On May 8, 2015, the Treasury Department and the Internal Revenue Service published temporary and proposed regulations under IRC §§ 446 and 956 (T.D. 9719; REG-102656-15), clarifying when nonperiodic payments made pursuant to certain notional principal contracts (NPCs), must be bifurcated, for tax purposes, into a loan and an on-market, level-payment swap (the embedded loan rule). The new regulations provide welcome clarification of the embedded loan rules, and generally exempt collateralized swaps cleared through registered derivative-clearing organizations (as well as swaps with similar terms) from the bifurcation requirement.
The new regulations may also raise questions regarding their intended application to NPCs other than swaps, such as interest rate caps and floors. The new regulations state that they apply to “certain” NPCs, but do not specify the NPCs to which they apply. If the new regulations were intended to apply to all NPCs rather than being limited to swaps, the effect on existing regulations which apply to NPCs other than swaps should be clarified.
The embedded loan rule in the existing regulations was adopted in 1993 (the 1993 regulations). The 1993 regulation applied to swaps with “significant” nonperiodic payments, which were required to be bifurcated into a loan and an on-market, level-payment swap. The 1993 regulations did not define a “significant” payment. Although examples in the regulations offered some guidance as to the magnitude of such a payment, substantial uncertainty remained.
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) mandated certain swap contracts be cleared through registered derivative-clearing organizations, generally U.S.-registered clearinghouses. Cleared swap contracts generally must have standardized terms, which often give rise to nonperiodic payments. Standardized terms (and nonperiodic payments) are also in increasing use even in swap contracts not subject to the Dodd-Frank clearing requirements. The increasing prevalence of nonperiodic payments magnified the uncertainty in the 1993 regulations with respect to whether such payments were “significant,” and created potentially burdensome information reporting and withholding obligations with respect to increasing numbers of swap transactions.
Moreover, because of a Dodd-Frank mandate, the U.S.-registered clearinghouses require that each party to a cleared swap contract provide margin in an amount that fully collateralizes the credit risk of the contract. Thus, the recipient of a nonperiodic payment on such a contract would no longer have unrestricted use of the funds, a fact which undermined the theoretical underpinnings of treatment of the bifurcated amount as a loan for tax purposes.
Embedded Loan Rule under the New Temporary and Proposed Regulations
General Rule. The new regulations require that all NPCs with nonperiodic payments (whether or not such payments are significant) must be bifurcated into a loan and an on-market, level-payment swap, unless one of two exceptions discussed below applies. By eliminating the need to determine whether a nonperiodic payment is “significant,” the new regulations provide taxpayers with welcome certainty as to the U.S. tax treatment of their transactions. Moreover, as discussed below, the exemptions from bifurcation for short-term and fully collateralized contracts appropriately simplify the tax treatment of such transactions. In this regard, the Treasury Department and the Internal Revenue Service should be commended for their willingness to engage with taxpayers and address concerns arising in the current mutable regulatory and commercial derivatives environment.
The Short-Term Exception. A nonperiodic payment on an NPC with a stated term of one year or less will generally not be treated as a loan under the new regulations (the short-term exception). Any extension, optional or otherwise, provided for in the terms of the contract is included in the stated term of the contract, without regard to whether the extension is unilateral, is subject to approval by one or both parties, or is based on the occurrence or non-occurrence of a specified event. The short-term exception does not apply for purposes of the unrelated business income tax for exempt organizations under IRC §514, or determination of status as an investment in United States property under IRC §956 of a controlled foreign corporation (CFC). Exempt organizations and CFCs thus will be required to bifurcate short-term NPCs with nonperiodic payments unless the second exception applies.
An anti-abuse rule provides that two or more contracts may be treated as a single contract if a principal purpose of entering into separate contracts is to qualify for the short-term exception. A purpose may be a principal purpose even though it is outweighed by other purposes, taken together or separately.
The Full Margin Exception. A nonperiodic payment on an NPC will not be treated as a loan if the NPC is subject to certain prescribed margin or collateral requirements (the full margin exception). To qualify for the full margin exception, two requirements must be met: (1) the parties to the contract must be required to post and collect margin or collateral in an amount that fully collateralizes the mark-to-market exposure on the contract (including the nonperiodic payment) on a daily basis for the entire term of the contract and (2) the margin or collateral posted and collected must be paid in cash.
In the case of cleared contracts, the requirement of posting and collecting margin is imposed by the clearing organization or clearing agency. In the case of uncleared contracts, the requirements may be imposed by: (1) the terms of the contract or (2) the requirements of the SEC, the CFTC or a Prudential Regulator.
In the case of both cleared and uncleared contracts, the parties must be required to post and collect margin or collateral to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) on a daily basis through the entire term of the contract. The mark-to-market exposure will only be treated as fully collateralized if the contract is subject to both initial variation margin or collateral posted in cash in an amount equal to the nonperiodic payment and daily variation margin or collateral posted in cash in an amount equal to the daily change in the fair market value of the contract. If cash margin or collateral is posted in excess of the amount necessary to fully collateralize the mark-to-market exposure, such excess will be treated as a loan.
Potential Uncertainty Regarding Application of the New Regulations to NPCs Other than Swaps. With certain exceptions, the new regulations generally use the broader term “NPC” rather than the narrower term, “swap,” which was used in the 1993 regulations. The term “swap” is used, however, in describing the portion of a bifurcated transaction that is not a loan. The implications of the new regulations for other types of NPCs that contemplate upfront payments, such as interest rate caps and interest rate floors, are uncertain. For example, the treatment of nonperiodic payments on interest rate caps and floors is governed by an existing regulation which was not amended by the new regulation. In addition, a “reserved” section of the existing regulations, also not amended by the new regulations, was intended to provide a special rule for interest rate caps and floors that were significantly in-the money. These transactions are addressed by proposed regulations. A clarification that the temporary and proposed rules are not intended to affect transactions other than swap transactions would be welcome.
Section 956 Consequences of the Embedded Loan Rule
The 1993 regulations provided that for purposes of determining the investment in United States property of a CFC, the Commissioner may treat any nonperiodic payment, whether or not “significant,” as one or more loans. This rule created potential complications for CFCs with respect to whether the embedded loan would be treated as United States property under IRC §956.
The new regulations continue the approach of 2012 temporary and proposed regulations and provide that an obligation of a United States person arising from a nonperiodic payment made by a CFC with respect to an NPC will not be treated as United States property under IRC §956 if the full margin exception discussed above applies and the CFC is a dealer in securities or commodities.
A nonperiodic payment pursuant to an NPC entered on or after November 4, 2015 will generally be treated as a loan without regard to whether such payment is significant. The two exceptions described above generally apply to nonperiodic payments pursuant to an NPC entered on or after May 8, 2015, though taxpayers may elect to apply these exceptions to nonperiodic payments pursuant to an NPC entered prior to this date. If not finalized, the temporary regulations expire pursuant to IRC §7805(e)(2) on May 7, 2018.