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The Service has issued temporary regulations with a cross-referenced notice of proposed rulemaking (the regulations) on the US federal income tax treatment of upfront payments made under certain notional principal contracts (NPCs). The regulations provide that obligations of US persons arising from upfront payments made by controlled foreign corporations (CFCs) under certain cleared contracts do not constitute US property under Section 956(a). The new rules alleviate some concerns of US shareholders of CFCs that make these payments. The regulations apply to payments made on or after May 11, 2012.

Background

Section 956 requires an income inclusion by US shareholders of CFCs that invest certain earnings and profits (E&P) in US property, based on the broad policy view that such investment is essentially equivalent to a dividend. Generally, the amount taken into account with respect to any US property for these purposes is the adjusted basis of the property reduced by any liability to which the property is subject. Section 956(c)(1) includes within the definition of US property generally an obligation of a US person that is related to the relevant CFC by share ownership (e.g., the obligation of the CFC's sole stockholder).

A party to an NPC who makes a below-market periodic payment or receives an above-market periodic payment under the NPC will typically make a non-periodic payment, such as an upfront payment, to the counterparty to compensate for the off-market coupon payments. For US federal income tax purposes generally, only "significant" non-periodic payments on a swap are treated as creating a loan. For the purposes of Section 956, however, the Commissioner may treat any non-periodic payment made in connection with an NPC, whether or not it is "significant," as one or more loans under Treas. Reg. Section 1.446-3(g)(4). Under these rules, practitioners expressed concern that a CFC that entered into an NPC requiring the CFC to make an upfront payment with its parent could be viewed as making an investment in US property, potentially triggering an immediate income inclusion to the parent in the amount of the upfront payment.

This issue has become more widespread in recent years. Certain NPCs have begun to be cleared through US-registered clearing houses, which generally require the contracts to have standardized terms (for example, a coupon of either 100 or 500 basis points). Because these standardized coupons will be off-market, they require a non-periodic, upfront payment to equalize the present value of the payment obligations under the contract. The volume of NPCs cleared this way is expected to substantially increase because of the Dodd-Frank Act (for discussion of the Dodd-Frank Act, see Tax Alert 2010-1035). US-registered clearing houses manage the credit risk of NPC counterparties by requiring the posting of margin. "Daily variation margin" is generally payable by both parties on a daily basis to reflect fair market value variations of the contract. "Initial variation margin" is posted by the upfront-payment recipient generally on the same day that the upfront payment is made, and is usually of an amount equal to the upfront payment. Because the upfront payment recipient does not receive any net advance after taking into account the initial variation margin, the obligation of a US person created by an upfront payment made on a cleared NPC does not appear to be the type of transaction intended to be covered by Section 956. Nonetheless, absent a specific exception in the Code or regulations for this type of transaction, these transactions presented a substantial risk of immediate taxation to the parent.

New Exception

The new regulations remove the concern that upfront payments made with respect to certain cleared contracts that are properly classified as NPCs could constitute an investment in US property and thus require an immediate income inclusion by the CFC's parent. Specifically, the regulations provide that obligations of US 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 US property for purposes of Section 956(a). To qualify for this exception, the following five conditions must be met:

(1) The upfront payment must be required under a contract that is cleared by a derivatives clearing organization (as defined in section 1a of the Commodity Exchange Act (7 U.S.C. 1a)) or a clearing agency (as 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.

(2) The CFC must make the upfront payment to or through a US person that is a clearing member of the derivatives clearing organization or clearing agency, or directly to the derivatives clearing organization or clearing agency, if the CFC is a clearing member of the derivatives clearing organization or clearing agency.

(3) The upfront payment must be made, directly or indirectly, to the counterparty to the contract.

(4) The counterparty to the contract must be required to make a payment in the nature of initial variation margin that equals (before taking into account any change in the value of the contract between the time the contract is entered into and the time at which the payment is made) to the amount of the upfront payment made by the CFC.

(5) A payment in the nature of initial variation margin must be paid, directly or indirectly, to the CFC.

Implications

The new rule is eminently reasonable, because an upfront payment on an NPC should not, as a policy matter, constitute an investment in US property for purposes of Section 956, as long as corresponding amounts are immediately posted as collateral with the CFC. The relief granted, however, is very narrow, because it is limited to CFCs that are dealers and to contracts that are cleared by US-registered clearinghouses. The rationale of the new rule would suggest that it should apply to a fact pattern wider than contemplated in the preamble, including fact patterns involving non-dealer CFCs or contracts cleared by non US-registered clearing houses or both. The preamble to the regulations notes that the government is considering (and soliciting comment) under what circumstances the exception might be extended to other contracts, including those that are not cleared by a US-registered clearing house. Interested taxpayers may want to consider submitting comments to the government, on broadening the exception's scope.

As stated above, by their terms the new regulations apply to payments made on or after May 11, 2012. This effective date leaves open the possibility that the Service could attempt to treat as investments in US property payments made before that date. Given the policy decision implicit in the regulations, however, this treatment would appear to be unlikely.