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stroock & stroock & lavan llp 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 stroock & s troock & l avan llp • new york • los angeles • mi ami 180 m aiden lane, new york, ny 100 3 8-4982 te l 2 12.806 .540 0 fax 212.8 06. 6006 www.s troock. com stroock special bulletin 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 2 stroock special bulletin 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 3 stroock special bulletin 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] 4 stroock special bulletin New York 180 Maiden Lane New York, NY 10038-4982 Tel: 212.806.5400 Fax: 212.806.6006 Los Angeles 2029 Century Park East Los Angeles, CA 90067-3086 Tel: 310.556.5800 Fax: 310.556.5959 Miami Southeast Financial Center 200 South Biscayne Boulevard, Suite 3100 Miami, FL 33131-5323 Tel: 305.358.9900 Fax: 305.789.9302 www.stroock.com __________________________________________________________________________________________________ This Stroock Special Bulletin is a publication of Stroock & Stroock & Lavan llp © 2011 Stroock & Stroock & Lavan llp. All rights reserved. Quotation with attribution is permitted. This Stroock publication offers general information and should not be taken or used as legal advice for specific situations, which depend on the evaluation of precise factual circumstances. Please note that Stroock does not undertake to update its publications after their publication date to reflect subsequent developments. This Stroock publication may contain attorney advertising. Prior results do not guarantee a similar outcome. Stroock & Stroock & Lavan llp is a law firm with a national and international practice serving clients that include investment banks, commercial banks, insurance and reinsurance companies, mutual funds, multinationals and foreign governments, industrial enterprises, emerging companies and technology and other entrepreneurial ventures. For further information about Stroock Special Bulletins, or other Stroock publications, please contact Richard Fortmann, Senior Director-Legal Publications, at 212.806.5522.