On May 8, 2015, the Internal Revenue Service (“IRS”) and the Department of the Treasury (“Treasury”) issued proposed and temporary regulations (the “Regulations”) relating to the treatment of notional principal contracts (“NPCs”) with nonperiodic payments.[1] The Regulations are designed to resolve questions that have arisen with the enactment of Dodd-Frank. The Regulations are a fundamental change in the treatment of NPCs. The rules apply to NPCs entered into on or after November 4, 2015, but taxpayers may apply the rules to NPCs entered into before November 4, 2015. The Regulations package also includes regulations under section 956 of the Internal Revenue Code of 1986 (the “Code”).
While the Regulations are designed to resolve issues, many unanswered questions remain.
Background
Since being finalized in 1993, the regulations under section 446 call for separate treatment for periodic payments, nonperiodic payments, and termination payments under NPCs. A periodic payment is prorated among the days in each calculation period, and the amount allocated to each day is recognized as gross income or a deduction for the year that includes that day.[2] A nonperiodic payment is any payment made or received with respect to an NPC that is not a periodic payment or a termination payment. Examples of nonperiodic payments are the premium for a cap or floor agreement (even if it is paid in installments), the payment for an off-market swap, the prepayment of part or all of one leg of a swap, and the premium for an option to enter into a swap if and when the option is exercised.[3] Termination payments are payments made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under an NPC. A payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under an NPC is a termination payment to the party making the termination payment and the party receiving the payment.[4] Prior to the 1993 regulations and earlier guidance contained in Notice 89-21,[5] taxpayers had taken the position that upfront payments could be treated as ordinary income, thereby allowing taxpayers with net operating losses to freshen them.
Nonperiodic payments that are significant are subject to embedded loan treatment. Under such treatment, the contract is generally treated as two separate transactions consisting of an on-market, level payment swap and a loan. The loan must be accounted for by the parties to the contract separately from the swap. The time-value component associated with the loan is recognized as interest for all purposes of the Code. The 1993 regulations do not provide a corresponding rule with respect to other forms of NPCs, such as caps or floors.[6]
The regulations do not define a significant nonperiodic payment as compared to a non-significant nonperiodic payment. However, two examples are provided to illustrate the difference. One example indicates that a yield adjustment payment is not considered significant if it is less than 9.1% of the present value of the fixed payments due under the swap contract.[7] In a second example, where a yield adjustment payment is designed to compensate for five years of below-market payments, a yield adjustment is considered significant where it represents 40% of the present value of the total fixed payments due under the contract.[8] Once it is determined that a payment is significant, the transaction is subject to embedded loan treatment for all purposes of the Code.[9] For purposes of section 956, the IRS may treat any nonperiodic swap payment, whether or not it is significant, as one or more loans.
Usually, above- or below-market payments reflect differences between the rate on the instrument and market rates. If a party to an NPC makes below-market periodic payments or receives above-market periodic payments under the terms of the contract, typically that party will make a nonperiodic payment, such as an upfront payment, to the counterparty in order to compensate for the off-market coupon payments specified in the contract. For example, if A and B enter into an off-market interest rate swap, the terms of which require A to make periodic below-market fixed rate payments to B and require B to make periodic on-market floating rate payments to A, then A typically will compensate B (for receiving the below-market fixed rate payments) by making a nonperiodic payment (whether as installments or as an upfront payment) so that the present value of the fixed rate leg of the swap will equal the present value of the floating rate leg of the swap.
With the commencement of clearing of swap contracts on standard terms, the use of off-market payments has become more prevalent. As an example, once a swap is cleared, a party wishing to exit the swap position must do so by entering into an equal and offsetting trade. Because it is highly unlikely that rates will be unchanged at the time the offsetting trade is entered into, the execution of such an offsetting position usually will result in a new position with an upfront payment. Upfront payments that might be deemed to be significant are also more likely to occur in connection with swaps that trade with predetermined coupons, such as “market agreed coupon” interest rate swaps and credit default swaps, because it is unlikely to be the case that the marketplace will ever precisely match the specified coupon rates as of the execution date of the swap.
2012 Proposed and Temporary Regulations under Section 956
On May 11, 2012, the IRS issued proposed and temporary regulations related to the treatment of upfront payments made pursuant to certain NPCs for purposes of section 956. As noted in the preamble to the Regulations, there have been significant changes in market practices for cleared and uncleared NPCs since the regulations were first issued. The preamble to the 2012 regulations states:
Recently, certain contracts (cleared contracts), including some credit default swaps and interest rate swaps, have begun to be cleared through U.S.-registered derivatives clearing organizations or clearing agencies (collectively, U.S.-registered clearinghouses). Contracts cleared through a U.S.-registered clearinghouse generally are required to have standardized terms. For example, credit default swaps that are cleared through a U.S.-registered clearinghouse have common documentation and standardized coupons (currently 100 or 500 basis points). Consequently, except for the rare instance when the market coupon rate for a particular credit default swap is exactly 100 or 500 basis points, a credit default swap with a standardized coupon will be off-market and will require an upfront payment to equalize the present value of the payment obligations under the contract.
The volume of contracts cleared by U.S.-registered clearinghouses is expected to increase substantially as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Public Law No. 111-203, 124 Stat. 1376 (the Dodd-Frank Act). Title VII of the Dodd-Frank Act, among other things: (1) provides for the registration and comprehensive regulation of swap dealers and major swap participants; (2) imposes clearing and trade execution requirements on many swap contracts; and (3) creates rigorous recordkeeping and real-time reporting regimes.[10]
Limiting the scope of the 1993 regulations, which treated any nonperiodic payment (whether or not significant) as one or more loans and as “U.S. property” for purposes of section 956, the 2012 proposed and temporary regulations established an exception to the definition of “U.S. property” for obligations of U.S. persons arising from upfront payments made with respect to certain cleared contracts that are properly classified as NPCs. Section 956 generally is based on the principle that the acquisition by a controlled foreign corporation (“CFC”) of certain U.S. property, including NPCs, has the practical effect of a dividend payment to its controlling stockholders and should be taxed to them. The 2012 proposed and temporary regulations provide an exception to this general rule: Obligations of U.S. persons arising from such upfront payments by a CFC that is a dealer in securities or commodities (within the meaning of section 475) do not constitute U.S. property for purposes of section 956(a).[11] As these were temporary regulations, this provision was to expire on May 8, 2015.[12]
The Regulations
The Regulations remove the exception to the embedded loan rule for non-significant nonperiodic payments because Treasury believes that the exception is not functioning as a rule of administrative convenience as intended. Instead, other than contracts for which there is an explicit exception, the Regulations treat all notional principal contracts that have nonperiodic payments as including one or more loans. Treasury and the IRS have determined that, unless an exception applies, the economic loan that is inherent in a nonperiodic payment should be taxed as one or more loans, and that it is reasonable to require taxpayers to separate the loan or loans from an NPC in the case of any nonperiodic payment, regardless of the relative size of such payment. Taxpayers may implement this change upon publication in the Federal Register, but the Regulations allow the effective date of this rule to be delayed until November 4, 2015.
Thus, with two exceptions, an NPC with one or more nonperiodic payments is treated as two separate transactions consisting of one on-market, level payment swap and one or more loans. The two exceptions are (i) NPCs with a term of one year or less; and (ii) NPCs subject to certain specified margin or collateral requirements.
The Short-Term Exception
An exception applies, solely for purposes of section 514 and 956, if the term of the contract is one year or less. The term of an NPC is the stated term of the contract, inclusive of any extensions (optional or otherwise) provided for in the terms of the contract, without regard to whether any extension is unilateral, is subject to approval by one or both parties to the contract, or is based on the occurrence or nonoccurrence of a specified event. For purposes of determining the term of a contract, an anti-abuse rule applies. The IRS may treat two or more contracts as a single contract if a principal purpose of entering into separate contracts is to qualify for the exception. A purpose may be a principal purpose even though it is outweighed by other purposes (taken together or separately).[13]
The Margin Exception
The margin exception applies if the contract is cleared by a derivatives clearing organization (as such term is defined in section 1a of the Commodity Exchange Act (7 U.S.C. 1a)) or by a clearing agency (as such term is defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)) that is registered as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act of 1934, respectively, and the derivatives clearing organization or clearing agency requires the parties to the contract to post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) on a daily basis for the entire term of the contract.[14] Under this provision, the mark-to-market exposure on a contract will be fully collateralized only if the contract is subject to both (i) an initial variation margin in an amount equal to the nonperiodic payment (except for variances permitted by intraday price changes) and (ii) a daily variation margin in an amount equal to the daily change in the fair market value of the contract.
For example, a domestic corporation (“A”) enters into an interest rate swap with unrelated counterparty (“B”). The swap is required to be cleared and is accepted for clearing by a U.S.-registered derivatives clearing organization (“DCO”). The standardized terms of the contract provide that A, for a term of X years, will pay B a fixed rate of 1% per year and receive a floating rate on a notional principal amount of $Y. When A and B enter into the interest rate swap, the fixed rate for similar interest rate swaps is 2% per year. The DCO requires A to make an upfront payment to compensate B for the below-market annual coupon payments that B will receive, and A makes the upfront payment in cash. The DCO also requires B to post an initial variation margin in an amount equal to the upfront payment and requires each party to post and collect daily variation margin in an amount equal to the change in the fair market value of the contract for the entire term of the contract. B posts the initial variation margin in U.S. dollars and the parties post and collect daily variation margin in U.S. dollars. Because the swap is subject to initial variation margin in an amount equal to the upfront payment and daily variation margin in an amount equal to the change in the fair market value of the swap on a daily basis for the entire term of the swap, the swap satisfies the margin exception.[15]
The Collateral Exception
The collateral requirement exception applies if the parties to the contract are required, pursuant to the terms of the contract or the requirements of a federal regulator (i.e., the Securities and Exchange Commission, the Commodity Futures Trading Commission, or a “prudential regulator” as defined in section 1a(39) of the Commodity Exchange Act (7 U.S.C. 1a), as amended by section 721 of the Dodd-Frank Act), to post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) on a daily basis for the entire term of the contract. The mark-to-market exposure on a contract will be fully collateralized only if the contract is subject to both initial variation margin or collateral in an amount equal to the nonperiodic payment (except for variances permitted by intraday price changes) and daily variation margin or collateral in an amount equal to the daily change in the fair market value of the contract.[16]
For example, on June 1, 2016, a domestic corporation (“P”) enters into an interest rate swap with an unrelated domestic counterparty (“CP”). Under the terms of the swap, CP agrees to make quarterly payments to P based on a fixed rate of 2% and a notional amount of $10,000,000 plus an upfront payment of $1,878,030. In exchange, P agrees to make quarterly payments to CP based on the same notional amount and 3-month LIBOR. At the time the parties enter into the swap, the fixed rate for an on-market swap is 3%. The swap is not required to be cleared and is not accepted for clearing by a U.S.-registered derivatives clearing organization. However, pursuant to the terms of the swap, P is obligated to post $1,878,030 as collateral with CP, and P and CP are obligated to post and collect collateral each business day in an amount equal to the daily change in the fair market value of the swap for the entire term of the swap. All collateral on the swap is required to be in U.S. dollars. Because the swap is required to be collateralized in an amount equal to the upfront payment and upon changes in the fair market value of the swap on a daily basis for the entire term of the swap, the swap satisfies the collateral exception.[17]
Other Rules
An NPC is only eligible for the margin or collateral exceptions to the extent the margin or collateral requirements are met by posting cash.[18] “Cash” is defined as U.S. dollars or cash in any currency in which payment obligations under the notional principal contact are determined.[19] To the extent there is excess collateral, it is accounted for under the general embedded loan rule.[20] If the parties post both cash and other property to satisfy margin or collateral requirements, any excess of the nonperiodic payment over the cash margin or collateral posted and collected is subject to the general embedded loan rule.[21] Additionally, contracts may not be netted for purposes of applying the rules. The rules proceed contract by contract. If a taxpayer’s posted margin is adjusted because it is owed money on another contract, it does not change the application of the rules to each contract.
Exception under Section 956
Included in the Regulations package are temporary and proposed regulations under section 956. The Regulations broaden the exception to the definition of “U.S. property” for purposes of section 956(a) that is contained in the 2012 proposed and temporary regulations: U.S. property does not include an obligation of a United States person arising from a nonperiodic payment by a CFC if the CFC that makes the nonperiodic payment is either a dealer in securities or a dealer in commodities and the conditions set forth relating to full margin or collateral in cash are satisfied.[22] Thus, the Regulations extend the exception beyond just cleared contracts. The Regulations would apply to payments described made on or after May 8, 2015. However, taxpayers may apply them to payments made before May 8, 2015.
Observations
The Regulations create a number of concerns.
First, although they are deferred, the Regulations are self-executing. Unless the IRS and Treasury decide to defer their effective date, they will become the law on November 4, 2015.
Second, the Regulations create interesting issues with respect to various types of contracts. The rules apply to NPCs broadly. There is no carve-out for particular types of contracts.[23] For example, proposed regulations issued on September 15, 2011, take the position that credit default swaps are NPCs.[24] Because these contracts trade with standardized fixed rates, there will usually be an upfront payments reflecting a mark to market adjustment. The upfront payment associated with a credit default swap is a nonperiodic payment and, therefore, within the scope of the rules. This may not have been intended. Similarly, with respect to swaptions, a premium is paid for an option to enter into a swap on a future date at specified rates and if the option is in the money on the future date, the swaption can be cash settled or the swap may be entered into at the rate negotiated upon entering into the option. The swaption premium will be treated as a nonperiodic payment if the swap is entered into. Additionally, there may be circumstances in which time value is appropriately accounted for under the contract because applying the embedded loan rule would not alter the tax consequences of the contract; for example, NPCs with nonperiodic payments that are subject to mark-to-market accounting.
Third, there is also a potential “cliff effect” created if the margin payment does not cover the entire upfront payment. It is common practice for the margin payment to be the same amount as the upfront payment; however, there is the potential for such a payment not to be 100 percent of the collateral, but instead some very high percentage. A taxpayer may fall outside the scope of the rules even though it is a technical issue with no real policy implications.
Fourth, the exceptions are based on U.S. regulatory standards. Cleared swaps are those cleared by a derivatives clearing organization (as such term is defined in section 1a of the Commodity Exchange Act (7 U.S.C. 1a)) or by a clearing agency (as such term in defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)) that is registered as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act of 1934. No exception is created for comparable foreign clearing organizations or agencies. Similarly, the full margin exception applies where the parties to the contract are required to post margin pursuant to the terms of the contract or the requirements of a “federal regulator.”
Finally, unlike the 1993 regulations, while there are two broad exceptions to the embedded loan treatment, there is no longer a de minimis rule with respect to non-significant nonperiodic payments. Although Treasury believes otherwise, the addition of such a rule would greatly ease the administration of the new provisions. Many upfront payments are small and a de minimis rule for such payments could avoid the unnecessary burden of treating a small payment as a loan only for tax purposes.
While the Regulations pose some concerns, on balance, they are a step in the right direction of modifying the embedded loan rule to reflect the realities of the current swap regulatory environment.
[1] T.D. 9719.
[2] Treas. Reg. § 1.446-3(e)(1).
[3] Treas. Reg. § 1.446-3(f)(1).
[4] Treas. Reg. § 1.446-3(h)(1).
[5] 1989-1 C.B. 651.
[6] Treas. Reg. § 1.446-3(g)(5) (reserving treatment with respect to caps or floors that are significantly in the money).
[7] Treas. Reg. § 1.446-3(g)(6) ex. 2(former regulations).
[8] Treas. Reg. § 1.446-3(g)(6) ex. 3 (former regulations).
[9] Treas. Reg. § 1.446-3(g)(4).
[10] T.D. 9589.
[11] Treas. Reg. § 1.956-2T(b)(1)(xi).
[12] Treas. Reg. § 1.956-2T(g). The Regulations broaden this provision and extend its expiration to May 7, 2018.
[13] Treas. Reg. § 1.446-3T(g)(4)(ii)(A).
[14] Treas. Reg. § 1.446-3T(g)(4)(ii)(B)(1).
[15] Treas. Reg. § 1.446-3T(g)(6), Ex. 3.
[16] Treas. Reg. § 1.446-3T(g)(4)(ii)(B)(2).
[17] Treas. Reg. § 1.446-3T(g)(6), Ex. 4
[18] Treas. Reg. § 1.446-3T(g)(4)(ii)(C)(1).
[19] Id.
[20] Treas. Reg. § 1.446-3T(g)(4)(ii)(C)(2).
[21] Treas. Reg. § 1.446-3T(g)(4)(ii)(C)(3).
[22] Treas. Reg. § 1.956-2T(b)(1)(xi).
[23] Additionally, there may be circumstances in which time value is appropriately accounted for under a contract (making application of the embedded loan rule unnecessary) because applying the embedded loan rule would not alter the tax consequences of the contract; for example, NPCs with nonperiodic payments that are subject to mark-to-market accounting.
[24] REG-111283-11; Prop. Treas. Reg. 1.446-3(c)(1)(iii) (2011).