Jay McInerney's 1980s classic novella, Bright Lights/Big City, about starting a career in New York City in the fact-checking department of a major (and perhaps selfimportant) magazine, resonated with us as we began our careers writing memos on tax issues at major New York law firms. As Mr. McInerney weaved lyrics from the Talking Heads into his story, including Facts all come with points of view; Facts don't do what I want them to,1 we felt an affinity with the novel's unnamed protagonist for our parallel tasks. Well, the Internal Revenue Service (IRS) must have been feeling some 1980s-style ennui when it reviewed its approach to the area of notional principal contracts (“NPCs” or “swaps”) and futures contracts in connection with writing rules to make the U.S. Tax Code compliant with the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). In proposed regulations issued on September 15, 2011 (the "Proposed Regulations"), the IRS showed an unusual degree of flexibility in its approach to these two types of financial products. Even swaps all come with a point of view. The Proposed Regulations are to be effective after final regulations are published, but practitioners are likely to take comfort from these rules for transactions entered into prior to such time.
I. What is a Swap for Tax Purposes Anyhow?
The Proposed Regulations would make myriad amendments to the existing swap rules. The Proposed Regulations would make nuanced changes to the two or more payment rule, the applicability of the swap regulations to non-financial indices, such as longevity and weather and would specifically sweep in credit default swaps ("CDS"). In addition, an anti-abuse rule has been proposed for swaps with varying indices.
A. The 2 or More Payment Rule
There are several definitions of the term “swap” contained in existing federal income tax regulations.2 There is very little variation from one of these definitions to the other, although the regulations have not been specifically coordinated. The general swap regulations, finalized in 1993, provide that a swap must provide for the payment of "amounts" by one party in exchange for specified consideration or an obligation to "pay similar amounts."3 The import of the word, "amounts" was clarified in 2004 when the IRS proposed a regulation affecting so-called bullet swaps.4 Under the proposed bullet swap regulation, a swap contract would not be treated as an NPC for federal income tax purposes if there is only a single payment due at the maturity of the contract. In other words, the IRS took the position that unless a swap provided for a periodic cash or physical settlement during the life of the contract (as well as a payment at maturity), it would be taxed as a forward contract and not as a swap.
Proposed Treasury Regulation § 1.446-3(c)(1)(i) further clarifies the IRS's thinking about periodic payments. The new proposed definition of a NPC specifically requires one party to make two or more payments to a counterparty in order for a contract to be treated as a swap. The new regulation, however, provides for a twist on the basic rule. Specifically, Proposed Treasury Regulation § 1.446-3(c)(1)(ii) provides that the fixing of an amount is treated as a payment, even if the actual payment reflecting that amount is to be made at a later date.5 The Proposed Regulation illustrates this rule by providing that when a contract provides for a final settlement payment referenced to the appreciation or depreciation on a specified number of shares of common stock, adjusted for actual dividends paid during the term of the contract (frequently referred to as a total return equity swap), the contract will be treated as a contract with more than one payment. In addition, the fact that the swap provided for compounding of the funding leg payments (LIBOR-based in the example) was likewise held to provide for two or more payments. Proposed Treasury Regulation § 1.446-3(c)(1)(iii) provides specific list of contracts covered under this definition: (i) interest rate swaps, (ii) currency swaps, (iii) basis swaps, (iv) interest rate caps, (v) interest rate floors, (vi) commodity swaps, (vii) equity swaps, (viii) equity index swaps, (ix) credit default swaps, (x) weather-related swaps, and (xi) similar agreements that satisfy the requirements of Proposed Treasury Regulation §1.446-3(c)(1)(i).
The Proposed Regulation would seem to apply to swaps referencing stocks that have not historically paid dividends nor would be expected to pay dividends during the life of the swap. If this is a correct interpretation of the rule, the Proposed Regulation would provide a high degree of tax electivity to taxpayers entering into bullet swaps referencing stocks that would not be expected to pay a dividend during the swap term, provided that there was no compounding of the funding leg of the swap. Taxpayers who wanted ordinary gains or losses in such a bullet swap transaction would add a provision for dividend adjustments, even though no dividend could reasonably be expected to be paid on the referenced stock during the duration of the swap.6 On the other hand, taxpayers desiring capital gain or loss treatment would enter into price return swaps, that is, swaps without dividend adjustments and be entitled to bullet swap (i.e., forward contract) treatment. In order to achieve forward contract treatment, however, the parties would be required to chose an interest rate index that did not require compounding for the funding leg of the swap because a compounding of the funding leg would result in the swap being considered to have two or more payments.
B. Credit default swaps (CDS)
There has been some degree of uncertainty as to the correct characterization of credit default swaps for federal income tax purposes.7 The IRS has been studying this issue for at least seven years.8 In the Proposed Regulations, the IRS finally "cut bait" and agreed to treat CDS contracts as NPCs. The Proposed Regulations contain neither a definition for CDSs nor specific examples of transactions that will be treated as CDSs. Notice 2004-52 does, however, contain examples. Since guarantees remain outside of the realm of what can be treated as a swap, some uncertainty remains.9
C. Foreign currency denominated NPCs
The Proposed Regulations contain special rules for currency swaps. There is explicit treatment of cross-currency swaps, that is, swaps that require the delivery of one or both of the currencies referenced in the swap, as NPCs for federal income tax purposes, provided that such a swap is treated as a currency swap under the foreign currency tax rules.10 For the first time, the foreign currency swap regulations would be coordinated with the general swap rules by incorporating the NPC definition contained in the general rules. The definition of a currency swap has been refined to specify that a currency swap only includes a swap referencing currency or the value of property which is determined by reference to an interest rate.11
D. Swaps Held in Foreign Currency Integration Transactions
Many taxpayers exposed to foreign currency movements hedge such exposure by entering into derivatives to offset such risk. When possible, an election to integrate the hedged transaction with the hedge is beneficial for federal income tax purposes. The Proposed Regulations contain a coordination rule with the foreign currency integration rules providing that the integration rules will supersede the normal swap timing and character rules.12 This had not been in doubt, however, because the foreign currency rules already specified that the components of an integrated transaction "are treated as a single transaction with respect to the taxpayer."13 While the Proposed Regulations do not specify an equivalent priority rule for non foreign currency integrated transactions under Treas. Reg. §1.1275-6, we can assume a similar result for such transaction.
E. Weather-Related and other Non-Financial Index Based Swaps
The Preamble to the Proposed Regulations states weather-related swaps, that is NPCs providing for pay-outs based upon non-financial indices such as temperature, precipitation, snowfall, or frost are not treated as swaps under existing regulations for federal income tax purposes because the underlying indices are not financial indices. While this is true, we note that the existing regulations further provide that a specified index includes an index that is based on “objective financial information.”14 Objective financial information is defined as any current, objectively determinable financial or economic information that is not within the control of any of the parties to the contract.15
The specified index for weather swaps is temperature at a particular location – an index that is not within the control of any party. The Webster dictionary includes a definition of economic as “having practical or industrial significance or uses: affecting material resources.”16 Temperature has a dramatic impact on the business of the energy industry because demand for electricity is directly correlated with air conditioner use in the summer and heating equipment use in the winter. Stated alternatively, the weather has a direct affect on the electricity demand by consumers. Thus, weather should be considered to be within the definition of economic information for the energy industry and financial entities with exposure to the energy industry.
The definition of specified index in the final 1993 regulations was expanded from the definition contained in the original proposed regulations in response to comments made to the IRS. The IRS then believed that, so long as the specified index was not in the control of any party to the notional principal contract, there was no federal income tax policy that would have been served by a narrow definition:
To accommodate these requests [that the definition of specified index be expanded], the final regulations provide that a specified index may include almost any fixed rate, price or amount based on current, objectively determinable financial or economic information. 17
Accordingly, many practitioners believe that weather-related swaps would be treated as NPCs under the existing regulations.
The Proposed Regulations would end any lingering uncertainty by providing that swaps on non-financial indices should be treated as notional principal contracts. Accordingly, Proposed Treasury Regulation § 1.446- 3(c)(2)(ii) expands (clarifies in our view) that the definition of a “specified index” for determining whether a contract is an NPC for federal income tax purposes includes nonfinancial indices that are comprised of any objectively determinable information that is (i) not within the control of any of the parties to the contract; (ii) is not unique to one of the parties’ circumstances; and (iii) cannot be reasonably expected to front-load or back-load payments accruing under the contract. While the Proposed Regulations illustrate this expansion with weather derivatives, one could think of many other types of existing (and possible) swaps that reference nonfinancial indices that would qualify as notional principal contracts if the Proposed Regulations are adopted (e.g., disaster derivatives).
Another such non-financial index is mortality. The Proposed Regulation would also offer comfort to participants in the mortality swap market that contracts referencing longevity should be treated as NPCs for federal income tax purposes. In structuring these transactions, however, it may be prudent to include a significant number of lives with short expected durations so that the swap does not back-load the investor pay-out and thereby be challengeable on that ground in accordance with the newly proposed anti-abuse rule (see below). We note that mortality swaps offer non-U.S. investors significantly more favorable tax treatment than a direct investment in life settlement contracts.18
F. Excluded Contracts
Treasury Regulation § 1.446-3(c)(1)(ii) currently provides that a regulated futures contract, that is, an exchange or interbank traded contract subject to mandatory mark-to-market treatment under Section 1256 of the Internal Revenue Code of 1986, as amended (the "Code") is not taxed as an NPC. The Proposed Regulations clarify that an option or forward contract which entitles or obligates a person to enter into a NPC is not taxed as a swap, but such an option may meet the conditions necessary to be taxed as a non-equity option (i.e., a listed option that is not an equity option) and subject to mark-to-market accounting under Code § 1256(g)(3).19
G. Conforming Amendments
For the first time, there is proposed coordination among the various definitions of a NPC. Specifically, the Proposed Regulations rework the various definitions and state that the general definition in Proposed Treasury Regulation §1.446-3(c) is intended to be the operative definition for all Federal income tax purposes, except where a different or more limited definition is specifically prescribed. Thus, the regulations under Code §§ 512, 863, 954, and 988 have been amended to reference the definition of a notional principal contract in Proposed Treasury Regulation § 1.446-3(c). In addition, the Proposed Regulations specifically provide that to the extent that the tax accounting rules for swaps are inconsistent with the mark-to-market rules for securities dealers and electing securities and commodities traders, the mark-to-market rules prevail.20
H. Notional Principal Amount Anti-Abuse Rules
The existing NPC rules permit the parties to a swap to vary the notional amount of the swap provided that the change is set in advance.21 The Proposed Regulations contain an anti-abuse rule pursuant to which, a swap with varying notional amounts or that references a different notional principal amount for each party, may be recharacterized according to its substance, including by separating the contract into a series of swaps or by treating the contract, in whole or in part, as a loan, if a principal purpose for entering into the contract is to avoid the application of the swap accounting rules.22
Certain swaps provide exposure to one type of strategy for a period of time, such as equities and then provide exposure to a second strategy, such as fixed income beginning after the equity exposure has been terminated. The proposed anti-abuse rule described above could have an impact on termination payments made on these swaps. Specifically, if the duration of the first exposure is less than the required holding period for long-term capital gains, the IRS could assert that the anti-abuse rule provides it with the authority to bifurcate the swap into an equity swap and an interest rate swap with the net effect that determination of the any gain or loss on each exposure is determined independently and not with reference to the duration of the instrument as a whole. On the other hand, a multi-exposure swap, such as the one described herein, does not avoid the application of the swap rules and arguably is outside the ambit of the anti-abuse rule.
II. Coordination with Mark-to-Market Instruments Under the Dodd-Frank Act
The Proposed Regulations also clarify which “swaps and similar agreements” fall within the exclusion from markto- market treatment under Code § 1256(b)(2)(B).23 Code § 1256(b)(2)(B) was added to the Code by section 1601 of the Dodd-Frank Act and provides that certain “swaps and similar agreements” are not subject to the mark-tomarket regime (and the 60/40 capital gain rule) of Code § 1256, even if traded on or subject to the rules of a qualified board or exchange. The Preamble to the Proposed Regulations (the “Preamble”) states, “[t]he parallel language [between the statute and the existing] tax regulation suggests that Congress was attempting to harmonize the category of swaps excluded under section 1256(b)(2)(B) with swaps that qualify as notional principal contracts under §1.446-3(c), rather than with the contracts defined as ‘swaps’ under section 721 of the Dodd-Frank Act.” To facilitate this parallel treatment, Proposed Treasury Regulation § 1.1256(b)-1(a) provides that a “section 1256 contract” does not include a contract that qualifies as a notional principal contract as defined in Prop. Treas. Reg. § 1.446-3(c)."
A. Swaptions (Options on Swaps)
The plain language of Code § 1256(b)(2)(B) does not address whether an option on a swap that is traded on a qualified board or exchange would constitute a “similar agreement” (and thereby excluded from the application of Code § 1256) or would be treated as a” non-equity option” and, therefore, be subject to Code § 1256.24 The Preamble explains, because “an option on a notional principal contract is closely connected with the underlying contract," Proposed Treasury Regulation §1.1256(b)-1(a) provides that a section 1256 contract does not include an option on any contract that is an NPC within the definition contained in Proposed Treasury Regulation § 1.446- 3(c)
B. Ordering (Priority) Rule
If a contract that trades as a futures contract regulated by the Commodity Futures Trading Commission (CFTC), and also meets the definition of an NPC, an issue arises as to whether the rules of Code § 1256 or the swap regulations should govern. The Preamble clarifies that such a contract is “not a commodity futures contract of the kind envisioned by Congress when it enacted section 1256.” Thus, such a contract that satisfies both definitions should not, according to Treasury and the IRS, be subject to Code § 1256. Accordingly, Proposed Treasury Regulation § 1.1256(b)-1(a) provides that Code § 1256 does not include any contract, or option on such contract, that is both a section 1256 contract and an NPC defined in Proposed Treasury Regulation § 1.446-3(c). Proposed Treasury Regulation § 1.1256(b)-1(b) contains a conforming amendment providing that a regulated futures contract is a section 1256 contract only if the contract is a futures contract that is not required to be reported as a swap under the Commodity Exchange Act (7 U.S.C. 1).25
The Proposed Regulations have three focuses. First, the Proposed Regulations expand and update what types of contracts should be within the definition of a NPC for federal income tax purposes. On this point, Treasury and IRS clearly want to expand the definition to more contracts, including, in particular to credit default swaps and contracts that reference nonfinancial indices such as weather derivatives. The obvious result of adopting such a broader definition is to allow more certainty for taxpayers entering into such contracts. Second, the Proposed Regulations provide a bright line test for distinguishing between contract that should be marked to market (and subject to the draconian 60/40 rule) of Code § 1256 and contracts that should not. The result, of course, would result in not only more certainty, but also fewer contracts being subject to Code § 1256. The last goal of the Proposed Regulations is to define and explain certain relevant terms in connection with Code § 1256 and the swap regulations. We expect that affected taxpayers and practitioners will be pleased by the new guidance, even though "you will have to learn everything over again."26