(a) Overview. This section provides rules relating to section 987 hedging transactions. Paragraph (b) of this section provides the definition of a section 987 hedging transaction. Paragraph (c) of this section provides identification requirements for section 987 hedging transactions. Paragraph (d) of this section provides rules relating to the taxation of section 987 hedging transactions. Paragraph (e) of this section provides examples illustrating the rules of this section.

(b) Section 987 hedging transaction—(1) In general. A section 987 hedging transaction is a financial instrument or a combination or series of financial instruments (a hedge), that is entered into by the owner of a section 987 QBU as part of the normal course of the owner's trade or business for the purpose of managing exchange rate risk with respect to all or part of the owner's net investment in the section 987 QBU (the hedged QBU), provided that the requirements of paragraph (b)(2) of this section are met. If only part of a financial instrument (or combination or series of financial instruments) is described in the preceding sentence, that part is treated as a section 987 hedging transaction for purposes of this section.

(2) Requirements. A transaction is a section 987 hedging transaction described in paragraph (b)(1) of this section for a taxable year only if the following requirements are met.

(i) Identification. The hedge must be identified as a section 987 hedging transaction with respect to the hedged QBU under paragraph (c) of this section. The financial instrument or instruments that comprise the hedge must not be identified as a section 987 hedging transaction with respect to any other section 987 QBU. If only part of a financial instrument (or combination or series of financial instruments) is a section 987 hedging transaction, that part must be clearly identified.

(ii) Current rate election. A current rate election must be in effect for the taxable year.

(iii) Mark-to-market method of accounting. Section 988 gain or loss of the owner with respect to the hedge must be accounted for under a mark-to-market method of accounting (for example, under section 1256). In addition, if a member of the owner's controlled group is a party to the hedge, any section 988 gain or loss of the controlled group member with respect to the hedge must be accounted for under a mark-to-market method of accounting.

(iv) Treatment under U.S. generally accepted accounting principles. Foreign currency gain or loss on the hedge must be properly accounted for under generally accepted accounting principles as a cumulative foreign currency translation adjustment to shareholders' equity.

(v) Hedge entered into by owner of the hedged QBU. The hedge must be entered into by the owner of the hedged QBU (and not by a section 987 QBU of the owner). In the case of a hedged QBU that is owned by a member of a consolidated group, the hedge must be entered into by the member that owns the hedged QBU.

(3) Anti-abuse rule. If a taxpayer enters into a hedge or a related transaction with a principal purpose of effectively converting section 987 gain or loss into section 988 gain or loss (or another type of income or loss) of the owner or a related party, the hedge is not treated as a section 987 hedging transaction.

(4) Partial termination of a section 987 hedging transaction. If only part of a financial instrument is a section 987 hedging transaction, and a part of the financial instrument is terminated or disposed of, a proportionate part of the section 987 hedging transaction is treated as terminated or disposed of.

(c) Identification requirements—(1) In general. The owner of a hedged QBU must clearly identify the hedge as a section 987 hedging transaction with respect to the hedged QBU in its books and records on or before the close of the day on which the owner entered into the hedge. The identification must meet the requirements of § 1.1221-2(f)(4) and must include the following information—

(i) The date on which the hedge is entered into by the owner of the hedged QBU and the date on which the hedge is identified as a section 987 hedging transaction;

(ii) A description of the hedge; and

(iii) Identification of the hedged QBU.

(2) Inadvertent error. If a hedge is not identified under paragraph (c)(1) of this section, but the hedge would otherwise qualify as a section 987 hedging transaction with respect to a hedged QBU within the meaning of paragraph (b) of this section and the taxpayer can demonstrate to the satisfaction of the Commissioner that its failure to identify the hedge was due to inadvertent error, the taxpayer may treat the hedge as a section 987 hedging transaction if all of the owner's hedges described in paragraph (b) of this section in all open years are being treated on either original or, if necessary, amended returns as section 987 hedging transactions subject to the rules of paragraph (d) of this section.

(d) Taxation of section 987 hedging transactions—(1) Hedging gain or loss with respect to a hedged QBU. If the owner of a section 987 QBU has entered into a section 987 hedging transaction with respect to the section 987 QBU, the owner's hedging gain or loss with respect to the hedged QBU for a taxable year is equal to the gain or loss that the owner would (but for the application of this paragraph (d)) recognize under section 988 with respect to the section 987 hedging transaction in the taxable year under the mark-to-market method of accounting described in paragraph (b)(2)(iii) of this section (including gain or loss that would be recognized in connection with a complete or partial disposition or termination of the section 987 hedging transaction). If only part of a financial instrument is a section 987 hedging transaction, a proportionate part of the gain or loss that would (but for the application of this paragraph (d)) be recognized under section 988 with respect to the financial instrument in the taxable year is treated as hedging gain or loss with respect to the hedged QBU. See paragraph (d)(3) of this section for rules relating to the determination of hedging gain or loss in the taxable year in which the hedged QBU terminates.

(2) Adjustment to unrecognized section 987 gain or loss for the taxable year—(i) Hedging loss. In a taxable year in which an owner has hedging loss with respect to a hedged QBU and has unrecognized section 987 gain for the taxable year with respect to the hedged QBU (as determined under § 1.987-4(d), without regard to this paragraph (d)), the unrecognized section 987 gain for the taxable year is reduced (but not below zero) by the amount of the hedging loss. The amount of hedging loss that reduces unrecognized section 987 gain under this paragraph (d)(2)(i) is not recognized under section 988. Any hedging loss that does not reduce unrecognized section 987 gain under this paragraph (d)(2)(i) is recognized under section 988.

(ii) Hedging gain. In a taxable year in which an owner has hedging gain with respect to a hedged QBU and has unrecognized section 987 loss for the taxable year with respect to the hedged QBU (as determined under § 1.987-4(d), without regard to this paragraph (d)), the unrecognized section 987 loss for the taxable year is reduced (but not below zero) by the amount of the hedging gain. The amount of hedging gain that reduces unrecognized section 987 loss under this paragraph (d)(2)(ii) is not recognized under section 988. Any hedging gain that does not reduce unrecognized section 987 loss under this paragraph (d)(2)(ii) is recognized under section 988.

(3) Termination of a hedged QBU. If the owner of a section 987 QBU has entered into a section 987 hedging transaction with respect to the section 987 QBU and the hedged QBU terminates, the owner's hedging gain or loss with respect to the hedged QBU for the taxable year is equal to the hedging gain or loss that the owner would (but for the application of this paragraph (d)) recognize with respect to the section 987 hedging transaction under the mark-to-market method of accounting described in paragraph (b)(2)(iii) of this section if the taxable year ended on the termination date. Appropriate adjustments must be made to prevent the section 988 gain or loss from being taken into account again after it is applied to reduce unrecognized section 987 gain or loss under this paragraph (d).

(e) Examples. The following examples illustrate the application of this section. For purposes of the examples, DC1 is a domestic corporation that owns Business A, a section 987 QBU that has the euro as its functional currency. A current rate election is in effect for years 1 and 2, but no other elections are in effect. In year 1, DC1 had net unrecognized section 987 loss (determined under § 1.987-4(b)) of $1,000x with respect to Business A, and Business A did not make a remittance in year 1. As a result, in year 2, DC1's net accumulated unrecognized section 987 loss from prior taxable years (determined under § 1.987-4(c)) was $1,000x. In year 2, DC1 had unrecognized section 987 loss for the taxable year (determined under § 1.987-4(d) before the application of paragraph (d) of this section) of $500x.

(1) Example 1: Section 987 hedging transaction—(i) Facts. In year 2, DC1 entered into a six-month foreign currency forward contract with an unrelated bank in the normal course of DC1's trade or business for the purpose of managing exchange rate risk with respect to DC1's net investment in Business A. On the same day, DC1 identified the forward contract as a section 987 hedging transaction with respect to Business A under paragraph (c) of this section. Under generally accepted accounting principles, currency gain or loss from the forward contract is accounted for as a cumulative translation adjustment to shareholder's equity. For Federal income tax purposes, DC1 accounts for section 988 gain or loss with respect to the forward contract under a mark-to-market method of accounting. But for the application of paragraph (d) of this section, DC1 would recognize $400x of section 988 gain with respect to the forward contract.

(ii) Analysis—(A) Qualification of the hedge as a section 987 hedging transaction. The forward contract qualifies as a section 987 hedging transaction under paragraph (b) of this section because it is a financial instrument that manages DC1's exchange rate risk with respect to Business A (the hedged QBU) as part of the normal course of DC1's trade or business, and the hedge meets the requirements of paragraph (b)(2) of this section.

(B) Treatment of the section 987 hedging transaction. But for the application of paragraph (d) of this section, DC1 would recognize $400x of section 988 gain with respect to the forward contract in year 2. Therefore, DC1 has $400x of hedging gain in year 2. In year 2, DC1 had unrecognized section 987 loss of $500x for the taxable year (determined under § 1.987-4(d) before the application of paragraph (d) of this section). Therefore, under paragraph (d)(2)(ii) of this section, DC1's unrecognized section 987 loss for the taxable year of $500x is reduced by the $400x of hedging gain. Accordingly, DC1 has unrecognized section 987 loss of $100x for the taxable year with respect to Business A. Under § 1.987-4(b), DC1 has $1,100x of net unrecognized section 987 loss in year 2 (equal to the sum of its net accumulated section 987 loss of $1,000x from prior taxable years and its unrecognized section 987 loss for the taxable year of $100x). DC1 does not recognize its hedging gain under section 988 because all of the hedging gain reduces unrecognized section 987 loss for the taxable year.

(2) Example 2: Excess hedging gain from a section 987 hedging transaction—(i) Facts. The facts are the same as in paragraph (e)(1) of this section (Example 1) except that, but for the application of paragraph (d) of this section, DC1 would recognize $600x of section 988 gain with respect to the forward contract.

(ii) Analysis. Under paragraph (d)(2)(ii) of this section, DC1's unrecognized section 987 loss for the taxable year of $500x is reduced by the hedging gain, but not below zero. Accordingly, $500x of the hedging gain is applied to reduce DC1's unrecognized section 987 loss for the taxable year to zero. DC1 has $1,000x of net unrecognized section 987 loss in year 2 under § 1.987-4(b) (equal to its net accumulated section 987 loss of $1,000x from prior taxable years). The $500x hedging gain that reduces unrecognized section 987 loss for the taxable year is not recognized under section 988. The excess amount of hedging gain ($100x) is recognized by DC1 under section 988.