PwC alternatives alert, September 18, 2011
New Proposed Regulations Address Tax Characterization of Credit Default Swaps and Other Financial Derivatives
On September 15, 2011, the IRS and Treasury released proposed regulations (1) addressing the tax treatment of credit default swaps ("CDS"), (2) confirming that no swap (CDS or otherwise) will be considered a "section 1256 contract" (even if traded or cleared on an exchange), and (3) proposing important changes to the existing regulations governing swaps.
Of particular importance, the IRS and Treasury propose to treat most CDSs as "notional principal contracts" ("NPC") for U.S. federal income tax purposes. In addition, the proposed regulations provide that a contract that requires only a single payment at maturity can nevertheless be an NPC, if the single payment at maturity is calculated by reference to a series of notional periodic payments. (Thus, the proposed regulations would prevent parties from "rolling up" a series of periodic payments to be paid/netted at maturity, in order to avoid NPC treatment.)
More importantly, by expanding the scope of contracts that are treated as NPCs, the proposed regulations increase the section 212 risk for funds that are not engaged in a trade or business. For these funds, net annual expense on an NPC is deductible under section 212, and therefore subject to limitation. Many non-trader funds characterize CDS as put options, giving rise to capital losses (thereby avoiding the section 212 limitation). In addition, some non-trader funds have carefully structured certain derivative contracts to have a single payment at maturity (again, to ensure that any losses are capital losses, and not subject to section 212). The proposed regulations would eliminate both of these strategies on a prospective basis.
Key Features of the Proposed Regulations
The regulations address three key areas:[1]1. Characterization of CDSs as NPCs. The proposed regulations would largely resolve the debate over the U.S. Federal income tax treatment of credit default swaps. Historically, the government has been undecided as to whether CDSs constitute an NPC, an option, a guarantee or insurance.[2] The proposed regulations treat most CDSs as notional principal contracts.[3](A CDS in which the protection buyer makes only a single payment would not appear to be an NPC under the proposed regulations.) This characterization applies regardless of whether a CDS requires or permits settlement by physical delivery of the referenced debt instrument or instruments.[4]
ObservationsAs noted above, the proposed regulations would have a substantial negative impact on funds characterized as "investors." Specifically, funds investing in CDSs would find net annual deductions attributable to periodic payments (and mark-to-market losses) limited by section 212. (As noted above, most non-trader funds currently treat CDSs as a series of put options, so that any net deductions for the year results in capital loss.)
Furthermore, the proposed regulations do not address difficult issues regarding the timing of income/loss on CDSs. If a CDS is an NPC, arguably, the payment to be made upon default is a "contingent nonperiodic payment" that must be accounted for under another set of proposed regulations (proposed in 2004). The preamble to those 2004 proposed regulations indicated that taxpayers that have not previously adopted a method of accounting with respect to "contingent nonperiodic payments" are not allowed to use a "wait and see" methodology, but must account for the contingent payment over the term of the swap. It is not entirely clear whether or how the IRS will depart from the approach outlined in the 2004 proposed regulations, now that it has concluded that CDSs are NPCs. We expect that the IRS will re-propose the 2004 proposed regulations to accommodate CDSs.
The proposed regulations also largely eliminate the risk that payments on CDSs to foreign funds will be subject to U.S. withholding tax.
2. Definition of "swap" for purposes of the exclusion from section 1256. Under section 1256(b)(2)(B) (as added by the Dodd-Frank Act), "swaps" and "similar agreements" are excluded from the definition of section 1256 contract. Under the proposed regulations, the term "swap," as used in the exclusion from section 1256, is defined as a "notional principal contract." Further, the proposed regulations provide that an NPC is not subject to section 1256, even if it otherwise satisfies the statutory definition of a section 1256 contract.[5] In other words, NPC status "trumps" status as a section 1256 contract.[6]
ObservationsThis aspect of the proposed regulations is sensible. Because certain aspects of the proposed regulations cross-reference CFTC guidance and other Dodd-Frank provisions, further revisions may be necessary.
3. Revision to the definition of "payment" under the swap regulations. The proposed regulations confirm that a contract must provide for multiple payments to/from a counterparty, in order to qualify as an NPC. Significantly, the proposed regulations treat the "fixing" of an amount as a periodic payment, even if the amount is "rolled up" and netted with other payments at maturity.[7] In other words, a "payment" is not determined by reference to a cash flow, but by reference to the "fixing" of an amount that impacts a later computation and that may never actually be paid. (The preamble suggests that this counter-intuitive interpretation of a "payment" might even be the IRS's view under current law.)
ObservationsThe new definition of "payment" would convert into NPCs many contracts that provide for only a single payment at maturity. For non-trader funds, this may result in the section 212 deduction whipsaw, described above.
We believe this new definition of "payment" was likely crafted with section 871(m) in mind. Section 871(m), enacted in March 2010, imposes a U.S. withholding tax on payments made pursuant to NPCs, to the extent those payments are contingent on the payment of a dividend on a U.S. stock. By expanding the scope of NPCs to include single payment contracts that calculate that payment by reference to dividends, the proposed regulations expand the scope of section 871(m).
Furthermore, because the proposed regulations draw a distinction between contracts with "resets" (i.e., periodic fixing of amounts) versus those that fix all payments at the contract maturity, the proposed regulations heighten the necessity to fully understand the computational mechanics of the trades to figure out the tax characterization. Given that there may be multiple mechanisms to achieve the same financial result, funds may also consider the new "payment" definition in structuring swaps on a prospective basis.
For more information, please contact your PwC tax advisor or one of the subject matter specialists listed below:
David Shapiro
Michael Feder
Jeffrey Maddrey
Rebecca Lee
[2] See,e.g., Notice 2004-52.
[3] Prop. Reg. § 1.446-3(c)(1)(iii).
[4] Prop. Reg. § 1.446-3(c)(1)(iii)(A).
[5] Prop. Reg. § 1.1256(b)-1(a).
[6] The proposed regulations also provide that an option on a notional principal contract is not subject to Section 1256 (as a " similar agreement"). See Prop. Reg. § 1.1256(b)-1(a).
[7] The Proposed Regulations provide two examples demonstrating the new rules: (1) a contract that provides for a single settlement payment referenced to the appreciation or depreciation in a specified number of shares of stock, adjusted for dividends paid during the term of the contract, net of an interest rate index periodically applied to a notional principal amount is treated as a contract that requires multiple payments (i.e., because the dividend and interest-rate based indices included in the calculation of amounts payable at settlement become fixed periodically); and (2) to contrast, a forward rate agreement with a final payment based on the spread between LIBOR and a fixed rate does not represent a notional principal contract because the contract provides for a single payment.
