The US Department of the Treasury (the “Treasury”) and the Internal Revenue Service (the “Service”) issued proposed regulations on September 16, 2011 (the “proposed regulations”) that, if finalized, will treat credit default swaps (CDSs) and certain other swaps as notional principal contracts (NPCs). The proposed regulations also modify the definition of contracts that constitute NPCs and clarify that NPCs will not be subject to the mark-to-market rules of Section 1256 of the Internal Revenue Code of 1986, as amended (the “Code”).
CDSs Treated as NPCs
Tax practitioners have historically struggled to characterize the proper tax treatment of a CDS. This uncertainty was highlighted in 2004 when the Service and the Treasury issued IRS Notice 2004-52 suggesting four possible characterizations of a CDS: (i) an insurance contract; (ii) a financial guarantee or standby letter of credit; (iii) a contingent option or (iv) a notional principal contract.1
The proposed regulations generally resolve the uncertainty highlighted in Notice 2004-52 by adding CDSs to the list of swaps categorized as NPCs.2 Additionally, a CDS that permits or requires the delivery of specified debt instruments will still be considered an NPC.3
The characterization of a CDS as an NPC is generally favorable to non-US persons, because NPC payments (other than payments treated as interest under Treasury regulations section 1.446-3(e)(4)(iii)) made to a non-US person generally are not US source and, thus, are not subject to US federal withholding tax. In addition, the characterization of CDSs as NPCs (and not as insurance contracts) also minimizes the risk that an offshore entity writing CDS contracts would be (i) subject to the foreign insurer excise tax of Code section 4371 or (ii) considered engaged in a US trade or business.
The proposed regulations do not define a “CDS.” Such uncertainty regarding the definition of a CDS raises questions as to how to treat contracts or swaps that are substantively comparable to a CDS. In addition, the proposed regulations provide no transitional guidance for taxpayers with existing CDSs that have been treated as other than NPCs.
Clarifications to NPC Definition
Two or more payments. Under existing Treasury regulations, an NPC is defined as a financial 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.”4 Such definition caused considerable uncertainty in the classification of financial instruments, including, for example, instruments that provide for payments that are contingent as to time rather than based on specific intervals.
The proposed regulations expressly provide that an NPC requires one party to make two or more payments to a counterparty.5 For this purpose, 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, for example, a contract that provides for a settlement payment referenced to the appreciation or depreciation of a specified number of common stock shares, adjusted for actual dividends paid during the term of the contract, would be treated as a contract with more than one payment with respect to that leg of the contract. Notwithstanding the foregoing, as provided in the proposed regulations, a forward interest rate swap that contemplates a single net payment at settlement based on the interest rates in effect on such date would not constitute an NPC under this definition.6
Expansion of Specified Index. As mentioned above, under existing Treasury regulations, in order for a financial instrument to qualify as an NPC, the payments on the instrument must be made by reference to a “specified index.” For this purpose, a specified index is defined as either a financial or economic index. The proposed regulations would expand the definition of specified index to include non-financial indices. An index will qualify as a non-financial index if it is comprised of any objectively determinable information that is not within the control of any of the parties to the contract and 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.7 While the proposed regulations only specifically reference “weather-related swaps,”8 other similar contracts related to catastrophic risk would likely qualify as NPCs under these proposed regulations.
Because the definition of an NPC in the proposed regulations is intended to be the operative definition for all US federal income tax purposes (except where a different or more limited definition is specifically prescribed), conforming amendments would be made to the Treasury regulations under Code sections 512, 863, 954 and 988 to reference such NPC definition.
NPCs not Subject to Section 1256
Code section 1256 generally requires mark-to-market treatment for contracts classified as “1256 Contracts,” with any gain or loss generally treated as 60 percent long-term capital gain or loss and 40 percent short-term capital gain or loss.9 In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act added section 1256(b)(2)(B) to the Code to clarify that swap contracts, even if traded on a qualified board or exchange, are not 1256 Contracts.10
The preamble to the proposed regulations describes the Treasury and Service view that, in enacting Code section 1256(b)(2)(B), Congress generally intended to harmonize the category of swaps excluded under Code section 1256(b)(2)(B) with swaps that qualify as NPCs under Treasury regulation section 1.446-3(c). In light of such fact, the proposed regulations clarify that Section 1256 Contracts exclude contracts that constitute NPCs as defined in the proposed regulations.11 Further, a 1256 Contract does not include an option on a contract that qualifies as an NPC as defined in the proposed regulations.12 Accordingly, where a contract qualifies as both an NPC (or an option on an NPC) and a 1256 Contract, such contract would be excluded from treatment as a 1256 Contract.13
Effective Date of Proposed Regulations and Public Hearing
The proposed regulations are expected to apply to contracts entered into on or after the date of finalization. The Service and Treasury are accepting comments on the proposed regulations and will hold a hearing related to the proposed regulations on January 19, 2012.
For more information about the proposed regulations or any other matter raised in this Legal Update, please contact James R. Barry at +1 312 701 7169, James E. Clegg at +1 212 506 2529, Michael K. Marion at +1 212 506 2651, or Russell E. Nance at +1 212 506 2534.