Friday, December 16, 2011

IRS Proposes Regulations under Dodd-Frank Swap Exclusion for Section 1256 Contracts

The IRS has proposed regulations describing swaps and similar agreements that fall within the meaning of Section 1256(b)(2)(B) of the Internal Revenue Code, which was added to the Code by Section 1601 of the Dodd-Frank Act to exclude certain swaps and similar agreements from the reach of Section 1256 of the Code.

Section 1256 provides that contracts classified as Section 1256 contracts are marked to market and 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. Section 1256(b)(1) defines the term “section 1256 contract” as a regulated futures contract, foreign currency contract, non-equity option, dealer equity option, and dealer securities futures contract. With the exception of a foreign currency contract, a Section 1256 contract must be traded on or subject to the rules of a qualified board or exchange. Section 1601 of Dodd-Frank excluded securities futures contracts and swaps and similar agreements from the definition of a Section 1256 contract.

In Dodd-Frank Section 1601, Congress was resolving uncertainty under Section 1256 for swap contracts that are traded on regulated exchanges. Section 1601 contemplates that a swap contract, even if traded on or subject to the rules of a qualified board or exchange, will not be a Section 1256.

The IRS noted that Congress incorporated into Section 1601 a list of swaps, including interest rate swaps and credit default swaps, that parallels the list of swaps included under the definition of a notional principal contract in IRS Regulation § 1.446-3(c) with the addition of credit default swaps. According to the IRS, the parallel language suggests that Congress was attempting to harmonize the category of swaps excluded under Section 1601 with swaps that qualify as notional principal contracts under § 1.446-3(c), rather than with the contracts defined as swaps under Section 721 of Dodd-Frank. Thus, the proposed regulations provide that a Section 1256 contract does not include a contract that qualifies as a notional principal contract. The proposed regulations expressly provide that a credit default swap is a notional principal contract.

Section 1601 raises questions as to whether an option on a notional principal contract that is traded on a qualified board or exchange would constitute a “similar agreement” under the section or would instead be treated as a non-equity option under Section 1256(g)(3)of the Code. Since an option on a notional principal contract is closely connected with the underlying contract, the IRS reasoned that such an option should be treated as a similar agreement within the meaning of Section 1601. Thus, the proposed regulations also provide that a Section 1256 contract does not include an option on any contract that is a notional principal contract.

The proposed regulations also provide an ordering rule for a contract that trades as a futures contract regulated by the CFTC, but that also meets the definition of a notional principal contract. The IRS believes that such a contract is not a commodity futures contract of the kind envisioned by Congress when it enacted Section 1256. Thus, the proposed regulations provide that Section 1256 does not include any contract, or option on such contract, that is both a Section 1256 contract and a notional principal contract.

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