IRS Proposes Regulations Expanding the Definition of a “Notional Principal Contract”

The IRS has proposed regulations that clarify and expand the definition of what contracts qualify to be treated as notional principal contracts — the typical way swaps are treated for federal income tax purposes. A payment to a non-U.S. person under a swap contract that qualifies as a notional principal contract is generally not subject to U.S. withholding tax (unless the payment relates to dividend payments on stock). 

The proposed regulations provide that credit default swaps (although the exact parameters of what constitutes a credit default swap are still ambiguous) and weather derivatives are treated as notional principal contracts, treatment that was at least somewhat in doubt in both cases before. In addition, the proposed regulations provide a broader rule for when a swap contract will be treated as having two or more payments — a requirement for notional principal contract treatment. This treatment narrows the set of swaps that can qualify as so-called “bullet” swaps, swaps which are not subject to the accrual and character rules applicable to notional principal contracts — a potential concern for U.S. taxpayers. These proposed regulations provide that they are effective when finalized.

Discussion

Section 1256 of the Internal Revenue Code imposes a mark to market regime on certain traded financial contracts (a “section 1256 contract”). The Dodd-Frank Act added Section 1256(b)(2)(B) to the Code, which excludes swaps and similar agreements from the definition of a section 1256 contract. Code Section 1256(b)(2)(B) contemplates that a swap contract, even if traded on or subject to the rules of a qualified board or exchange, will not be a section 1256 contract. The IRS has now issued proposed regulations that provide that a “swap contract” for purposes of Code Section 1256 is a contract that constitutes a notional principal contract as defined in regulations issued under Code Section 446. In addition, the IRS has proposed expanding what is considered to be a notional principal contract.¹

Under the proposed regulations, a section 1256 contract does not include a contract that qualifies as a notional principal contract. In addition, the definition of a notional principal contract is expanded and modified to expressly cover credit default swaps and weather derivatives, as well as certain contracts that previously were thought excluded as a single payment or “bullet” payment swap. The proposed regulations also provide that a section 1256 contract does not include an option on any contract that is a notional principal contract (often referred to as a “swaption”).

Definition and Scope of a Notional Principal Contract

     1. Payments under a notional principal contract

     A notional principal contract is defined in Treasury regulations 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. Questions have arisen as to the proper interpretation of this requirement. The proposed regulations expressly provide that a notional principal contract requires one party to make two or more payments to a counterparty (i.e., a contract that provides only one payment from each party is not a notional principal contract). However, for this purpose, the fixing of an amount is treated as a payment, even if the actual payment reflecting that amount is to be made at a later date. Thus, for example, a contract that provides for a settlement payment referenced to the appreciation or depreciation on a specified number of shares of common stock, adjusted for actual dividends paid during the term of the contract, is treated as a contract with more than one payment with respect to that leg of the contract.

     In Notice 2004-52 (2004-2 CB 168), the Treasury Department and the IRS described four possible characterizations of a credit default swap for tax purposes without resolving which characterization should prevail. These proposed regulations resolve this uncertainty by adding credit default swaps to the list of swaps categorized as notional principal contracts governed by the rules of Treasury regulation §1.446-3. This helps resolve the uncertainty that existed as to whether a credit default swap could be treated as a form of insurance or guarantee subject to U.S. withholding tax rather than as a notional principal contract not subject to U.S. withholding tax. However, some uncertainty remains because the proposed regulations state a guarantee is not a notional principal contract.

     Since the adoption of the Treasury regulations defining notional principal contracts, markets have developed for contracts based on non-financial indices. Many of these contracts are structured as swaps, and payments are calculated based on indices such as temperature, precipitation, snowfall or frost. For example, payments made under a weather derivative may be based on heating degree days and cooling degree days. As a technical matter, a weather-related swap currently is not a notional principal contract because a weather index does not qualify as a “specified index” under current regulations, which generally require that such index be a financial index. The proposed regulations expand the definition of a “specified index” to include non-financial indices that are comprised of any objectively determinable information that is not within the control of any of the parties to the contract and is not unique to one of the parties’ circumstances, and that cannot be reasonably expected to front-load payments accruing under the contract.

These regulations are proposed to apply to contracts entered into on or after the date the final regulations are published in the Federal Register.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

New York
Charles R. Bogle