On September 15, 2011, the Internal Revenue Service (“IRS”) proposed regulations intended to clarify the U.S. federal income tax treatment of swaps and similar agreements under the Internal Revenue Code of 1986 (“Code”). Among other things, the proposed regulations would implement Section 1256(b)(2)(B) of the Code, which was added to the Code by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). The Dodd-Frank Act excluded from so-called “Section 1256 contract” treatment a variety of swaps and “similar agreements.” Section 1256 contracts are marked to market at the end of each taxable year, with any gain or loss treated as a 60% long-term and 40% short-term gain or loss. The proposed regulations would create a bright-line rule, excluding from Section 1256 those contracts that are “notional principal contracts” as defined in Treasury Regulation § 1.446-3(c) (“NPCs”) and options on such NPCs (rather than excluding “swaps” as defined in the Dodd-Frank Act). Under an ordering rule, a contract that qualifies as both a Section 1256 contract and an NPC would be treated as an NPC.

In addition, the proposed regulations would expand the definition of NPC under Treasury Regulation § 1.446-3(c) to include credit default swaps and swaps on qualifying non-financial indices (e.g., weather-related swaps). Significantly, the proposed regulations also would narrow the scope of swap contracts considered to be “bullet swaps” (very generally, a swap providing for the settlement of all of the parties’ obligations under the swap at its maturity and thus eligible for more favorable tax treatment under current law than swaps that are NPCs). Instead, certain common forms of bullet swaps would be treated as NPCs under the proposed regulations (e.g., total return swaps that provide for a single payment at maturity based on the change in value of a specified number of shares of stock, adjusted for actual dividends paid on the stock during the term of the contract). The proposed regulations raise a number of questions, including regarding how the NPC accounting rules would apply to payments made under these new classes of NPCs.

The proposed regulations would apply prospectively to contracts entered into on or after the date such regulations are ultimately published, and are available here. The IRS has invited comments regarding the proposed regulations, and a public hearing has been scheduled for January 19, 2012.