IRS Publishes Proposed Regulations on Swaps and Notional Principal Contracts


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., mark-to 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 Internal Revenue Service (“IRS”) and Treasury Department (“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 long-term 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.”

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.

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