United States Tax Alert - 11 May 2012
Treasury creates new exception from §956 for certain swap payments by CFC dealers
By Harrison Cohen, Jo Lynn Ricks and Robert Rothenberg
On 10 May 2012, the U.S. Internal Revenue Service (IRS) and Treasury Department issued temporary regulations1 creating a new exception under §956 of the Internal Revenue Code. The regulations set forth conditions under which upfront swap payments made by a controlled foreign corporation (CFC) to a U.S. person will not give rise to an investment in “United States property” (U.S. property), and therefore will not subject the U.S. shareholders of the CFC to U.S. tax that would otherwise apply. Taxpayers may apply this new exception retroactively.
The new exception applies to an obligation deemed to arise from an upfront payment made by a CFC that is a securities or commodities dealer in connection with a notional principal contract (NPC) cleared through a registered clearinghouse. The new exception applies to payments made on or after 11 May 2012; taxpayers may also apply the new exception to payments made prior to 11 May 2012.
Under §951(a)(1)(B), if the CFC holds “U.S. property” as defined in §956, some or all of a CFC’s earnings may be subject to tax in the hands of certain U.S. shareholders of the CFC before the earnings are repatriated to the shareholder. Subject to exceptions, U.S. property for this purpose generally includes the debt obligation of a related U.S. person. For example, a loan made by a CFC to a U.S. shareholder may give rise to an income inclusion for the U.S. shareholder.
Loans deemed created by upfront payments on NPCs
An NPC is a contract 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.2 The timing of income and deductions from NPCs generally follows rules provided in Reg. §1.446-3. Under these rules, a party to an NPC is required to recognize the ratable daily portion of each periodic payment3 and each nonperiodic payment4 under the NPC for the period to which it relates.5 A common example of a nonperiodic payment is an upfront payment made by one party to the other to compensate the counterparty for entering into an off-market swap (a swap position the present value of which would otherwise be less than the present value of the other party’s position due to a discrepancy between the fixed terms of the swap and prevailing market prices).
The §446 regulations contain a special recharacterization rule for “significant nonperiodic payments.” A swap with significant nonperiodic payments is treated as two separate transactions consisting of an on-market, level payment swap and a separate loan. The loan is treated as repaid through installments of principal and interest over the term of the NPC.6 In addition, the §446 regulations provide that, for purposes of §956, the IRS Commissioner may treat any nonperiodic payment – significant or not – as one or more loans.7 Thus, putting aside the new exception described more fully below, if a CFC enters into an NPC with a U.S. shareholder or other related U.S. person and the CFC makes a lump sum “yield adjustment fee” or other payment to the counterparty that is “significant” in amount, the CFC may be treated as holding U.S. property for §956 purposes.
The payment of upfront yield adjustment fees is becoming more and more common as NPCs are increasingly cleared through registered derivatives clearing organizations or clearing agencies (“clearing houses”), which require contracts to have standardized coupon rates and other terms that may not precisely correspond to market conditions at the time the NPC is entered into. Currently, a large proportion of credit default swaps and some interest rate swaps are cleared. The trend will continue in the aftermath of the Dodd-Frank Wall Street Reform and Consumer Protection Act,8 which imposes clearing requirements on many swap contracts.
New §956 regulation
In light of this trend, the Treasury has promulgated new Reg. §1.956-2T(b)(1)(xi), which carves out a new exception from the definition of U.S. property for an obligation of a U.S. person deemed to arise from an upfront payment where all of the following conditions are satisfied:
(A) The CFC that makes the upfront payment is a dealer in securities or commodities (within the meaning of §475);
(B) The upfront payment is required under a contract that is cleared by a clearing house that is registered under the Commodity Exchange Act or the Securities Exchange Act of 1934;
(C) The CFC makes the upfront payment: (1) to or through a U.S. person that is a clearing member of a clearing house, or (2) directly to the clearing house if the CFC is a clearing member of such clearing house;
(D) The upfront payment is made by the clearing house, directly or indirectly, to the original counterparty to the contract;
(E) The original counterparty is required to make a payment to the clearing house in the nature of initial variation margin equal to the amount of the upfront payment by the close of the same day that the upfront payment is made; and
(F) The payment in the nature of initial variation margin is paid by the clearing house, directly or indirectly, to the CFC.
The new §956 regulations contain three examples illustrating that the exception will apply even if either, or both, the clearing member and the counterparty are related U.S. persons.
In the new temporary regulations, Treasury and the IRS have indicated that they do not believe loans deemed to arise from certain upfront payments are properly treated as U.S. property for §956 purposes. The government is also considering whether this exception should be extended to contracts that are not cleared by a clearing house.
1TD 9589, 77 Fed. Reg. 27612 (11 May 2012). The text of the temporary regulations serves as the text of proposed regulations issued the same day. REG–107548–11, 77 Fed. Reg. 27669 (11 May 2012).
2 Reg. §1.446-3(c)(1)(i).
3 Periodic payments are payments made or received at intervals of one year or less during the entire term of the contract that are based on a specified index and either a single notional principal amount or a notional principal amount that varies over the term of the contract in the same proportion as the notional principal amount that measures the other party's payments. Reg. §1.446-3(e).
4 A nonperiodic payment is any payment made or received that is neither a periodic payment nor a termination payment. Nonperiodic payments are generally recognized over the duration of the NPC in a manner that reflects the economic substance of the contract, for example by amortization in annual level payments. Reg. §1.446-3(f).
5 Reg. §1.446-3(d).
6 Reg. §1.446-3(g)(4). While there is no clear line between significant nonperiodic payments and other nonperiodic payments, the purpose of the rule is to catch payments that are in substance loans between the parties disguised as NPC payments. Examples in the regulations indicate that a nonperiodic payment equaling less than 9% of the present value of all fixed payments due under an interest rate swap is not significant, but one that equals 66% of the present value of all fixed payments due under an interest rate swap is significant. Reg. § 1.446-3(g)(6), Examples 2 and 3.
7 Reg. §1.446-3(g)(4).
8 Pub. L. No. 111-203, 124 Stat. 1376 (2010).