On July 15th, the Department of the Treasury, Internal Revenue Service (“IRS”), issued temporary and proposed regulations (the “Temporary Regulations”)[1] addressing when a transfer of certain derivative contracts does not result in an “exchange” to the remaining party for purposes of Section 1.1001-1(a) of the Income Tax Regulations (the “Tax Regulations”) of the Internal Revenue Code (the “Code”). The significance of the Temporary Regulations is that they clarify that, subject to certain specified conditions, a transfer of a derivative contract by a counterparty does not, in and of itself, result in an event for which gain or loss must be calculated by a remaining party, irrespective of whether the terms of the derivative contract itself require the consent of the remaining party for the transfer.
Section 1001 of the Code provides rules for the calculation and recognition of gain or loss from a sale or other disposition of property. Section 1.1001-1(a) of the Tax Regulations requires that such a gain or loss be realized (i.e., that a taxable disposition exist) upon an exchange of properties that differ materially, whether in kind or in extent. This rule has applied to a remaining party to a “notional principal contract”[2] if the resulting contract (i.e., between the transferee and remaining party) differs materially from the original contract (i.e., between the transferor and the remaining party). However, Section 1.1001-4(a) of the Tax Regulations provides that the substitution of a new party to a notional principal contract does not constitute an exchange if: (i) the transfer occurs between dealers; and (ii) the terms of the contract permit the transfer. Significant uncertainty has existed in connection with the second prong of this test. Moreover, historically, this test has applied solely to derivatives contracts that qualify as notional principal contracts.
The standard boilerplate language of the various master agreements published by the International Swaps and Derivatives Association, Inc., the predominant forms of master agreement governing derivatives transactions in the marketplace, states that, with certain limited exceptions, the transfer of the master agreement or any interest in or under the agreement, requires the prior written consent of the other party. This provision is often modified by the contracting parties to provide for certain additional flexibility (e.g., that consent to transfer shall not be unreasonably withheld or to permit a party to transfer to its affiliate, so long as the credit profile remains the same), but it is quite exceptional for a master agreement to require no consent to transfer. As a result of the consent requirement, there has been uncertainty as to whether most derivatives contracts satisfy the requirement that they “permit” transfer. The impending implementation of the Dodd-Frank legislation has heightened the focus on this ambiguity, as it may compel market participants to effect certain transfers of transactions (and, in some cases, entire portfolios of transactions).
The Temporary Regulations expand the Section 1.1001-4 test to include derivative contracts (which is broadly defined) other than notional principal contracts. Moreover, the Temporary Regulations specifically state that there is no “exchange” to the remaining party solely because a dealer in securities (or a clearinghouse) transfers a derivative contract to another dealer in securities (or a clearinghouse), so long as: (i) the transfer is permitted by the terms of the contract; and (ii) the terms of the derivative contract are not otherwise modified in a manner that results in a taxable exchange under Section 1001. The Temporary Regulations further clarify that transfers are deemed to be “permitted” by the terms of a contract even when consent of the remaining party is required and that the treatment of the remaining party for purposes of Section 1.1001-4 is not affected by the exchange of consideration between the transferor and transferee in connection with a transfer.[3]
The IRS requested comment on the Temporary Regulations within 90 days of their effective date, which was July 22nd.
[1] The temporary regulations may be found at http://www.gpo.gov/fdsys/pkg/FR-2011-07-22/html/2011-18529.htm.
[2] A “notional principal contract” is defined as a financial instrument that 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 to pay similar amounts, including interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, and similar agreements. 26 C.F.R. §1.446-3.
[3] Note, however, that if any consideration is paid to or received by the remaining party, such a payment will need to be analyzed to determine its impact on the remaining party. Also, any changes to the terms of a derivative contract will require additional analysis to determine whether a taxable disposition has occurred.