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Tax Law Update

September 30, 2011

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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.