Tax News Update    Email this document    Print this document  

The IRS has issued final, temporary (TD 9719) and proposed (REG-102656-15) regulations (the 2015 regulations) that eliminate in many cases the requirement to treat nonperiodic payments made with respect to notional principal contracts (NPCs) as one or more loans and in all remaining cases require loan treatment regardless of whether the nonperiodic payment is significant. The 2015 regulations also provide an exception from Section 956 for certain related-party NPCs that might otherwise be treated as an investment in United States property.

Background

A party to an NPC making below-market periodic payments or receiving above-market periodic payments under the terms of the NPC will typically be required to make a nonperiodic payment, such as an upfront payment, to the counterparty to compensate for the off-market periodic payments. For US federal income tax purposes, under Section 446 regulations issued in 1993 (the 1993 regulations), "significant" nonperiodic payments on a swap are treated as creating a loan (the embedded loan rule), which the parties to the NPC must treat separately from the swap. For purposes of Section 956 (which requires an income inclusion by US shareholders of controlled foreign corporations (CFCs) that invest certain earnings and profits in US property), however, the Commissioner may treat any nonperiodic payment made in connection with an NPC, whether or not it is "significant," as one or more loans under the 1993 regulations.

In 2012, the IRS issued temporary and proposed regulations (the 2012 regulations) providing that obligations of US persons arising from upfront payments made by CFCs under certain cleared NPCs do not constitute US property under Section 956(a). The 2012 regulations were intended to alleviate concerns that a CFC that entered into an NPC requiring the CFC to make an upfront payment to 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. See Tax Alert 2012-902.

As a result of the 2010 Dodd-Frank Act (see Tax Alert 2010-1035), it has become more common for NPCs to be cleared through US-registered clearing houses, which generally require the contracts to have standardized terms and the posting of margin. Additionally, certain over-the-counter NPC markets have voluntarily begun to adopt standardized terms, and some uncleared contracts have margin requirements. Because the standardized terms are generally off-market, the terms of the contract require a nonperiodic, upfront payment to equalize the present value of the payment obligations under the contract. Posted margin includes "daily variation margin," which is generally payable by both parties on a daily basis to reflect fair market value variations of the contract, and "initial variation margin," which is posted by the upfront-payment recipient generally on the same day that the upfront payment is made, and is usually of an amount roughly equal to the upfront payment.

2015 regulations

The 2015 regulations simplify the embedded loan rule included in the 1993 regulations by eliminating the exception for non-significant, nonperiodic payments from the embedded loan rule. Thus, under the general rule, all NPCs with nonperiodic payments will be treated as including one or more loans. The 2015 regulations, however, provide two new exceptions to this general rule, which will exempt large numbers of NPCs from having deemed loans. They also modify and replace the rule included in the 2012 regulations providing an exception to the Section 956 definition of US property for certain NPCs.

The IRS concluded that the exception for non-significant nonperiodic payments in the 1993 regulations has failed as a rule of administrative convenience because of the uncertainty for taxpayers for which payments are "significant" without a clear regulatory definition. Accordingly, the 2015 regulations apply the embedded loan rule to NPCs with nonperiodic payments, regardless of whether the payment is significant, unless an exception applies.

The 2015 regulations create two new exceptions to the embedded loan rule: (1) the short-term exception and (2) the full margin exception. Except for purposes of Section 514 (Unrelated Debt-Financed Income) and Section 956 (Investments in US Property), the short-term exception applies for nonperiodic payments made under an NPC with a term of one year or less. The term of an NPC includes any extensions (optional or otherwise) provided in the terms of the contract, regardless of the nature of the triggering event. Additionally, the 2015 regulations provide an anti-abuse rule allowing the Commissioner, for purposes of determining the term of a contract, to treat two or more contracts as a single contract if a principal purpose of entering into the separate contracts is to qualify for the short-term exception.

The full margin exception applies for certain NPCs with nonperiodic payments that are subject to prescribed margin or collateral requirements. To qualify for the full margin exception, the NPC must either:

(1) Be cleared by a derivatives clearing organization or clearing agency that requires the parties to post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract on a daily basis for the entire term of the contract or

(2) Require the parties to the contract, either under the terms of the contract or the requirements of a federal regulator, to post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract on a daily basis for the entire term of the contract

In general, the mark-to-market exposure on a contract will be fully collateralized only if the contract is subject to both initial variation margin/collateral in an amount approximately equal to the nonperiodic payment and daily variation margin/collateral in an amount equal to the daily change in the fair market value of the contract. To qualify for the full margin exception, margin or collateral posted and collected must be paid in cash.

Regarding Section 956, the 2015 regulations provide an exception to the definition of US property for certain obligations of US persons arising from nonperiodic payments made with respect to NPCs that qualify for the full margin exception to the embedded loan rule. To qualify for the exception, the upfront payment must be made by a CFC that is either a dealer in securities under Section 475(c)(1) or a dealer in commodities, and the payment must be made in cash.

The general rule of the 2015 regulations applies to NPCs entered into on or after November 4, 2015. A taxpayer may, however, apply the general rules to NPCs entered before that date. The exceptions to the 2015 regulations apply to NPCs entered on or after May 8, 2015, but again a taxpayer may apply the exceptions to NPCs entered before that date.

Implications

The 2015 regulations greatly simplify the issue of whether an NPC has an embedded loan by generally treating any NPC with a nonperiodic payment as resulting in a loan, regardless of the size of the nonperiodic payment. Swaps with only upfront nonperiodic payments, however, should qualify for one of the exceptions, assuming they are either short-term or are cleared. The requirements for the exceptions are specific and taxpayers should assess whether the terms of their particular NPC satisfies the requirements for either of the exceptions. For example, over-the-counter swaps may not qualify for the full margin exception if margin or collateral is not required on a daily basis or if the parties are not required to collect the margin or collateral. The posting of Treasuries, which used to be a common practice in over-the-counter swaps, appears not to qualify for the full margin exception. In addition, it is not clear whether or how the rules apply to caps and floors or to NPCs with contingent nonperiodic payments. Finally, taxpayers with CFCs entering into NPC contracts with related parties should analyze whether these CFCs qualify as dealers in order to qualify for the exception to US property treatment.

———————————————