Tax Talk, Volume 4, Issue 3 - October 2011

Dateline: Occupied Wall Street (Oct. 19, 2011). The 24th anniversary of Black Monday, October 19, 1987, dawns on an occupied Wall Street amid persistent gloom in global financial markets. The largest U.S. banks are in the midst of announcing their Q3 earnings, of which at least $12 billion comes from accounting gains due to a decline in their credit quality (we're not kidding). Nevertheless, our readers will be pleased to know that the tax law marches on and the Internal Revenue Service ("IRS") and the courts continue to work through the backlog of tax issues left over from the golden era in financial instruments. Thus, in the Q3 edition of Tax Talk we discuss proposed regulations that treat credit default swaps as notional principal contracts and that may spell doom for certain types of "bullet swaps," an IRS ruling addressing the connection (or lack thereof) between the deferral of cancellation of debt income and unamortized hedge gain and the Ninth Circuit's affirmation of the Tax Court's ruling in Samueli v. Commissioner. We also provide a brief summary of the IRS and Treasury Department ("Treasury") 2011-2012 priority guidance plan in the capital markets area and a summary of the GOP Presidential candidates' income, corporate, capital gains, and sales tax positions. In the return of our "Classroom," we address the rules that apply to "synthetic debt instruments."

Proposed Regulations Would Expand and Clarify What Contracts Qualify as NPCs for Tax Purposes

In response to the financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd- Frank") to, among other things, increase regulation of the capital markets. In Congress's attempt to increase regulation, Dodd-Frank requires the Commodity Futures Trading Commission ("CFTC") to establish a comprehensive regulatory framework for swaps,1 which includes the trading of swaps on registered exchanges. With the advent of swaps trading on registered exchanges, however, Congress feared such swaps would now qualify as "section 1256 contracts," resulting in specific character and timing (e.g., markto- market) treatment for tax purposes. As a result, Congress included section 1256(b) (2)(B)2 in Dodd-Frank, which carves out swaps and other similar agreements, even if traded on or subject to the rules of an exchange, from the definition of a "section 1256 contract." On September 16, 2011, the IRS and Treasury published proposed regulations providing guidance on the category of swaps and similar agreements that are included in the carve-out from a "section 1256 contract" and on the scope of the notional principal contract definition.

Section 1256 provides that "section 1256 contracts" are marked-to-market at the end of each year and that any gain or loss is generally treated as 60 percent longterm capital gain or loss and 40 percent short-term capital gain or loss. A "section 1256 contract" is defined as a regulated futures contract, foreign currency contract, nonequity option, dealer equity option, or dealer securities futures contract which, with the exception of a foreign currency contract, must be traded on or subject to the rules of a "qualified board or exchange."

Clarifying the Definition of a Section 1256 Contract

A primary focus of the proposed regulations is to clarify the scope of swaps excluded from section 1256 treatment (i.e., swaps excluded from the definition of a "section 1256 contract"). As enacted under Dodd- Frank, swaps included in the section 1256 carve-out were modeled after the Treasury Regulation definition of a notional principal contract with the addition of credit default swaps, as opposed to the Dodd-Frank definition of "swaps." Following this principle, the proposed regulations provide that a section 1256 contract does not include a contract that qualifies as a notional principal contract.3 Also, according to the preamble to the proposed regulations, the IRS and Treasury believe that an option on a notional principal contract should be treated as an agreement similar to a notional principal contract; therefore, the proposed regulations carve out options on notional principal contracts from section 1256 treatment as well. The proposed regulations provide that any contract that is both a section 1256 contract and a notional principal contract is treated as a notional principal contract, with the result that such contract does not qualify for section 1256 treatment.

Expanded Swap Definition

The proposed regulations also provide an updated definition for the term "notional principal contract." As the scope of the current definition of a notional principal contract4 has been questioned by many, especially post-Dodd-Frank, the proposed regulations refine the scope by providing that a notional principal contract requires one party to make two or more payments to a counterparty. For this purpose, 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. With respect to this definition, the preamble to the proposed regulations provides the following example: a contract that provides for a 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, is treated as a contract with more than one payment with respect to that leg of the contract.

We understand this proposal has caused a lot of excitement because it would substantially expand the notional principal contract definition. For example, a "bullet swap," which provides for payments only at maturity, is currently treated as a forward contract for federal income tax purposes. If, however, the bullet swap provides for the interim fixing of payments then under the proposed regulations it would be treated as a notional principal contract, subject to current accrual and ordinary income and loss.

The definition of a notional principal contract is also expanded under the proposed regulations by expressly providing that credit default swaps are included in such definition.5 This includes credit default swaps that permit or require physical settlement in satisfaction of one leg of the swap. This proposed definition of a notional principal contract is intended to be the operative definition for all federal income tax purposes, except where a different or more limited definition is specifically provided.

The proposed regulations also expand those "specified indices" which notional principal contracts can reference. According to the preamble, the IRS and Treasury felt that a swap on a non-financial index should be treated as a notional principal contract. The proposed regulations expand a "specified index" to include those non-financial indices that comprise any objectively determinable information that is not within the control of any of the parties to the contract and is not unique to one of the parties' circumstances, and that cannot be reasonably expected to front-load or backload payments accruing under the contract. For example, a "weather swap" would be treated as a notional principal contract under the proposed regulations.6

Effective Date

If adopted, the proposed regulations would be effective for all contracts entered into on or after the date such regulations are finalized.

The Handwriting is on the Wall

In light of the proposed NPC regulations discussed in the prior piece, we noted with interest a comment by Steve Larson, IRS Associate Chief Counsel (Financial Institutions and Products) last week in New York reported in Tax Notes.7 Mr. Larson said that the IRS will issue revised regulations for contingent payment notional principal contracts (proposed regulations were issued in 2005) and for prepaid forward contracts. He also said the rules for prepaid forwards will be "roughly similar" to the rules for contingent notional principal contracts. Coupled with the proposed regulations' treatment of payment "fixing" as a payment under the notional principal contract definition, this all points to an expanded current accrual regime for non-option financial instruments possibly including certain "bullet" swaps, as well as prepaid forward contracts and non-debt structured notes.8 Right now, current law generally gives these instruments "wait and see" capital gain and loss tax treatment. The timing of such guidance (and exactly how the new regime will work) is currently unknown (and it may not happen all at once) but it appears the wheels are starting to turn in Washington, DC on the issue.

Recognition of Unamortized Hedge...