On September 15, the Internal Revenue Service (the “IRS”) proposed new regulations (the “Proposed Regulations”) that would clarify the tax treatment of certain notional principal contracts, credit default swaps and bullet swaps for federal income tax purposes.
As discussed in more detail below, the Proposed Regulations, if finalized, would (1) consistent with the Dodd-Frank Act, provide that swaps and similar contracts which are traded on an exchange would not be subject to the mark-to-market accounting and “60/40” capital gains treatment of Internal Revenue Code Section 1256, (2) treat credit default swaps as “notional principal contracts” for tax purposes, and (3) treat most bullet swaps as “notional principal contracts” for tax purposes.
Exclusion of Most Swaps from Mark-to-Market Rules of Section 1256
Internal Revenue Code 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 and 40% short-term capital gain. Historically, Section 1256 has primarily applied to commodities futures contracts which are traded on an exchange regulated by the Commodity Futures Trading Commission or certain foreign exchanges designated by the IRS.
Treasury Regulations require that payments made or received under a notional principal contract 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 notional principal contract at intervals of one year or less) are typically accounted for in the year they are received or paid. A “nonperiodic payment” (for example, a payment received at the beginning or the end of the term of a notional principal contract) must be accounted for over the life of the contract using the so-called “noncontingent swap method” or a similar method of accounting. Gain realized on the sale or exchange of a notional principal contract is capital gain or loss, which may be treated as long-term capital gain or loss if the notional principal contract has been held by the taxpayer for more than one year at the time of the sale or exchange.
Under the Dodd-Frank Act, trades in certain over-the-counter derivative contracts are required to be cleared on an exchange. However, the Dodd-Frank Act also specifically provided that, notwithstanding the fact that they may be traded on an exchange, swaps and similar contracts (including credit default swaps) are not subject to Section 1256.
Under the Proposed Regulations, the IRS has specifically provided that a contract (such as a swap) which would qualify as both a Section 1256 contract and a “notional principal contract” will be treated as a notional principal contract for federal income tax purposes. Therefore, swaps will generally not be subject to the mark-to-market rules of Section 1256.
Treatment of Credit Default Swaps as Notional Principal Contracts
The federal income tax treatment of credit default swaps has long been uncertain. Credit default swaps could conceivably be treated as notional principal contracts, guarantees, insurance contracts, options or some other type of financial or services contracts. In Notice 2004-52, the IRS requested comments regarding the proper federal income tax treatment of credit default swaps. The Proposed Regulations would generally treat credit default swaps as notional principal contracts for federal income tax purposes. As a result, if the Proposed Regulations are finalized in current form, a taxpayer may be required to accrue for payments received (or to be received) under a credit default swap upon a credit event over the life of the contract and treat such accrued amounts as ordinary income.1
The treatment of credit default swaps as notional principal contracts for federal income tax purposes provides needed certainty regarding the treatment of these instruments for private investment funds. In particular, some private investment partnerships rely on the 90% “qualifying income” exception to avoid being treated as a “publicly traded partnership” taxable as a corporation for federal income tax purposes. Notional principal contracts generally produce “qualifying income” for this purpose, whereas the treatment of credit default swaps was uncertain. The Proposed Regulations effectively clarify that credit default swaps produce “qualifying income” for purposes of this rule and will allow private investment partnerships to invest in credit default swaps without being concerned that such investments could cause the partnership to fail the qualifying income test.
Changes in Treatment of Certain Bullet Swaps
Under current regulations, a “notional principal contract” is “a financial instrument which 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 [by the other party] to pay similar amounts.” Therefore, a “bullet swap”2 is generally not treated as a “notional principal contract” for federal income tax purposes since it provides for payment of an amount only by one party at the conclusion of the swap.
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 on a later date (such as LIBOR or an amount of dividends). 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 swap.
Under current law, payments received on a bullet swap with a term of more than 12 months are generally treated as long-term capital gain. However, if a bullet swap is treated as a notional principal contract, the amounts included in income under the contract will generally be treated as ordinary income for federal income tax purposes. Further, in the case of a taxpayer that is not considered to be engaged in a trade or business (e.g., an investment fund that is treated as an “investor” in securities rather than a “trader” in securities), payments made (or accrued with respect to the swap may be treated as investment expenses that are subject to various limitations on deductibility. However, gain or loss realized on the sale or exchange of a bullet swap prior to its maturity would continue to be treated as capital gain or capital loss.
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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.
We will continue to monitor the progress of the Proposed Regulations. If you have any questions regarding this, please contact one of the attorneys listed below.
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1 In the preamble to regulations proposed in 2004, the IRS stated that a taxpayer must apply the non-contingent swap method or another similar method of accounting to notional principal contracts unless the taxpayer already had an existing method of accounting in place for notional principal contracts on or before March 25, 2004. As a result, many investment funds already effectively treat credit default swaps as notional principal contracts for federal income tax purposes (usually by marking them to market at the end of each year).
2 A “bullet swap” is a financial instrument in which all of the obligations of the parties are settled via a single payment (usually a net payment). For example, Party A would agree to pay any depreciation on a security plus the three-month LIBOR rate multiplied by the notional value of the security to Party B, and Party B would agree to pay the appreciation in the value of the security plus any dividends thereon to Party A, in each case at the conclusion of the contract. The payments would be netted against one another so that only Party A or Party B (but not both of them) would make a payment. Since only one party is making a payment, this instrument is not a “notional principal contract.”
