New Proposed Regulations on Certain Derivatives in Connection With the Enactment of the Dodd-Frank Act

On September 15, 2011, the Internal Revenue Service (IRS) proposed new regulations that will make significant changes to the taxation of certain derivatives by expanding and updating what types of contracts should be within the definition of a notional principal contract (NPC) as explained below.

Why the New Regulations Were Proposed

The proposed regulations provide clarity for swap contracts that are now traded on regulated exchanges.

Section 1601 of the Dodd-Frank Act added Internal Revenue Code (IRC) Section 1256(b)(2)(B) which provides that certain swaps and similar agreements are not subject to IRC Section 1256, as explained below.Congress incorporated a list of swaps that parallels the list of swaps included under the definition of NPC with the addition of credit default swaps and bullet swaps. The parallel language suggests that Congress was attempting to standardize the list of swaps excluded under IRC Section 1256(b)(2)(B) with swaps that qualify as NPCs rather than with the contracts defined as “swaps” under Section 721 of the Dodd-Frank Act.

The plain language of IRC 1256(b)(2)(B) does not address whether an option on a swap (i.e., swaption) that is traded on a qualified board or exchange would constitute a “similar arrangement” and thereby excluded from the application of IRC 1256.

Explanation of IRC Section 1256 Provisions

Under the Dodd-Frank Act and the mandatory use of clearinghouses, Congress was concerned that swaps and similar contracts which are now traded on an exchange should not be afforded similar tax treatment as arrangements included under the rules of IRC Section 1256.

IRC Section 1256 provides that certain contracts which are traded on, or subject to the rules of, a “qualified board or exchange” (Section 1256 contracts) are marked-to-market at the end of each taxable year and the gain or loss realized thereon is treated as 60% long-term capital gain/loss and 40% short-term capital gain/loss. Historically, Section 1256 has primarily applied to certain commodities futures and foreign currency contracts which are traded on an exchange regulated by the Commodity Futures Trading Commission or certain foreign exchanges designated by the IRS.

What is a Notional Principal Contract (NPC)?

A NPC is an instrument that provides for payments 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 (by the other party) to pay similar amounts. A swap is generally treated under tax law as a NPC.

Tax Treatment of NPCs

Treasury Regulations require that payments made or received under a NPC generally must be included in income or deducted on a current basis and are treated as ordinary income or deduction.Periodic payments (that is payments received during the term of a NPC at intervals of one year or less) are typically accounted for in the year they are received or paid.A “non-periodic” payment (for example, a payment received at the beginning or the end of the term of a NPC) must be accounted for over the life of the contract using the so-called “non-contingent swap method” or a similar method of accounting.Gain or loss realized on the sale or exchange of a NPC is capital gain or loss, which may be treated as long-term capital gain or loss if the NPC has been held by the taxpayer for more than one year at the time of the sale or exchange.

Treatment of Credit Default Swaps as NPC

In Notice 2004-52, the Treasury Department and the IRS described four possible characteristics of a credit default swap. In the past, the federal tax treatment of credit default swaps has been a question for many- some treat these contracts as notional principal contracts, options, guarantees or even insurance contracts. These proposed regulations resolve this uncertainty by adding credit default swaps to the list of swaps categorized as NPCs. As a result, if the proposed regulations are finalized in current form, a taxpayer will be required to accrue for payments received (or to be received) and treat such amounts as ordinary income over the life of the contract.

Changes in Treatment of Certain Bullet Swaps

A bullet swap is a financial instrument in which all the obligations of the parties are settled via a single payment (usually a net payment).

The proposed regulations would define a “notional principal contract” to include a financial instrument in which at least one party is required to make two or more payments to the counterparty.In addition, the proposed regulations would define a “payment” to include an amount that is fixed on one date even if the actual payment reflecting that amount is made or taken into account at a later date. Under this approach, the Treasury would bifurcate a bullet swap contract into two payments, whereby the interest component of the contract would be deemed the first payment and the payment of the principal would be considered the second payment.For example, a total return equity swap provides for periodic dividend or interest accruals, and under the proposed regulations, these accruals will be treated as payments and must be recognized as ordinary income. As a result, under the proposed regulations many bullet swaps would be treated as “notional principal contracts” notwithstanding the fact that all actual payments are made at the conclusion of the transaction. The downside of these proposed regulations is bullet swaps would lose their ability to be treated as forward contracts for capital gain or loss purposes.

Effective Date

The IRS has requested comments on the proposed regulations by December 14, 2011 and will hold a public hearing on the proposed regulations in January 2012.

Final Comments

This technical bulletin is designed to communicate to our Marcum LLP clients and friends the recent developments surrounding taxation of certain derivative instruments, specifically credit default and bullet swap vehicles.Please reach out to your tax professionals for additional guidance related to this area.