Download IRS Proposes Regulations Addressing Notional Principal Contracts

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STROOCK
SPECIAL BULLETIN
IRS Proposes Regulations Addressing
Notional Principal Contracts and
Section 1256 Contracts
September 16, 2011
Yesterday morning, the IRS released proposed
regulations which, if finalized in their current form,
would significantly modify and refine the scope of
contracts that constitute “notional principal contracts”
for United States federal income tax purposes and
clarify the application of the “swap” exclusion added
to Section 1256 of the Internal Revenue Code by
the Dodd-Frank Wall Street Reform and Consumer
Protection Act (P.L. 111-203) (the “Dodd-Frank
Act”) in July 2010.
Notional Principal Contracts
Currently, Treasury Regulations § 1.446-3(c)
generally defines a “notional principal contract” 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.”
The proposed regulations would make a number
of very significant changes to this definition and its
application.
Two or More Payment Requirement
In an effort to resolve interpretational issues
relating to the notional principal contract definition,
the proposed regulations would define a notional
principal contract as “a financial instrument that
requires one party to make two or more payments to
the counterparty 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,”
essentially clarifying that there must be two or more
payments on at least one leg of the contract.
However, for this purpose, the proposed
regulations would provide that a payment includes an
amount that is fixed on one date, but which is paid or
otherwise taken into account on a later date. So, as
an example, the proposed regulations indicate that a
single payment made at the end of a contract and
which is based on the appreciation on a notional
amount of stock, as well as the dividends paid on that
notional amount of stock over the term of the
contract, would be treated as more than one payment
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otherwise have applied absent the treatment of those
contracts as notional principal contracts.
(by virtue of the fact that the dividend payments
become fixed during the term of the contract). This
appears to be the case even if the underlying
reference stock historically has not paid, and is not
expected to pay, any dividends.
Credit Default Swaps
The proper characterization of, and treatment of
payments under, credit default swaps has been, and
continues to be, uncertain. In 2004, the IRS, in
Notice
2004-52,
described
four
possible
characterizations
that,
depending
on
the
circumstances, might be applied by analogy to a
particular
credit
default
swap;
namely,
characterization as (i) a contingent option, (ii) a
notional principal contract, (iii) a financial guarantee
or standby letter of credit, or (iv) a form of insurance
contract. Each such characterization would have
different cross-border withholding tax and other
significant tax implications.
The proposed regulations, which are intended to
resolve this uncertainty, add credit default swaps to
the list of swaps that are categorized as notional
principal contracts under Treasury Regulations §
1.446-3(c). However, some uncertainty remains
since the proposed regulations, like the currently
applicable regulations, provide that forward contracts
and options are not notional principal contracts, and
additionally provide that a guarantee is not a notional
principal contract. The proposed regulations do not
define “credit default swap” or “guarantee,” such
that, even if the proposed regulations are finalized in
their current form, taxpayers would still lack specific
guidance on how to determine whether a particular
contract is in fact a “credit default swap” for purposes
of the regulations or might instead be a guarantee,
forward, or other type of contract.
This is
particularly the case if the contract contains nonvanilla features that can blur the distinctions among
the various types of contracts.
Uncertainty would also remain as to how income
is to be accounted for and characterized under a
Specified Non-Financial Index
Permitted
As described above, under both the current
regulations and the proposed regulations, payments
under at least one leg of a notional principal contract
must be calculated by reference to a “specified index”
upon a notional principal amount. Under current
law, to the extent a specified index is based on
objective information, it must, among other
requirements, be based on current, objectively
determinable “financial or economic” information.
The proposed regulations would expand the
definition of “specified index” to include any “nonfinancial” objectively determinable information so
long as it is not within the control of, or unique to
the circumstances of, any party to the contract, and
cannot be reasonably expected to back-load or frontload payments accruing under the contract.
The proposed regulations illustrate the application
of this concept by adding weather-related swaps to
the list of swaps that are categorized as notional
principal contracts under Treasury Regulations §
1.446-3(c). On the other hand, because of potential
back-loaded or front-loaded payment expectations, a
mortality or longevity swap, in certain cases, might
not qualify as a notional principal contract under the
proposed regulations. It is important to note that,
among other things, cross-border payments under
contracts that qualify as notional principal contracts
by virtue of the expanded definition of specified
index in the proposed regulations may be subject to
more favorable withholding tax rules than might
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options and dealer securities futures contracts that,
except in the case of foreign currency contracts, are
traded on or subject to the rules of a qualified board
of exchange.
The Dodd-Frank Act provides that the Section
1256 mark-to-market regime will not apply to “any
interest rate swap, currency swap, basis swap, interest
rate cap, interest rate floor, commodity swap, equity
swap, equity index swap, credit default swap, or
similar agreement.” Since each of the foregoing types
of swaps and contracts (other than credit default
swaps) is currently listed among the types of contracts
that constitute notional principal contracts under
Treasury Regulations § 1.446-3(c), the proposed
regulations interpret the Dodd-Frank Act swap
exclusion as applying to any contract, or any option
on a contract, that is a notional principal contract
under Treasury Regulations § 1.446-3(c) (taking into
account the changes to that regulation described
above in the discussion of notional principal
contracts), as opposed to utilizing a definition of
“swap” contained in the Dodd-Frank Act.
Notwithstanding the foregoing, the Dodd-Frank
Act conception of “swap” is used in the proposed
regulations to refine the scope of “regulated futures
contracts” that are subject to Section 1256 mark-tomarket accounting. Specifically, a contract that
would otherwise fit within the definition of a
regulated futures contract under Section 1256 will
not be treated as such under the proposed regulations
if the contract is required to be reported as a swap
under the Commodity Exchange Act in accordance
with the Dodd-Frank Act and implementing rules to
be enacted by the Commodity Futures Trading
Commission. The proposed regulations do not
address whether an option on such a swap could
constitute a nonequity option subject to Section 1256
mark-to-market accounting if the swap is not a
credit default swap. Certain payments under credit
default swaps are contingent as to both timing and
amount. The timing of income and deductions from
contingent nonperiodic payments under notional
principal contracts is uncertain, as a general matter,
and is the subject of a complex set of regulations that,
although proposed in 2004, has not been finalized
(the “2004 proposed regulations”). Until the 2004
proposed regulations are finalized, the preamble to
those regulations indicates that contingent
nonperiodic payments under a notional principal
contract generally must be taken into account under a
reasonable amortization method, which need not
necessarily satisfy the rules set forth in the 2004
regulations.
Commentators have argued that credit default
swaps, in any case, should be specifically excluded
from the “noncontingent swap method” of
accounting set forth in the 2004 proposed regulations.
Accordingly, the treatment of credit default swaps as
notional principal contracts does not resolve the issues
relating to the appropriate tax accounting method for
contingent nonperiodic payments under credit default
swaps. Similarly, since there is also some uncertainty,
generally, as to whether settlement payments under a
notional principal contract should be ordinary
income (akin to other payments under the terms of a
contract) or capital gain (akin to “termination
payments”), the treatment of credit default swaps as
notional principal contracts does not resolve the issues
relating to the character of settlement payments under
credit default swaps.
Section 1256 Dodd-Frank Swap
Exclusion
Section 1256 of the Internal Revenue Code
provides a detailed “mark-to-market” tax accounting
regime for certain regulated futures contracts, foreign
currency contracts, nonequity options, dealer equity
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notional principal contract
Regulations § 1.446-3(c).
under
Treasury
to be used, and cannot be used, for the
purpose of (i) avoiding penalties under the
Internal Revenue Code or (ii) promoting,
marketing or recommending to another party
any matter addressed herein.
________________________
By Micah W. Bloomfield, a Partner in the Tax
Practice Group of Stroock & Stroock & Lavan LLP,
and Susan R. Cohen, Special Counsel in Stroock’s
Tax Practice Group.
Effective Dates
The proposed regulations are generally effective
with respect to contracts entered into on or after the
date of publication of a Treasury decision adopting
the proposed regulations as final regulations in the
Federal Register. A public hearing on the proposed
regulations is scheduled for January 19, 2012.
IRS Circular 230 Disclosure: To ensure
compliance with requirements imposed by the
Internal Revenue Service in Circular 230, we
inform you that any tax advice contained in
this communication is not intended or written
For More Information
Micah W. Bloomfield
Susan R. Cohen
212.806.6007
212.806.6604
[email protected] [email protected]
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stroock special bulletin
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