Nonperiodic Payments Under Notional Principal Contracts Treated as Two Separate Transactions

By Sally P. Schreiber, J.D.

Regulations

The IRS issued temporary and proposed regulations (T.D. 9719, REG-102656-15) under Secs. 446 and 956 amending how nonperiodic payments made or received under certain notional principal contracts (NPCs) are treated.

The temporary regulations under Sec. 446 provide that, subject to the exceptions described below, an NPC with a nonperiodic payment, regardless of whether it is significant, must be treated as two separate transactions consisting of one or more loans and an on-market, level payment swap (the embedded loan rule). Under the existing rule, this treatment only applied when the payment was significant. The IRS made this change in response to comments that distinguishing whether a payment was significant was a compliance burden.

The temporary regulations contain two exceptions to this rule. Except for purposes of Secs. 514 (unrelated debt-financed income) and 956 (investment of earnings in U.S. property), the first exception is for a nonperiodic payment made under an NPC of one year or less (short-term exception). The second exception applies to certain NPCs with nonperiodic payments that are subject to prescribed margin or collateral requirements.

The temporary regulations under Sec. 956 provide an exception to the definition of U.S. property for certain obligations of U.S. persons arising from upfront payments made for NPCs that qualify for the full margin exception to the embedded loan rule under Sec. 446. To qualify for this exception, the upfront payment must be made by a CFC (as defined in Sec. 957(a)) that is either a dealer in securities under Sec. 475(c)(1) or a dealer in commodities.

These rules are also issued in identical form as proposed regulations by cross-reference and withdraw temporary regulations from 2012.

The amended rules were effective May 8, the date they were published in the Federal Register, but taxpayers that were unable to comply with the embedded loan rule by then have until Nov. 4, 2015, to implement it.    

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