an annual rate of 10% paid quarterly in pounds and has a stated redemption price at maturity of BP100,000. X's becoming the obligor under the note is a section 988 transaction pursuant to paragraphs (a)(1)(ii) and (2)(i) of this section. Because X is an accrual basis taxpayer, the accrual of interest expense under X's note is a section 988 transaction pursuant to paragraphs (a)(1)(ii) and (2)(ii) of this section. In addition, the acquisition of the British pounds to make payments under the note is a section 988 transaction for purposes of establishing X's basis in such pounds, and the disposition of such pounds is a section 988 transaction under paragraph (a)(1)(i) of this section. See section 1.988-2(b) with respect to the translation of accrued interest expense and the determination of exchange gain or loss upon payment of accrued interest expense.

EXAMPLE 4. On January 1, 1989, X purchases at original issue for 74,621.54 British pounds (BP) a 3-year bond maturing on December 31, 1991, at a stated redemption price of BP100,000. The bond provides for no stated interest. The bond has a yield to maturity of 10% compounded semiannually and has BP25,378.46 of original issue discount. The acquisition of the bond is a section 988 transaction as provided in paragraphs (a)(1)(ii) and (2)(i) of this section. The accrual of original issue discount with respect to the bond is a section 988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of this section. See section 1.988-2(b) with respect to the translation of original issue discount and the determination of exchange gain or loss upon receipt of such amounts.

EXAMPLE 5. On January 1, 1989, X sells and delivers inventory to Y for 10,000,000 Italian lira for payment on April 1, 1989. Under X's method of accounting, January 1, 1989 is the accrual date. Because X is an accrual basis taxpayer, the accrual of a nonfunctional currency denominated item of gross receipts on January 1, 1989, for payment after the date of accrual is a section 988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of this section.

EXAMPLE 6. On January 1, 1989, X agrees to purchase a machine from Y for delivery on March 1, 1990 for 1,000,000 yen. The agreement calls for X to pay Y for the machine on June 1, 1990. Under X's method of accounting, the expenditure for the machine does not accrue until delivery on March 1, 1990. The agreement to purchase the machine is not a section 988 transaction. In particular, the agreement to purchase the machine is not described in paragraph (a)(2)(ii) of this section because the agreement is not an item of expense taken into account under subtitle A (but rather is an agreement to purchase a capital asset in the future). However, the payable that will arise on the delivery date is a section 988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of this section even though the payable relates to a capital expenditure. In addition, the disposition of yen to satisfy the payable on June 1, 1990, is a section 988 transaction under paragraph (a)(1)(i) of this section.

EXAMPLE 7. On January 1, 1989, X purchases and takes delivery of inventory for 10,000 French francs with payment to be made on April 1, 1989. Under X's method of accounting, the expense accrues on January 1, 1989. On January 1, 1989, X also enters into a forward contract with a bank to purchase 10,000 French francs for $2,000 on April 1, 1989. Because X is an accrual basis taxpayer, the accrual of a nonfunctional currency denominated item of expense on January 1, 1989, for payment after the date of accrual is a section 988 transaction under paragraphs (a)(1)(ii) and (2)(ii) of this section. Entering into the forward contract to purchase the 10,000 French francs is a section 988 transaction under paragraphs (a)(1)(ii) and (2)(iii) of this section.

EXAMPLE 8. On January 1, 1989, X acquires 100,000 Norwegian krone. On January 15, 1989, X purchases and takes delivery of 1,000 shares of common stock with the 100,000 krone acquired on January 1, 1989. On August 1, 1989, X sells the 1,000 shares of common stock and receives 120,000 krone in payment. On August 30, 1989, X converts the 120,000 krone to U.S. dollars. The acquisition of the 100,000 krone on January 1, 1989, and the acquisition of the 120,000 krone on August 1, 1989, are section 988 transactions for purposes of establishing the basis of such krone. The disposition of the 100,000 krone on January 15, 1989, and the 120,000 krone on August 30, 1989, are section 988 transactions as provided in paragraph (a)(1)(i) of this section. Neither the acquisition on January 15, 1989, nor the disposition on August 1, 1989, of the stock is a section 988 transaction.

EXAMPLE 9. On May 11, 1989, X purchases a one year note at original issue for its issue price of $1,000. The note pays interest in dollars at the rate of 4 percent compounded semiannually. The amount of principal received by X upon maturity is equal to $1,000 plus the equivalent of the excess, if any, of (a) the Financial Times One Hundred Stock Index (an index of stocks traded on the London Stock Exchange hereafter referred to as the FT100) determined and translated into dollars on the last business day prior to the maturity date, over (b) BP2,150, the "stated value" of the FT100, which is equal to 110% of the average value of the index for the six months prior to the issue date, translated at the exchange rate of BP1 = $1.50. The purchase by X of the instrument described above is not a section 988 transaction because the index used to compute the principal amount received upon maturity is determined with reference to the value of stock and not nonfunctional currency.

EXAMPLE 10. On April 9, 1989, X enters into an interest rate swap that provides for the payment of amounts by X to its counterparty based on 4% of a 10,000 yen principal amount in exchange for amounts based on yen LIBOR rates. Pursuant to paragraphs (a)(1)(ii) and (2)(iii) of this section, this yen for yen interest rate swap is a section 988 transaction.

EXAMPLE 11. On August 11, 1989, X enters into an option contract for sale of a group of stocks traded on the Japanese Nikkei exchange. The contract is not a section 988 transaction within the meaning of section 1.988-1(a)(2)(iii) because the underlying property to which the option relates is a group of stocks and not nonfunctional currency.

(7) SPECIAL RULES FOR REGULATED FUTURES CONTRACTS AND NON-EQUITY OPTIONS -- (i) IN GENERAL. Except as provided in paragraph (a)(7)(ii) of this section, paragraph (a)(2)(iii) of this section shall not apply to any regulated futures contract or non-equity option which would be marked to market under section 1256 if held on the last day of the taxable year.

(ii) ELECTION TO HAVE PARAGRAPH (a)(2)(iii) OF THIS SECTION APPLY. Notwithstanding paragraph (a)(7)(i) of this section, a taxpayer may elect to have paragraph (a)(2)(iii) of this section apply to regulated futures contracts and non-equity options as provided in paragraph (a)(7)(iii) and (iv) of this section.

(iii) PROCEDURE FOR MAKING THE ELECTION. A taxpayer shall make the election provided in paragraph (a)(7)(ii) of this section by sending to the Internal Revenue Service Center, Examination Branch, Stop Number 92, Kansas City, MO 64999 a statement titled "ELECTION TO TREAT REGULATED FUTURES CONTRACTS AND NON-EQUITY OPTIONS AS SECTION 988 TRANSACTIONS UNDER SECTION 988(c)(1)(D)(ii)" that contains the following:

(A) The taxpayer's name, address, and taxpayer identification number;

(B) The date the notice is mailed or otherwise delivered to the Internal Revenue Service Center;

(C) A statement that the taxpayer (including all members of such person's affiliated group as defined in section 1504 or in the case of an individual all persons filing a joint return with such individual) elects to have section 988(c)(1)(D)(i) and section 1.988-1(a)(7)(i) not apply;

(D) The date of the beginning of the taxable year for which the election is being made;

(E) If the election is filed after the first day of the taxable year, a statement regarding whether the taxpayer has previously held a contract described in section 988(c)(1)(D)(i) or section 1.988-1(a)(7)(i) during such taxable year, and if so, the first date during the taxable year on which such contract was held; and

(F) The signature of the person making the election (in the case of individuals filing a joint return, the signature of all persons filing such return).

The election shall be made by the following persons: in the case of an individual, by such individual; in the case of a partnership, by each partner separately; effective for taxable years beginning after [DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER], in the case of tiered partnerships, each ultimate partner; in the case of an S corporation, by each shareholder separately; in the case of a trust (other than a grantor trust) or estate, by the fiduciary of such trust or estate; in the case of any corporation other than an S corporation, by such corporation (in the case of a corporation that is a member of an affiliated group that files a consolidated return, such election shall be valid and binding only if made by the common parent, as that term is used in section 1.1502-77(a)); in the case of a controlled foreign corporation, by its controlling United States shareholders under section 1.964-1(c)(3). With respect to a corporation (other than an S corporation), the election, when made by the common parent, shall be binding on all members of such corporation's affiliated group as defined in section 1504 that file a consolidated return. The election shall be binding on any income or loss derived from the partner's share (determined under the principles of section 702(a)) of all contracts described in section 988(c)(1)(D)(i) or paragraph (a)(7)(i) of this section in which the taxpayer holds a direct interest or indirect interest through a partnership or S corporation; however, the election shall not apply to any income or loss of a partnership for any taxable year if such partnership made an election under section 988(c)(1)(E)(iii)(V) for such year or any preceding year. Generally, a copy of the election must be attached to the taxpayer's income tax return for the first year it is effective. It is not required to be attached to subsequent returns. However, in the case of a partner, a copy of the election must be attached to the taxpayer's income tax return for every year during which the taxpayer is a partner in a partnership that engages in a transaction that is subject to the election.

(iv) TIME FOR MAKING THE ELECTION -- (A) IN GENERAL. Unless the requirements for making a late election described in paragraph (a)(7)(iv)(B) of this section are satisfied, an election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section for any taxable year shall be made on or before the first day of the taxable year or, if later, on or before the first day during such taxable year on which the taxpayer holds a contract described in section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section. The election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section shall apply to contracts entered into or acquired after October 21, 1988, and held on or after the effective date of the election. The election shall be effective as of the beginning of the taxable year and shall be binding with respect to all succeeding taxable years unless revoked with the prior consent of the Commissioner. In determining whether to grant revocation of the election, recapture of the tax benefit derived from the election in previous taxable years will be considered.

(B) LATE ELECTIONS. A taxpayer may make an election under section 988(c)(1)(D)(ii) and paragraph (a)(7)(ii) of this section within 30 days after the time prescribed in the first sentence of paragraph (a)(7)(iv)(A) of this section. Such a late election shall be effective as of the beginning of the taxable year; however, any losses recognized during the taxable year with respect to contracts described in section 988(c)(1)(D)(ii) or paragraph (a)(7)(ii) of this section which were entered into or acquired after October 21, 1988, and held on or before the date on which the late election is mailed or otherwise delivered to the Internal Revenue Service Center shall not be treated as derived from a section 988 transaction. A late election must comply with the procedures set forth in paragraph (a)(7)(iii) of this section.

(v) TRANSITION RULE. An election made prior to September 21, 1989 which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, shall be deemed to satisfy the requirements of paragraphs (a)(7)(iii) and (iv) of this section.

(vi) GENERAL EFFECTIVE DATE PROVISION. This paragraph (a)(7) shall apply with respect to futures contracts and options entered into or acquired after October 21, 1988.

(8) SPECIAL RULES FOR QUALIFIED FUNDS -- (i) DEFINITION OF QUALIFIED FUND. The term "qualified fund" means any partnership if --

(A) At all times during the taxable year (and during each preceding taxable year to which an election under section 988(c)(1)(E)(iii)(V) applied) such partnership has at least 20 partners and no single partner owns more than 20 percent of the interests in the capital or profits of the partnership;

(B) The principal activity of such partnership for such taxable year (and each such preceding taxable year) consists of buying and selling options, futures, or forwards with respect to commodities;

(C) At least 90 percent of the gross income of the partnership for the taxable year (and each such preceding year) consists of income or gains described in subparagraph (A), (B), or (G) of section 7704(d)(1) or gain from the sale or disposition of capital assets held for the production of interest or dividends;

(D) No more than a de minimis amount of the gross income of the partnership for the taxable year (and each such preceding taxable year) was derived from buying and selling commodities; and

(E) An election under section 988(c)(1)(E)(iii)(V) as provided in paragraph (a)(8)(iv) of this section applies to the taxable year.

(ii) SPECIAL RULES RELATING TO PARAGRAPH (a)(8)(i)(A) OF THIS SECTION -- (A) CERTAIN GENERAL PARTNERS. The interest of a general partner in the partnership shall not be treated as failing to meet the 20 percent ownership requirement of paragraph (a)(8)(i)(A) of this section for any taxable year of the partnership if, for the taxable year of the partner in which such partnership's taxable year ends, such partner (and each corporation filing a consolidated return with such partner) had no ordinary income or loss from a section 988 transaction (other than income from the partnership) which is exchange gain or loss (as the case may be).

(B) TREATMENT OF INCENTIVE COMPENSATION. For purposes of paragraph (a)(8)(i)(A) of this section, any income allocable to a general partner as incentive compensation based on profits rather than capital shall not be taken into account in determining such partner's interest in the profits of the partnership.

(C) TREATMENT OF TAX EXEMPT PARTNERS. The interest of a partner in the partnership shall not be treated as failing to meet the 20 percent ownership requirements of paragraph (a)(5)(8)(A) of this section if none of the income of such partner from such partnership is subject to tax under chapter 1 of subtitle A of the Internal Revenue Code (whether directly or through one or more pass-through entities).

(D) LOOK-THROUGH RULE. In determining whether the 20% ownership requirement of paragraph (a)(8)(i)(A) of this section is met with respect to any partnership, any interest in such partnership held by another partnership shall be treated as held proportionately by the partners in such other partnership.

(iii) OTHER SPECIAL RULES -- (A) RELATED PERSONS. Interests in the partnership held by persons related to each other (within the meaning of section 267(b) or 707(b)) shall be treated as held by one person.

(B) PREDECESSORS. Reference to any partnership shall include a reference to any predecessor thereof.

(C) TREATMENT OF CERTAIN DEBT INSTRUMENTS. Solely for purposes of paragraph (a)(8)(i)(D) of this section, any debt instrument which is described in both paragraph (a)(1) (ii) and (2)(i) of this section shall be treated as a commodity.

(iv) PROCEDURE FOR MAKING THE ELECTION PROVIDED IN SECTION 988(c)(1)(E)(iii)(V). A partnership shall make the election provided in section 988(c)(1)(E)(iii)(V) by sending to the Internal Revenue Service Center, Examination Branch, Stop Number 92, Kansas City, MO 64999 a statement titled "QUALIFIED FUND ELECTION UNDER SECTION 988 (c)(1)(E)(iii)(V)" that contains the following:

(A) The partnership's name, address, and taxpayer identification number;

(B) The name, address and taxpayer identification number of the general partner making the election on behalf of the partnership;

(C) The date the notice is mailed or otherwise delivered to the Internal Revenue Service Center;

(D) A brief description of the activity of the partnership;

(E) A statement that the partnership is making the election provided in section 988(c)(1)(E)(iii)(V);

(F) The date of the beginning of the taxable year for which the election is being made;

(G) If the election is filed after the first day of the taxable year, then a statement regarding whether the partnership previously held an instrument referred to in section 988(c)(1)(E)(i) during such taxable year and, if so, the first date during the taxable year on which such contract was held; and

(H) The signature of the general partner making the election.

The election shall be made by a general partner with management responsibility of the partnership's activities and a copy of such election shall be attached to the partnership's income tax return (Form 1065) for the first taxable year it is effective. It is not required to be attached to subsequent returns.

(v) TIME FOR MAKING THE ELECTION. The election under section 988(c)(1)(E)(iii)(V) for any taxable year shall be made on or before the first day of the taxable year or, if later, on or before the first day during such year on which the partnership holds an instrument described in section 988(c)(1)(E)(i). The election under section 988(c)(1)(E)(iii)(V) shall apply to the taxable year for which made and all succeeding taxable years. Such election may only be revoked with the consent of the Commissioner. In determining whether to grant revocation of the election, recapture by the partners of the tax benefit derived from the election in previous taxable years will be considered.

(vi) OPERATIVE RULES APPLICABLE TO QUALIFIED FUNDS -- (A) IN GENERAL. In the case of a qualified fund, any bank forward contract or any foreign currency futures contract traded on a foreign exchange which is not otherwise a section 1256 contract shall be treated as a section 1256 contract for purposes of section 1256.

(B) GAINS AND LOSSES TREATED AS SHORT-TERM. In the case of any instrument treated as a section 1256 contract under paragraph (a)(8)(vi)(A) of this section, subparagraph (A) of section 1256(a)(3) shall be applied by substituting "100 percent" for "40 percent" (and subparagraph (B) of such section shall not apply).

(vii) TRANSITION RULE. An election made prior to September 21, 1989, which satisfied the requirements of Notice 88-124, 1988-51 I.R.B. 6, shall be deemed to satisfy the requirements of section 1.988-1(a)(8)(iv) and (v).

(viii) GENERAL EFFECTIVE DATE RULES -- (A) The requirements of subclause (IV) of section 988(c)(1)(E) (iii) shall not apply to contracts entered into or acquired on or before October 21, 1988.

(B) In the case of any partner in an existing partnership, the 20 percent ownership requirements of subclause (I) of section 988(c)(1)(E)(iii) shall be treated as met during any period during which such partner does not own a percentage interest in the capital or profits of such partnership greater than 33 1/3 percent (or, if lower, the lowest such percentage interest of such partner during any period after October 21, 1988, during which such partnership is in existence). For purposes of the preceding sentence, the term "existing partnership" means any partnership if --

(1) such partnership was in existence on October 21, 1988, and principally engaged on such date in buying and selling options, futures, or forwards with respect to commodities; or

(2) a registration statement was filed with respect to such partnership with the Securities and Exchange Commission on or before such date and such registration statement indicated that the principal activity of such partnership will consist of buying and selling instruments referred to in paragraph (a)(8)(viii)(B)(1) of this section.

(9) EXCEPTION FOR CERTAIN TRANSACTIONS ENTERED INTO BY AN INDIVIDUAL -- (i) IN GENERAL. A transaction entered into by an individual which otherwise qualifies as a section 988 transaction shall be considered a section 988 transaction only to the extent expenses properly allocable to such transaction meet the requirements of section 162 or 212 (other than the part of section 212 dealing with expenses incurred in connection with taxes).

(ii) EXAMPLES. The following examples illustrate the application of paragraph (a)(9) of this section.

EXAMPLE 1. X is a U.S. citizen who therefore has the U.S. dollar as his functional currency. On January 1, 1990, X enters into a spot contract to purchase 10,000 British pounds (BP) for $15,000 for delivery on January 3, 1990. Immediately upon delivery, X acquires at original issue a pound denominated bond with an issue price of BP10,000. The bond matures on January 3, 1993, pays interest in pounds at a rate of 10% compounded semiannually, and has no original issue discount. Assume that all expenses properly allocable to these transactions would meet the requirements of section 212. Under section 1.988-2(d)(1) (ii), entering into the spot contract on January 1, 1990, is not a section 988 transaction. The acquisition of the pounds on January 3, 1990, under the spot contract is a section 988 transaction for purposes of establishing X's basis in the pounds. The disposition of the pounds and the acquisition of the bond by X are section 988 transactions. These transactions are not excluded from the definition of a section 988 transaction under paragraph (a)(9) of this section because expenses properly allocable to such transactions meet the requirements of section 212.

EXAMPLE 2. X is a U.S. citizen who therefore has the dollar as his functional currency. In preparation for X's vacation, X purchases 1,000 British pounds (BP) from a bank on June 1, 1989. During the period of X's vacation in the United Kingdom beginning June 10, 1989, and ending June 20, 1989, X spends BP500 for hotel rooms, BP300 for food and BP200 for miscellaneous vacation expenses. The expenses properly allocable to such dispositions do not meet the requirements of section 162 or 212. Thus, the disposition of the pounds by X on his vacation are not section 988 transactions.

(10) INTRA-TAXPAYER TRANSACTIONS -- (i) IN GENERAL. Except as provided in paragraph (a)(10)(ii) of this section, transactions between or among the taxpayer and/or qualified business units of that taxpayer ("intra-taxpayer transactions") are not section 988 transactions. See section 987 and the regulations thereunder.

(ii) CERTAIN TRANSFERS. Exchange gain or loss with respect to nonfunctional currency or any item described in paragraph (a)(2) of this section entered into with another taxpayer shall be realized upon an intra-taxpayer transfer of such currency or item where as the result of the transfer the currency or other such item --

(A) Loses its character as nonfunctional currency or an item described in paragraph (a)(2) of this section; or

(B) Where the source of the exchange gain or loss could be altered absent the application of this paragraph (a)(10)(ii).

Such exchange gain or loss shall be computed in accordance with section 1.988-2 (without regard to section 1.988-2(b)(8)) as if the nonfunctional currency or item described in paragraph (a)(2) of this section had been sold or otherwise transferred at fair market value between unrelated taxpayers. For purposes of the preceding sentence, a taxpayer must use the translation rate that it uses for purposes of computing section 987 gain or loss with respect to the QBU branch that makes the transfer. In the case of a gain or loss incurred in a transaction described in this paragraph (a)(10)(ii) that does not have a significant business purpose, the Commissioner, may defer such gain or loss.

(iii) EXAMPLE. The following example illustrates the provisions of this paragraph (a)(10).

EXAMPLE. (A) X, a corporation with the U.S. dollar as its functional currency, operates through foreign branches Y and Z. Y and Z are qualified business units as defined in section 989 (a) with the LC as their functional currency. X computes Y's and Z's income under section 987 (relating to branch transactions). On November 12, 1988, Y transfers $25 to the home office of X when the fair market value of such amount equals LC120. Y has a basis of LC100 in the $25. Under paragraph (a)(10)(ii) of this section, Y realizes foreign source exchange gain of LC20 (LC120 - LC100) as the result of the $25 transfer. For purposes of determining whether the transfer is a remittance resulting in additional gain or loss, see section 987 and the regulations thereunder.

(B) If instead Y transfers the $25 to Z, exchange gain is not realized because the $25 is nonfunctional currency with respect to Z and if Z were to immediately convert the $25 into LCs, the gain would be foreign source. For purposes of determining whether the transfer is a remittance resulting in additional gain or loss, see section 987 and the regulations thereunder.

(11) AUTHORITY TO INCLUDE OR EXCLUDE TRANSACTIONS FROM SECTION 988 -- (i) IN GENERAL. The Commissioner may recharacterize a transaction (or series of transactions) in whole or in part as a section 988 transaction if the effect of such transaction (or series of transactions) is to avoid section 988. In addition, the Commissioner may exclude a transaction (or series of transactions) which in form is a section 988 transaction from the provisions of section 988 if the substance of the transaction (or series of transactions) indicates that it is not properly considered a section 988 transaction.

(ii) EXAMPLE. The following example illustrates the provisions of this paragraph (a)(11).

EXAMPLE. B is an individual with the U.S. dollar as its functional currency. B holds 500,000 Swiss francs which have a basis of $100,000 and a fair market value of $400,000 as of October 15, 1989. On October 16, 1989, B transfers the 500,000 Swiss francs to a newly formed U.S. corporation, X, with the dollar as its functional currency. On October 16, 1989, B sells the stock of X for $400,000. Assume the transfer to X qualified for nonrecognition under section 351. Because the sale of the stock of X is a substitute for the disposition of an asset subject to section 988, the Commissioner may recharacterize the sale of the stock as a section 988 transaction. The same result would obtain if B transferred the Swiss francs to a partnership and then sold the partnership interest.

(b) SPOT CONTRACT. A spot contract is a contract to buy or sell nonfunctional currency on or before two business days following the date of the execution of the contract. See section 1.988-2(d)(1)(ii) for operative rules regarding spot contracts.

(c) NONFUNCTIONAL CURRENCY. The term "nonfunctional currency" means with respect to a taxpayer or a qualified business unit (as defined in section 989(a)) a currency (including the European Currency Unit) other than the taxpayer's or the qualified business unit's functional currency as defined in section 985 and the regulations thereunder. For rules relating to nonrecognition of exchange gain or loss with respect to certain dispositions of nonfunctional currency, see section 1.988-2(a)(1)(iii).

(d) SPOT RATE -- (1) IN GENERAL. Except as otherwise provided in this paragraph, the term "spot rate" means a rate demonstrated to the satisfaction of the District Director or the Assistant Commissioner (International) to reflect a fair market rate of exchange available to the public for currency under a spot contract in a free market and involving representative amounts. In the absence of such a demonstration, the District Director or the Assistant Commissioner (International), in his or her sole discretion, shall determine the spot rate from a source of exchange rate information reflecting actual transactions conducted in a free market. For example, the taxpayer or the District Director or the Assistant Commissioner (International) may determine the spot rate by reference to exchange rates published in the pertinent monthly issue of "International Financial Statistics" or a successor publication of the International Monetary Fund; exchange rates published by the Board of Governors of the Federal Reserve System pursuant to 31 U.S.C. section 5151; exchange rates published in newspapers, financial journals or other daily financial news sources; or exchange rates quoted by electronic financial news services.

(2) CONSISTENCY REQUIRED IN VALUING TRANSACTIONS SUBJECT TO SECTION 988. If the use of inconsistent sources of spot rate quotations results in the distortion of income, the District Director or the Assistant Commissioner (International) may determine the appropriate spot rate.

(3) USE OF CERTAIN SPOT RATE CONVENTIONS FOR PAYABLES AND RECEIVABLES DENOMINATED IN NONFUNCTIONAL CURRENCY. If consistent with the taxpayer's financial accounting, a taxpayer may utilize a spot rate convention determined at intervals of one quarter year or less for purposes of computing exchange gain or loss with respect to payables and receivables denominated in a nonfunctional currency that are incurred in the ordinary course of business with respect to the acquisition or sale of goods or the obtaining or performance of services. For example, if consistent with the taxpayer's financial accounting, a taxpayer may accrue all payables and receivables incurred during the month of January at the spot rate on December 31 or January 31 (or at an average of any spot rates occurring between these two dates) and record the payment or receipt of amounts in satisfaction of such payables and receivables consistent with such convention. The use of a spot rate convention cannot be changed without the consent of the Commissioner.

(4) CURRENCY WHERE AN OFFICIAL GOVERNMENT ESTABLISHED RATE DIFFERS FROM A FREE MARKET RATE -- (i) IN GENERAL. If a currency has an official government established rate that differs from a free market rate, the spot rate shall be the rate which most clearly reflects the taxpayer's income. Generally, this shall be the free market rate.

(ii) EXAMPLES. The following examples illustrate the application of this paragraph (d)(4).

EXAMPLE 1. X is an accrual method U.S. corporation with the dollar as its functional currency. X owns all the stock of a Country L subsidiary, CFC. CFC has the currency of Country L, the LC, as its functional currency. Country L imposes restrictions on the remittance of dividends. On April 1, 1990, CFC pays a dividend to X in the amount of LC10O. Assume that the official government established rate is $1 = LC1 and the free market rate, which takes into account the remittance restrictions and which is the rate that most clearly reflects income, is $1 = LC4. On April 1, 1990, X donates the LC100 in a transaction that otherwise qualifies as a charitable contribution under section 170(c). Both the amount of the dividend income and the deduction under section 170 is $25 (LC100 x the free market rate, $.25).

EXAMPLE 2. X, a corporation with the U.S. dollar as its functional currency, operates in foreign country L through branch Y. Y is a qualified business unit as defined in section 989(a). X computes Y's income under the dollar approximate separate transactions method as described in section 1.985-3. The currency of L is the LC. X can purchase legally United States dollars ($) in L only from the L government. In order to take advantage of an arbitrage between the official and secondary dollar to LC exchange rates in L:

(i) X purchases LC100 for $60 in L on the secondary market when the official exchange rate is $1 = LC1;

(ii) X transfers the LC100 to Y;

(iii) Y purchases $100 for LC100; and

(iv) Y transfers $65 ($100 less an L tax withheld of $35 on the transfer) to the home office of X.

Under paragraph (a)(7) of this section, the transfer of the LC100 by X to Y is a realization event. X has a basis of $60 in the LC100. Under these facts, the appropriate dollar to LC exchange rate for computing the amount realized by X is the official exchange rate. Therefore, X realizes $40 ($100 - $60) of U.S. source gain from the transfer to Y. The same result would obtain if Y rather than X purchased the LC10O on the secondary market in L with $60 supplied by X, because the substance of this transaction is that X is performing the arbitrage.

(e) EXCHANGE GAIN OR LOSS. The term "exchange gain or loss" means the amount of gain or loss realized as determined in section 1.988-2 with respect to a section 988 transaction. Except as otherwise provided in these regulations (e.g., section 1.988-5), the amount of exchange gain or loss from a section 988 transaction shall be separately computed for each section 988 transaction, and such amount shall not be integrated with gain or loss recognized on another transaction (whether or not such transaction is economically related to the section 988 transaction). See section 1.988-2(b)(8) for a special rule with respect to debt instruments.

(f) HYPERINFLATIONARY CURRENCY. For the definition of hyperinflationary currency see section 1.985-2(b)(2). Unless otherwise provided, the currency in any example used in sections 1.988-1 through 1.988-5 is not a hyperinflationary currency.

(g) FAIR MARKET VALUE. The fair market value of an item shall, where relevant, reflect an appropriate premium or discount for the time value of money (e.g., the fair market value of a forward contract to buy or sell nonfunctional currency shall reflect the present value of the difference between the units of nonfunctional currency times the market forward rate at the time of valuation and the units of nonfunctional currency times the forward rate set forth in the contract). However, if consistent with the taxpayer's method of financial accounting (and consistently applied from year to year), the preceding sentence shall not apply to a financial instrument that matures within one year from the date of issuance or acquisition. Unless otherwise provided, the fair market value given in any example used in sections 1.988-1 through 1.988-5 is deemed to reflect appropriately the time value of money. If the use of inconsistent sources of forward or other market rate quotations results in the distortion of income, the District Director or the Assistant Commissioner (International) may determine the appropriate rate.

(h) INTERACTION WITH SECTIONS 1092 AND 1256. Unless otherwise provided, it is assumed for purposes of sections 1.988-1 through 1.988-5 that any contract used in any example is not a section 1256 contract and is not part of a straddle as defined in section 1092. No inference is intended regarding the application of section 1092 or 1256 unless expressly stated.

(i) EFFECTIVE DATE. Except as otherwise provided in this section, this section shall be effective for taxable years beginning after December 31, 1986. Thus, except as otherwise provided in this section, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section.

SECTION 1.988-2 RECOGNITION AND COMPUTATION OF EXCHANGE GAIN OR LOSS.

(a) DISPOSITION OF NONFUNCTIONAL CURRENCY --

(1) RECOGNITION OF EXCHANGE GAIN OR LOSS -- (i) IN GENERAL. Except as otherwise provided in this section, section 1.988-1(a)(7)(ii), and section 1.988-5, the recognition of exchange gain or loss upon the sale or other disposition of nonfunctional currency shall be governed by the recognition provisions of the Internal Revenue Code which apply to the sale or disposition of property (e.g., section 1001 or, to the extent provided in regulations, section 1092). The disposition of nonfunctional currency in settlement of a forward contract, futures contract, option contract, or similar financial instrument is considered to be a sale or disposition of the nonfunctional currency for purposes of the preceding sentence.

(ii) CLARIFICATION OF SECTION 1031. An amount of one nonfunctional currency is not "property of like kind" with respect to an amount of a different nonfunctional currency.

(iii) COORDINATION WITH SECTION 988(c)(1)(C)(ii). No exchange gain or loss is recognized with respect to the following transactions --

(A) An exchange of units of nonfunctional currency for different units of the same nonfunctional currency;

(B) The deposit of nonfunctional currency in a demand or time deposit or similar instrument (including a certificate of deposit) issued by a bank or other financial institution if such instrument is denominated in such currency;

(C) The withdrawal of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution if such instrument is denominated in such currency;

(D) The receipt of nonfunctional currency from a bank or other financial institution from which the taxpayer purchased a certificate of deposit or similar instrument denominated in such currency by reason of the maturing or other termination of such instrument; and

(E) The transfer of nonfunctional currency from a demand or time deposit or similar instrument issued by a bank or other financial institution to another demand or time deposit or similar instrument denominated in the same nonfunctional currency issued by a bank or other financial institution.

The taxpayer's basis in the units of nonfunctional currency or other property received in the transaction shall be the adjusted basis of the units of nonfunctional currency or other property transferred. See paragraph (b) of this section with respect to the timing of interest income or expense and the determination of exchange gain or loss thereon.

(iv) EXAMPLE. The following example illustrates the provisions of paragraph (a)(1)(iii) of this section.

EXAMPLE. X is a corporation on the accrual method of accounting with the U.S. dollar as its functional currency. On January 1, 1989, X acquires 1,500 British pounds (BP) for $2,250 (BP1) = $1.50). On January 3, 1989, when the spot rate is BP1) = $1.49, X deposits the BP1,500 with a British financial institution in a non-interest bearing demand account. On February 1, 1989, when the spot rate is BP1 = $1.45, X withdraws the BP1,500. On February 5, 1989, when the spot rate is BP1 = $1.42, X purchases inventory in the amount of BP1,500. Pursuant to paragraph (a)(1)(iii) of this section, no exchange loss is realized until February 5, 1989, when X disposes of the BP1,500 for inventory. At that time, X realizes exchange loss in the amount of $120 computed under paragraph (a)(2) of this section. The loss is not an adjustment to the cost of the inventory.

(2) COMPUTATION OF GAIN OR LOSS -- (i) IN GENERAL. Exchange gain realized from the sale or other disposition of nonfunctional currency shall be the excess of the amount realized over the adjusted basis of such currency, and exchange loss realized shall be the excess of the adjusted basis of such currency over the amount realized.

(ii) AMOUNT REALIZED -- (A) IN GENERAL. The amount realized from the disposition of nonfunctional currency shall be determined under section 1001(b). A taxpayer that uses a spot rate convention under section 1.988-1(d)(3) to determine exchange gain or loss with respect to a payable shall determine the amount realized upon the disposition of nonfunctional currency paid in satisfaction of the payable in a manner consistent with such convention.

(B) EXCHANGE OF NONFUNCTIONAL CURRENCY FOR PROPERTY. For purpose of paragraph (a)(2) of this section, the exchange of nonfunctional currency for property (other than nonfunctional currency) shall be treated as --

(1) An exchange of the units of nonfunctional currency for units of functional currency at the spot rate on the date of the exchange, and

(2) The purchase or sale of the property for such units of functional currency.

(C) EXAMPLE. The following example illustrates the provisions of paragraph (a)(2)(ii)(B) of this section.

EXAMPLE. G is a U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1989, G enters into a contract to purchase a paper manufacturing machine for 10,000,000 British pounds (BP) for delivery on January 1, 1991. On January 1, 1991, when G exchanges BP10,000,000 (which G purchased for $12,000,000) for the machine, the fair market value of the machine is BP17,000,000. On January 1, 1991, the spot exchange rate is BP1 = $1.50. Under paragraph (a)(2)(ii)(B) of this section, the transaction is treated as an exchange of BP10,000,000 for $15,000,000 and the purchase of the machine for $15,000,000. Accordingly, in computing G's exchange gain of $3,000,000 on the disposition of the BP10,000,000, the amount realized is $15,000,000. G's basis in the machine is $15,000,000. No gain is recognized on the bargain purchase of the machine.

(iii) ADJUSTED BASIS -- (A) IN GENERAL. Except as provided in paragraph (a)(2)(iii)(B) of this section, the adjusted basis of nonfunctional currency is determined under the applicable provisions of the Internal Revenue Code (e.g., sections 1011 through 1023). A taxpayer that uses a spot rate convention under section 1.988-1(d)(3) to determine exchange gain or loss with respect to a receivable shall determine the basis of nonfunctional currency received in satisfaction of such receivable in a manner consistent with such convention.

(B) DETERMINATION OF THE BASIS OF NONFUNCTIONAL CURRENCY WITHDRAWN FROM AN ACCOUNT WITH A BANK OR OTHER FINANCIAL INSTITUTION -- (1) IN GENERAL. The basis of nonfunctional currency withdrawn from an account with a bank or other financial institution shall be determined under any reasonable method that is consistently applied from year to year by the taxpayer to all accounts denominated in a nonfunctional currency. For example, a taxpayer may use a first in first out method, a last in first out method, a prorata method (as illustrated in the example below), or any other reasonable method that is consistently applied. However, a method that consistently results in units of nonfunctional currency with the highest basis being withdrawn first shall not be considered reasonable.

(2) EXAMPLE. The following example illustrates the provisions of this paragraph (a)(2)(iii)(B).

EXAMPLE. (i) X, a cash basis individual with the dollar as his functional currency, opens a demand account with a Swiss bank. Assume expenses associated with the demand account are deductible under section 212. The following chart indicates Swiss franc deposits to the account, Swiss franc interest credited to the account, the dollar basis of each deposit, and the determination of the aggregate dollar basis of all Swiss francs in the account. Assume that the taxpayer has properly translated all the amounts specified in the chart and that all transactions are subject to section 988.

 Swiss                          U.S.      Aggregate

 500 Sf x $600 = $250

(iv) PURCHASE AND SALE OF STOCK OR SECURITIES TRADED ON AN ESTABLISHED SECURITIES MARKET BY CASH BASIS TAXPAYER -- (A) AMOUNT REALIZED. If stock or securities traded on an established securities market are sold by a cash basis taxpayer for nonfunctional currency, the amount realized with respect to the stock or securities (as determined on the trade date) shall be computed by translating the units of nonfunctional currency received into functional currency at the spot rate on the settlement date of the sale. This rule applies notwithstanding that the stock or securities are treated as disposed of on a date other than the settlement date under another section of the Code. See section 453(k).

(B) BASIS. If stock or securities traded on an established securities market are purchased by a cash basis taxpayer for nonfunctional currency, the basis of the stock or securities shall be determined by translating the units of nonfunctional currency paid into functional currency at the spot rate on the settlement date of the purchase.

(C) EXAMPLE. The following example illustrates the provisions of this paragraph (a)(2)(iv).

EXAMPLE. On November 1, 1989 (the trade date), X, a calendar year cash basis U.S. individual, purchases stock for BP100 for settlement on November 5, 1989. On November 1, 1989, the spot value of the BP100 is $140. On November 5, 1989, X purchases BP100 for $141 which X uses to pay for the stock. X's basis in the stock is $141. On December 30, 1990 (the trade date), X sells the stock for BP110 for settlement on January 5, 1991. On December 30, 1990, the spot value of BP110 is $165. On January 5, 1991, X transfers the stock and receives BP110 which, translated at the spot rate, equal $166. Under section 453(k), the stock is considered disposed of on December 30, 1990. The amount realized with respect to such disposition is the value of the BP110 on January 5, 1991 ($166). Accordingly, X's gain realized on December 30, 1990, from the disposition of the stock is $25 ($166 amount realized less $141 basis). X's basis in the BP110 received from the sale of the stock is $166.

(v) PURCHASE AND SALE OF STOCK OR SECURITIES TRADED ON AN ESTABLISHED SECURITIES MARKET BY ACCRUAL BASIS TAXPAYER. For taxable years beginning after [DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER], an accrual basis taxpayer may elect to apply the rules of paragraph (a)(2)(iv) of this section. The election shall be made by filing a statement with the taxpayer's first return in which the election is effective clearly indicating that the election has been made. A method so elected must be applied consistently from year to year and cannot be changed without the consent of the Commissioner.

(b) TRANSLATION OF INTEREST INCOME OR EXPENSE AND DETERMINATION OF EXCHANGE GAIN OR LOSS WITH RESPECT TO DEBT INSTRUMENTS -- (1) TRANSLATION OF INTEREST INCOME RECEIVED WITH RESPECT TO A NONFUNCTIONAL CURRENCY DEMAND ACCOUNT. Interest income received with respect to a demand account with a bank or other financial institution which is denominated in (or the payments of which are determined by reference to) a nonfunctional currency shall be translated into functional currency at the spot rate on the date received or accrued or pursuant to any reasonable spot rate convention consistently applied by the taxpayer to all taxable years and to all accounts denominated in nonfunctional currency in the same financial institution. For example, a taxpayer may translate interest income received with respect to a demand account on the last day of each month of the taxable year, on the last day of each quarter of the taxable year, on the last day of each half of the taxable year, or on the last day of the taxable year. No exchange gain or loss is realized upon the receipt or accrual of interest income with respect to a demand account subject to this paragraph (b)(1).

(2) TRANSLATION OF NONFUNCTIONAL CURRENCY INTEREST INCOME OR EXPENSE RECEIVED OR PAID WITH RESPECT TO A DEBT INSTRUMENT DESCRIBED IN SECTION 1.988-1(a)(1)(ii) AND (2)(i) -- (i) SCOPE -- (A) IN GENERAL. Paragraph (b) of this section only applies to debt instruments described in section 1.988-1(a)(1)(ii) and (2)(i) where all payments are denominated in, or determined with reference to, a single nonfunctional currency. Except as provided in paragraph (b)(2)(i)(B) of this section, this paragraph (b) shall not apply to contingent payment debt instruments.

(B) NONFUNCTIONAL CURRENCY CONTINGENT PAYMENT DEBT INSTRUMENTS-- (1) OPERATIVE RULES. [RESERVED]

(2) CERTAIN INSTRUMENTS ARE NOT CONTINGENT PAYMENT DEBT INSTRUMENTS. For purposes of section 1275(d), a debt instrument denominated in, or all payments of which are determined with reference to, a single nonfunctional currency (with no contingencies) is not a contingent payment debt instrument. See section 1.988-1(a)(4) and (5) for the treatment of dual currency and multi-currency debt instruments.

(ii) DETERMINATION AND TRANSLATION OF INTEREST INCOME OR EXPENSE -- (A) IN GENERAL. Interest income or expense on a debt instrument described in paragraph (b)(2)(i) of this section (including original issue discount determined in accordance with sections 1271 through 1275 and 163(e) as adjusted for acquisition premium under section 1272(a)(7), and acquisition discount determined in accordance with sections 1281 through 1283) shall be determined in units of nonfunctional currency and translated into functional currency as provided in paragraphs (b)(2)(ii)(B) and (C) of this section. For purposes of sections 483, 1273(b)(5) and 1274, the nonfunctional currency in which an instrument is denominated (or by reference to which payments are determined) shall be considered money.

(B) TRANSLATION OF INTEREST INCOME OR EXPENSE THAT IS NOT REQUIRED TO BE ACCRUED PRIOR TO RECEIPT OR PAYMENT. With respect to an instrument described in paragraph (b)(2)(i) of this section, interest income or expense received or paid that is not required to be accrued by the taxpayer prior to receipt or payment shall be translated at the spot rate on the date of receipt or payment. No exchange gain or loss is realized with respect to the receipt or payment of such interest income or expense (other than the exchange gain or loss that might be realized under paragraph (a) of this section upon the disposition of the nonfunctional currency so received or paid).

(C) TRANSLATION OF INTEREST INCOME OR EXPENSE THAT IS REQUIRED TO BE ACCRUED PRIOR TO RECEIPT OR PAYMENT. With respect to an instrument described in paragraph (b)(2)(i) of this section, interest income or expense that is required to be accrued prior to receipt or payment (e.g., under section 1272, 1281 or 163(e) or because the taxpayer uses an accrual method of accounting) shall be translated at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for the interest accrual period or, with respect to an interest accrual period that spans two taxable years, at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for the partial period within the taxable year. See paragraphs (b)(3) and (4) of this section for the determination of exchange gain or loss on the receipt or payment of accrued interest income or expense.

(iii) DETERMINATION OF AVERAGE RATE OR OTHER ACCRUAL CONVENTION -- (A) IN GENERAL. For purposes of this paragraph (b), the average rate for an accrual period (or partial period) shall be a simple average of the spot exchange rates for each business day of such period or other average exchange rate for the period reasonably derived and consistently applied by the taxpayer.

(B) ELECTION TO USE SPOT ACCRUAL CONVENTION. For taxable years beginning after [DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER], a taxpayer may elect to translate interest income and expense at the spot rate on the last day of the interest accrual period (and in the case of a partial accrual period, the spot rate on the last day of the taxable year). If the last day of the interest accrual period is within five business days of the date of receipt or payment, the taxpayer may translate interest income or expense at the spot rate on the date of receipt or payment. The election shall be made by filing a statement with the taxpayer's first return in which the election is effective clearly indicating that the election has been made. A method so elected must be applied consistently to all debt instruments from year to year and cannot be changed without the consent of the Commissioner.

(3) EXCHANGE GAIN OR LOSS RECOGNIZED BY THE HOLDER WITH RESPECT TO ACCRUED INTEREST INCOME. The holder of a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to accrued interest income on the date such accrued interest income is received or the instrument is disposed of (including a deemed disposition under section 1001 that results from a material change in terms of the instrument)). Except as otherwise provided in this paragraph (b) (e.g., paragraph (b)(8) of this section), exchange gain or loss realized with respect to accrued interest income shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized with respect to accrued interest income is determined for each accrual period by --

(i) Translating the units of nonfunctional currency interest income received with respect to such accrual period (as determined under the ordering rules of paragraph (b)(7) of this section) into functional currency at the spot rate on the date the interest income is received or the instrument is disposed of (or deemed disposed of), and

(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency interest income accrued with respect to such income received at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for the accrual period.

(4) EXCHANGE GAIN OR LOSS RECOGNIZED BY THE OBLIGOR WITH RESPECT TO ACCRUED INTEREST EXPENSE. The obligor under a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to accrued interest expense on the date such accrued interest expense is paid or the obligation to make payments is transferred or extinguished (including a deemed disposition under section 1001 that results from a material change in terms of the instrument)). Except as otherwise provided in this paragraph (b) (e.g., paragraph (b)(8) of this section), exchange gain or loss realized with respect to accrued interest expense shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized with respect to accrued interest expense is determined for each accrual period by --

(i) Translating the units of nonfunctional currency interest expense accrued with respect to the amount of interest paid into functional currency at the average rate (or other rate specified in paragraph (b)(2)(iii)(B) of this section) for such accrual period; and

(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency interest paid (or, if the obligation to make payments is extinguished or transferred, the units accrued) with respect to such accrual period (as determined under the ordering rules in paragraph (b)(7) of this section) into functional currency at the spot rate on the date payment is made or the obligation is transferred or extinguished (or deemed extinguished).

(5) EXCHANGE GAIN OR LOSS RECOGNIZED BY THE HOLDER OF A DEBT INSTRUMENT WITH RESPECT TO PRINCIPAL. The holder of a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to the principal amount of such instrument on the date principal (determined under the ordering rules of paragraph (b)(7) of this section) is received from the obligor or the instrument is disposed of (including a deemed disposition under section 1001 that results from a material change in terms of the instrument)). For purposes of computing exchange gain or loss, the principal amount of a debt instrument is the holder's purchase price in units of nonfunctional currency. See paragraph (b)(10) of this section for rules regarding the amortization of that part of the principal amount that represents bond premium and the computation of exchange gain or loss thereon. If, however, the holder acquired the instrument in a transaction in which exchange gain or loss was realized but not recognized by the transferor, the nonfunctional currency principal amount of the instrument with respect to the holder shall be the same as that of the transferor. Except as otherwise provided in this paragraph (b) (e.g., paragraph (b)(8) of this section), exchange gain or loss realized with respect to such principal amount shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized by the holder with respect to principal is determined by --

(i) Translating the units of nonfunctional currency principal at the spot rate on the date payment is received or the instrument is disposed of (or deemed disposed of); and

(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date the holder (or a transferor from whom the nonfunctional principal amount is carried over) acquired the instrument (is deemed to acquire the instrument).

(6) EXCHANGE GAIN OR LOSS RECOGNIZED BY THE OBLIGOR OF A DEBT INSTRUMENT WITH RESPECT TO PRINCIPAL. The obligor under a debt instrument described in paragraph (b)(2)(i) of this section shall realize exchange gain or loss with respect to the principal amount of such instrument on the date principal (determined under the ordering rules of paragraph (b)(7) of this section) is paid or the obligation to make payments is transferred or extinguished (including a deemed disposition under section 1001 that results from a material change in terms of the instrument)). For purposes of computing exchange gain or loss, the principal amount of a debt instrument is the amount received by the obligor for the debt instrument in units of nonfunctional currency. See paragraph (b)(10) of this section for rules regarding the amortization of that part of the principal amount that represents bond premium and the computation of exchange gain or loss thereon. If, however, the obligor became the obligor in a transaction in which exchange gain or loss was realized but not recognized by the transferor, the nonfunctional currency principal amount of the instrument with respect to such obligor shall be the same as that of the transferor. Except as otherwise provided in this paragraph (b) (e.g., paragraph (b)(8) of this section), exchange gain or loss realized with respect to such principal shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. The amount of exchange gain or loss so realized by the obligor is determined by --

(i) Translating the units of nonfunctional currency principal at the spot rate on the date the obligor (or a transferor from whom the principal amount is carried over) became the obligor (or is deemed to have become the obligor); and

(ii) Subtracting from such amount the amount computed by translating the units of nonfunctional currency principal at the spot rate on the date payment is made or the obligation is transferred or extinguished (or deemed extinguished).

(7) PAYMENT ORDERING RULES -- (i) DEBT INSTRUMENTS SUBJECT TO THE RULES OF SECTIONS 163(e), OR 1271 THROUGH 1288. In the case of a debt instrument described in paragraph (b)(2)(i) of this section that is subject to the rules of sections 163(e), or 1272 through 1288, units of nonfunctional currency (or an amount determined with reference to nonfunctional currency) received or paid with respect to such debt instrument shall be treated first as a receipt or payment of periodic interest under the principles of section 1273 and the regulations thereunder, second as a receipt or payment of original issue discount to the extent accrued as of the date of the receipt or payment, and finally as a receipt or payment of principal. Units of nonfunctional currency (or an amount determined with reference to nonfunctional currency) treated as a receipt or payment of original issue discount under the preceding sentence are attributed to the earliest accrual period in which original issue discount has accrued and to which prior receipts or payments have not been attributed. No portion thereof shall be treated as prepaid interest. These rules are illustrated by EXAMPLE 10 of paragraph (b)(9) of this section.

(ii) OTHER DEBT INSTRUMENTS. In the case of a debt instrument described in paragraph (b)(2)(i) of this section that is not subject to the rules of section 163(e) or 1272 through 1288, whether units of nonfunctional currency (or an amount determined with reference to nonfunctional currency) received or paid with respect to such debt instrument are treated as interest or principal shall be determined under section 163 or other applicable section of the Code.

(8) LIMITATION OF EXCHANGE GAIN OR LOSS ON PAYMENT OR DISPOSITION OF A DEBT INSTRUMENT. When a debt instrument described in paragraph (b)(2)(i) of this section is paid or disposed of, or when the obligation to make payments thereunder is satisfied by another person, or extinguished or assumed by another person, exchange gain or loss is computed with respect to both principal and any accrued interest (including original issue discount), as provided in paragraph (b)(3) through (7) of this section. However, pursuant to section 988(b)(1) and (2), the sum of any exchange gain or loss with respect to the principal and interest of any such debt instrument shall be realized only to the extent of the total gain or loss realized on the transaction. The gain or loss realized shall be recognized in accordance with the general principles of the Code. See EXAMPLES 3, 4 and 6 of paragraph (b)(9) of this section.

(9) EXAMPLES. The preceding provisions are illustrated in the following examples. The examples assume that any transaction involving an individual is a section 988 transaction.

EXAMPLE 1. (i) X is an individual on the cash method of accounting with the dollar as his functional currency. On January 1, 1992, X converts $13,000 to 10,000 British pounds (BP) at the spot rate of BP1 = $1.30 and loans the BP10,000 to Y for 3 years. The terms of the loan provide that Y will make interest payments of BP1,000 on December 31 of 1992, 1993, and 1994, and will repay X's BP10,000 principal on December 31, 1994. Assume the spot rates for the pertinent dates are as follows:

 Date                 Spot rate (pounds to dollars)

(iii) Under paragraph (b)(5) of this section, X will realize exchange gain upon repayment of the BP10,000 principal amount determined by translating the BP10,000 at the spot rate on the date it is received (BP10,000 x $1.45 = $14,500) and subtracting from such amount, the amount determined by translating the BP10,000 at the spot rate on the date the loan was made (BP10,000 x $1.30 = $13,000). Accordingly, X will realize an exchange gain of $1,500 on the repayment of the loan on December 31, 1994.

EXAMPLE 2. (i) Assume the same facts as in EXAMPLE 1 except that X is an accrual method taxpayer and that average rates are as follows:

 Accrual Period       Average rate (pounds to dollars)

 Spot           Accrued

EXAMPLE 3. Assume the same facts as in EXAMPLE 1 except that X is a calendar year taxpayer on the accrual method of accounting that elects to use a spot rate convention to translate interest income as provided in section 1.988-2(b)(2)(iii)(B). Interest income is received by X on the last day of each accrual period. Under paragraph (b)(2)(ii)(C), X will translate the interest income at the spot rate on the last day of each interest accrual period. Accordingly, X will have interest income of $1,350 in 1992, and $1,400 in 1993, $1,450 in 1994. Because the rate at which the interest income is translated is the same as the rate on the day of receipt, X will not realize any exchange gain or loss with respect to the interest income. Under paragraph (b)(5) of this section, X will realize exchange gain upon repayment of the BP10,000 loan principal determined in the same manner as in EXAMPLE 1. Accordingly, X will realize an exchange gain of $1,500 on the repayment of the loan principal on December 31, 1994.

EXAMPLE 4. Assume the same facts as in EXAMPLE 1 except that on December 31, 1993, X sells Y's note for 9,821.13 British pounds (BP) after the interest payment. Under paragraph (b)(8) of this section, X will compute exchange gain on the BP10,000 principal. The exchange gain is $1,000 [(BP10,000 x $1.40) - (BP10,000 x $1.30)]. This exchange gain, however, is only realized to the extent of the total gain on the disposition. X's total gain is $749.58 [(BP9,821.13 x $1.40) - (BP10,000 x $1.30)]. Thus, X will realize $749.58 of exchange gain (and will realize no market loss).

EXAMPLE 5. (i) The facts are the same as in EXAMPLE 1 except that Y becomes insolvent and fails to repay the full BP10,000 principal when due. Instead, X and Y agree to compromise the debt for a payment of BP8,000 on December 31, 1994. Under paragraph (b) (8) of this section, X will compute exchange gain on the BP10,000 originally booked. The exchange gain is $1,500 [(BP10,000 x $1.45) - (BP10,000 x $1.30) = $1,500]. This exchange gain, however, is only realized to the extent of the total gain on the disposition. X realizes an overall loss on the disposition of $1,400 [(BP8,000 x $1.45) - (BP10,000 x $1.30) = ($1,400)]. Thus, X will realize no exchange gain (and a $1400 market loss).

(ii) If the exchange rate on December 31, 1994, were BP1 = $1.25, rather than BP1 = $1.45, X would compute exchange loss under paragraph (b)(8) of this section, on the BP10,000 originally booked. The exchange loss would be $500 [(BP10,000 x $1.25) - (BP10,000 x $1.30) = ($500)]. X's total loss on the disposition would be $3,000 [(BP8,000 x $1.25) - (BP10,000 x $1.30) = ($3,000)]. Thus, X would realize $500 of exchange loss and a $2,500 market loss on the disposition.

EXAMPLE 6. (i) X is an individual with the dollar as his functional currency. X is on the cash method of accounting. On January 1, 1989, X borrows 10,000 British pounds (BP) from Y, an unrelated person. The terms of the loan provide that X will make interest payments of BP1,200 on December 31 of 1989 and 1990 and will repay Y's BP10,000 principal on December 31, 1990. The spot rates for the pertinent dates are as follows:

 DATE                     SPOT RATE (pounds to dollars)

(ii) Under paragraph (b)(2)(ii)(B) of this section, X translates the BP1,200 interest payments at the spot rate on the day paid. Thus, X paid $1,920 (BP1,200 x $1.60) of interest on December 31, 1989 and $2,040 (BP1,200 x $1.70) of interest on December 31, 1990. In addition, X will realize exchange gain or loss on the disposition of the BP1,200 on December 31, 1989 and 1990, under paragraph (a) of this section. Pursuant to paragraph (a)(2) of this section, X will realize an exchange loss of $80 [(BP1,200 x $1.60) - $2,000] on December 31, 1989 and exchange gain of $20 [(BP1,200 x $1.70) - $2,020] on December 31, 1990.

(iii) Under paragraph (b)(6) of this section, X will realize exchange loss on December 31, 1990 upon repayment of the BP10,000 principal amount determined by translating the BP10,000 received at the spot rate on January 1, 1989 (BP10,000 x $1.50 = $15,000) and subtracting from such amount, the amount determined by translating the BP10,000 paid at the spot rate on December 31, 1990 (BP10,000 x $1.70 = $17,000). Thus, under paragraph (b)(6) of this section, X has an exchange loss with respect to the BP10,000 principal of $2,000. Further, under paragraph (a)(2) of this section, X will realize an exchange gain upon disposition of the BP10,000 on December 31, 1990. Under paragraph (a)(2) of this section, X will subtract his adjusted basis in the BP10,000 ($16,000) from the amount realized upon the disposition of the BP10,000 (BP10,000 x $1.70 = $17,000) resulting in a gain of $1,000. Accordingly, X's combined exchange gain and loss realized on December 31, 1990 with respect to the repayment of the BP10,000 is a $1,000 exchange loss.

EXAMPLE 7. (i) X is a calendar year corporation on the accrual method of accounting and with the dollar as its functional currency. On January 1, 1989, X purchases at original issue for 82.64 Canadian dollars (C$) M corporation's 2 year note maturing on December 31, 1990, at a stated redemption price of C$ 100. The yield to maturity in Canadian dollars is 10 percent and the accrual period is the one year period beginning January 1 and ending December 31. The note has C$ 17.36 of original issue discount. Assume that the spot rates are as follows: C$1 = U.S.$.72 on January 1, 1989; C$1 = U.S.$.80 on January 1, 1990; C$1 = U.S.$ .82 on December 31, 1990. Assume further that the average rate for 1989 is C$1 = U.S.$ .76 and for 1990 is C$1 = U.S. $.81.

(ii) Under paragraph (b)(2)(ii)(A) of this section, X will determine its interest income in Canadian dollars. Accordingly, under section 1272, X must take into account original issue discount in the amount of C$8.26 on December 31, 1989 and C$9.10 on December 31, 1990. Pursuant to paragraph (b)(2)(ii)(C) of this section, X will translate these amounts into U.S. dollars at the average exchange rate for the relevant accrual period. Thus, the amount of interest income taken into account in 1989 is U.S.$6.28 (C$8.26 x U.S.$.76) and in 1990 is U.S.$7.37 (C$9.10 x U.S.$ .81). Pursuant to paragraph (b)(3)(ii) of this section, X will realize exchange gain or loss with respect to the accrued interest determined for each accrual period by translating the Canadian dollars received with respect to such accrual period into U.S. dollars at the spot rate on the date the interest is received and subtracting from that amount the amount accrued in U.S. dollars. Thus, the amount of exchange gain realized on December 31, 1990, is U.S. $.58 (U.S.$ .49 from 1989 + U.S.$.09 from 1990). Pursuant to paragraph (b)(5) of this section, X shall realize exchange gain or loss with respect to the principal (C$82.64) on December 31, 1990, computed by translating the C$82.64 at the spot rate on December 31, 1990 (U.S. $ 67.76) and subtracting the C$82.64 translated at the spot rate on January 1, 1989 (U.S.$ 59.50) for an exchange gain of U.S.$8.26. Thus, X's combined exchange gain is U.S.$8.84 (U.S.$.49 + U.S.$.09 + U.S.$8.26).

(iii) Assume instead that on January 1, 1990, X sells the note for C$86.95, which it immediately converts to U.S. dollars. X's exchange gain is computed under paragraph (b)(8) of this section with reference to the nonfunctional currency denominated principal amount (C$82.64) and the nonfunctional currency denominated accrued original issue discount (C$8.26). X will compute an exchange gain of U.S.$6.61 with respect to the issue price [(C$82.64 x U.S.$ .80) - (C$82.64 x U.S.$ .72)] and an exchange gain of U.S.$.33 with respect to the accrued original issue discount [(C$8.26 x U.S.$.80) - (C$8.26 x U.S.$ .76)]. Accordingly, prior to the application of paragraph (b)(8) of this section, X's total exchange gain is U.S. $ 6.94 (U.S.$6.61 + U.S.$.33), and X's market loss is U.S.$ 3.16 [(C$90.90 - C$86.95) x U.S.$.80]. Pursuant to paragraph (b)(8) of this section, however, X's market loss on the note of U.S.$3.16 is netted against X's exchange gain of U.S.$6.94, resulting in a realized exchange gain of U.S.$3.78 and no market loss.

EXAMPLE 8. (i) The facts are the same as in EXAMPLE 7 (i) except that on January 1, 1990, X contributes the M corporation note to Y, a wholly-owned U.S. subsidiary of X with the dollar as its functional currency, and Y collects C$100 from M corporation at maturity on December 31, 1990, when the spot rate is C$1=U.S.$.82. The transfer of the note from X to Y qualifies for nonrecognition of gain under section 351(a). On December 31, 1990, Y includes C$9.10 of accrued interest in income which translated at the average exchange rate of C$1 = U.S. $.81 for the year results in U.S. $7.37 of interest income.

(ii) Y's exchange gain is computed under paragraph (b)(3) of this section with respect to accrued interest income and paragraph (b)(5) of this section with respect to the nonfunctional currency principal amount. Under paragraph (b)(3) of this section, Y will realize exchange gain or loss for each accrual period computed by translating the units of nonfunctional currency interest income received with respect to such accrual period at the spot rate on the day received and subtracting the amounts of interest income accrued for such period. Thus, Y will realize $.49 of exchange gain with respect to original issue discount accrued in 1989 [(C$8.26 x U.S.$.82) - (C$8.26 x U.S.$.76) = U.S. $.49] and $.09 of exchange gain with respect to original issue discount accrued in 1990 [(C$9.10 x U.S.$.82) - (C$9.10 x U.S.$.81) = $.09].

(iii) Pursuant to paragraph (b)(5) of this section, the nonfunctional currency principal amount of the M bond in the hands of Y is C$82.64, the amount carried over from X, the transferor. Y's exchange gain with respect to the nonfunctional currency principal amount is $8.26 [(C$82.64 x U.S.$.82) - (C$82.64 x U.S. $.72) = U.S. $8.26]. Accordingly, Y's combined exchange gain is U.S. $8.84 ($.49 + $.09 + $8.26). Because the amount realized in Canadian dollars equals the adjusted issue price (C$100) on retirement of the M note, there is no market loss, and the netting rule of paragraph (b)(8) of this section does not limit realization of the exchange gain.

EXAMPLE 9. (i) X is a calendar year corporation on the accrual method of accounting and with the dollar as its functional currency. X elects to use the spot rate convention to translate interest income as provided in paragraph (b)(2)(iii)(B) of this section. On January 31, 1992, X loans BP1000 to Y, an unrelated person. Under the terms of the loan, Y will pay X interest of BP50 on July 31, 1992, and January 31, 1993, and will repay the BP1000 principal on January 31, 1993. Assume the following spot exchange rates:

 Date                     Spot rate (pounds to dollars)

(iii) Under paragraph (b)(5) of this section, X will realize exchange gain upon repayment of the BP100 principal amount determined by translating the BP100 at the spot rate on the date it is received (BP100 x $1.61 = $161.00) and subtracting from such amount, the amount determined by translating the BP100 at the spot rate on the date the loan was made (BP100 x $1.50 = $150.00). Accordingly, X will realize an exchange gain of $11 on the repayment of the loan on January 31, 1993.

EXAMPLE 10. (i) X, a cash basis taxpayer with the dollar as its functional currency, has the calendar year as its taxable year. On January 1, 1992, X purchases at original issue for 65.88 British pounds (BP) M corporation's 5-year bond maturing on December 31, 1996, having a stated redemption price at maturity of BP100. The bond provides for annual payments of interest in pounds of 1 pound per year on December 31 of each year. The bond has 34.12 British pounds of original issue discount. The yield to maturity is 10 percent in British pounds and the accrual period is the one year period beginning January 1 and ending December 31 of each calendar year. The amount of original issue discount is determined in pounds for each accrual period by multiplying the adjusted issue price expressed in pounds by the yield and subtracting from such amount the periodic interest payments expressed in pounds for such period. The periodic interest payments are translated at the spot rate on the payment date (December 31 of each year). The original issue discount is translated at the average rate for the accrual period (January 1 through December 31). The following chart describes the determination of interest income with respect to the facts presented and provides other pertinent information.

 Table 1

 Table 2

EXAMPLE 11. (i) The facts are the same as in EXAMPLE 10 except that X makes an election under paragraph (b)(2)(iii) of this section to translate accrued interest on the last day of the accrual period. Accordingly, columns 8, 9 and 10 in Table 1 would change as follows:

 1               8                    9                 10

 1                 5                 6                   7

EXAMPLE 12. (i) C is a corporation that is a calendar year accrual method taxpayer with the dollar as its functional currency. On January 1, 1989, C lends 100 British pounds (BP) in exchange for a note under the terms of which C will receive two equal payments of BP57.62 on December 31, 1989, and December 31, 1990. Each payment of BP57.62 represents the annual payment necessary to amortize the BP100 principal amount at a rate of 10% compounded annually over a two year period. The following tables reflect the amounts of principal and interest that compose each payment and assumptions as to the relevant exchange rates:

 Date           Principal            Interest

(iii) Because C is an accrual basis taxpayer, C will translate the interest income at the average rate for the annual accrual period pursuant to paragraph (b)(2)(ii)(C) of this section. Thus, C's interest income is $13.50 (BP10.00 x $1.35) in 1989, and $7.60 (BP5.24 x $1.45) in 1990. C will realize exchange gain or loss upon receipt of accrued interest computed in accordance with paragraph (b) (3) of this section. Thus, C will realize exchange gain in the amount of $ .50 [(BP10.00 x $1.40) - $13.50] in 1989, and $ .26 [(BP 5.24 x $ 1.50) - $7.60] in 1990.

(iv) In addition, C will realize exchange gain or loss upon the receipt of principal each year computed under paragraph (b)(5) of this section. Thus, C will realize exchange gain in the amount of $ 4.76 [(BP47.62 x $1.40) - (BP47.62 x $1.30)] in 1989, and $10.48 [(BP52.38 x $1.50) - (BP52.38 x $1.30)] in 1990.

(10) TREATMENT OF BOND PREMIUM -- (i) IN GENERAL. Amortizable bond premium on a bond described in paragraph (b)(2)(i) of this section shall be computed in the units of nonfunctional currency in which the bond is denominated (or in which the payments are determined). Amortizable bond premium properly taken into account under section 171 or section 1.61-12 (or the successor provision thereof) shall reduce interest income or expense in units of nonfunctional currency. Exchange gain or loss is realized with respect to bond premium described in the preceding sentence by treating the portion of premium amortized with respect to any period as a return of principal. With respect to a holder that does not elect to amortize bond premium under section 171, the amount of bond premium will constitute a market loss when the bond matures. See paragraph (b)(8) of this section. The principles set forth in this paragraph (b)(10) shall apply to determine the treatment of acquisition premium described in section 1272(a)(7).

(ii) EXAMPLE. The following example illustrates the provisions of this paragraph (b)(10).

EXAMPLE. (A) X is an individual on the cash method of accounting with the dollar as his functional currency. On January 1, 1989, X purchases Y corporation's note for 107.99 British pounds (BP) from Z, an unrelated party. The note has an issue price of BP100, a stated redemption price at maturity of BP100, pays interest in pounds at the rate of 10% compounded annually, and matures on December 31, 1993. X elects to amortize the bond premium of BP7.99 under the rules of section 171. Pursuant to paragraph (b)(10)(i) of this section, bond premium is determined and amortized in British pounds. Assume the amortization schedule is as follows:

 Year         Bond        Unamortized

(11) MARKET DISCOUNT -- (i) IN GENERAL. Market discount as defined in section 1278(a)(2) shall be determined in units of nonfunctional currency in which the market discount bond is denominated (or in which the payments are determined). Accrued market discount (other than market discount currently included in income pursuant to section 1278(b)) shall be translated into functional currency at the spot rate on the date the market discount bond is disposed of. No part of such accrued market discount is treated as exchange gain or loss. Accrued market discount currently includible in income pursuant to section 1278(b) shall be translated into functional currency at the average exchange rate for the accrual period. Exchange gain or loss with respect to accrued market discount currently includible in income under section 1278(b) shall be determined in accordance with paragraph (b)(3) of this section relating to accrued interest income.

(ii) EXAMPLE. The following example illustrates the provisions of this paragraph (b)(11).

EXAMPLE -- (A) X is a calendar year corporation with the U.S. dollar as its functional currency. On January 1, 1990, X purchases a bond of M corporation for 96,530 British pounds (BP). The bond, which was issued on January 1, 1989, has an issue price of BP100,000, a stated redemption price at maturity of BP100,000, and provides for annual pound payments of interest at 8 percent. The bond matures on December 31, 1991. X purchased the bond at a market discount of 3,470 pounds and did not elect to include the market discount currently in income under section 1278(b). X holds the bond to maturity and on December 31, 1991, receives payment of BP100,000 (plus BP8,000 interest) when the exchange rate is BP1 = $1.50.

(B) Pursuant to paragraph (b)(11) of this section, X computes market discount in units of nonfunctional currency. Thus, the market discount as defined under section 1278(a)(2) is BP3,470. Accrued market discount (other than market discount currently included in income pursuant to section 1278(b)) is translated at the spot rate on the date the market discount bond is disposed of. Accordingly, X will translate the accrued market discount of BP3,470 at the spot rate on December 31, 1991 (BP3,470 x $1.50 = $5,205). No exchange gain or loss is realized with respect to the BP3,470 of accrued market discount. See paragraphs (b)(3) and (5) of this section for the realization and recognition of exchange gain or loss with respect to accrued interest and principal.

(12) TAX EXEMPT BONDS. See section 1.988-3(c)(2), which characterizes exchange loss realized with respect to a nonfunctional currency tax exempt bond as a reduction of interest income.

(13) NONFUNCTIONAL CURRENCY DEBT EXCHANGED FOR STOCK OF OBLIGOR -- (i) IN GENERAL. Notwithstanding any other section of the Code other than section 267, 1091 or 1092, exchange gain or loss shall be realized and recognized by the holder and the obligor in accordance with the rules of paragraphs (b)(3) through (7) of this section with respect to the principal and accrued interest of a debt instrument described in paragraph (b)(2)(i) of this section that is acquired by the obligor in exchange for its stock, provided however, that such gain or loss shall be recognized only to the extent of the total gain or loss on the exchange (regardless of whether such gain or loss would otherwise be recognized). This rule shall apply whether the debt instrument is converted into stock according to its terms or exchanged pursuant to a separate agreement between the obligor and the holder. A debt instrument that is acquired by the obligor from a shareholder as a contribution to capital shall be treated for purposes of this section as exchanged for stock, whether or not additional stock is issued.

(ii) COORDINATION WITH SECTION 108. Section 988 and this section shall apply before section 108. Exchange gain realized by the obligor on an exchange described in paragraph (b)(13)(i) of this section shall not be treated as discharge of indebtedness income, but shall be considered to reduce the amount of the liability for purposes of computing the obligor's income on the exchange under section 108(e)(4), section 108(e)(6) or section 108(e)(10).

(iii) EFFECTIVE DATE. This paragraph (b)(13) shall be effective for exchanges of debt for stock effected after September 21, 1989.

(iv) EXAMPLES. The following examples illustrate the operation of this paragraph (b)(13). In each such example, assume that sections 267, 1091 and 1092 do not apply.

EXAMPLE 1. (i) X is a calendar year U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1990 (the issue date), X acquired a convertible bond maturing on December 31, 1998, issued by Y corporation, a U.K. corporation with the British pound (BP) as its functional currency. The issue price of the bond is BP100,000, the stated redemption price at maturity is BP100,000, and the bond provides for annual pound interest payments at the rate of 10%. The terms of the bond also provide that at any time prior to December 31, 1998, the holder may surrender all of his interest in the bond in exchange for 20 shares of Y common stock. On January 1, 1994, X surrenders his interest in the bond for 20 shares of Y common stock. Assume the following: (a) The spot rate on January 1, 1990, is BP1 = $1.30, (b) The spot rate on January 1, 1994, is BP1 = $1.50, and (c) The 20 shares of Y common stock have a market value of BP200,000 on January 1, 1994.

(ii) Pursuant to paragraph (b)(13) of this section, X will realize and recognize exchange gain with respect to the issue price (BP100,000) of the bond on January 1, 1994, when the bond is converted to stock. X will compute exchange gain pursuant to paragraph (b)(5) of this section by translating the issue price at the spot rate on the conversion date (BP100,000 x $1.50 = $150,000) and subtracting from such amount the issue price translated at the spot rate on the date X acquired the bond (BP100,000 x $1.30 = $130,000). Thus, X will realize and recognize $20,000 of exchange gain. X's basis in the 20 shares of Y common stock is $150,000 ($130,000 substituted basis + $20,000 recognized gain).

EXAMPLE 2. (i) X, a foreign corporation with the British pound (BP) as its functional currency, lends BP100 at a market rate of interest to Y, its wholly-owned U.S. subsidiary, on January 1, 1990, on which date the spot exchange rate is BP1 = $1. Y's functional currency is the U.S. dollar. On January 1, 1992, when the spot exchange rate is BP1 = $.50, X cancels the debt as a contribution to capital. Pursuant to paragraph (b)(13) of this section, Y will realize and recognize exchange gain with respect to the BP100 issue price of the debt instrument on January 1, 1992. Y will compute exchange gain pursuant to paragraph (b)(6) of this section by translating the issue price at the spot rate on the date Y became the obligor (BP100 x $1 = $100) and subtracting from such amount the issue price translated at the spot rate on the date of extinguishment (BP100 x $.50 = $50). Thus, Y will realize and recognize $50 of exchange gain.

(ii) Under section 108(e)(6), on the acquisition of its indebtedness from X as a contribution to capital Y is treated as having satisfied the debt with an amount of money equal to X's adjusted basis in the debt (BP100). For purposes of section 108(e)(6), X's adjusted basis is translated into United States dollars at the spot rate on the date Y acquires the debt (BP1 = $.50). Therefore, Y is treated as having satisfied the debt for $50. Pursuant to paragraph (b)(13) of this section, for purposes of section 108 the amount of the indebtedness is considered to be reduced by the exchange gain from $100 to $50. Accordingly, Y recognizes $50 of exchange gain and no discharge of indebtedness income on the extinguishment of its debt to X.

(iii) If X were a United States taxpayer with a dollar functional currency and a $100 basis in Y's obligation, X would realize and recognize an exchange loss of $50 under paragraph (b)(5) of this section on the contribution of the debt to Y. The recognized loss would reduce X's adjusted basis in the debt from $100 to $50, so that for purposes of applying section 108(e)(6) Y is treated as having satisfied the debt for $50. Accordingly, under these facts as well Y would recognize $50 of exchange gain and no discharge of indebtedness income.

EXAMPLE 3. (i) X and Y are unrelated calendar year U.S. corporations with the U.S. dollar as their functional currency. On January 1, 1990 (the issue date), X acquires Y's bond maturing on December 31, 1999. The issue price of the bond is BP100,000, the stated redemption price at maturity is BP100,000, and the bond provides for annual pound interest payments at the rate of 10%. On January 1, 1994, X and Y agree that Y will redeem its bond from X in exchange for 20 shares of Y common stock. Assume the following:

(a) The spot rate on January 1, 1990, is BP1 = $1.00,

(b) The spot rate on January 1, 1994, is BP1 = $.50,

(c) Interest rates on equivalent bonds have increased so that as of January 1, 1994, the value of Y's bond has declined to BP90,000, and

(d) The 20 shares of Y common stock have a market value of BP90,000 as of January 1, 1994.

(ii) Pursuant to paragraph (b)(13) of this section, X will realize and recognize exchange loss with respect to the issue price (BP100,000) of the bond on January 1, 1994, when the bond is exchanged for stock. X will compute exchange loss pursuant to paragraph (b)(5) of this section by translating the issue price at the spot rate on the exchange date (BP100,000 x $.50 = $50,000) and subtracting from such amount the issue price translated at the spot rate on the date X acquired the bond (BP100,000 x $1.00 = $100,000). Thus, X will compute $50,000 of exchange loss, all of which will be realized and recognized because it does not exceed the total $55,000 realized loss on the exchange ($45,000 worth of stock received less $100,000 basis in the exchanged bond).

(iii) Pursuant to paragraph (b)(13) of this section, Y will realize and recognize exchange gain with respect to the issue price, computed under paragraph (b)(6) of this section by translating the issue price at the spot rate on the date Y became the obligor (BP100,000 x $1.00 = $100,000) and subtracting from such amount the issue price translated at the spot rate on the exchange date (BP100,000 x $.50 = $50,000). Thus, Y will realize and recognize $50,000 of exchange gain. Under section 108(e)(10), on the transfer of stock to X in satisfaction of its indebtedness Y is treated as having satisfied the indebtedness with an amount of money equal to the fair market value of the stock (BP90,000 x $.50 = $45,000). Pursuant to paragraph (b)(13) of this section, for purposes of section 108 the amount of the indebtedness is considered to be reduced by the recognized exchange gain from $100,000 to $50,000. Accordingly, Y recognizes an additional $5,000 of discharge of indebtedness income on the exchange.

EXAMPLE 4. (i) The facts are the same as in Example 3 except that interest rates on equivalent bonds have declined, rather than increased, so that the value of Y's bond on January 1, 1994, has risen to BP112,500; and X and Y agree that Y will redeem its bond from X on that date in exchange for 25 shares of Y common stock worth BP112,500. Pursuant to paragraphs (b)(13) and (b)(5) of this section, X will compute $50,000 of exchange loss on the exchange with respect to the BP100,000 issue price of the bond. See EXAMPLE 3. However, because X's total loss on the exchange is only $43,750 ($56,250 worth of stock received less $100,000 basis in the exchanged bond), under the netting rule of paragraph (b)(13) of this section the realized exchange loss is limited to $43,750.

(ii) Pursuant to paragraphs (b)(13) and (b)(6) of this section, Y will compute $50,000 of exchange gain with respect to the issue price. See Example 3. Under section 108(e)(10), Y is treated as having satisfied the $100,000 indebtedness with an amount of money equal to the fair market value of the stock (BP112,500 x $.50 = $56,250), resulting in a total gain on the exchange of $43,750. Accordingly, under paragraph (b)(13) of this section Y's realized (and recognized) exchange gain on the exchange is limited to $43,750. Also pursuant to paragraph (b)(13) of this section, for purposes of section 108 the amount of the indebtedness is considered to be reduced by the recognized exchange gain from $100,000 to $56,250. Accordingly, Y recognizes no discharge of indebtedness income on the exchange.

(14)-(15) [Reserved]

(16) COORDINATION WITH SECTION 267 REGARDING DEBT INSTRUMENTS -- (i) TREATMENT OF A CREDITOR. For rules applicable to a corporation included in a controlled group that is a creditor under a debt instrument see section 1.267(f)-1(h).

(ii) TREATMENT OF A DEBTOR. [Reserved]

(17) COORDINATION WITH INSTALLMENT METHOD UNDER SECTION 453. [Reserved]

(c) ITEM OF EXPENSE OR GROSS INCOME OR RECEIPTS WHICH IS TO BE PAID OR RECEIVED AFTER THE DATE ACCRUED -- (1) IN GENERAL. Except as provided in section 1.988-5, exchange gain or loss with respect to an item described in section 1.988-1(a)(1)(ii) and (2)(ii) (other than accrued interest income or expense subject to paragraph (b) of this section) shall be realized on the date payment is made or received. Except as provided in the succeeding sentence, such exchange gain or loss shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. If the taxpayer's right to receive income, or obligation to pay an expense, is transferred or modified in a transaction in which gain or loss would otherwise be recognized, exchange gain or loss shall be realized and recognized only to the extent of the total gain or loss on the transaction.

(2) DETERMINATION OF EXCHANGE GAIN OR LOSS WITH RESPECT TO AN ITEM OF GROSS INCOME OR RECEIPTS. Exchange gain or loss realized on an item of gross income or receipts described in paragraph (c)(1) of this section shall be determined by multiplying the units of nonfunctional currency received by the spot rate on the payment date, and subtracting from such amount the amount determined by multiplying the units of nonfunctional currency received by the spot rate on the booking date. The term "spot rate on the payment date" means the spot rate determined under section 1.988-1(d) on the date payment is received or otherwise taken into account. Pursuant to section 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the payment date. The term "spot rate on the booking date" means the spot rate determined under section 1.988-1(d) on the date the item of gross income or receipts is accrued or otherwise taken into account. Pursuant to section 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the booking date.

(3) DETERMINATION OF EXCHANGE GAIN OR LOSS WITH RESPECT TO AN ITEM OF EXPENSE. Exchange gain or loss realized on an item of expense described in paragraph (c)(1) of this section shall be determined by multiplying the units of nonfunctional currency paid by the spot rate on the booking date and subtracting from such amount the amount determined by multiplying the units of nonfunctional currency paid by the spot rate on the payment date. The term "spot rate on the booking date" means the spot rate determined under section 1.988-1(d) on the date the item of expense is accrued or otherwise taken into account. Pursuant to section 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the booking date. The term "spot rate on the payment date" means the spot rate determined under section 1.988-1(d) on the date payment is made or otherwise taken into account. Pursuant to section 1.988-1(d)(3), a taxpayer may use a spot rate convention for purposes of determining the spot rate on the payment date.

(4) EXAMPLES. The following examples illustrate the application of paragraph (c) of this section.

EXAMPLE 1. X is a calendar year corporation with the dollar as its functional currency. X is on the accrual method of accounting. On January 15, 1989, X sells inventory for 10,000 Canadian dollars (C$). The spot rate on January 15, 1989, is C$1 = U.S. $.55. On February 23, 1989, when X receives payment of the C$10,000, the spot rate is C$1 = U.S. $.50. On February 23, 1989, X will realize exchange loss. X's loss is computed by multiplying the C$10,000 by the spot rate on the date the C$10,000 are received (C$10,000 x .50 = U.S. $5,000) and subtracting from such amount, the amount computed by multiplying the C$10,000 by the spot rate on the booking date (C$10,000 x .55 = U.S. $5,500). Thus, X's exchange loss on the transaction is U.S. $500 (U.S. $5,000 - U.S. $5,500).

EXAMPLE 2. The facts are the same as in Example 1 except that X uses a spot rate convention to determine the spot rate as provided in section 1.988-1(d)(3). Pursuant to X's spot rate convention, the spot rate at which a payable or receivable is booked is determined monthly for each nonfunctional currency payable or receivable by adding the spot rate at the beginning of the month and the spot rate at the end of the month and dividing by two. All payables and receivables in a nonfunctional currency booked during the month are translated into functional currency at the rate described in the preceding sentence. Further, the translation of nonfunctional currency paid with respect to a payable, and nonfunctional currency received with respect to a receivable, is also performed pursuant to the spot rate convention. Assume the spot rate determined under the spot rate convention for the month of January is C$1 = U.S. $.54 and for the month of February is C$1 = U.S. $.51. On the last date in February, X will realize exchange loss. X's loss is computed by multiplying the C$10,000 by the spot rate convention for the month of February (C$10,000 x U.S. $.51 = U.S. $5,100) and subtracting from such amount, the amount computed by multiplying the C$10,000 by the spot rats convention for the month of January (C$10,000 x U.S. $.54 = $5,400). Thus, X's exchange loss on the transaction is U.S. $300 (U.S. $5,100 - U.S. $5,400). X's basis in the C$10,000 is U.S. $5,400.

EXAMPLE 3. The facts are the same as in EXAMPLE 2 except that X has a standing order with X's bank for the bank to convert any nonfunctional currency received in satisfaction of a receivable into U.S. dollars on the day received and to deposit those U.S. dollars in X's U.S. dollar bank account. X may use its convention to translate the amount booked into U.S. dollars, but must use the U.S. dollar amounts received from the bank with respect to such receivables to determine X's exchange gain or loss. Thus, if X receives payment of the C$10,000 on February 23, 1989, when the spot rate is C$1 = U.S.$ .50, X determines exchange gain or loss by subtracting the amount booked under X's convention (U.S.$5,400) from the amount of U.S. dollars received from the bank under the standing conversion order (assume $5,000). X's exchange loss is U.S.$400.

(d) EXCHANGE GAIN OR LOSS WITH RESPECT TO FORWARD CONTRACTS FUTURES CONTRACTS AND OPTION CONTRACTS -- (1) SCOPE -- (i) IN GENERAL. This paragraph (d) applies to forward contracts, futures contracts and option contracts described in section 1.988-1(a)(1)(ii) and (2)(iii). For rules applicable to currency swaps and notional principal contracts described in section 1.988-1(a)(1)(ii) and (2)(iii), see paragraph (e) of this section.

(ii) TREATMENT OF SPOT CONTRACTS. Solely for purposes of this paragraph (d), a spot contract as defined in section 1.988-1(b) to buy or sell nonfunctional currency is not considered a forward contract or similar transaction described in section 1.988-1(a)(2)(iii) unless such spot contract is disposed of (or otherwise terminated) prior to making or taking deliver of the currency. For example, if a taxpayer with the dollar as its functional currency enters into a spot contract to purchase British pounds, and takes deliver of such pounds under the contract, the deliver of the pounds is not a realization event under section 988(c)(5) and paragraph (e)(4)(ii) of this section because the contract is not considered a forward contract or similar transaction described in section 1.988-1(a)(2)(iii). However, if the taxpayer sells or otherwise terminates the contract before taking deliver of the pounds, exchange gain or loss shall be realized and recognized in accordance with paragraphs (d)(2) and (3) of this section.

(2) REALIZATION OF EXCHANGE GAIN OR LOSS -- (i) IN GENERAL. Except as provided in section 1.988-5, exchange gain or loss on a contract described in section 1.988-2(d)(1) shall be realized in accordance with the applicable realization section of the Internal Revenue Code (e.g., sections 1001, 1092, and 1256). See also section 988(c)(5). For purposes of determining the timing of the realization of exchange gain or loss, sections 1092 and 1256 shall take precedence over section 988(c)(5).

(ii) REALIZATION BY OFFSET -- (A) IN GENERAL. Except as provided in paragraphs (d)(2)(ii)(B) and (C) of this section, exchange gain or loss with respect to a transaction described in section 1.988-1(a)(1)(ii) and (2)(iii) shall not be realized solely because such transaction is offset by another transaction (or transactions).

(B) EXCEPTION WHERE ECONOMIC BENEFIT IS DERIVED. If a transaction described in section 1.988-1(a)(1)(ii) and (2)(iii) is offset by another transaction or transactions, exchange gain shall be realized to the extent the taxpayer derives, by pledge or otherwise, an economic benefit (e.g., cash, property or the proceeds from a borrowing) from any gain inherent in such offsetting positions. Proper adjustment shall be made in the amount of any gain or loss subsequently realized for gain taken into account by reason of the preceding sentence. This paragraph (d)(2)(ii)(B) shall apply to transactions creating an offset after September 21, 1989.

(C) CERTAIN CONTRACTS TRADED ON AN EXCHANGE. If a transaction described in section 1.988-1(a)(1)(ii) and (2)(iii) is traded on an exchange and it is the general practice of the exchange to terminate offsetting contracts, entering into an offsetting contract shall be considered a termination of the contract being offset.

(iii) CLARIFICATION OF SECTION 988(c)(5). If the deliver date of a contract subject to section 988(c)(5) and paragraph (d)(4)(ii) of this section is different than the date the contract expires, then for purposes of determining the date exchange gain or loss is realized, the term delivery date shall mean expiration date.

(iv) EXAMPLES. The following examples illustrate the rules of this paragraph (d)(1) and (2).

EXAMPLE 1. On August 1, 1989, X, a calendar year corporation with the dollar as its functional currency, enters into a forward contract with Bank A to buy 100 New Zealand dollars for $80 for deliver on January 31, 1990. (The forward purchase contract is not a section 1256 contract.) On November 1, 1989, the market price for the purchase of 100 New Zealand dollars for deliver on January 31, 1990, is $76. On November 1, 1989, X cancels its obligation under the forward purchase contract and pays Bank A $3.95 (the present value of $4 discounted at 12% for the period) in cancellation of such contract. Under section 1001(a), X realizes an exchange loss of $3.95 on November 1, 1989, because cancellation of the forward purchase contract for cash results in the termination of X's contract.

EXAMPLE 2. X is a corporation with the dollar as its functional currency. On January 1, 1989, X enters into a currency swap contract with Bank A under which X is obligated to make a series of Japanese yen payments in exchange for a series of dollar payments. On February 21, 1992, X has a gain of $100,000 inherent in such contract as a result of interest rate and exchange rate movements. Also on February 21, 1992, X enters into an offsetting swap with Bank A to lock in such gain. If on February 21, 1992, X pledges the gain inherent in such offsetting positions as collateral for a loan, X's initial swap contract is treated as being terminated on February 21, 1992, under paragraph (d)(2)(ii)(B) of this section. Proper adjustment is made in the amount of any gain or loss subsequently realized for the gain taken into account by reason of paragraph (d)(2)(ii)(B) of this section.

EXAMPLE 3. X is a calendar year corporation with the dollar as its functional currency. On October 1, 1989, X enters into a forward contract to buy 100,000 Swiss francs (Sf) for deliver on March 1, 1990, for $51,220. Assume that the contract is a section 1256 contract under section 1256(g)(2) and that section 1256(e) does not apply. Pursuant to section 1256(a)(1), the forward contract is treated as sold for its fair market value on December 31, 1989. Assume that the fair market value of the contract is $1,000 determined under section 1.988-1(g). Thus X will realize an exchange gain of $1,000 on December 31, 1989. Such gain is subject to the character rules of section 1.988-3 and the source rules of section 1.988-4.

(v) EXTENSION OF THE MATURITY DATE OF CERTAIN CONTRACTS. An extension of time for making or taking delivery under a contract described in paragraph (d)(1) of this section (e.g. a historical rate rollover as defined in section 1.988-5(b)(2)(iii)(C)) shall be considered a sale or exchange of the contract for its fair market value on the date of the extension and the establishment of a new contract on such date. If, under the terms of the extension, the time value of any gain or loss recognized pursuant to the preceding sentence adjusts the price of the currency to be bought or sold under the new contract, the amount attributable to such time value shall be treated as interest income or expense for all purposes of the Code. However, the preceding sentence shall not apply and the amount attributable to the time value of any gain or loss recognized shall be treated as exchange gain or loss if the period beginning on the first date the contract is rolled over and ending on the date payment is ultimately made or received with respect to such contract does not exceed 183 days.

(3) RECOGNITION OF EXCHANGE GAIN OR LOSS. Except as provided in section 1.988-5 (relating to section 988 hedging transactions), exchange gain or loss realized with respect to a contract described in paragraph (d)(1) of this section shall be recognized in accordance with the applicable recognition provisions of the Internal Revenue Code. For example, a loss realized with respect to a contract described in paragraph (d)(1) of this section which is part of a straddle shall be recognized in accordance with the provisions of section 1092 to the extent such section is applicable.

(4) DETERMINATION OF EXCHANGE GAIN OR LOSS -- (i) IN GENERAL. Exchange gain or loss with respect to a contract described in section 1.988-2(d)(1) shall be determined by subtracting the amount paid (or deemed paid), if any, for or with respect to the contract (including any amount paid upon termination of the contract) from the amount received (or deemed received), if any, for or with respect to the contract (including any amount received upon termination of the contract). Any gain or loss determined according to the preceding sentence shall be treated as exchange gain or loss.

(ii) SPECIAL RULES WHERE TAXPAYER MAKES OR TAKES DELIVERY. If the taxpayer makes or takes delivery in connection with a contract described in paragraph (d)(1) of this section, any gain or loss shall be realized and recognized in the same manner as if the taxpayer sold the contract (or paid another person to assume the contract) on the date on which he took or made delivery for its fair market value on such date. See paragraph (d)(2)(iii) of this section regarding the definition of the term "delivery date." This paragraph (d)(4)(ii) shall not apply in any case in which the taxpayer makes or takes delivery before June 11, 1987.

(iii) EXAMPLES. The following examples illustrate the application of paragraph (d)(4) of this section.

EXAMPLE 1. X is a calendar year corporation with the dollar as its functional currency. On October 1, 1989, when the six month forward rate is $.4907, X enters into a forward contract to buy 100,000 New Zealand dollars (NZD) for delivery on March 1, 1990. On March 1, 1990, when X takes delivery of the 100,000 NZD, the spot rate is 1NZD equals $.48. Pursuant to section 988(c)(5) and paragraph (d)(4)(ii) of this section, a taxpayer that takes delivery of nonfunctional currency under a forward contract that is subject to section 988 is treated as if the taxpayer sold the contract for its fair market value on the date delivery is taken. If X sold the contract on March 1, 1990, the transferee would require a payment of $1,070 [($.48 x 100,000NZD) - ($.4907 x 100,000NZD)] to compensate him for the loss in value of the 100,000NZD. Therefore, X realizes an exchange loss of $1,070. X has a basis in the 100,000NZD of $48,000.

EXAMPLE 2. Assume the same facts as in Example 1 except that the contract is for Swiss francs and is a section 1256 contract. Assume further that on December 31, 1989, the value to X of the contract as marked to market is $1,000. Pursuant to section 1256(a), X realizes an exchange gain of $1,000. Such gain, however, is characterized as ordinary income under section 1.988-3 and will be sourced under section 1.988-4.

EXAMPLE 3. X is a calendar year corporation with the dollar as its functional currency. On May 2, 1989, X enters into an option contract with Bank A to purchase 50,000 Canadian dollars (C$) for U.S. $42,500 (C$1 = U.S. $.85) for delivery on or before September 18, 1989. X pays a $285 premium to Bank A to obtain the option contract. On September 18, 1989, when X exercises the option and takes delivery of the C $50,000, the spot rate is C$1 equals U.S. $.90. Pursuant to section 988(c)(5) and paragraph (d)(4)(ii) of this section, a taxpayer that takes delivery under an option contract that is subject to section 988 is treated as if the taxpayer sold the contract for its fair market value on the date delivery is taken. If X sold the contract for its fair market value on September 18, 1989, X would receive U.S. $2,500 [(C$50,000 x U.S. $.90) - (C$50,000 x U.S. $.85)]. Accordingly, X is deemed to have received U.S. $2,500 on the sale of the contract at its fair market value. X will realize U.S. $2,215 ($2,500 deemed received less $285 paid) of exchange gain with respect to the delivery of Canadian dollars under the option contract. X's basis in the 50,000 Canadian dollars is U.S. $45,000.

(5) [Reserved]

(e) CURRENCY SWAPS AND OTHER NOTIONAL PRINCIPAL CONTRACTS -- (1) IN GENERAL. Except as provided in paragraph (e)(2) of this section or in section 1.988-5, the timing of income, deduction and loss with respect to a notional principal contract that is a section 988 transaction shall be governed by section 446 and the regulations thereunder. Such income, deduction and loss is characterized as exchange gain or loss (except as provided in another section of the Internal Revenue Code (or regulations thereunder), section 1.988-5, or in paragraph (f) of this section).

(2) SPECIAL RULES FOR CURRENCY SWAPS -- (i) IN GENERAL. Except as provided in paragraph (e)(2)(iii)(B) of this section, the provisions of this paragraph (e)(2) shall apply solely for purposes of determining the realization, recognition and amount of exchange gain or loss with respect to a currency swap contract, and not for purposes of determining the source of such gain or loss, or characterizing such gain or loss as interest. Except as provided in section 1.988-3(c), any income or loss realized with respect to a currency swap contract shall be characterized as exchange gain or loss (and not as interest income or expense). Any exchange gain or loss realized in accordance with this paragraph (e)(2) shall be recognized unless otherwise provided in an applicable section of the Code. For purposes of this paragraph (e)(2), a currency swap contract is a contract defined in paragraph (e)(2)(ii) of this section. With respect to a contract which requires the payment of swap principal prior to maturity of such contract, see paragraph (f) of this section. For purposes of this paragraph (e), the rules of paragraph (d)(2)(ii) of this section (regarding realization by offset) apply. See Example 2 of paragraph (d)(2)(iv) of this section.

(ii) DEFINITION OF CURRENCY SWAP CONTRACT -- (A) IN GENERAL. A currency swap contract is a contract involving different currencies between two or more parties to --

(1) Exchange periodic interim payments, as defined in paragraph (e)(2)(ii)(C) of this section, on or prior to maturity of the contract; and

(2) Exchange the swap principal amount upon maturity of the contract.

A currency swap contract may also require an exchange of the swap principal amount upon commencement of the agreement.

(B) SWAP PRINCIPAL AMOUNT. The swap principal amount is an amount of two different currencies which, under the terms of the currency swap contract, is used to determine the periodic interim payments in each currency and which is exchanged upon maturity of the contract. If such amount is not clearly set forth in the contract, the Commissioner may determine the swap principal amount.

(C) EXCHANGE OF PERIODIC INTERIM PAYMENTS. An exchange of periodic interim payments is an exchange of one or more payments in one currency specified by the contract for one or more payments in a different currency specified by the contract where the payments in each currency are computed by reference to an interest index applied to the swap principal amount. A currency swap contract must clearly indicate the periodic interim payments, or the interest index used to compute the periodic interim payments, in each currency.

(iii) TIMING AND COMPUTATION OF PERIODIC INTERIM PAYMENTS -- (A) IN GENERAL. Except as provided in paragraph (e)(2)(iii)(B) of this section and section 1.988-5, the timing and computation of the periodic interim payments provided in a currency swap agreement shall be determined by treating --

(1) Payments made under the swap as payments made pursuant to a hypothetical borrowing that is denominated in the currency in which payments are required to be made (or are determined with reference to) under the swap, and

(2) Payments received under the swap as payments received pursuant to a hypothetical loan that is denominated in the currency in which payments are received (or are determined with reference to) under the swap.

Except as provided in paragraph (e)(2)(v) of this section, the hypothetical issue price of such hypothetical borrowing and loan shall be the swap principal amount. The hypothetical stated redemption price at maturity is the total of all payments (excluding any exchange of the swap principal amount at the inception of the contract) provided under the hypothetical borrowing or loan other than periodic interest payments under the principles of section 1273. For purposes of determining economic accrual under the currency swap, the number of hypothetical interest compounding periods of such hypothetical borrowing and loan shall be determined pursuant to a semiannual compounding convention unless the currency swap contract indicates otherwise. For purposes of determining the timing and amount of the periodic interim payments, the principles regarding the amortization of interest (see generally, sections 1272 through 1275 and 163(e)) shall apply to the hypothetical interest expense and income of such hypothetical borrowing and loan. However, such principles shall not apply to determine the time when principal is deemed to be paid on the hypothetical borrowing and loan. See paragraph (d)(2)(iii) of this section and Example 2 of paragraph (d)(5) of this section with respect to the time when principal is deemed to be paid. With respect to the translation and computation of exchange gain or loss on any hypothetical interest income or expense, see section 1.988-2(b). The amount treated as exchange gain or loss by the taxpayer with respect to the periodic interim payments for the taxable year shall be the amount of hypothetical interest income and exchange gain or loss attributable to such interest income from the hypothetical borrowing and loan for such year less the amount of hypothetical interest expense and exchange gain or loss attributable to the interest expense from such hypothetical borrowing and loan for such year.

(B) EFFECT OF PREPAYMENT FOR PURPOSES OF SECTION 956. For purposes of section 956, the Commissioner may treat any prepayment of a currency swap as a loan.

(iv) TIMING AND DETERMINATION OF EXCHANGE GAIN OR LOSS WITH RESPECT TO THE SWAP PRINCIPAL AMOUNT. Exchange gain or loss with respect to the swap principal amount shall be realized on the day the units of swap principal in each currency are exchanged. (See paragraph (e)(2)(ii)(A)(2) of this section which requires that the entire swap principal amount be exchanged upon maturity of the contract.) Such gain or loss shall be determined on the date of the exchange by subtracting the value (on such date) of the units of swap principal paid from the value of the units of swap principal received. This paragraph (e)(2)(iv) does not apply to an equal exchange of the swap principal amount at the commencement of the agreement at a market exchange rate.

(v) ANTI-ABUSE RULES -- (A) METHOD OF ACCOUNTING DOES NOT CLEARLY REFLECT INCOME. If the taxpayer's method of accounting for income, expense, gain or loss attributable to a currency swap does not clearly reflect income, or if the present value of the payments to be made is not equivalent to that of the payments to be received (including the swap premium or discount, as defined in paragraph (e)(3)(ii) of this section) on the day the taxpayer enters into or acquires the contract, the Commissioner may apply principles analogous to those of section 1274 or such other rules as the Commissioner deems appropriate to clearly reflect income. For example, in order to clearly reflect income the Commissioner may determine the hypothetical issue price, the hypothetical stated redemption price at maturity, and the amounts required to be taken into account within a taxable year. Further, if the present value of the payments to be made is not equivalent to that of the payments to be received (including the swap premium or discount, as defined in paragraph (e)(3)(ii) of this section) on the day the taxpayer enters into or acquires the contract, the Commissioner may integrate the swap with another transaction (or transactions) in order to clearly reflect income.

(B) TERMS MUST BE CLEARLY STATED. If the currency swap contract does not clearly set forth the swap principal amount in each currency, and the periodic interim payments in each currency (or the interest index used to compute the periodic interim payments in each currency), the Commissioner may defer any income, deduction, gain or loss with respect to such contract until termination of the contract.

(3) AMORTIZATION OF SWAP PREMIUM OR DISCOUNT IN THE CASE OF OFF- MARKET CURRENCY SWAPS -- (i) IN GENERAL. An "off-market currency swap" is a currency swap contract under which the present value of the payments to be made is not equal to that of the payments to be received on the day the taxpayer enters into or acquires the contract (absent the swap premium or discount, as defined in paragraph (e)(3)(ii) of this section). Generally, such present values may not be equal if the swap exchange rate (as defined in paragraph (e)(3)(iii) of this section) is not the spot rate, or the interest indices used to compute the periodic interim payments do not reflect current values, on the day the taxpayer enters into or acquires the currency swap.

(ii) TREATMENT OF TAXPAYER ENTERING INTO OR ACQUIRING AN OFF- MARKET CURRENCY SWAP. If a taxpayer that enters into or acquires a currency swap makes a payment (that is, the taxpayer pays a premium, "swap premium," to enter into or acquire the currency swap) or receives a payment (that is, the taxpayer enters into or acquires the currency swap at a discount, "swap discount") in order to make the present value of the amounts to be paid equal the amounts to be received, such payment shall be amortized in a manner which places the taxpayer in the same position it would have been in had the taxpayer entered into a currency swap contract under which the present value of the amounts to be paid equal the amounts to be received (absent any swap premium or discount). Thus, swap premium or discount shall be amortized as follows --

(A) The amount of swap premium or discount that is attributable to the difference between the swap exchange rate (as defined in paragraph (e)(3)(iii) of this section) and the spot rate on the date the contract is entered into or acquired shall be taken into account as income or expense on the date the swap principal amounts are taken into account; and

(B) The amount of swap premium or discount attributable to the difference in values of the periodic interim payments shall be amortized in a manner consistent with the principles of economic accrual. Cf., section 171.

Any amount taken into account pursuant to this paragraph (e)(3)(ii) shall be treated as exchange gain or loss.

(iii) DEFINITION OF SWAP EXCHANGE RATE. The swap exchange rate is the single exchange rate set forth in the contract at which the swap principal amounts are determined. If the swap exchange rate is not clearly set forth in the contract, the Commissioner may determine such rate.

(iv) [Reserved]

(4) TREATMENT OF TAXPAYER DISPOSING OF A CURRENCY SWAP. Any gain or loss realized on the disposition or the termination of a currency swap is exchange gain or loss.

(5) EXAMPLES. The following examples illustrate the application of this paragraph (e).

EXAMPLE 1. (i) C is an accrual method calendar year corporation with the dollar as its functional currency. On January 1, 1989, C enters into a currency swap with J with the following terms:

(1) the principal amount is $150 and 100 British pounds (British pounds) (the equivalent of $150 on the effective date of the contract assuming a spot rate of 1 British pound = $ 1.50 on January 1, 1989);

(2) C will make payments equal to 10% of the dollar principal amount on December 31, 1989, and December 31, 1990;

(3) J will make payments equal to 12% of the pound principal amount on December 31, 1989, and December 31, 1990; and

(4) on December 31, 1990, C will pay to J the $150 principal amount and J will pay to C the 100 British pounds principal amount. Assume that the spot rate is 1 British pound = $1.50 on January 1, 1989, 1 British pound = $ 1.40 on December 31, 1989, and 1 British pound = $ 1.30 on December 31, 1990.

Assume further that the average rate for 1989 is 1 British pound = $1.45 and for 1990 is 1 british pound = $1.35.

(ii) Solely for determining the realization of gain or loss in accordance with paragraph (e)(2) of this section (and not for purposes of determining whether any payments are treated as interest), C will treat the dollar payments made by C as payments made pursuant to a dollar borrowing with an issue price of $150, a stated redemption price at maturity of $150, and yield to maturity of 10%. C will treat the pound payments received as payments received pursuant to a pound loan with an issue price of 100 British pounds, a stated redemption price at maturity of 100 British pounds, and a yield of 12% to maturity. Pursuant to section 1.988-2(b), C is required to compute hypothetical accrued pound interest income at the average rate for the accrual period and then determine exchange gain or loss on the day payment is received with respect to such accrued amount. Accordingly, C will accrue $17.40 (12 British pound x $1.45) in 1989 and $16.20 (12 British pounds x $1.35) in 1990. C also will compute hypothetical exchange loss of $.60 on December 31, 1989 [(12 British pounds x $1.40) - (12 British pounds x $1.45)] and hypothetical exchange loss of $.60 on December 31, 1990 [12 British pounds x $1.30) - (12 British pounds x $1.35)]. All such hypothetical interest income and exchange loss are characterized and sourced as exchange gain and loss. Further, C is treated as having paid $15 ($150 x 10%) of hypothetical interest on December 31, 1989, and again on December 31, 1990. Such hypothetical interest expense is characterized and sourced as exchange loss. Thus, C will have a net exchange gain of $1.80 ($17.40 - $.60 - $15.00) with respect to the periodic interim payments in 1989 and a net exchange gain of $.60 ($16.20 - $.60 - $15.00) with respect to the periodic interim payments in 1990. Finally, C will realize an exchange loss on December 31, 1990 with respect to the exchange of the swap principal amount. This loss is determined by subtracting the value of the units of swap principal paid ($150) from the value of the units of swap principal received (100 British pounds x $1.30 = $130) resulting in a $20 exchange loss.

EXAMPLE 2. (i) C is an accrual method calendar year corporation with the dollar as its functional currency. On January 1, 1989, when the spot rate is 1 British pound = $1.50, C enters into a currency swap contract with J under which C agrees to make and receive the following payments:

 Date                     C Pays         J Pays

 Amount        Adjusted

EXAMPLE 3. (i) X is a corporation on the accrual method of accounting with the dollar as its functional currency and the calendar year as its taxable year. On January 1, 1989, X enters into a three year currency swap contract with Y with the following terms. The swap principal amount is $100 and the Swiss franc (Sf) equivalent of such amount which equals Sf200 translated at the swap exchange rate of $1 = Sf2. There is no initial exchange of the swap principal amount. The interest rates used to compute the periodic interim payments are 10% compounded annually for U.S. dollar payments and 5% compounded annually for Swiss franc payments. Thus, under the currency swap, X agrees to pay Y $10 (10% x $100) on December 31st of 1989, 1990 and 1991 and to pay y the swap principal amount of $100 on December 31, 1991. Y agrees to pay X Sf10 (5% x Sf200) on December 31st of 1989, 1990 and 1991 and to pay X the swap principal amount of Sf200 on December 31, 1991. Assume that the average rate for 1989 and the spot rate on December 31, 1989, is $1 = Sf2.5.

(ii) Under paragraph (e)(2)(iii) of this section, on December 31, 1989, X will realize an exchange loss of $6 (the sum of $10 of loss by reason of the $10 periodic interim payment paid to Y and $4.00 of gain, the value of Sf10 on December 31, 1989, from the receipt of Sf10 on such date).

(iii) On January 1, 1990, X transfers its rights and obligations under the swap contract to Z, an unrelated corporation. Z has the dollar as its functional currency, is on the accrual method of accounting, and has the calendar year as its taxable year. On January 1, 1990, the exchange rate is $1 = Sf2.50. The relevant dollar interest rate is 8% compounded annually and the relevant Swiss franc interest rate is 5% compounded annually. Because of the movement in exchange and interest rates, the agreement between X and Z to transfer the currency swap requires X to pay Z $23.56 (the swap discount as determined under paragraph (e)(3) of this section).

(iv) Pursuant to paragraph (e)(4) of this section, X may deduct the loss of $23.56 in 1990. The loss is characterized under section 1.988-3 and sourced under section 1.988-4.

(v) Pursuant to paragraph (e)(3)(ii) of this section, Z is required to amortize the $23.56 received as follows. The amount of the $23.56 payment that is attributable to movements in exchange rates ($20) is taken into account on December 31, 1991, the date the swap principal amounts are exchanged, under paragraph (e)(3)(ii)(A) of this section. This amount is the present value (discounted at 10%, the rate under the currency swap contract used to compute the dollar periodic interim payments) of the financial asset required to compensate Z for the loss in value of the hypothetical Swiss franc loan resulting from movements in exchange rates between January 1, 1989 and January 1, 1990. This amount is determined by assuming that interest rates did not change from the date the swap originally was entered into (January 1, 1989), but that the exchange rate is $1 = Sf2.50. Under this assumption, a taxpayer undertaking the obligation to pay dollars under the currency swap on January 1, 1990, would only agree to pay $8 for Sf10 on December 31, 1990 and $88 for Sf21O on December 31, 1991, because the exchange rates have moved from $1 = Sf 2 to $1 = Sf 2.50. Thus, Z requires $2 on December 31, 1990 and $22 on December 31, 1991 to compensate for the amount of dollar payments Z is required to make in exchange for the Swiss francs received on December 31, 1990 and 1991. The present value of $2 on December 31, 1990 and $22 on December 31, 1991 discounted at the rate for U.S. dollar payments of 10% is $20 ($1.82 + $18.18). This amount is discounted at the rate for U.S. dollar payments (i.e., at the historic rate) because the amount of the $23.56 payment received by Z that is attributable to movements in interest rates is computed and amortized separately as provided in the following paragraph.

(vi) Pursuant to paragraph (e)(3)(ii)(B) of this section, Z is required to amortize the portion of the $23.56 payment attributable to movements in interest rates under principles of economic accrual over the term of the currency swap agreement. The amount of the $23.56 payment that is attributable to movements in interest rates (assuming that exchange rates have not changed) is the present value ($3.56) of the excess ($2.00 in 1990 and $2.00 in 1991) of the periodic interim payments Z is required to pay under the currency swap agreement ($10 in 1990 and $10 in 1991) over the amount Z would be required to pay if the currency swap agreement reflected current interest rates on the day Z acquired the swap contract ($8 in 1990 and $8 in 1991) discounted at the appropriate dollar interest rate on January 1, 1990. Thus, under principles of economic accrual (e.g., see section 171 of the Code), Z will include in income $1.72 on December 31, 1990, the amount that, when added to the interest ($.28) on the $3.56 computed at the 8% rate on the date Z acquired the currency swap contract, will equal the $2.00 needed to compensate Z for the movement in interest rates between January 1, 1989 and January 1, 1990. Z also will include in income $1.85 on December 31, 1991, the amount that, when added to the interest ($.15) on the $1.85 (the remaining balance of the $3.56 payment) computed at the 8% rate on the date Z acquired the currency swap contract, will equal the $2.00 needed to compensate Z for the movement in interest rates between January 1, 1990 and January 1, 1991. This amount is computed assuming exchange rates have not changed because the amount attributable to movements in exchange rates is computed and amortized separately under the preceding paragraph.

(6) SPECIAL EFFECTIVE DATE FOR RULES REGARDING CURRENCY SWAPS. Paragraph (e)(3) of this section regarding amortization of swap premium or discount in the case of off-market currency swaps shall be effective for transactions entered into after September 21, 1989, unless such swap premium or discount was paid or received pursuant to a binding contract with an unrelated party that was entered into prior to such date. For transactions entered into prior to this date, see Notice 89-21, 1989-8 I.R.B. 23.

(7) [Reserved]

(f) SUBSTANCE OVER FORM -- (1) IN GENERAL. If the substance of a transaction described in section 1.988-1(a)(1) differs from its form, the timing, source, and character of gains or losses with respect to such transaction may be recharacterized by the Commissioner in accordance with its substance. For example, if a taxpayer enters into a transaction that it designates a "currency swap contract" that requires the prepayment of all payments to be made or to be received (but not both), the Commissioner may recharacterize the contract as a loan. In applying the substance over form principle, separate transactions may be integrated where appropriate. See also section 1.861-9T(b)(1).

(2) EXAMPLE. The following example illustrates the provisions of this paragraph (f).

EXAMPLE. (i) On January 1, 1990, X, a U.S. corporation with the dollar as its functional currency, enters into a contract with Y under which X will pay Y $100 and Y will pay X LC100 on January 1, 1990, and X will pay Y LC109.3 and Y will pay X $133 on December 31, 1992. On January 1, 1990, the spot exchange rate is LC1 = $1 and the 3 year forward rate is LC1 = $ .8218. X's cash flows are summarized below:

 Date               Dollar           LC

(g) EFFECTIVE DATE. Except as otherwise provided in this section, this section shall be effective for taxable years beginning after December 31, 1986. Thus, except as otherwise provided in this section, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section.

SECTION 1.988-3 CHARACTER OF EXCHANGE GAIN OR LOSS.

(a) IN GENERAL. The character of exchange gain or loss recognized on a section 988 transaction is governed by section 988 and this section. Except as otherwise provided in section 988 (c)(1)(E), section 1092, section 1.988-5 and this section, exchange gain or loss realized with respect to a section 988 transaction (including a section 1256 contract that is also a section 988 transaction) shall be characterized as ordinary gain or loss. Accordingly, unless a valid election is made under paragraph (b) of this section, any section providing special rules for capital gain or loss treatment, such as sections 1233, 1234, 1234A, 1236 and 1256(f)(3), shall not apply.

(b) ELECTION TO CHARACTERIZE EXCHANGE GAIN OR LOSS ON CERTAIN IDENTIFIED FORWARD CONTRACTS FUTURES CONTRACTS AND OPTION CONTRACTS AS CAPITAL GAIN OR LOSS -- (1) IN GENERAL. Except as provided in paragraph (b)(2) of this section, a taxpayer may elect, subject to the requirements of paragraph (b)(3) of this section, to treat any gain or loss recognized on a contract described in section 1.988-2(d)(1) as capital gain or loss, but only if the contract --

(i) Is a capital asset in the hands of the taxpayer;

(ii) Is not part of a straddle within the meaning of section 1092(c) (without regard to subsections (c)(4) or (e)); and

(iii) Is not a regulated futures contract or nonequity option with respect to which an election under section 988(c)(1)(D)(ii) is in effect.

If a valid election under this paragraph (b) is made with respect to a section 1256 contract, section 1256 shall govern the character of any gain or loss recognized on such contract.

(2) SPECIAL RULE FOR CONTRACTS THAT BECOME PART OF A STRADDLE AFTER AN ELECTION IS MADE. If a contract which is the subject of an election under paragraph (b)(1) of this section becomes part of a straddle within the meaning of section 1092 (c) (without regard to subsections (c)(4) or (e)) after the date of the election, the election shall be invalid with respect to gains from such contract and the Commissioner, in his sole discretion, may invalidate the election with respect to losses.

(3) REQUIREMENTS FOR MAKING THE ELECTION. A taxpayer elects to treat gain or loss on a transaction described in paragraph (b)(1) of this section as capital gain or loss by clearly identifying such transaction on its books and records on the date the transaction is entered into. No specific language or account is necessary for identifying a transaction referred to in the preceding sentence. However, the method of identification must be consistently applied and must clearly identify the pertinent transaction as subject to the section 988(a)(1)(B) election. The Commissioner, in his sole discretion, may invalidate any purported election that does not comply with the preceding sentence.

(4) VERIFICATION. A taxpayer that has made an election under section 1.988-3(b)(3) must attach to his income tax return a statement which sets forth the following:

(i) A description and the date of each election made by the taxpayer during the taxpayer's taxable year;

(ii) A statement that each election made during the taxable year was made before the close of the date the transaction was entered into;

(iii) A description of any contract for which an election was in effect and the date such contract expired or was otherwise sold or exchanged during the taxable year;

(iv) A statement that the contract was never part of a straddle as defined in section 1092; and

(v) A statement that all transactions subject to the election are included on the statement attached to the taxpayer's income tax return.

In addition to any penalty that may otherwise apply, the Commissioner, in his sole discretion, may invalidate any or all elections made during the taxable year under section 1.988-3(b)(1) if the taxpayer fails to verify each election as provided in this section 1.988-3(b)(4). The preceding sentence shall not apply if the taxpayer's failure to verify each election was due to reasonable cause or bona fide mistake. The burden of proof to show reasonable cause or bona fide mistake made in good faith is on the taxpayer.

(5) INDEPENDENT VERIFICATION -- (i) EFFECT OF INDEPENDENT VERIFICATION. If the taxpayer receives independent verification of the election in paragraph (b)(3) of this section, the taxpayer shall be presumed to have satisfied the requirements of paragraphs (b)(3) and (4) of this section. A contract that is a part of a straddle as defined in section 1092 may not be independently verified and shall be subject to the rules of paragraph (b)(2) of this section.

(ii) REQUIREMENTS FOR INDEPENDENT VERIFICATION. A taxpayer receives independent verification of the election in paragraph (b)(3) of this section if --

(A) The taxpayer establishes a separate account(s) with an unrelated broker(s) or dealer(s) through which all transactions to be independently verified pursuant to this paragraph (b)(5) are conducted and reported.

(B) Only transactions entered into on or after the date the taxpayer establishes such account may be recorded in the account.

(C) Transactions subject to the election of paragraph (b)(3) of this section are entered into such account on the date such transactions are entered into.

(D) The broker or dealer provides the taxpayer a statement detailing the transactions conducted through such account and includes on such statement the following: "Each transaction identified in this account is subject to the election set forth in section 988(a)(1)(B)."

(iii) SPECIAL EFFECTIVE DATE FOR INDEPENDENT VERIFICATION. The rules of this paragraph (b)(5) shall be effective for transactions entered into after [DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER].

(6) EFFECTIVE DATE. Except as otherwise provided, this paragraph (b) is effective for taxable years beginning on or after September 21, 1989. For prior taxable years, any reasonable contemporaneous election meeting the requirements of section 988(a)(1)(B) shall satisfy this paragraph (b).

(c) EXCHANGE GAIN OR LOSS TREATED AS INTEREST -- (1) IN GENERAL. Except as provided in this paragraph (c)(1), exchange gain or loss realized on a section 988 transaction shall not be treated as interest income or expense. Exchange gain or loss realized on a section 988 transaction shall be treated as interest income or expense as provided in paragraph (c)(2) of this section with regard to tax exempt bonds, section 1.988-2(e)(2)(ii)(B), section 1.988-5, and in administrative pronouncements. See section 1.861-9T(b), providing rules for the allocation of certain items of exchange gain or loss in the same manner as interest expense.

(2) EXCHANGE LOSS REALIZED BY THE HOLDER ON NONFUNCTIONAL CURRENCY TAX EXEMPT BONDS. Exchange loss realized by the holder of a debt instrument the interest on which is excluded from gross income under section 103(a) or any similar provision of law shall be treated as an offset to and reduce total interest income received or accrued with respect to such instrument. Therefore, to the extent of total interest income, no exchange loss shall be recognized. This paragraph (c)(2) shall be effective with respect to debt instruments acquired on or after June 24, 1987.

(d) EFFECTIVE DATE. Except as otherwise provided in this section, this section shall be effective for taxable years beginning after December 31, 1986. Thus, except as otherwise provided in this section, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section. Thus, for example, a payment made prior to January 1, 1987, under a forward contract that results in the deferral of a loss under section 1092 to a taxable year beginning after December 31, 1986, is not characterized as an ordinary loss by virtue of paragraph (a) of this section because payment was made prior to January 1, 1987.

SECTION 1.988-4 SOURCE OF GAIN OR LOSS REALIZED ON A SECTION 988 TRANSACTION.

(a) IN GENERAL. Except as otherwise provided in section 1.988-5 and this section, the source of exchange gain or loss shall be determined by reference to the residence of the taxpayer. This rule applies even if the taxpayer has made an election under section 1.988-3(b) to characterize exchange gain or loss as capital gain or loss. This section takes precedence over section 865.

(b) QUALIFIED BUSINESS UNIT -- (1) IN GENERAL. The source of exchange gain or loss shall be determined by reference to the residence of the qualified business unit of the taxpayer on whose books the asset, liability, or item of income or expense giving rise to such gain or loss is properly reflected.

(2) PROPER REFLECTION ON THE BOOKS OF THE TAXPAYER OR QUALIFIED BUSINESS UNIT -- (i) IN GENERAL. Whether an asset, liability, or item of income or expense is properly reflected on the books of a qualified business unit is a question of fact.

(ii) PRESUMPTION IF BOOKING PRACTICES ARE INCONSISTENT. It shall be presumed that an asset, liability, or item of income or expense is not properly reflected on the books of the qualified business unit if the taxpayer and its qualified business units employ inconsistent booking practices with respect to the same or similar assets liabilities or items of income or expense. If not properly reflected on the books the Commissioner may allocate any asset, liability, or item of income or expense between or among the taxpayer and its qualified business units to properly reflect the source (or realization) of exchange gain or loss.

(c) EFFECTIVELY CONNECTED EXCHANGE GAIN OR LOSS. Notwithstanding paragraphs (a) and (b) of this section, exchange gain or loss that under principles similar to those set forth in section 1.864-4(c) arises from the conduct of a United States trade or business shall be sourced in the United States and such gain or loss shall be treated as effectively connected to the conduct of a United States trade or business for purposes of sections 871(b) and 882(a)(1).

(d) RESIDENCE -- (1) IN GENERAL. Except as otherwise provided in this paragraph (d), for purposes of sections 985 through 989, the residence of any person shall be --

(i) In the case of an individual, the country in which such individual's tax home (as defined in section 911(d)(3)) is located;

(ii) In the case of a corporation, partnership, trust or estate which is a United States person (as defined in section 7701(a)(30)), the United States; and

(iii) In the case of a corporation, partnership, trust or estate which is not a United States person, a country other than the United States.

If an individual does not have a tax home (as defined in section 911(d)(3)), the residence of such individual shall be the United States if such individual is a United States citizen or a resident alien and shall be a country other than the United States if such individual is not a United States citizen or resident alien. If the taxpayer is a U.S. person and has no principal place of business outside the United States, the residence of the taxpayer is the United States. Notwithstanding paragraph (d)(1)(ii) of this section, if a partnership is formed or availed of to avoid tax by altering the source of exchange gain or loss, the source of such gain or loss shall be determined by reference to the residence of the partners rather than the partnership.

(2) EXCEPTION. In the case of a qualified business unit of any taxpayer (including an individual), the residence of such unit shall be the country in which the principal place of business of such qualified business unit is located.

(3) PARTNER IN A PARTNERSHIP NOT ENGAGED IN A U.S. TRADE OR BUSINESS UNDER SECTION 864(b)(2). The determination of residence shall be made at the partner level (without regard to whether the partnership is a qualified business unit of the partners) in the case of partners in a partnership that are not engaged in a U.S. trade or business by reason of section 864(b)(2).

(e) SPECIAL RULE FOR CERTAIN RELATED PARTY LOANS -- (1) IN GENERAL. In the case of a loan by a United States person or a related person to a 10 percent owned foreign corporation, or a corporation that meets the 80 percent foreign business requirements test of section 861(c)(1), other than a corporation subject to section 1.861-11T(e)(2)(i), which is denominated in, or determined by reference to, a currency other than the U.S. dollar and bears interest at a rate at least 10 percentage points higher than the Federal mid-term rate (as determined under section 1274(d)) at the time such loan is entered into, the following rules shall apply --

(i) For purposes of section 904 only, such loan shall be marked to market annually on the earlier of the last business day of the United States person's (or related person's) taxable year or the date the loan matures; and

(ii) Any interest income earned with respect to such loan for the taxable year shall be treated as income from sources within the United States to the extent of any notional loss attributable to such loan under paragraph (d)(1)(i) of this section.

(2) UNITED STATES PERSON. For purposes of this paragraph (e), the term "United States person" means a person described in section 7701(a)(30).

(3) LOANS BY RELATED FOREIGN PERSONS -- (i) IN GENERAL. [Reserved]

(ii) DEFINITION OF RELATED PERSON. For purposes of this paragraph (e), the term "related person" has the meaning given such term by section 954(d)(3) except that such section shall be applied by substituting "United States person" for "controlled foreign corporation" each place such term appears.

(4) 10 PERCENT OWNED FOREIGN CORPORATION. For purposes of this paragraph (e), the term "10 percent owned foreign corporation" means any foreign corporation in which the United States person owns directly or indirectly (within the meaning of section 318(a)) at least 10 percent of the voting stock.

(f) EXCHANGE GAIN OR LOSS TREATED AS INTEREST UNDER SECTION 1.988-3. Notwithstanding the provisions of this section, any gain or loss realized on a section 988 transaction that is treated as interest income or expense under section 1.988-3(c)(1) shall be sourced or allocated and apportioned pursuant to section 861(a)(1), 862(a)(1), or 864(e) as the case may be.

(g) EXCHANGE GAIN OR LOSS ALLOCATED IN THE SAME MANNER AS INTEREST UNDER SECTION 1.861-9T. The allocation and apportionment of exchange gain or loss under section 1.861-9T shall not affect the source of exchange gain or loss for purposes of sections 871(a) 881, 1441, 1442 and 6049.

(h) EFFECTIVE DATE. This section shall be effective for taxable years beginning after December 31, 1986. Thus, any payments made or received with respect to a section 988 transaction in taxable years beginning after December 31, 1986, are subject to this section.

SECTION 1.988-5 SECTION 988(d) HEDGING TRANSACTIONS.

(a) INTEGRATION OF A NONFUNCTIONAL CURRENCY DEBT INSTRUMENT AND A SECTION 1.988-5(A) HEDGE -- (1) IN GENERAL. This paragraph (a) applies to a qualified hedging transaction as defined in this paragraph (a)(1). A qualified hedging transaction is an integrated economic transaction, as provided in paragraph (a)(5) of this section, consisting of a qualifying debt instrument as defined in paragraph (a)(3) of this section and a section 1.988-5(a) hedge as defined in paragraph (a)(4) of this section. If a taxpayer enters into a transaction that is a qualified hedging transaction, no exchange gain or loss is recognized by the taxpayer on the qualifying debt instrument or on the section 1.988-5(a) hedge for the period that either is part of a qualified hedging transaction, and the transactions shall be integrated as provided in paragraph (a)(9) of this section. However, if the qualified hedging transaction results in a synthetic nonfunctional currency denominated debt instrument, such instrument shall be subject to the rules of section 1.988-2(b).

(2) EXCEPTION. This paragraph (a) does not apply with respect to a qualified hedging transaction that creates a synthetic asset or liability denominated in, or determined by reference to, a currency other than the U.S. dollar if the rate that approximates the Federal short-term rate in such currency is at least 20 percentage points higher than the Federal short term rate (determined under section 1274(d)) on the date the taxpayer identifies the transaction as a qualified hedging transaction.

(3) QUALIFYING DEBT INSTRUMENT -- (i) IN GENERAL. A qualifying debt instrument is a debt instrument described in section 1.988-1(a)(2)(i), regardless of whether denominated in, or determined by reference to, nonfunctional currency (including dual currency debt instruments, multi-currency debt instruments and contingent payment debt instruments). A qualifying debt instrument does not include accounts payable, accounts receivable or similar items of expense or income.

(ii) SPECIAL RULE FOR DEBT INSTRUMENT OF WHICH ALL PAYMENTS ARE PROPORTIONATELY HEDGED. If a debt instrument satisfies the requirements of paragraph (a)(3)(i) of this section, and all principal and interest payments under the instrument are hedged in the same proportion, then for purposes of this paragraph (a), that portion of the instrument that is hedged is eligible to be treated as a qualifying debt instrument, and the rules of this paragraph (a) shall apply separately to such qualifying debt instrument. See Example 8 in paragraph (a)(9)(iv) of this section.

(4) SECTION 1.988-5(a) HEDGE -- (i) IN GENERAL. A section 1.988-5 (a) hedge (hereinafter referred to in this paragraph (a) as a "hedge") is a spot contract, futures contract, forward contract, option contract, notional principal contract, currency swap contract, similar financial instrument, or series or combination thereof, that when integrated with a qualifying debt instrument permits the calculation of a yield to maturity (under principles of section 1272) in the currency in which the synthetic debt instrument is denominated (as determined under paragraph (a)(9)(ii)(A) of this section).

(ii) RETROACTIVE APPLICATION OF DEFINITION OF CURRENCY SWAP CONTRACT. A taxpayer may apply the definition of currency swap contract set forth in section 1.988-2(e)(2)(ii) in lieu of the definition of swap agreement in section 2(e)(5) of Notice 87-11, 1987-1 C.B. 423 to transactions entered into after December 31, 1986 and before September 21, 1989.

(5) DEFINITION OF INTEGRATED ECONOMIC TRANSACTION. A qualifying debt instrument and a hedge are an integrated economic transaction if all of the following requirements are satisfied --

(i) All payments to be made or received under the qualifying debt instrument (or amounts determined by reference to a nonfunctional currency) are fully hedged on the date the taxpayer identifies the transaction under paragraph (a) of this section as a qualified hedging transaction such that a yield to maturity (under principles of section 1272) in the currency in which the synthetic debt instrument is denominated (as determined under paragraph (a)(9)(ii)(A) of this section) can be calculated. Any contingent payment features of the qualifying debt instrument must be fully offset by the hedge such that the synthetic debt instrument is not classified as a contingent payment debt instrument. See Examples 6 and 7 of paragraph (a)(9)(iv) of this section.

(ii) The hedge is identified in accordance with paragraph (a)(8) of this section on or before the date the acquisition of the financial instrument (or instruments) constituting the hedge is settled or closed.

(iii) None of the parties to the hedge are related. The term "related" means the relationships defined in section 267(b) or section 707(b).

(iv) In the case of a qualified business unit with a residence, as defined in section 988(a)(3)(B), outside of the United States, both the qualifying debt instrument and the hedge are properly reflected on the books of such qualified business unit throughout the term of the qualified hedging transaction.

(v) Subject to the limitations of paragraph (a)(5) of this section, both the qualifying debt instrument and the hedge are entered into by the same individual, partnership, trust, estate, or corporation. With respect to a corporation, the same corporation must enter into both the qualifying debt instrument and the hedge whether or not such corporation is a member of an affiliated group of corporations that files a consolidated return.

(vi) With respect to a foreign person engaged in a U.S. trade or business that enters into a qualifying debt instrument or hedge through such trade or business, all items of income and expense associated with the qualifying debt instrument and the hedge (other than interest expense that is subject to section 1.882-5), would have been effectively connected with such U.S. trade or business throughout the term of the qualified hedging transaction had this paragraph (a) not applied.

(6) SPECIAL RULES FOR LEGGING IN AND LEGGING OUT OF INTEGRATED TREATMENT -- (i) LEGGING IN. "Legging in" to integrated treatment under this paragraph (a) means that a hedge is entered into after the date the qualifying debt instrument is entered into or acquired, and the requirements of this paragraph (a) are satisfied on the date the hedge is entered into ("leg in date"). If a taxpayer legs into integrated treatment, the following rules shall apply --

(A) Exchange gain or loss shall be realized with respect to the qualifying debt instrument determined solely by reference to changes in exchange rates between --

(1) The date the instrument was acquired by the holder, or the date the obligor assumed the obligation to make payments under the instrument; and

(2) The leg in date.

(B) The recognition of such gain or loss will be deferred until the date the qualifying debt instrument matures or is otherwise disposed of.

(C) The source and character of such gain or loss shall be determined on the leg in date as if the qualifying debt instrument was actually sold or otherwise terminated by the taxpayer.

(ii) LEGGING OUT. With respect to a qualifying debt instrument and hedge that are properly identified as a qualified hedging transaction, "legging out" of integrated treatment under this paragraph (a) means that the taxpayer disposes of or otherwise terminates all or a part of the qualifying debt instrument or hedge prior to maturity of the qualified hedging transaction, or the taxpayer changes a material term of the qualifying debt instrument (e.g., exercises an option to change the interest rate or index, or the maturity date) or hedge (e.g., changes the interest or exchange rates underlying the hedge, or the expiration date) prior to maturity of the qualified hedging transaction. A taxpayer that disposes of or terminates a qualified hedging transaction (i.e., disposes of or terminates both the qualifying transaction and the hedge on the same day) shall be considered to have disposed of or otherwise terminated the synthetic debt instrument rather than as legging out. If a taxpayer legs out of integrated treatment, the following rules shall apply --

(A) The transaction will be treated as a qualified hedging transaction during the time the requirements of this paragraph (a) were satisfied.

(B) If the hedge is disposed of or otherwise terminated, the qualifying debt instrument shall be treated as sold for its fair market value on the date the hedge is disposed of or otherwise terminated (the "leg-out date"), and any gain or loss (including gain or loss resulting from factors other than movements in exchange rates) from the identification date to the leg-out date is realized and recognized on the leg-out date. The spot rate on the leg-out date shall be used to determine exchange gain or loss on the debt instrument for the period beginning on the leg-out date and ending on the date such instrument matures or is disposed of or otherwise terminated. Proper adjustment to the principal amount of the debt instrument must be made to reflect any gain or loss taken into account. The netting rule of section 1.988-2(b)(8) shall apply.

(C) If the qualifying debt instrument is disposed of or otherwise terminated, the hedge shall be treated as sold for its fair market value on the date the qualifying debt instrument is disposed of or otherwise terminated (the "leg-out date"), and any gain or loss from the identification date to the leg-out date is realized and recognized on the leg-out date. The spot rate on the leg-out date shall be used to determine exchange gain or loss on the hedge for the period beginning on the leg-out date and ending on the date such hedge is disposed of or otherwise terminated.

(D) Except as provided in paragraph (a)(8)(iii) of this section (regarding identification by the Commissioner), that part of the qualified hedging transaction that has not been terminated (i.e., the remaining debt instrument in its entirety even if partially hedged, or hedge) cannot be pert of a qualified hedging transaction for any period subsequent to the leg out date.

(E) If a taxpayer legs out of a qualified hedging transaction and realizes a gain with respect to the terminated instrument, then paragraph (a)(6)(ii)(B) or (C) of this section, as appropriate, shall not apply if during the period beginning 30 days before the leg-out date and ending 30 days after that date the taxpayer enters into another transaction that hedges at least 50% of the remaining currency flow with respect to the qualifying debt instrument which was part of the qualified hedging transaction (or, if appropriate, an equivalent amount under the section 1.988-5 hedge which was part of the qualified hedging transaction).

(7) TRANSACTIONS PART OF A STRADDLE. At the discretion of the Commissioner, a transaction shall not satisfy the requirements of paragraph (a)(5) of this section if the debt instrument making up the qualified hedging transaction is part of a straddle as defined in section 1092(c) prior to the time the qualified hedging transaction is identified.

(8) IDENTIFICATION REQUIREMENTS -- (i) IDENTIFICATION BY THE TAXPAYER. A taxpayer must establish a record and before the close of the date the hedge is entered into, the taxpayer must enter into the record for each qualified hedging transaction the following information --

(A) The date the qualifying debt instrument and hedge were entered into;

(B) The date the qualifying debt instrument and the hedge are identified as constituting a qualified hedging transaction;

(C) The amount that must be deferred, if any, under paragraph (a)(6) of this section and the source and character of such deferred amount;

(D) A description of the qualifying debt instrument and the hedge; and

(E) A summary of the cash flow resulting from treating the qualifying debt instrument and the hedge as a qualified hedging transaction.

(ii) IDENTIFICATION BY TRUSTEE ON BEHALF OF BENEFICIARY. A trustee of a trust that enters into a qualified hedging transaction may satisfy the identification requirements described in paragraph (a)(8)(i) of this section on behalf of a beneficiary of such trust.

(iii) IDENTIFICATION BY THE COMMISSIONER. If --

(A) A taxpayer enters into a qualifying debt instrument and a hedge but fails to comply with one or more of the requirements of this paragraph (a), and

(B) On the basis of all the facts and circumstances, the Commissioner concludes that the qualifying debt instrument and the hedge are, in substance, a qualified hedging transaction,

then the Commissioner may treat the qualifying debt instrument and the hedge as a qualified hedging transaction. The Commissioner may identify a qualifying debt instrument and a hedge as a qualified hedging transaction regardless of whether the qualifying debt instrument and the hedge are held by the same taxpayer.

(9) TAXATION OF QUALIFIED HEDGING TRANSACTIONS -- (i) IN GENERAL -- (A) GENERAL RULE. If a transaction constitutes a qualified hedging transaction, the qualifying debt instrument and the hedge are integrated and treated as a single transaction with respect to the taxpayer that has entered into the qualified hedging transaction during the period that the transaction qualifies as a qualified hedging transaction. Neither the qualifying debt instrument nor the hedge that makes up the qualified hedging transaction shall be subject to section 263(g), 1092 or 1256 for the period such transactions are integrated. However, the qualified hedging transaction may be subject to section 263(g) or 1092 if such transaction is part of a straddle.

(B) SPECIAL RULE FOR INCOME OR EXPENSE OF FOREIGN PERSONS EFFECTIVELY CONNECTED WITH A U.S. TRADE OR BUSINESS. Interest income of a foreign person resulting from a qualified hedging transaction entered into by such foreign person that satisfies the requirements of paragraph (a)(5)(vii) of this section shall be treated as effectively connected with a U.S. trade or business. Interest expense of a foreign person resulting from a qualified hedging transaction entered into by such foreign person that satisfies the requirements of paragraph (a)(5)(vii) of this section shall be allocated and apportioned under section 1.882-5 of the regulations.

(C) SPECIAL RULE FOR FOREIGN PERSONS THAT ENTER INTO QUALIFIED HEDGING TRANSACTIONS GIVING RISE TO U.S. SOURCE INCOME NOT EFFECTIVELY CONNECTED WITH A U.S. TRADE OR BUSINESS. If a foreign person enters into a qualified hedging transaction that gives rise to U.S. source interest income (determined under the source rules for synthetic asset transactions as provided in this section) not effectively connected with a U.S. trade or business of such foreign person, for purposes of sections 871(a), 881, 1441, 1442 and 6049, the provisions of this paragraph (a) shall not apply and such sections of the Internal Revenue Code shall be applied separately to the qualifying debt instrument and the hedge. To the extent relevant to any foreign person, if the requirements of this paragraph (a) are otherwise met, the provisions of this paragraph (a) shall apply for all other purposes of the Internal Revenue Code (e.g., for purposes of calculating the earnings end profits of a controlled foreign corporation that enters into a qualified hedging transaction through a qualified business unit resident outside the United States, income or expense with respect to such qualified hedging transaction shall be calculated under the provisions of this paragraph (a)).

(ii) INCOME TAX EFFECTS OF INTEGRATION. The effect of integrating and treating a transaction as a single transaction is to create a synthetic debt instrument for income tax purposes, which is subject to the original issue discount provisions of sections 1272 through 1288 and 163(e), the terms of which are determined as follows:

(A) DENOMINATION OF SYNTHETIC DEBT INSTRUMENT. In the case where the qualifying debt instrument is a borrowing, the denomination of the synthetic debt instrument is the same as the currency paid under the terms of the hedge to acquire the currency used to make payments under the qualifying debt instrument. In the case where the qualifying debt instrument is a lending, the denomination of the synthetic debt instrument is the same as the currency received under the terms of the hedge in exchange for amounts received under the qualifying debt instrument. For example, if the hedge is a forward contract to acquire British pounds for dollars, and the qualifying debt instrument is a borrowing denominated in British pounds, the synthetic debt instrument is considered a borrowing in dollars.

(B) TERM AND ACCRUAL PERIODS. The term of the synthetic debt instrument shall be the period beginning on the identification date and ending on the date the qualifying debt instrument matures or such earlier date that the qualifying debt instrument or hedge is disposed of or otherwise terminated. Unless otherwise clearly indicated by the payment interval under the hedge, the accrual period shall be a six month period which ends on the dates determined under section 1272(a)(5).

(C) ISSUE PRICE. The issue price of the synthetic debt instrument is the adjusted issue price of the qualifying debt instrument translated into the currency in which the synthetic debt instrument is denominated at the spot rate on the identification date.

(D) STATED REDEMPTION PRICE AT MATURITY. In the case where the qualifying debt instrument is a borrowing, the stated redemption price at maturity shall be determined under section 1273(a)(2) on the identification date by reference to the amounts to be paid under the hedge to acquire the currency necessary to make interest and principal payments on the qualifying debt instrument. In the case where the qualifying debt instrument is a lending, the stated redemption price at maturity shall be determined under section 1273(a)(2) on the identification date by reference to the amounts to be received under the hedge in exchange for the interest and principal payments received pursuant to the terms of the qualifying debt instrument.

(iii) SOURCE OF INTEREST INCOME AND ALLOCATION OF EXPENSE. Interest income from a synthetic debt instrument described in paragraph (a)(9)(ii) of this section shall be sourced by reference to the source of income under sections 861(a)(1) and 862(a)(1) of the qualifying debt instrument. The character for purposes of section 904 of interest income from a synthetic debt instrument shall be determined by reference to the character of the interest income from qualifying debt instrument. Interest expense from a synthetic debt instrument described in paragraph (a)(9)(ii) of this section shall be allocated and apportioned under sections 1.861-8T through 1.861-12T or the successor sections thereof or under section 1.882-5.

(iv) EXAMPLES. The following examples illustrate the application of this paragraph (a)(9).

EXAMPLE 1. (i) K is a U.S. corporation with the U.S. dollar as its functional currency. On December 24, 1989, K agrees to close the following transaction on December 31, 1989. K will borrow from an unrelated party on December 31, 1989, 100 British pounds ([pound sign = Bp]) for 3 years at a 10 percent rate of interest, payable annually, with no principal payment due until the final installment. K will also enter into a currency swap contract with an unrelated counterparty under the terms of which --

(a) K will swap, on December 31, 1989, the Bp100 obtained from the borrowing for $100; and

(b) K will exchange dollars for pounds pursuant to the following table in order to obtain the pounds necessary to make payments on the pound borrowing:

      DATE                     U.S. Dollars        Pounds

(iii) The pound borrowing (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly, the pound borrowing and the swap are integrated and treated as one transaction with the following consequences:

(A) The integration of the pound borrowing and the swap results in a synthetic dollar borrowing with an issue price of $100 under section 1273(b)(2).

(B) The total amount of interest and principal of the synthetic dollar borrowing is equal to the dollar payments made by K under the currency swap contract (i.e., $8 in 1990, $8 in 1991, and $108 in 1992).

(C) The stated redemption price at maturity (defined in section 1273(a)(2)) is $100. Because the stated redemption price equals the issue price, there is no OID on the synthetic dollar borrowing.

(D) K may deduct the annual interest payments of $8 under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) according to its regular method of accounting. K has also paid $100 as a return of principal in 1992.

(E) K must allocate and apportion its interest expense with respect to the synthetic dollar borrowing under the rules of sections 1.861-8T through 1.861-12T.

EXAMPLE 2. (i) K a U.S. corporation, has the U.S. dollar as its -- functional currency. On December 24, 1989, when the spot rate for Swiss francs (Sf) is Sf1 = $1, K enters into a forward contract to purchase Sf100 in exchange for $100.04 for delivery on December 31, 1989. The Sf100 are to be used for the purchase of a franc denominated debt instrument on December 31, 1989. The instrument will have a term of 3 years, an issue price of Sf100, and will bear interest at 6 percent, payable annually, with no repayment of principal until the final installment. On December 24, 1989, K also enters into a series of forward contracts to sell the franc interest and principal payments that will be received under the terms of the franc denominated debt instrument for dollars according to the following schedule:

     Date                     U.S. dollars        Francs

(A) The integration of the franc debt instrument and the forward contracts results in a synthetic dollar debt instrument in an amount equal to the dollars exchanged under the forward contract to purchase the francs necessary to acquire the franc debt instrument. Accordingly, the issue price is $100.04 (section 1273(b)(2) of the Code).

(B) The total amount of interest and principal received by K with respect to the synthetic dollar debt instrument is equal to the dollars received under the forward sales contracts (i.e., $6.12 in 1990, $6.23 in 1991, and $112.16 in 1992).

(C) The synthetic dollar debt instrument is an installment obligation and its stated redemption price at maturity is $106.15 (i.e., $6.12 of the payments in 1990, 1991, and 1992 are treated as periodic interest payments under the principles of section 1273). Because the stated redemption price at maturity exceeds the issue price, under section 1273(a)(1) the synthetic dollar debt instrument has OID of $6.11.

(D) The yield to maturity of the synthetic dollar debt instrument is 8.00 percent, compounded annually. Assuming K is a calendar year taxpayer, it must include interest income of $8.00 in 1990 (of which $1.88 constitutes OID), $8.15 in 1991 (of which $2.03 constitutes OID), and $8.32 in 1992 (of which $2.20 constitutes OID). The amount of the final payment received by K in excess of the interest income includible is a return of principal and a payment of previously accrued OID.

(E) The source of the interest income shall be determined by applying sections 861(a)(1) and 862(a)(1) with reference to the franc interest income that would have been received had the transaction not been integrated.

EXAMPLE 3. (i) K is an accrual method U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1992, K borrows 100 British pounds ([pound sign = Bp]) for 3 years at a 10% rate of interest payable on December 31 of each year with no principal payment due until the final installment. The spot rate on January 1, 1992, is Bp = $1.50. On January 1, 1993, when the spot rate is Bp = $1.60, K enters into a currency swap contract with an unrelated counterparty under the terms of which K will exchange dollars for pounds pursuant to the following table in order to obtain the pounds necessary to make the remaining payments on the pound borrowing:

 DATE                     U.S. Dollars        Pounds

(iii) Additionally, the qualified hedging transaction is treated as a synthetic U.S. dollar debt instrument with an issue date of January 1, 1993, and a maturity date of December 31, 1994. The issue price of the synthetic debt instrument is 8160 (BP100 x 1.60, the spot rate on January 1, 1993) and the total amount of interest and principal is $185.60. The accrual period is the one year period beginning on January 1 and ending December 31 of each year. The stated redemption price at maturity is $160. Thus, K is treated as paying $12.80 of interest in 1993, $12.80 of interest in 1994, and $160 of principal in 1994. The interest expense from the synthetic instrument is allocated and apportioned in accordance with the rules of sections 1.861-8T through 1.861-12T. Sections 263(g), 1092, and 1256 do not apply to the positions comprising the synthetic dollar borrowing.

EXAMPLE 4. (i) K is an accrual method U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1990, K borrows 100 British pounds (BP) for 3 years at a 10% rate of interest payable on December 31 of each year with no principal payment due until the final installment. The spot rate on January 1, 1990, is BP1 = $1.50. Also on January 1, 1990, K enters into a currency swap contract with an unrelated counterparty under the terms of which K will exchange dollars for pounds pursuant to the following table in order to obtain the pounds necessary to make the remaining payments on the pound borrowing:

 DATE                      U.S. Dollars          Pounds

(iii) The pound borrowing (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly, the pound borrowing and the swap are integrated and treated as one transaction with the following consequences:

(A) The integration of the pound borrowing and the swap results in a synthetic dollar borrowing with an issue price of $150 under section 1273(b)(2).

(B) The total amount of interest and principal of the synthetic dollar borrowing is equal to the dollar payments made by K under the currency swap contract (i.e., $12 in 1990, $12 in 1991, and $162 in 1992).

(C) The stated redemption price at maturity (defined in section 1273(a)(2)) is $150. Because the stated redemption price equals the issue price, there is no OID on the synthetic dollar borrowing.

(D) K may deduct the annual interest payments of $12 under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) according to its regular method of accounting. K has also paid $150 as a return of principal in 1992.

(E) K must allocate and apportion its interest expense from the synthetic instrument under the rules of sections 1.861-8T through 1.861-12T.

(iv) Assume that on January 1, 1991, the spot exchange rate is BP1 = $1.60, interest rates have not changed since January 1, 199O,(accordingly, assume that the market value of K's bond in pounds has not changed) and that K transfers its rights and obligations under the currency swap contract in exchange for $10. Under section 1.988-2(e)(3)(iii), K will include in income as exchange gain $10 on January 1, 1991. Pursuant to paragraph (a)(6)(ii) of this section, the pound borrowing and the currency swap contract are treated as a qualified hedging transaction for 1990. The loss inherent in the pound borrowing from January 1, 1990, to January 1, 1991, is realized and recognized on January 1, 1991. Such loss is exchange loss in the amount of $10.00 [(BP100 x $1.50, the spot rate on January 1, 1990) - (BP100 x $1.60, the spot rate on January 1, 1991)]. For purposes of determining exchange gain or loss on the BP100 principal amount of the debt instrument for the period January 1, 1991, to December 31, 1992, the spot rate on January 1, 1991 is used rather than the spot rate on the issue date. Thus, assuming that the spot rate on December 31, 1992, the maturity date, is BP1 = $1.80, K realizes exchange loss in the amount of $20 [(BP100 x $1.60) - (BP100 x $1.80)]. Except as provided in paragraph (a)(8)(iii) (regarding identification by the Commissioner), the pound borrowing cannot be part of a qualified hedging transaction for any period subsequent to the leg out date.

EXAMPLE 5. (i) K, a U.S. corporation, has the U.S. dollar as its functional currency. On January 1, 1990, when the spot rate for Swiss francs (Sf) is Sf1 = $.50, K converts $100 to Sf200 and purchases a franc denominated debt instrument. The instrument has a term of 3 years, an adjusted issue price of Sf200, and will bear interest at 5 percent, payable annually, with no repayment of principal until the final installment. The U.S. dollar interest rate on an equivalent instrument is 8% on January 1, 1990, compounded annually. On January 1, 1990, K also enters into a series of forward contracts to sell the franc interest and principal payments that will be received under the terms of the franc denominated debt instrument for dollars according to the following schedule:

 Date                       U.S. dollars          Francs

(iii) The purchase of the franc debt instrument (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the series of forward contracts (which constitute a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction under paragraph (a)(1) of this section. Accordingly, the franc debt instrument and all the forward contracts are integrated for the period beginning January 1, 1990, and ending January 1, 1991.

(A) The integration of the franc debt instrument and the forward contracts results in a synthetic dollar debt instrument with an issue price of $100.

(B) The total amount of interest and principal to be received by K with respect to the synthetic dollar debt instrument is equal to the dollars to be received under the forward sales contracts (i.e., $5.14 in 1990, $5.29 in 1991, and $114.26 in 1992).

(C) The synthetic dollar debt instrument is an installment obligation and its stated redemption price at maturity is $109.27 (i.e., $5.14 of the payments in 1990, 1991, and 1992 is treated as periodic interest payments under the principles of section 1273). Because the stated redemption price at maturity exceeds the issue price, under section 1273(a)(1) the synthetic dollar debt instrument has OID of $9.27.

(D) The yield to maturity of the synthetic dollar debt instrument is 8.00 percent, compounded annually. Assuming K is a calendar year taxpayer, it must include interest income of $8.00 in 1990 (of which $2.86 constitutes OID).

(E) The source of the interest income is determined by applying sections 861(a)(1) and 862(a)(1) with reference to the franc interest income that would have been received had the transaction not been integrated.

(iv) Because K disposed of the forward contracts on January 1, 1991, the rules of paragraph (a)(6)(ii) of this section shall apply. Accordingly, the $3.62 loss from the disposition of the forward contracts is realized and recognized on January 1, 1991. Additionally, K is deemed to have sold the franc debt instrument for $102.86, its fair market value in dollars on January 1, 1991. K will compute gain or loss with respect to the deemed sale of the franc debt instrument by subtracting its adjusted basis in the instrument ($102.86 -- the value of the Sf200 issue price at the spot rate on the identification date plus $2.86 of original issue discount accrued on the synthetic dollar debt instrument for 1990) from the amount realized on the deemed sale of $102.86. Thus K realizes and recognizes no gain or loss from the deemed sale of the debt instrument. The dollar amount used to determine exchange gain or loss with respect to the franc debt instrument is the Sf200 issue price on January 1, 1991, translated into dollars at the spot rate on January 1, 1991, of Sf1 = U.S.$0.5143. Except as provided in paragraph (a)(8)(iii) of this section (regarding identification by the Commissioner), the franc borrowing cannot be part of a qualified hedging transaction for any period subsequent to the leg out date.

EXAMPLE 6. (i) K is a U.S. corporation with the dollar as its functional currency. On January 1, 1992, K issues a debt instrument with the following terms: the issue price is $1,000, the instrument pays interest annually at a rate of 8% on the $1,000 principal amount, the instrument matures on December 31, 1996, and the amount paid at maturity is the greater of zero or $2,000 less the U.S. dollar value (determined on December 31, 1996) of 150,000 Japanese yen.

(ii) Also on January 1, 1992, K enters into the following hedges with respect to the instrument described in the preceding paragraph: a forward contract under which K will sell 150,000 yen for $1,000 on December 31, 1996 (note that this forward rate assumes that interest rates in yen and dollars are equal); and an option contract that expires on December 31, 1996, under which K has the right (but not the obligation) to acquire 150,000 yen for $2,000. K will pay for the option by making payments to the writer of the option equal to $5 each December 31 from 1992 through 1996.

(iii) The net economic effect of these transactions is that K has created a liability with a principal amount and amount paid at maturity of $1,000, with an interest cost of 8.5% (8% on debt instrument, 0.5% option price) compounded annually. For example, if on December 31, 1996, the spot exchange rate is $1 = 100 yen, K pays $500 on the bond [$2,000 - (150,000 yen/$100)], and $500 in satisfaction of the forward contract [$1,000 - (150,000 yen/$100)]. If instead the spot exchange rate on December 31, 1996 is $1 = 200 yen, K pays $1,250 on the bond [$2,000 - (150,000 yen/$200)] and K receives $250 in satisfaction of the forward contract [$1,000 - (150,000 yen/$200)]. Finally, if the spot exchange rate on December 31, 1996 is $1 = 50 yen, K pays $0 on the bond [$2,000 - (150,000 yen/$50], but the bond holder is not required under the terms of the instrument to pay additional principal]; K exercises the option to buy 150,000 yen for $2,000; and K then delivers the 150,000 yen as required by the forward contract in exchange for $1,000.

(iv) Assume K satisfies the identification requirements of paragraph (a)(8) of this section. The debt instrument described in paragraph (i) of this EXAMPLE 6 (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the forward contract and option contract described in paragraph (ii) of this example (which constitute a hedge under paragraph (a)(4) of this section and are collectively referred to hereafter as "the contracts") together are a qualified hedging transaction under paragraph (a)(1) of this section. Accordingly, with respect to K, the debt instrument and the contracts are integrated, resulting in a synthetic dollar debt instrument with an issue price of $1000, a stated redemption price at maturity of $1000 and a yield to maturity of 8.5% compounded annually (with no original issue discount). K must allocate and apportion its annual interest expense of $85 under the rules of sections 1.861-8T through 1.861-12T.

EXAMPLE 7. (i) R is a U.S. corporation with the dollar as its functional currency. On January 1, 1995, R issues a debt instrument with the following terms: the issue price is 504 British pounds (BP), the instrument pays interest at a rate of 3.7% (compounded semi-annually) on the 504 british pounds principal amount, the instrument matures on December 31, 1999, with a repayment at maturity of the BP504 principal plus the proportional gain, if any, in the "Financial Times" 100 Stock Exchange (FTSE) index (determined by the excess of the value of the FTSE index on the maturity date over the value of the FTSE on the issue date, divided by the value of the FTSE index on the issue date, multiplied by the number of FTSE index contracts that could be purchased on the issue date for BP504).

(ii) Also on January 1, 1995, R enters into a contract with a bank under which on January 1, 1995, R will swap the 504 British pounds for $1,000 (at the current spot rate). R will make U.S. dollar payments to the bank equal to 8.15% on the notional principal amount of $1,000 (compounded semi-annually) for the period beginning January 1, 1995 and ending December 31, 1999. R will receive pound payments from the bank equal to 3.7% on the notional principal amount of 504 British pounds (compounded semi-annually) for the period beginning January 1, 1995 and ending December 31, 1999. On December 31, 1999, R will swap with the bank $1,000 for BP504 plus the proportional gain, if any, in the FTSE index (computed as provided above).

(iii) Economically, both the indexed debt instrument and the hedging contract are hybrid instruments with the following components. The indexed debt instrument is composed of a par pound debt instrument that is assumed to have a 10.85% coupon (compounded semi-annually) plus an embedded FTSE equity index option for which the investor pays a premium of 7.15% (amortized semi-annually) on the pound principal amount. The combined effect is that the premium paid by the investor partially offsets the coupon payments resulting in a return of 3.7% (10.85% - 7.15%). Similarly, the dollar payments under the hedging contract to be made by R are computed by multiplying the dollar notional principal amount by an 8.00% rate (compounded semi-annually) which the facts assume would be the rate paid on a conventional currency swap plus a premium of 0.15% (amortized semi-annually) on the dollar notional principal amount for an embedded FTSE equity index option.

(iv) Assume R satisfies the identification requirements of paragraph (a)(8) of this section. The indexed debt instrument described in paragraph (i) of this EXAMPLE 7 constitutes a qualifying debt instrument under paragraph (a)(3) of this section. The hedging contract described in paragraph (ii) of this EXAMPLE 7 constitutes a hedge under paragraph (a)(4) of this section. Since both the pound exposure of the indexed debt instrument and the exposure to movements of the FTSE embedded in the indexed debt instrument are hedged such that a yield to maturity can be determined in dollars, the transaction satisfies the requirement of paragraph (a)(5)(i) of this section. Assuming the transactions satisfy the other requirements of paragraph (a)(5) of this section, the indexed debt instrument and hedge are a qualified hedging transaction under paragraph (a)(1) of this section. Accordingly, with respect to R, the debt instrument and the contracts are integrated, resulting in a synthetic dollar debt instrument with an issue price of $1000, a stated redemption price at maturity of $1000 and a yield to maturity of 8.15% compounded semi-annually (with no original issue discount). K must allocate and apportion its interest expense from the synthetic instrument under the rules sections 1.861-8T through 1.861-12T.

EXAMPLE 8. (i) K is a U.S. corporation with the U.S. dollar as its functional currency. On December 24, 1992, K agrees to close the following transaction on December 31, 1992. K will borrow from an unrelated party on December 31, 1992, 200 British pounds (BP) for 3 years at a 10 percent rate of interest, payable annually, with no principal payment due until the final installment. K will also enter into a currency swap contract with an unrelated counterparty under the terms of which --

(A) K will swap, on December 31, 1992, BP1000 obtained from the borrowing for $100; and

(B) K will exchange dollars for pounds pursuant to the following table:

 DATE                     U.S. Dollars            Pounds

(iii) The BP200 debt instrument satisfies the requirements of paragraph (a)(3)(i) of this section. Because all principal and interest payments under the instrument are hedged in the same proportion (50% of all interest and principal payments are hedged), 50% of the payments under the BP200 instrument (principal amount of BP100 and annual interest of BP10) are treated as a qualifying debt instrument for purposes of paragraph (a) of this section. Thus, the distinct BP100 borrowing and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly BP100 of the pound borrowing and the swap are integrated and treated as one synthetic dollar transaction with the following consequences:

(A) The integration of BP100 of the pound borrowing and the swap results in a synthetic dollar borrowing with an issue price of $100 under section 1273(b)(2).

(B) The total amount of interest and principal of the synthetic dollar borrowing is equal to the dollar payments made by K under the currency swap contract (i.e., $8 in 1993, $8 in 1994, and $108 in 1995).

(C) The stated redemption price at maturity (defined in section 1273(a)(2)) is $100. Because the stated redemption price equals the issue price, there is no OID on the synthetic dollar borrowing.

(D) K may deduct the annual interest payments of $8 under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) according to its regular method of accounting. K has also paid $100 as a return of principal in 1995.

(E) K must allocate and apportion its interest expense from the synthetic instrument under the rules of sections 1.861-8T through 1.861-12T.

That portion of the BP200 debt instrument that is not hedged (i.e., BP100) is treated as a separate debt instrument subject to the rules of section 1.988-2(b) and sections 1.861-8T through 1.861-12T.

EXAMPLE 9. (i) K is an accrual method U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1992, K borrows 100 British pounds (BP) for 3 years at a 10% rate of interest payable on December 31 of each year with no principal payment due until the final installment. On the same day, K enters into a currency swap agreement with an unrelated bank under which K agrees to the following:

(A) On January 1, 1992, K will exchange the BP100 borrowed for $150.

(B) For the period beginning January 1, 1992 and ending December 31, 1994, K will pay at the end of each month an amount determined by multiplying $150 by one month LIBOR less 65 basis points and receive from the bank on December 31st Of 1992, 1993, and 1994, BP10.

(C) On December 31, 1994, K will exchange $150 for BP100.

Assume K satisfies the identification requirements of paragraph (a)(8) of this section.

(ii) The pound borrowing (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly, the pound borrowing and the swap are integrated and treated as one transaction with the following consequences:

(A) The integration of the pound borrowing and the swap results in a synthetic dollar borrowing with an issue price of $150 under section 1273(b)(2).

(B) The total amount of interest and principal of the synthetic dollar borrowing is equal to the dollar payments made by K under the currency swap contract.

(C) The stated redemption price at maturity (defined in section 1273(a)(2)) is $150. Because the stated redemption price equals the issue price, there is no OID on the synthetic dollar borrowing.

(D) K may deduct the monthly variable interest payments under section 163(a) (subject to any limitations on deductibility imposed by other provisions of the Code) according to its regular method of accounting. K has also paid $150 as a return of principal in 1994.

(E) K must allocate and apportion its interest expense from the synthetic instrument under the rules of sections 1.861-8T through 1.861-12T.

EXAMPLE 10. (i) K is an accrual method U.S. corporation with the U.S. dollar as its functional currency. On January 1, 1992, K loans 100 British pounds (BP) for 3 years at a 10% rate of interest payable on December 31 of each year with no principal payment due until the final installment. The spot rate on January 1, 1992, is BP1 = $1.50. Also on January 1, 1992, K enters into a currency swap contract with an unrelated counterparty under the terms of which K will exchange pounds for dollars pursuant to the following table:

 DATE                         Pounds             Dollars

(iii) The pound loan (which constitutes a qualifying debt instrument under paragraph (a)(3) of this section) and the currency swap contract (which constitutes a hedge under paragraph (a)(4) of this section) are a qualified hedging transaction as defined in paragraph (a)(1) of this section. Accordingly, the pound loan and the swap are integrated and treated as one transaction with the following consequences:

(A) The integration of the pound loan and the swap results in a synthetic dollar loan with an issue price of $150 under section 1273(b)(2).

(B) The total amount of interest and principal of the synthetic dollar loan is equal to the dollar payments received by K under the currency swap contract (i.e., $12 in 1992, $12 in 1993, and $162 in 1994).

(C) The stated redemption price at maturity (defined in section 1273(a)(2)) is $150. Because the stated redemption price equals the issue price, there is no OID on the synthetic dollar loan.

(D) K must include in income as interest $12 in 1992, 1993, and 1994.

(E) The source of the interest income shall be determined by applying sections 861(a)(1) and 862(a)(1) with reference to the pound interest income that would have been received had the transaction not been integrated.

(iv) On January 1, 1993, K transfers both the pound loan and the currency swap to B, its wholly owned U.S. subsidiary, in exchange for B stock in a transfer that satisfies the requirements of section 351. Under paragraph (a)(6) of this section, the transfer of both instruments is not "legging out." Rather, K is considered to have transferred the synthetic dollar loan to B in a transaction in which gain or loss is not recognized. B's basis in the loan under section 362 is $100.

(10) TRANSITION RULES AND EFFECTIVE DATES FOR CERTAIN PROVISIONS -- (i) COORDINATION WITH NOTICE 87-11. Any transaction entered into prior to September 21, 1989 which satisfied the requirements of Notice 87-11, 1987-1 C.B. 423, shall be deemed to satisfy the requirements of paragraph (a) of this section.

(ii) PROSPECTIVE APPLICATION TO CONTINGENT PAYMENT DEBT INSTRUMENTS. In the case of a contingent payment debt instrument, the definition of qualifying debt instrument set forth in paragraph (a)(3)(i) of this section applies to transactions entered into after [DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER].

(iii) PROSPECTIVE APPLICATION OF PARTIAL HEDGING RULE. Paragraph (a)(3)(ii) of this section is effective for transactions entered into after [DATE THESE REGULATION ARE PUBLISHED IN THE FEDERAL REGISTER].

(iv) EFFECTIVE DATE FOR PARAGRAPH (a)(6)(i) of this section. The rules of paragraph (a)(6)(i) of this section are effective for qualified hedging transactions that are legged into after [DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER].

(b) HEDGED EXECUTORY CONTRACTS -- (1) IN GENERAL. If the taxpayer enters into a hedged executory contract as defined in paragraph (b)(2) of this section, the executory contract and the hedge shall be integrated as provided in paragraph (b)(4) of this section.

(2) DEFINITIONS -- (i) HEDGED EXECUTORY CONTRACT. A hedged executory contract is an executory contract as defined in paragraph (b)(2)(ii) of this section that is the subject of a hedge as defined in paragraph (b)(2)(iii) of this section, provided that the following requirements are satisfied --

(A) The executory contract and the hedge are identified as a hedged executory contract as provided in paragraph (b)(3) of this section.

(B) The hedge is entered into (i.e., settled or closed, or in the case of nonfunctional currency deposited in a account with a bank or other financial institution, such currency is acquired and deposited) on or after the date the executory contract is entered into and before the accrual date as defined in paragraph (b)(2)(iv) of this section.

(C) The executory contract is hedged in whole or in part throughout the period beginning with the date the hedge is identified in accordance with paragraph (b)(3) of this section and ending on or after the accrual date.

(D) None of the parties to the hedge are related. The term related means the relationships defined in section 267(b) and section 707(c)(1).

(E) In the case of a qualified business unit with a residence, as defined in section 988(a)(3)(B), outside of the United States, both the executory contract and the hedge are properly reflected on the books of the same qualified business unit.

(F) Subject to the limitations of paragraph (b)(2)(i)(E) of this section, both the executory contract and the hedge are entered into by the same individual, partnership, trust, estate, or corporation. With respect to a corporation, the same corporation must enter into both the executory contract and the hedge whether or not such corporation is a member of an affiliated group of corporations that files a consolidated return.

(G) With respect to a foreign person engaged in a U.S. trade or business that enters into an executory contract or hedge through such trade or business, all items of income and expense associated with the executory contract and the hedge would have been effectively connected with such U.S. trade or business throughout the term of the hedged executory contract had this paragraph (b) not applied.

(ii) EXECUTORY CONTRACT -- (A) IN GENERAL. Except as provided in paragraph (b)(2)(ii)(B) of this section, an executory contract is an agreement entered into before the accrual date to pay nonfunctional currency (or an amount determined with reference thereto) in the future with respect to the purchase of property used in the ordinary course of the taxpayer's business, or the acquisition of a service (or services), in the future, or to receive nonfunctional currency (or an amount determined with reference thereto) in the future with respect to the sale of property used or held for sale in the ordinary course of the taxpayer's business, or the performance of a service (or services), in the future. Notwithstanding the preceding sentence, a contract to buy or sell stock shall be considered an executory contract. (Thus, for example, a contract to sell stock of an affiliate is an executory contract for this purpose.) On the accrual date, such agreement ceases to be considered an executory contract and is treated as an account payable or receivable.

(B) EXCEPTIONS. An executory contract does not include a section 988 transaction. For example, a forward contract to purchase nonfunctional currency is not an executory contract. An executory contract also does not include a transaction described in paragraph (c) of this section.

(C) EFFECTIVE DATE FOR CONTRACTS TO BUY OR SELL STOCK. That part of paragraph (b)(2)(ii)(A) of this section which provides that a contract to buy or sell stock shall be considered an executory contract applies to contracts to buy or sell stock entered into on or after [DATE THESE REGULATIONS ARE PUBLISHED IN THE FEDERAL REGISTER].

(iii) HEDGE -- (A) IN GENERAL. For purposes of this paragraph (b), the term hedge means a deposit of nonfunctional currency in a hedging account (as defined paragraph (b)(3)(iii)(D) of this section), a forward or futures contract described in section 1.988-1(a)(1)(ii) and (2)(iii), or combination thereof, which reduces the risk of exchange rate fluctuations by reference to the taxpayer's functional currency with respect to nonfunctional currency payments made or received under an executory contract. The term hedge also includes an option contract described in section 1.988-1(a)(1)(ii) and (2)(iii), but only if the option's expiration date is on or before the accrual date. The premium paid for an option that lapses shall be integrated with the executory contract.

(B) SPECIAL RULE FOR SERIES OF HEDGES. A series of hedges as defined in paragraph (b)(3)(iii)(A) of this section shall be considered a hedge if the executory contract is hedged in whole or in part throughout the period beginning with the date the hedge is identified in accordance with paragraph (b)(3)(i) of this section and ending on or after the accrual date. A taxpayer that enters into a series of hedges will be deemed to have satisfied the preceding sentence if the hedge that succeeds a hedge that has been terminated is entered into no later than the business day following such termination.

(C) SPECIAL RULES FOR HISTORICAL RATE ROLLOVERS -- (1) DEFINITION. A historical rate rollover is an extension of the maturity date of a forward contract where the new forward rate is adjusted on the rollover date to reflect the taxpayer's gain or loss on the contract as of the rollover date plus the time value of such gain or loss through the new maturity date.

(2) CERTAIN HISTORICAL RATE ROLLOVERS CONSIDERED A HEDGE. A historical rate rollover is considered a hedge if the rollover date is before the accrual date.

(3) TREATMENT OF TIME VALUE COMPONENT OF CERTAIN HISTORICAL RATE ROLLOVERS THAT ARE HEDGES. Interest income or expense determined under section 1.988-2(d)(2)(v) with respect to a historical rate rollover shall be considered part of a hedge if the period beginning on the first date a hedging contract is rolled over and ending on the date payment is made or received under the executory contract does not exceed 183 days. Such interest income or expense shall not be recognized and shall be an adjustment to the income from, or expense of, the services performed or received under the executory contract, or to the amount realized or basis of the property sold or purchased under the executory contract. For the treatment of such interest income or expense that is not considered part of a hedge, see section 1.988-2(d)(2)(v).

(D) SPECIAL RULES REGARDING DEPOSITS OF NONFUNCTIONAL CURRENCY IN A HEDGING ACCOUNT. A hedging account is an account with a bank or other financial institution used exclusively for deposits of nonfunctional currency used to hedge executory contracts. For purposes of determining the basis of units in such account that comprise the hedge, only those units in the account as of the accrual date shall be taken into consideration. A taxpayer may adopt any reasonable convention (consistently applied to all hedging accounts) to determine which units comprise the hedge as of the accrual date and the basis of the units as of such date.

(E) INTEREST INCOME ON DEPOSIT OF NONFUNCTIONAL CURRENCY IN A HEDGING ACCOUNT. Interest income on a deposit of nonfunctional currency in a hedging account may be taken into account for purposes of determining the amount of a hedge if such interest is accrued on or before the accrual date. However, such interest income shall be included in income as provided in section 61. For example, if a taxpayer with the dollar as its functional currency enters into an executory contract for the purchase and delivery of a machine in one year for 100 British pounds (BP), and on such date deposits BP90.91 in a properly identified bank account that bears interest at the rate of 10%, the interest that accrues prior to the accrual date shall be included in income and may be considered a hedge.

(iv) ACCRUAL DATE. The accrual date is the date when the item of income or expense (including a capital expenditure) that relates to an executory contract is required to be accrued under the taxpayer's method of accounting.

(v) PAYMENT DATE. The payment date is the date when payment is made or received with respect to an executory contract or the subsequent corresponding account payable or receivable.

(3) IDENTIFICATION RULES -- (i) IDENTIFICATION BY THE TAXPAYER. A taxpayer must establish a record and before the close of the date the hedge is entered into, the taxpayer must enter into the record a clear description of the executory contract and the hedge and indicate that the transaction is being identified in accordance with paragraph (b)(3) of this section.

(ii) IDENTIFICATION BY THE COMMISSIONER. If a taxpayer enters into an executory contract and a hedge but fails to satisfy one or more of the requirements of paragraph (b) of this section and, based on the facts and circumstances, the Commissioner concludes that the executory contract in substance is hedged, then the Commissioner may apply the provisions of paragraph (b) of this section as if the taxpayer had satisfied all of the requirements therein, and may make appropriate adjustments. The Commissioner may apply the provisions of paragraph (b) of this section regardless of whether the executory contract and the hedge are held by the same taxpayer.

(4) EFFECT OF HEDGED EXECUTORY CONTRACT -- (i) IN GENERAL. If a taxpayer enters into a hedged executory contract, amounts paid or received under the hedge by the taxpayer are treated as paid or received by the taxpayer under the executory contract, or any subsequent account payable or receivable, or that portion to which the hedge relates. Also, the taxpayer recognizes no exchange gain or loss on the hedge. If an executory contract, on the accrual date, becomes an account payable or receivable, the taxpayer recognizes no exchange gain or loss on such payable or receivable for the period covered by the hedge.

(ii) PARTIALLY HEDGED EXECUTORY CONTRACTS. The effect of integrating an executory contract and a hedge that partially hedges such contract is to treat the amounts paid or received under the hedge as paid or received under the portion of the executory contract being hedged, or any subsequent account payable or receivable. The income or expense of services performed or received under the executory contract, or the amount realized or basis of property sold or purchased under the executory contract, that is attributable to that portion of the executory contract that is not hedged shall be translated into functional currency on the accrual date. Exchange gain or loss shall be realized when payment is made or received with respect to any payable or receivable arising on the accrual date with respect to such unhedged amount.

(iii) DISPOSITION OF A HEDGE OR EXECUTORY CONTRACT PRIOR TO THE ACCRUAL DATE -- (A) IN GENERAL. If a taxpayer identifies an executory contract as part of a hedged executory contract as defined in paragraph (b)(2) of this section, and disposes of (or otherwise terminates) the executory contract prior to the accrual date, the hedge shall be treated as sold for its fair market value on the date the executory contract is disposed of and any gain or loss shall be realized and recognized on such date. Such gain or loss shall be an adjustment to the amount received or expended with respect to the disposition or termination, if any. The spot rate on the date the hedge is treated as sold shall be used to determine subsequent exchange gain or loss on the hedge. If a taxpayer identifies a hedge as part of a hedged executory contract as defined in paragraph (b) (2) of this section, and disposes of the hedge prior to the accrual date, any gain or loss realized on such disposition shall not be recognized and shall be an adjustment to the income from, or expense of, the services performed or received under the executory contract, or to the amount realized or basis of the property sold or purchased under the executory contract.

(B) CERTAIN EVENTS IN A SERIES OF HEDGES TREATED AS A TERMINATION OF THE HEDGED EXECUTORY CONTRACT. If the rules of paragraph (b)(2)(iii)(B) of this section are not satisfied, the hedged executory contract shall be terminated and the provisions of paragraph (b)(4)(iii)(A) of this section shall apply to any gain or loss previously realized with respect to such hedge. Any subsequent hedging contracts entered into to reduce the risk of exchange rate movements with respect to such executory contract shall not be considered a hedge as defined in paragraph (b)(2)(iii) of this section.

(C) EXECUTORY CONTRACTS BETWEEN RELATED PERSONS. If an executory contract is between related persons as defined in section 267(b) and 707(b), and the taxpayer disposes of the hedge or terminates the executory contract prior to the accrual date, the Commissioner may redetermine the timing, source, and character of gain or loss from the hedge or the executory contract if he determines that a significant purpose for disposing of the hedge or terminating the executory contract prior to the accrual date was to affect the timing, source, or character of income, gain, expense, or loss for Federal income tax purposes.

(iv) DISPOSITION OF A HEDGE ON OR AFTER THE ACCRUAL DATE. If a taxpayer identifies a hedge as part of a hedged executory contract as defined in paragraph (b)(2) of this section, and disposes of the hedge on or after the accrual date, no gain or loss is recognized on the hedge and the booking date as defined in section 1.988-2(c)(2) of the payable or receivable for purposes of computing exchange gain or loss shall be the date such hedge is disposed of. See Example 3 of paragraph (b)(4)(iv) of this section.

(v) SECTIONS 263(g), 1092 AND 1256 DO NOT APPLY. Sections 263(g), 1092, and 1256 do not apply with respect to an executory contract or hedge which comprise a hedged executory contract as defined in paragraph (b)(2) of this section. However, sections 263(g), 1092 and 1256 may apply to the hedged executory contract if such transaction is part of a straddle.

(vi) EXAMPLES. The principles set forth in paragraph (b) of this section are illustrated in the following examples. The examples assume that K is an accrual method, calendar year U.S. corporation with the dollar as its functional currency.

EXAMPLE 1. (i) On January 1, 1992, K enters into a contract with JPF, a Swiss machine manufacturer, to pay 500,000 Swiss francs for delivery of a machine on June 1, 1993. Also on January 1, 1992, K enters into a foreign currency forward agreement to purchase 500,000 Swiss francs for $250,000 for delivery on June 1, 1993. K properly identifies the executory contract and the hedge in accordance with paragraph (b)(3)(i) of this section. On June 1, 1993, K takes delivery of the 500,000 Swiss francs (in exchange for $250,000) under the forward contract and makes payment of 500,000 Swiss francs to JPF in exchange for the machine. Assume that the accrual date is June 1, 1993.

(ii) Under paragraph (b)(1) of this section, the hedge is integrated with the executory contract. Therefore, K is deemed to have paid $250,000 for the machine and there is no exchange gain or loss on the foreign currency forward contract. K's basis in the machine is $250,000. Section 1256 does not apply to the forward contract.

EXAMPLE 2. (i) On January 1, 1992, K enters into a contract with S, a Swiss machine manufacturer, to pay 500,000 Swiss francs for delivery of a machine on June 1, 1993. Under the contract, K is not obligated to pay for the machine until September 1, 1993. On February 1, 1992, K enters into a foreign currency forward agreement to purchase 500,000 Swiss francs for 8250,000 for delivery on September 1, 1993. K properly identifies the executory contract and the hedge in accordance with paragraph (b)(3) of this section. On June 1, 1993, K takes delivery of machine. Assume that under K's method of accounting the delivery date is the accrual date. On September 1, 1993, K takes delivery of the 500,000 Swiss francs (in exchange for $250,000) under the forward contract and makes payment of 500,000 Swiss francs to S.

(ii) Under paragraph (b)(1) of this section, the hedge is integrated with the executory contract. Therefore K is deemed to have paid $250,000 for the machine and there is no exchange gain or loss on the foreign currency forward contract. Thus K's basis in the machine is $250,000. In addition, no exchange gain or loss is recognized on the payable in existence from June 1, 1993, to September 1, 1993. Section 1256 does not apply to the forward contract.

EXAMPLE 3. The facts are the same as in Example 2 except that K disposed of the forward contract on August 1, 1993 for $10,000. Pursuant to paragraph (b)(4)(iv) of this section, K does not recognize the $10,000 gain. K's basis in the machine is $250,000 (the amount fixed by the forward contract), regardless of the amount in dollars that K actually pays to acquire the 500,000 Swiss francs when K pays for the machine. K has a payable with a booking date of August 1, 1993, payable on September 1, 1993 for 500,000 Swiss francs. Thus, K will realize exchange gain or loss on the difference between the amount booked on August 1, 1993 and the amount paid on September 1, 1993 under section 1.988-2 (c).

EXAMPLE 4. (i) On January 1, 1992, K enters into a contract with S, a Swiss machine repair firm, to pay 500,000 Swiss francs for repairs to be performed on June 1, 1992. Under the contract, K is not obligated to pay for the repairs until September 1, 1992. On February 1, 1992, K enters into a foreign currency forward agreement to purchase 500,000 Swiss francs for $250,000 for delivery on August 1, 1992. K properly identifies the executory contract and the hedge in accordance with paragraph (b)(3) of this section. On June 1, 1992, S performs the repair services. Assume that under K's method of accounting this date is the accrual date. On August 1, 1992, K takes delivery of the 500,000 Swiss francs (in exchange for $250,000) under the forward contract. On the same day, K deposits the 500,000 Swiss francs in a separate account with a bank and properly identifies the transaction as a continuation of the hedged executory contract. On September 1, 1992, K makes payment of the 500,000 Swiss francs in the account to S.

(ii) Under paragraph (b)(1) of this section, the hedge is integrated with the executory contract. Therefore K is deemed to have paid $250,000 for the services and there is no exchange gain or loss on the foreign currency forward contract or on the disposition of 500,000 Swiss francs in the account. Any interest on the Swiss francs in the account is included in income but is not considered part of the hedge (because the amount paid for the services must be set on or before the accrual date). In addition, no exchange gain or loss is recognized on the payable in existence from June 1, 1992, to September 1, 1992. Section 1256 does not apply to the forward contract.

EXAMPLE 5. (i) On January 1, 1992, K enters into a contract with S, a Swiss machine manufacturer, to pay 500,000 Swiss francs for delivery of a machine on June 1, 1993. Under the contract, K is not obligated to pay for the machine until September 1, 1993. On February 1, 1992, K enters into a foreign currency forward agreement to purchase 250,000 Swiss francs for $125,000 for delivery on September 1, 1993. K properly identifies the executory contract and the hedge in accordance with paragraph (b)(3) of this section. On June 1, 1993, K takes delivery of the machine. Assume that under K's method of accounting the delivery date is the accrual date. Assume further that the exchange rate is Sf1 = $.50 on June 1, 1993. On August 30, 1993, K purchases Sf250,000 for $135,000. On September 1, 1993, K takes delivery of the 250,000 Swiss francs (in exchange for $125,000) under the forward contract and makes payment of 500,000 Swiss francs (the Sf250,000 received under the contract plus the Sf250,000 purchased on August 30, 1993) to S. Assume the spot rate on September 1, 1993, is 1 Sf = $.5420 (Sf250,000 equal $135,500).

(ii) Under paragraph (b)(1) of this section, the partial hedge is integrated with the executory contract. K is deemed to have paid $250,000 for the machine [$125,000 on the hedged portion of the Sf500,000 and $125,000 ($.50, the spot rate on June 1, 1993, times Sf250,000) on the unhedged portion of the Sf500,000]. K's basis in the machine therefore is $250,000. K recognizes no exchange gain or loss on the foreign currency forward contract but K will realize exchange gain of $500 on the disposition of the Sf250,000 purchased on August 30, 1993 under section 1.988-2(a). In addition, exchange loss is realized on the unhedged portion of the payable in existence from June 1, 1993, to September 1, 1993. Thus, K will realize exchange loss of $10,500 ($125,000 booked less $135,500 paid) under section 1.988-2(c) on the payable. Section 1256 does not apply to the forward contract.

EXAMPLE 6. (i) On January 1, 1990, K enters into a contract with S, a Swiss steel manufacturer, to buy steel for 1,000,000 Swiss francs (Sf) for delivery and payment on December 31, 1990. On January 1, 1990, the spot rate is Sf1 = $.50, the U.S. dollar interest rate is 10% compounded annually, and the Swiss franc rate is 5% compounded annually. Under K's method of accounting, the delivery date is the accrual date.

(ii) Assume that on January 1, 1990, K enters into a foreign currency forward contract to buy Sf1,000,000 for $523,800 for delivery on December 31, 1990. K properly identifies the executory contract and the hedge in accordance with paragraph (b)(3) of this section. Pursuant to paragraph (b)(2)(iii) of this section, the forward contract constitutes a hedge. Assuming that the requirements of paragraph (b)(2)(i) of this section are satisfied, the executory contract to buy steel and the forward contract are integrated under paragraph (b)(1) of this section. Thus, K is deemed to have paid $523,800 for the steel and will have a basis in the steel of $523,800. No gain or loss is realized with respect to the forward contract and section 1256 does not apply to such contract.

(iii) Assume instead that on January 1, 1990, K enters into a foreign currency forward contract to buy Sf1,000,000 for $512,200 for delivery on July 1, 1990. K properly identifies the executory contract and the hedge in accordance with paragraph (b)(3) of this section. On July 1, 1990, when the spot rate is Sf1 = $.53, K cancels the forward contract in exchange for $17,800 ($530,000 - $512,200). On July 1, 1990, K enters into a second forward agreement to buy Sf1,000,000 for $542,900 for delivery on December 31, 1990. K properly identifies the second forward agreement as a hedge in accordance with paragraph (b)(3) of this section. Pursuant to paragraph (b)(2)(iii) of this section, the forward contract entered into on January 1, 1990, and the forward contract entered into on July 1, 1990, constitute a hedge. Assuming that the requirements of paragraph (b)(2)(i) of this section are satisfied, the executory contract to buy steel and the forward agreements are integrated under paragraph (b)(1) of this section. Thus, K is deemed to have paid $525,100 for the steel (the forward price in the second forward agreement of $542,900 less the gain on the first forward agreement of $17,800) and will have a basis in the steel of $525,100. No gain is realized with respect to the forward contracts and section 1256 does not apply to such contracts.

(iv) Assume instead that on January 1, 1990, K enters into a foreign currency forward contract to buy Sf1,000,000 for $512,200 for delivery on July 1, 1990. K properly identifies the executory contract and the hedge in accordance with paragraph (b)(3) of this section. On July 1, 1990, when the spot rate is Sf1 = $.53, K enters into a historical rate rollover of its $17,800 gain ($530,000 - $512,200) on the forward agreement. Thus, K enters into a second foreign currency forward agreement to buy Sf1,000,000 for $524,210 for delivery on December 31, 1990. (The forward price of $524,210 is the market forward price on July 1, 1990 for the purchase of Sf1,000,000 for delivery on December 31, 1990 of $542,900 less the $17,800 gain on January 1, 1990 contract and less the time value of such gain of $890.) K properly identifies the second forward agreement as a hedge in accordance with paragraph (b)(3) of this section. On December 31, 1990, when the spot rate is Sf1 = $.54, K takes delivery of the Sf1,000,000 (in exchange for $524,210) and purchases the steel for Sf1,000,000. Pursuant to paragraph (b)(2)(iii) of this section, the forward contract entered into on January 1, 1990, and the forward contract entered into on July 1, 1990, which incorporates the rollover of K's gain on the January 1, 1990 contract, constitute a hedge. Assuming that the requirements of paragraph (b)(2)(i) of this section are satisfied, the executory contract to buy steel and the forward agreements are integrated under paragraph (b)(1) of this section. Because the period from the rollover date to the date payment is made under the executory contract does not exceed 183 days, the $890 of interest income is considered part of the hedge and is not recognized. Thus, K is deemed to have paid $524,210 for the steel and will have a basis in the steel of $524,210. No gain is realized with respect to the forward contracts and section 1256 does not apply to such contracts.

(v) Assume instead that on January 1, 1990, K purchases Sf952,380.95 (the present value of Sf1,000,000 to be paid on December 31, 1990) for $476,190.48 and on the same day deposits the Swiss francs in a separate bank account that bears interest at a rate of 5%, compounded annually. K properly identifies the transaction as a hedged executory contract. Over the period beginning January 1, 1990, and ending December 31, 1990, K receives Sf47,619.05 in interest on the account that is included in income and that has a basis of $25,714.29. (Assume that under section 1.988-2(b)(1), K uses the spot rate of Sf1 = $.54 to translate the interest income). On December 31, 1990, K makes payment of the Sf1,000,000 principal and accrued interest in the account to S. Pursuant to paragraph (b)(2)(iii) of this section, the principal in the bank account and the interest constitute a hedge. Under paragraph (b)(1) of this section, the hedge is integrated with the executory contract. Therefore K is deemed to have paid $501,904.77 (the basis of the principal deposited plus the basis of the interest) for the steel and there is no exchange gain or loss on the disposition of the Sf1,000,000. K's basis in the steel therefore is $501,904.77.

(5) REFERENCES TO THIS PARAGRAPH (b). If the rules of this paragraph (b) are referred to in another paragraph of this section (e.g., paragraph (c) of this section), then the rules of this paragraph (b) shall be applied for purposes of such other paragraph by substituting terms appropriate for such other paragraph. For example, paragraph (c)(2) of this section refers to the identification rules of paragraph (b)(3) of this section. Accordingly, for purposes of paragraph (c)(2), the rules of paragraph (b)(3) will be applied by substituting the term "stock or security" for "executory contract".

(c) HEDGES OF PERIOD BETWEEN TRADE DATE AND SETTLEMENT DATE ON PURCHASE OR SALE OF PUBLICLY TRADED STOCK OR SECURITY. If a taxpayer purchases or sells stocks or securities which are traded on an established securities market and --

(1) Hedges all or part of such purchase or sale for any part of the period beginning on the trade date and ending on the settlement date; and

(2) Identifies the hedge and the underlying stock or securities as an integrated transaction under the rules of paragraph (b)(3) of this section;

then any gain or loss on the hedge shall be an adjustment to the amount realized or the adjusted basis of the stock or securities sold or purchased (and shall not be taken into account as exchange gain or loss). The term hedge means a deposit of nonfunctional currency in a hedging account (within the meaning of paragraph (b)(2)(iii)(D) of this section), or a forward or futures contract described in section 1.988-1(a)(1)(ii) and (2)(iii), or combination thereof, which reduces the risk of exchange rate fluctuations for any portion of the period beginning on the trade date and ending on the settlement date. The provisions of paragraphs (b)(2)(i)(D) through (G), and (b)(2)(iii)(D) and (E) of this section shall apply. Sections 263(g), 1092, and 1256 do not apply with respect to stock or securities and a hedge which are subject to this paragraph (c).

(d) [Reserved]

(e) ADVANCE RULINGS REGARDING NET HEDGING AND ANTICIPATORY HEDGING SYSTEMS. In his sole discretion, the Commissioner may issue an advance ruling addressing the income tax consequences of a taxpayer's system of hedging either its net nonfunctional currency exposure or anticipated nonfunctional currency exposure. The ruling may address the character, source, and timing of both the section 988 transaction(s) making up the hedge and the underlying transactions being hedged. The procedures for obtaining a ruling shall be governed by such pertinent revenue procedures and revenue rulings as the Commissioner may provide. The Commissioner will not issue a ruling regarding hedges of a taxpayer's investment in a foreign subsidiary.

(f) [Reserved]

(g) GENERAL EFFECTIVE DATE. Except as otherwise provided in this section, the rules of this section shall apply to qualified hedging transactions, hedged executory contracts and transactions described in paragraph (c) of this section entered into on or after September 21, 1989. This section shall apply even if the transaction being hedged (e.g., the debt instrument) was entered into or acquired prior to such date. The effective date regarding advance rulings for net and anticipatory hedging shall be governed by such revenue procedures that the Commissioner may publish.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 5. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 6. Section 602.101(c) is amended by removing from the table entries for "1.988-1T", "1.988-2T", "1.988-3T", "1.988-4T", and "1.988-5T" and by adding in the table "1.988-0 through 1.988-5......1545-1131".