Treasury Issues Proposed Regulations Addressing Tax Treatment of Credit Default Swaps

On September 15, 2011, the Treasury issued proposed regulations which would include Credit Default Swaps (“CDS”) in the definition of a Notional Principal Contract (“NPC”) under Treas. Regulation 1-446.3. The proposed regulations also confirm that swaps, including a Credit Default Swaps, would not fall under the Section 1256 regime and proposes significant changes to the existing NPC regulations. The proposals also provide conforming revisions to other relevant regulations.

What is a Credit Default Swap?

Seven years ago, the Treasury issued Notice 2004-52 seeking comments from users and their advisors on how a Credit Default Swaps should be treated for tax purposes. The popular view was that a CDS should be considered an Notional Principal Contract  while others suggested treatment as option, or an insurance product, or a guarantee. These new proposed regulations have ended this debate. The proposed regulations, when finalized, will treat most Credit Default Swaps contracts as Notional Principal Contracts.

What changes have been made to the existing Notional Principal Contract regulations?

Under existing law, an NPC is defined 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 amount, in exchange for specified consideration or a promise to pay a similar amount. The proposed regulations revise this definition by stating that a Notional Principal Contract  requires two or more payments to a counterparty. However, the “fixing” of an amount is treated as a payment even if the actual payment is to be made at a later date. The practical effect of this new definition is to prohibit creating an instrument, such as a “bullet” swap, where all of the anticipated payments are netted and made as one back end payment. Rather than looking at the sole ultimate payment, the proposed regulations require an understanding of the calculation of the expected payment. To the extent the ultimate payment consists of two or more calculations (i.e., dividend payments plus change in value) then the instrument will be considered an Notional Principal Contract.

What are some of the negative tax implications of a Notional Principal Contract?

As more instruments will fall under the expanded definition of an NPC, it is important to understand the potential negative tax treatment that these instruments carry. Under existing regulations most NPC payments, excluding a termination payment (i.e., an unscheduled payment made to extinguish the remaining obligations of any party under the contract), will be considered a Section 212 deduction if the taxpayer is not considered to be engaged in a trade or business. Section 212 deductions are considered miscellaneous itemized deductions at the individual tax level, subject to limitation in part or in full, depending on the taxpayer’s facts and circumstances. In addition, these Section 212 deductions are not deductible in many state jurisdictions.

In addition to taking into account the payments described above, proposed regulations issued in 2004 require taxpayers to adopt a method of accounting to take into account contingent nonperiodic payments (i.e., a final swap payment at end of the contract). Prior to issuance of these 2004 regulations, most taxpayers adopted a “wait and see” method on these payments. Under these proposed regulations, taxpayers are required to utilize the complex noncontingent swap method or, as an alternative, adopt a mark-to-market method. In practice, most taxpayers utilize a mark to market approach. This approach requires a taxpayer to annually include as “other” ordinary income any unrealized appreciation each year. Unrealized depreciation would also need to be taken into account as an expense. However, to the extent the taxpayer was not engaged in a trade or business, this amount would be included as a Section 212 deduction. Significant “whipsaw” can result for any taxpayer not engaged in a trade or business, as a taxpayer may be required to pick up ordinary income in a year of appreciation but not get the benefit of the deduction for a future’s year depreciation.

The newly issued proposed regulations do not address whether or not a Credit Default Swaps would be required to adopt the timing and inclusion rules of contingent nonperiodic payments. Presumably, if a Credit Default Swaps contract is now considered to be a Notional Principal Contract, the argument not to consider these as contingent nonperiodic payments are much weaker than were prior to issuance of the new proposed regulations.

To the extent that a taxpayer has not treated a Credit Default Swaps as a Notional Principal Contract, they may need to consider the application of the change in accounting method rules and filing requirements.

Exclusion of Swaps from Section 1256

The proposed regulations have clarified that “swaps” and “similar arrangements” are excluded from Section 1256. There has been previous uncertainty as to the treatment of swaps under provisions of the Dodd-Frank Act.

When is the effective date of the Proposed Regulation? 

A hearing is scheduled on the proposed regulation for January 19, 2012. The regulations are intended to be effective for contracts entered into on or after the date the final regulations are published. 

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