On July 21, 2011, the Internal Revenue Service (IRS) promulgated a temporary regulation providing very good news for users of derivative contracts. Under the temporary regulation, users of derivative contracts will not recognize gain or loss when the over-the-counter (OTC) contracts to which they are a party are assigned by one dealer to another or novated to an exchange pursuant to the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act.1 The temporary regulation significantly expands the safe-harbor rules contained in a regulation that was finalized in 1998.2 The temporary regulation is effective on Friday July 22, 2011.

I. Background

The U.S. tax law has long been concerned with “substance over form.” One manifestation of this concern has been in the area of contract modifications. The IRS has rules holding that when the fundamental nature of a contract changes, the holder of the contract should be taxed as though he surrendered the “old” (pre-modified) contract for the “new” (post-modified) contract. 3 The quintessential example of this rule is that the holder of a life insurance policy is considered to exchange the old policy for a new policy when there is a change in the insured life. In the context of recourse debt instruments, an IRS regulation states that a change in the obligor under the debt instrument results in a deemed exchange of the debt.4

As noted above, the IRS had promulgated a regulation that provided a limited exception to the deemed sale or exchange rules for swaps (notional principal contracts in tax parlance). Under this regulation, an assignment by a swaps dealer of its position under a swap to another swaps dealer did not result in a deemed sale of exchange of the swap by the non-assigning party, provided that “the terms of the contract permit the substitution.”5 In practice, most swaps only permit assignments with the consent of the non-assigning party. Most practitioners were concerned that when the consent of the non-assigning party is required, the terms of the swap would not be considered to permit the substitution. As a result, the 1998 regulation was not considered to provide much help on the deemed sale or exchange issue.

II. The New Temporary Regulation

The new temporary regulation addresses four areas of concern. First, it solves the issue presented by swaps that require non-assigning party consent to assignments by providing that the terms of a contract will be considered to permit consent even if consent of the non-assigning party is required. Second, the reference to who is a dealer has been broadened to include any dealer in securities.6 Third, the temporary regulation expands the types of derivatives that will not undergo a deemed sale or exchange in the hands of the non-assigning party when assigned. Fourth, the new temporary regulation provides that no deemed sale or exchange occurs when a derivative is novated to a clearinghouse.

The categories of derivatives eligible for the benefit of the rule that exempts the non-assigning party from gain or loss recognition upon an assignment has been expanded to include the following OTC derivatives:

  1. Interest rate, currency or equity notional principal contracts; 
  2. An evidence of an interest in, or a derivative financial instrument in, any security, stock, widely held partnership interest, debt instrument or any currency, including any option, forward contract, short position, and any similar financial instrument in such a security or currency; and  
  3. Positions that are not securities but are identified as hedges of any item that is treated as a security under Section 475(c) of the Internal Revenue Code of 1986, as amended.  

As noted above, no gain or loss will be recognized by the non-assigning party when the dealer counterparty assigns its position to another dealer. The rule now extends to transfers of the dealer position to a clearinghouse. A clearinghouse is defined as a derivatives clearing organization, as defined in Section 1a of the Commodities Exchange Act and a clearing agency as defined in section 3 of the Securities Exchange Act of 1934.7 The preamble makes clear that the non-assigning party will not recognize any gain or loss even if consideration passes between the assignee and the assignor.8 This rule will allow existing OTC derivatives to be novated to clearinghouses as mandated by the Dodd-Frank Act without causing the non-assigning party to experience gain or loss as a result of such assignment.

III. Input from Affected Parties

A public hearing has been scheduled for Thursday, October 27, 2011. Outlines of topics to be discussed at the public hearing must be received by the IRS by October 20, 2011.