IRS Issues
Proposed Regulations Addressing Treatment of Credit Default Swaps and
Swap Exclusion Under Section 1256
On September 15, 2011 the Treasury Department issued
proposed regulations that would add credit default swaps
("CDS") as well as non-financial indexed derivatives to a
revised definition of a notional principal contract
("NPC"). The proposed regulations also provide guidance
on the definition of swaps and similar agreements within the meaning of
section 1256(b)(2)(B) of the Internal Revenue Code of 1986 (the
"Code"). This is the second set of proposed regulations
adding Dodd-Frank related matters. Earlier this year, temporary and
proposed regulations were issued under section 1001, relating to
assignment of derivative contracts (see our client alert, Tax
Law Update – Treasury Regulations with Respect to Assignments of
Derivatives Contracts
Topics covered in
this alert:
Notional
Principal Contracts
Prior to the proposed regulations, an NPC was defined as an
instrument 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. While the NPC
regulations are predominantly tax accounting rules, NPC treatment is
sometimes preferable to alternative characterizations because of the
sourcing provisions, which generally source income to the residence of
the recipient.
As discussed below, there was uncertainty regarding whether
a number of popular instruments, most notably credit default swaps, were
within the scope of the NPC definition because of the question as to
whether the payment that might, or might not, occur on a credit event
meets either the specified consideration or multiple payment
requirement. The proposed regulations expressly provide that an NPC
requires one party to make two or more payments to a counterparty. For
this purpose, however, the fixing of an amount is treated as a payment,
even if the actual payment reflecting that amount is to be made at a
later date. Thus, if a financial instrument has a single payment at
maturity, but the payments are fixed during the payment period, the
instrument is an NPC. This change and the example in the proposed
regulations that illustrate the rule are not consistent with other
regulations regarding NPCs, which state that a payment made at maturity
by reference to interest or dividends paid over a period of time is a
non-periodic payment. This new interpretation will require
taxpayers to look beyond the timing of payments and examine the way the
payments are calculated—in other words, to consider the event (or events)
that cause a payment to be "fixed."
The proposed regulations also provide that an NPC that
permits or requires the delivery of specified currency in satisfaction of
one or both legs of the contract, but that otherwise qualifies as a
nonfunctional currency NPC, is an NPC. Additionally, the proposed
regulations explicitly state that a guarantee is not an NPC.
Similarly, as under the current regulations, instruments that are
forwards and options are not NPCs.
Credit
Default Swaps
Before the release of the proposed regulations, there was
uncertainty as to whether CDS were properly characterized as options or
NPCs. The proposed regulations resolve this question by expressly
providing that CDS are NPCs. Further, a CDS that is otherwise
treated as an NPC will continue to be so treated even if the contract
permits or requires settlement by physical delivery, i.e., the delivery
of specified debt instruments in satisfaction of one leg of the contract.
However, several related issues remain to be resolved.
In particular, rules need to be provided that address how to account for
the final contingent payment on a CDS that may not occur; most CDS mature
without any payment due. Proposed regulations, which were released
on February 25, 2004, do not address application of the contingent
notional principal contracts regulations to CDS. These proposed
regulations, which were likely aimed at total return equity swaps,
require an acceleration of the final payment. It is unclear whether those
proposed regulations were intended to cover derivatives in which there
was uncertainty whether there would be a final payment at all.
Additionally, guidance is needed regarding the transition of existing CDS
that are not accounted for as NPCs. Given that both options and
guarantees are excluded from NPC treatment, it will still be necessary to
make a determination under these proposed regulations regarding the
appropriate characterization of an instrument particularly if withholding
taxation or U.S. trade or business exposure is of concern.
Non-Financial
Index Based Swaps
Since the time that the NPC rules were adopted, markets have
developed for contracts based on non-financial indices. Many of these
contracts are structured as swaps, and payments are calculated based on
non-financial indices (such as temperature, precipitation, snowfall, or
frost). According to the preamble, "[a]s a technical matter, a swap
based on a non-financial index currently is not an NPC because a
non-financial index does not qualify as a 'specified index' under the
current regulations, which generally require that such index be a
financial index." This position will engender some controversy as
some taxpayers have taken the position under current law that the
financial data generated from events such as earthquakes and weather
related events makes those contracts NPCs, entitling them to apply the
residence based sourcing rules.
The proposed regulations expand a specified index to include
non-financial indices that are comprised of any objectively determinable
information that is not within the control of any of the parties to the
contract and is not unique to one of the parties' circumstances, and that
cannot be reasonably expected to front-load or back-load payments
accruing under the contract.
Conforming
Amendments
Other provisions of the regulations that reference the
definition of NPC that is set forth in the proposed regulations have been
modified to reflect the revised definition. These include the
regulations under Code section 512, dealing with unrelated business
taxable income, Code section 863, dealing with sourcing, Code section
954, dealing with foreign personal holding company income, and Code section
988, dealing with foreign currency contracts.
Section
1256(b)(2)(B)
Code section 1256(b)(2)(B) was added by the Dodd-Frank Wall
Street Reform and Consumer Protection Act (the "Dodd-Frank
Act") to address the recharacterization of income as a result of increased
exchange-trading of derivatives contracts by clarifying that Code section
1256 does not apply to certain derivatives contracts transacted on
exchanges. Code section 1256(b)(2)(B) provides that certain swaps and
similar agreements are not subject to Code section 1256, carving out
financial instruments that are not required or eligible to be marked to
market. Thus, Code section 1256(b)(2)(B) contemplates that a swap
contract, even if traded on or subject to the rules of a qualified board
or exchange, will not be a Code section 1256 contract. However, the
provision's list of instruments that are excluded from mark-to-market
treatment created uncertainty because the Dodd-Frank Act included a swap
definition that was much broader than that contained in existing Treasury
regulations on NPCs.
Treasury believes that Congress was attempting to harmonize
the category of swaps excluded under section 1256(b)(2)(B) with swaps
that qualify as NPCs, rather than with the contracts defined as
"swaps" under the Dodd-Frank Act and the proposed regulations
attempt to effectuate this Congressional intent. To accomplish
this, Treasury adopted an approach defining what is excluded from Code
section 1256 by reference to tax law and, in the case of regulated futures
contracts, what is included by reference to commodities law. While this
could create some areas of overlap or exclusion, the proposed regulations
establish a clear rule. A consequence of the proposed regulations is that
tax practitioners will have to understand what constitutes a swap under
the Commodity Exchange Act. The proposed regulations also provide
that a Code section 1256 contract does not include (1) an option on any
contract that is an NPC or (2) any contract, or option on such contract,
that is both a Code section 1256 contract and an NPC (that is, NPC
characterization trumps Code section 1256 characterization).
Code section 1256(g)(1) defines a regulated futures contract
as a contract (1) with respect to which the amount required to be
deposited and the amount which may be withdrawn depends on a system of
marking to market, and (2) which is traded on or subject to the rules of
a qualified board or exchange. The breadth of this definition has raised
questions as to whether a contract other than a futures contract can be a
regulated futures contract. Under the Dodd-Frank Act, a "designated
contract market" may trade both futures contracts and swap
contracts. In order to limit Code section 1256 to futures contracts that
trade on designated contract markets, the proposed regulations provide
that a regulated futures contract is a Code section 1256 contract only if
the contract is a futures contract that is not required to be reported as
a swap under the Commodity Exchange Act.
Questions have also been raised as to whether the
requirement that a regulated futures contract be "traded on or
subject to the rules of" a qualified board or exchange includes
off-exchange transactions such as an exchange of a futures contract for a
cash commodity, or an exchange of a futures contract for a swap, that are
carried out subject to the rules of a Commodity Futures Trading
Commission ("CFTC") designated contract market. As set for the
in the Preamble, Treasury and the IRS believe that a futures contract
that results from one of these transactions is a regulated futures
contract under Code section 1256(g)(1) because the contract is traded
subject to the rules of a designated contract market.
Qualified
Board or Exchange
Section 1256(g)(7)(C) provides that a qualified board or
exchange includes any other exchange, board of trade, or other market
which the Secretary determines has rules adequate to carry out the
purposes of section 1256. Section 1.1256(g)-1(a) of the proposed
regulations specifies that such determinations are only made through
published guidance in the Federal Register or in the Internal Revenue
Bulletin. According to the Preamble, the IRS has conditioned a
foreign exchange's qualified board or exchange status under section
1256(g)(7)(C) on the exchange continuing to satisfy all CFTC conditions
necessary to retain its direct access no-action relief letter. The
Preamble further states that if the CFTC adopts its proposed registration
system, an exchange that has previously received a qualified board or
exchange determination under Code section 1256(g)(7)(C) must obtain a
CFTC Order of Registration in order to maintain its qualified board or
exchange status. The IRS will continue to evaluate the CFTC's rules in
this regard to determine if any changes to the IRS's section
1256(g)(7)(C) guidance process are warranted.
Effective
Date and Public Hearing
The proposed regulations are expected to apply to contracts
entered into on or after the date final regulations are published.
Taxpayers will have the opportunity to comment at a hearing before the
IRS scheduled for January 19, 2012. Outlines of topics to be considered
at the hearing must be received by the IRS by December 14, 2011.
The delay in effective dates will undoubtedly cause some
uncertainty regarding the application of the new definition of NPC,
particularly as it relates to non-financial indices.
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