The IRS issued proposed regulations (REG-111283-11) clarifying when swap contracts and certain similar agreements will be subject to mark-to-market accounting and the other rules of Sec. 1256. The proposed regulations attempt to eliminate some of the uncertainty on this point that was created by the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, P.L. 111-203 (Dodd-Frank Act). The proposed regulations also provide that credit-default swaps, weather-related swaps, and certain other nonfinancial swaps would be treated as “notional principal contracts” for tax purposes.
In the past there had been substantial confusion about how such contracts were classified. Finally, the proposed regulations would reclassify “bullet swaps” and similar transactions, which provide for only one net payment but several dates on which components of the payment are to be determined, as notional principal contracts.
The regulations are proposed to apply to contracts entered into on or after the date that final regulations are published.
Sec. 1256: Sec. 1256 requires that certain option, futures, and forward contracts be accounted for on a mark-to-market basis, i.e., treated as if they were sold for fair market value at the end of every year. Gain or loss with respect to such Sec. 1256 contracts is deemed to be 40% short-term capital gain or loss and 60% long-term capital gain or loss, regardless of actual holding period, with certain exceptions for foreign-currency-related products. Sec. 1256 also provides, inter alia, expanded loss carryback rules with respect to Sec. 1256 contracts.
Historically, with one exception for certain foreign currency forwards, a contract could be within Sec. 1256 only if it was traded on or subject to the rules of an approved securities or commodities exchange (a qualified board or exchange). These exchanges required investors to post margin with a clearinghouse on a daily mark-to-market system, such that if a contract was in the money, the investor could withdraw some of the profits, and if the contract was out of the money, the investor had to post more margin. Thus, mark-to-market tax accounting under Sec. 1256 was consistent with the economics of the contract.
The Dodd-Frank Act expanded the types of contracts that have to go through a central clearinghouse. Congress did not wish to bring new types of contracts within Sec. 1256, and so the Dodd-Frank Act amended Sec. 1256(b)(2) to provide that no “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” would be treated as a Sec. 1256 contract.
Credit-default, weather-related, and other nonfinancial swaps: Under current law (Regs. Sec. 1.446-3), a “notional principal contract” is defined as a financial instrument that both (1) arguably requires at least one party to make a series of two or more payments, and (2) is based on certain “specified indices,” including current, objectively determinable financial or economic information that is not within the control of, or unique to, either of the parties. Certain newer types of financial instruments have evolved that do not fit this definition neatly, if at all, even though they might be viewed as analogous to notional principal contracts. Two examples are credit-default swaps and weather-related swaps. Simple credit-default swaps are based upon whether a particular obligor has defaulted on a particular loan. Weather-related swaps are based on measures of temperature, precipitation, etc. Other swaps have evolved that are based on nonfinancial measures. Even the IRS was not certain about what to do about credit-default swaps, and it asked for comments on the issue in 2004.
A slightly different definition of notional principal contracts is contained in Regs. Sec. 1.863-7, which governs the source of income from such contracts. The term also is used in subpart F, in the Sec. 988 foreign currency provisions, and in Sec. 871(m), a provision of the Hiring Incentives to Restore Employment Act, P.L. 111-147, that requires withholding on certain dividend equivalent amounts.
Bullet swaps: Under existing law, as noted above, arguably at least one side of a contract must provide for a series of two or more payments before it can be treated as a notional principal contract. Thus, a bullet swap over an equity, which provides for one net payment at the end based on interest rates at various dates, dividends paid from time to time, and the net appreciation or depreciation of the reference equity, was not a notional principal contract under Sec. 1234A regulations proposed in 2004.
Explanation of Provisions
Sec. 1256: The proposed regulations follow the statute in excluding notional principal contracts (the expanded definition of which is discussed below) from Sec. 1256. The proposed regulations would also provide that options over notional principal contracts are excluded from Sec. 1256, even if such options are listed and otherwise would be nonequity options under Sec. 1256(g)(3).
The proposed regulations would provide that contracts that must be reported as swaps under the Commodities Exchange Act, as amended by the Dodd-Frank Act, are not Sec. 1256 contracts, even if they are traded on a qualified board or exchange. The IRS notes, however, that the nontax rules on when a contract must be reported as a swap for this purpose have not been issued in final form, and so it might be necessary to revisit this issue later.
The Dodd-Frank Act repeals the historic prohibition against transactions in commodity futures contracts that are not carried out on, by, or through a commodity exchange and allows exchanges to permit certain off-exchange transactions for valid business reasons. The proposed regulations would specify that such permitted off-exchange transactions would be treated as Sec. 1256 contracts, because they are conducted subject to the rules of a qualified board or exchange, even though they are not conducted on such an exchange.
The proposed regulations also would modify when an exchange would be treated as a qualified board or exchange, to conform to certain nontax provisions of the Dodd-Frank Act.
Credit-default, weather-related, and other nonfinancial swaps: The IRS inferred from the language of the amendment to Sec. 1256 that Congress intended to expand the definition of a notional principal contract for tax purposes. Accordingly, the proposed regulations would expand the type of specified index on which a notional principal contract may be based to include a “specified non-financial index.” This is defined as 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.” The proposed regulations specifically provide that credit-default swaps and weather-related swaps are notional principal contracts.
The IRS generally intends for this revised definition of a notional principal contract to be used for all federal income tax purposes. Accordingly, the regulations under Secs. 512, 863, 954, and 988 would be amended to refer to this new definition, and the (generally parallel) definition previously contained in Regs. Sec. 1.863-7, used to determine the source of income from notional principal contracts, would be eliminated.
Bullet swaps: The proposed regulations provide that fixing an amount due under a contract is treated as a “payment” for purposes of the rule that at least one leg of a notional principal contract must provide for a series of two or more “payments.” An example provides that a bullet swap is a notional principal contract, because each fixing of LIBOR (London Interbank Offered Rate) or dividend payment constitutes a “payment” for this purpose.
The proposed regulations provide welcome clarity as to the scope of Sec. 1256, since there were some open questions about how to interpret the amendment that excluded swaps from the statutory definition.
The proposed regulations also provide welcome clarity about the treatment of credit-default swaps, weather-related swaps, and other swaps over nonfinancial indices. But given the mechanical definition of a notional principal contract, it is not obvious that all credit-related derivatives will be notional principal contracts. For example, taxpayers may structure an arrangement to have the purchaser of credit protection make a single payment upfront and the seller of credit protection deliver on its potential liability at the end. This change shows that characterization as a notional principal contract or some other derivative may be somewhat form driven, although often there are economic consequences to that type of choice.
In this regard, it should be noted that the notional principal contract rules can affect the character of swap income, which may have collateral tax consequences. For example, treating a bullet swap as a notional principal contract means that it might not necessarily produce capital gain or loss, given that swaps generate ordinary income or expense during their terms. Note also that such a bullet swap would provide for a contingent nonperiodic payment, and the rules for such payments have not been settled definitively yet. (That timing is discussed in regulations proposed in 2004 and not yet finalized (REG-166012-02).)
Michael Dell is a partner at Ernst & Young LLP in Washington, DC.
For additional information about these items, contact Mr. Dell at (202) 327-8788 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.