May 9, 2018 IRS announces forthcoming regulations expanding exception to definition of US property under Section 956 The Internal Revenue Service (IRS) has announced (Notice 2018-46) that it plans to issue regulations to expand the exception to the definition of United States (US) property under Section 956(c). Background Sections 951(a)(1)(B) and 956 generally require a US shareholder of a controlled foreign corporation (CFC) to include in gross income the shareholder's pro rata share of an amount equal to the quarterly average of the US property held by the CFC, so long as certain other requirements are met. Unless an exception applies, US property includes an obligation of a US person. When a party to a notional principal contract (NPC) must make below-market periodic payments or is entitled to receive above-market periodic payments under the terms of the contract, that party must typically make a nonperiodic payment to the counterparty, such as an upfront payment, as compensation for the off-market periodic payment terms of the transaction. Under Section 446 regulations, nonperiodic payments are deemed to create a loan between the NPC transaction parties (the embedded loan rule), including for purposes of Section 956, unless an exception applies. Taxpayers expressed concern that, as a result of the application of the embedded loan rule for NPCs, a CFC could be viewed as making an investment in US property when the CFC executes an NPC with its parent that requires it to make an upfront payment that results in a deemed loan (i.e., an obligation of a US person and resulting income inclusion to parent). Consequently, the IRS issued temporary and proposed regulations in 2012 (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 for purposes of Section 956(a). See Tax Alert 2012-0902. In 2015, proposed regulations issued under Section 956 (the 2015 Regulations) broadened the exception to the definition of US property for obligations of US persons that qualified for an exception to the embedded loan rule. Specifically, the 2015 Regulations extended the exception of the 2012 Regulations to apply to certain obligations of US persons arising from upfront payments made on uncleared NPCs, provided that, inter alia, the transaction requires parties to post and collect both initial variation margin/collateral and daily variation margin/collateral (which had to be paid in cash) to fully collateralize the mark-to-market exposure on the contract on a daily basis for its entire term (the full margin exception to the embedded loan rule). See Tax Alert 2015-0924. In response to the 2015 Regulations, comments were submitted requesting further IRS guidance on the application of the full margin exception for purposes of Section 956 when a combination of cash and other property is posted as margin. Further, commenters requested clarification that the posting of qualifying collateral as margin with respect to an upfront payment (i.e., the initial margin/collateral) be sufficient to trigger application of the exception from the definition of US property even where daily variation margin/collateral is not subsequently posted. Commenters also requested expansion of the exception to include obligations arising in connection with an NPC and other financial derivative instruments. Notice 2018-46 In response to comments to the 2015 Regulations, the IRS intends to promulgate regulations under Section 956 that will extend the exception from the definition of US property to an obligation of a US person provided that the principal amount of the obligation does not exceed the fair market value of cash and readily marketable securities that a US or foreign securities dealer posts or receives as initial variation margin/collateral for the obligation in the ordinary course of its business. Additionally, the exception from the definition of US property will no longer be limited to certain obligations related to payments made on NPCs, but will also be available for obligations arising in connection with the execution of other financial derivative instruments. For purposes of Section 956(a), taxpayers may rely either on the provisions of Notice 2018-46 or the full margin exception provided in the 2015 regulations until the forthcoming regulations are issued. Implications The IRS's decision to expand the scope of the exception from the definition of US property to include other financial derivative instruments in addition to NPCs will surely be welcomed by taxpayers. Likewise, the inclusion of readily marketable securities will make it much easier for taxpayers to qualify for the exception and prevent taxpayers from falling out of the exception when additional margin collateral takes the form of readily marketable securities. Importantly, taxpayers should note that they can rely on the Notice for obligations arising before May 4, 2018. This exception from Section 956 for certain obligations of US persons was developed in parallel with temporary regulations under Section 446. Those temporary regulations expired on May 7, 2018. Thus, it will be interesting to learn whether the divisions of the IRS and Treasury that address domestic tax issues intend to provide guidance under Section 446 that parallels the guidance provided under Notice 2018-46. ———————————————
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