IRS Delays Effective Date for New Regulations on Embedded Loans in Swaps

October 14, 2015

The Treasury and the IRS have delayed implementation of the recently announced rule change that treats certain types of upfront payments on swaps as loans for federal income tax purposes (including for purposes of the unrelated debt-financed income rules).

In May, the Internal Revenue Service (IRS) and US Department of the Treasury (the Treasury) released Proposed Regulation (REG-102656-15) and Temporary Regulation (T.D. 9719), which concern the treatment of nonperiodic (upfront) payments under § 1.446-3 and treat such payments as two separate transactions. The separate transactions consist of one or more loans (embedded loans) and an on-market notional principal contract (NPC, or commonly referred to as a “swap”), with certain exceptions. On October 13, the IRS amended the temporary regulations by delaying their effective date from November 4, 2015 to January 1, 2017, or 180 days after the date that the final regulations are published in the Federal Register. Although these regulations are generally considered helpful to taxpayers who fall within the two broad exceptions, concerns have been raised that compliance systems would not be ready prior to the former effective date of November 4. For tax-exempt entities, however, these regulations confirm that under certain circumstances, tax-exempt entities may be deemed to have unrelated debt-financed income under section 514 of the Internal Revenue Code from entering into certain swaps with an embedded loan.


These regulations were issued in response to letters from the Securities Industry and Financial Markets Association (SIFMA) and other organizations regarding certain changes in the swap market that arose from passage of the Dodd-Frank Wall Street Reform Act and the Consumer Protection Act of 2010. One of Dodd-Frank’s consequences has been the requirement to standardize swap terms and require that swaps be cleared on exchanges. Accordingly, increasing numbers of swaps are now subject to initial and variation margin requirements and must be fully collateralized. Under the prior §1.446-3 regulations, an upfront nonperiodic payment to satisfy a margin requirement was considered an “embedded loan” if the upfront payment was “significant” (a previously defined term) and, accordingly, could be considered a loan to a tax-exempt entity. There was uncertainty regarding the application of the “significant” payment rules and the bifurcation of the significant payment as a separate loan from the swap.

The New Embedded Loan Rule

The IRS has now abandoned the significant payment concept and confirmed that the bifurcation approach (i.e., there are two separate transactions, a loan and an on-market-level payment swap). Under the new embedded loan rule, unless an exception applies, the economic loan inherent in an upfront nonperiodic payment is to be taxed as one or more loans—regardless of the relative size of such payment.

However, there are two broad exceptions:

  • The short-term exception—the new embedded loan rule will not apply to an NPC for a term of one year or less (inclusive of extensions); however, this short-term exception will not apply for purposes of the unrelated debt-financed income rules of section 514 (or under section 956).
  • The fully collateralized exception—the embedded loan rule will not apply with respect to an upfront nonperiodic payment on an NPC that is fully collateralized by a margin or collateral payment required by a US regulator, a US clearinghouse, or the terms of the contract.

Dates of Applicability

The new embedded loan rule generally applies on a delayed basis to NPCs entered into, on, or after January 1, 2017, or 180 days after the date the final regulations are published in the Federal Register. Taxpayers, however, are permitted to apply the rules to NPCs entered into before such date. The two exceptions to the new embedded loan rule apply immediately, and taxpayers are permitted to apply the exceptions to NPCs entered into before May 8, 2015 (the regulations’ publication date).


At the May 2015 American Bar Association Tax Section meeting in Washington, DC, the IRS drafters of the regulations explained that the Tax-Exempt Government Entities division coordinated the additional language regarding the applicability of section 514 to the short-term exception described above. From a practical standpoint, these exceptions will be very helpful to tax-exempt entities because the majority of swaps will eventually fall within the fully collateralized exception described above, or they can be structured to fit within this exception. However, a tax-exempt entity would still need to be concerned with whether any over-the-counter swaps it enters into have embedded loans and whether such loans can qualify for the fully collateralized exception because there is no longer a de minimis exception for upfront nonperiodic payments. It is also now clear that tax-exempt entities cannot rely on §1.512(b)-1(a)(1) to argue that all income from an NPC is excluded from unrelated business taxable income without first determining whether there is an embedded loan and whether income derived from the NPC constitutes income from debt-financed property under section 514. The cross-reference to section 514 in the short-term exception appears to indicate that the IRS believes that in certain circumstances, an NPC can be considered debt financed when there is an embedded loan from an upfront nonperiodic payment.

The IRS and Treasury have also requested comments regarding whether there are other circumstances when the embedded loan rule should not apply.


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:

William P. Zimmerman

Washington, DC
Richard C. LaFalce