On May 8, 2015, the Treasury Department and the Internal Revenue Service (IRS) published final and temporary regulations (the “Temporary Regulations”) that modify the treatment of nonperiodic payments made or received pursuant to notional principal contracts (NPCs).1 Under an “Embedded Loan Rule” (as defined below) contained in existing regulations, NPCs that include “significant” nonperiodic payments are treated as including a deemed loan for federal income tax purposes. The Temporary Regulations broaden the scope of this rule in some respects and narrow it in others. Under the Temporary Regulations, all nonperiodic payments generally will be subject to the Embedded Loan Rule, whether or not those payments are “significant.” However, the Temporary Regulations also create exceptions for nonperiodic payments on certain NPCs with a term of one year or less and NPCs subject to certain margin or collateral requirements, including NPCs cleared with U.S.-registered derivatives organizations. The effective dates of the Temporary Regulations vary and are described in more detail below. The Temporary Regulations are scheduled to expire on May 7, 2018.
The existing regulations under section 446 of the Internal Revenue Code govern the timing of income and deductions with respect to NPCs. For purposes of these rules, an NPC is generally 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 principal amount in exchange for specified consideration or a promise to pay similar amounts. NPCs include, among other financial instruments, interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps and other similar agreements.
Under the existing regulations, an NPC that includes a “significant” nonperiodic payment is treated as consisting of two separate transactions — an on-market, level-payment swap and one or more loans (the “Embedded Loan Rule”). The deemed loan must be accounted for by the parties to the NPC separately from the on-market payments under the NPC. The time-value component associated with the deemed loan is not treated as a payment on the swap, but is instead required to be treated as interest for all purposes of the Internal Revenue Code. The existing regulations do not set forth a bright-line test for determining whether a nonperiodic payment is “significant.”
A common example of a nonperiodic payment in the swaps market is an upfront payment. Upfront payments may be necessary where one leg of a swap involves off-market payments. In such circumstances, the counterparty that is required to make above- or below-market payments will be required to compensate (or will require that it be compensated by) its counterparty for the off-market nature of the payments. This compensation may take the form of an upfront payment in an amount necessary to equalize the present value of each leg of the swap. Such an upfront payment is treated as a nonperiodic payment. Industry commentators have observed that the prevalence of swaps involving upfront payments has and will continue to increase as a result of the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act.2
The Embedded Loan Rule Under the Temporary Regulations
The Temporary Regulations broaden the Embedded Loan Rule by removing the requirement that the nonperiodic payment be “significant.” As a result, under the Temporary Regulations, all nonperiodic payments on NPCs generally will be treated as including one or more loans for federal income tax purposes. This expansion of the Embedded Loan Rule will apply to NPCs entered into on or after November 4, 2015, although taxpayers are permitted to apply the expanded Embedded Loan Rule to NPCs entered into before that date.
The Temporary Regulations also narrow the Embedded Loan Rule by providing two exceptions to the rule. Under the first exception, the Embedded Loan Rule generally will not apply to an NPC if the term of the contract is one year or less (inclusive of extensions provided for in the terms of the contract, including optional extensions).3
The second exception generally applies to NPCs that require the parties to the contract post and collect cash margin or cash collateral to fully collateralize the mark-to-market exposure on the contract (including the exposure on the nonperiodic payment) on a daily basis for the entire term of the contract. In general, these collateralization requirements must be imposed by: (1) certain derivatives organizations or clearing agencies through which the contract is cleared, (2) the terms of the contract or (3) certain federal regulators. To the extent the amount of cash margin or collateral exceeds the amount necessary to collateralize fully the mark-to-market exposure on the contract, the excess generally will be subject to the Embedded Loan Rule.
Both exceptions apply to NPCs entered into on or after May 8, 2015. The Temporary Regulations also permit taxpayers to apply the exceptions to NPCs entered into before May 8, 2015.
Section 956 of the Code
Certain U.S. shareholders of a controlled foreign corporation are generally required to include in gross income their pro rata share of the increase in the earnings invested by the controlled foreign corporation in U.S. property for the taxable year. Under existing regulations, obligations of U.S. persons arising from significant nonperiodic payments by controlled foreign corporations with respect to NPCs were, in certain limited circumstances, not treated as U.S. property for these purposes. Under the Temporary Regulations, nonperiodic payments will not be treated as U.S. property to the extent that the NPC meets the margin or collateralization requirements described above, provided that the controlled foreign corporation is a dealer in securities or commodities.