[Federal Register Volume 77, Number 92 (Friday, May 11, 2012)]
[Rules and Regulations]
[Pages 27612-27615]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-11329]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9589]
RIN 1545-BK11


Modifications to Definition of United States Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations 
relating to the treatment of upfront payments made pursuant to certain 
notional principal contracts for U.S. federal income tax purposes. The 
temporary regulations provide that certain obligations of United States 
persons arising from upfront payments made by controlled foreign 
corporations pursuant to contracts that are cleared by a derivatives 
clearing organization or clearing agency do not constitute United 
States property. These regulations affect United States shareholders of 
controlled foreign corporations that make such payments. The text of 
the temporary regulations also serves as the text of the proposed 
regulations set forth in the notice of proposed rulemaking (REG-107548-
11) on this subject in the Proposed Rules section in this issue of the 
Federal Register.

DATES: Effective Date. These regulations are effective on May 11, 2012.
    Applicability Date. These regulations apply to payments described 
in Sec.  1.956-2T(b)(1)(xi) made on or after May 11, 2012.

FOR FURTHER INFORMATION CONTACT: Kristine A. Crabtree at (202) 622-3840 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

A. Section 956

    Section 956 was enacted to require an income inclusion by United 
States shareholders (as defined in section 951(b)) of a controlled 
foreign corporation (as defined in section 957(a)) that invests certain 
earnings and profits in United States property (U.S. property) ``on the 
grounds that [the investment] is substantially the equivalent of a 
dividend being paid to them.'' S. Rep. No. 87-1881, 1962-3 CB 703, 794 
(1962). Under section 951(a)(1)(B), each United States shareholder 
(U.S. shareholder) of a controlled foreign corporation (CFC) is 
generally required to currently include in its gross income the amount 
determined under section 956 with respect to such shareholder.
    The amount determined under section 956 with respect to a U.S. 
shareholder of a CFC for any taxable year is the lesser of: (1) The 
excess, if any, of the shareholder's pro rata share of the average of 
the amounts of U.S. property held (directly or indirectly) by the CFC 
as of the close of each quarter of such taxable year, over the amount 
of earnings and profits of the CFC described in section 959(c)(1)(A) 
with respect to such shareholder; or (2) the shareholder's pro rata 
share of the applicable earnings of the CFC. In general, the amount 
taken into account with respect to any U.S. property for this purpose 
is the adjusted basis of such property as determined for purposes of 
computing earnings and profits, reduced by any liability to which the 
property is subject. Earnings and profits described in section 
959(c)(1)(A) are attributable to amounts previously included in gross 
income by the U.S. shareholder under section 951(a)(1)(B) (or which 
would have been included except for section 959(a)(2)).
    Section 956(c)(1) defines U.S. property to generally include stock 
of a domestic corporation and an obligation of a United States person 
(U.S. person). Section 956(c)(2), however, generally excludes from the 
definition of U.S. property the stock or obligations of a domestic 
corporation that is neither a U.S. shareholder of the CFC nor a 
domestic corporation, 25 percent or more of the total combined voting 
power of which, immediately after the CFC's acquisition of stock in 
such domestic corporation, is owned, or is considered as being owned, 
by U.S. shareholders of the CFC. Under Sec.  1.956-2T(d)(2), subject to 
certain exceptions not relevant here, the term ``obligation'' includes 
any bond, note, debenture, certificate, bill receivable, account 
receivable, note receivable, open account, or other indebtedness, 
whether or not issued at a discount and whether or not bearing 
interest.

B. NPCs With Nonperiodic (Upfront) Payments

    When a notional principal contract (within the meaning of Sec.  
1.446-3(c)(1)) (NPC) includes a significant nonperiodic payment, the 
contract is generally treated as two separate transactions. One 
transaction is an on-market, level payment swap; the other is a loan. 
For purposes of section 956, the Commissioner may treat any nonperiodic 
payment in connection with an NPC, whether or not it is

[[Page 27613]]

significant, as one or more loans. See Sec.  1.446-3(g)(4). If a party 
to an NPC makes below-market periodic payments or receives above-market 
periodic payments under the terms of the contract, typically that party 
will make a nonperiodic payment, such as an upfront payment, to the 
counterparty in order to compensate for the off-market coupon payments 
specified in the contract.
    For example, if A and B enter into an off-market interest rate swap 
the terms of which require A to make periodic below-market fixed rate 
payments to B and require B to make periodic on-market floating rate 
payments to A, then A typically will compensate B (for receiving the 
below-market fixed rate payments) by making a nonperiodic payment at 
the outset of the interest rate swap (henceforth, an upfront payment) 
so that the present value of the fixed rate leg of the swap will equal 
the present value of the floating rate leg of the swap.
    Recently, certain contracts (cleared contracts), including some 
credit default swaps and interest rate swaps, have begun to be cleared 
through U.S.-registered derivatives clearing organizations or clearing 
agencies (collectively, U.S.-registered clearinghouses). Contracts 
cleared through a U.S.-registered clearinghouse generally are required 
to have standardized terms. For example, credit default swaps that are 
cleared through a U.S.-registered clearinghouse have common 
documentation and standardized coupons (currently 100 or 500 basis 
points). Consequently, except for the rare instance when the market 
coupon rate for a particular credit default swap is exactly 100 or 500 
basis points, a credit default swap with a standardized coupon will be 
off-market and will require an upfront payment to equalize the present 
value of the payment obligations under the contract.
    The volume of contracts cleared by U.S.-registered clearinghouses 
is expected to increase substantially as a result of the Dodd-Frank 
Wall Street Reform and Consumer Protection Act of 2010, Public Law 111-
203, 124 Stat. 1376 (the Dodd-Frank Act). Title VII of the Dodd-Frank 
Act, among other things: (1) Provides for the registration and 
comprehensive regulation of swap dealers and major swap participants; 
(2) imposes clearing and trade execution requirements on many swap 
contracts; and (3) creates rigorous recordkeeping and real-time 
reporting regimes.

C. Clearinghouse Margin Requirements To Manage Credit Risk

    U.S.-registered clearinghouses manage credit risk (the risk of 
counterparty default) in part by requiring that each party to a cleared 
contract provide various types of margin, including initial variation 
margin and daily variation margin (both of which are discussed in this 
section of the preamble). Cash margin payments (as well as other 
payments made pursuant to the terms of a cleared contract) to and from 
a U.S.-registered clearinghouse are made to or through a clearing 
member (that is, a futures commission merchant, broker, or dealer who 
is a member of the clearinghouse) which, in turn, makes corresponding 
payments to or receives corresponding payments from a counterparty.
(1) Initial Variation Margin Required To Offset Upfront Payment
    The party that makes an upfront payment pursuant to a cleared 
contract (the first party) has credit risk with respect to that payment 
because, if the clearinghouse (or the first party's clearing member) 
were to default, the first party would not receive the full benefit it 
paid for (the benefit of making below-market fixed rate payments or 
receiving above-market payments for the term of the contract). When the 
U.S.-registered clearinghouse makes the upfront payment to the other 
party to the cleared contract (the second party), the U.S.-registered 
clearinghouse similarly has credit risk with respect to that second 
party (or its clearing member). The second party (the ultimate 
recipient of the upfront payment) is thus required to make a payment in 
the nature of variation margin (initial variation margin) to the U.S.-
registered clearinghouse, generally no later than the end of the 
business day on which the upfront payment is made, in an amount that is 
equal to the upfront payment.
    In some instances, the total amount of margin posted by the second 
party on the day that it is required to post initial variation margin 
may not equal the amount of the first party's upfront payment, due to 
either: (1) The netting of the second party's notional exposure to the 
first party, or to the clearinghouse, as a result of other 
transactions; or (2) changes in the value of the contract between the 
time the contract is entered into and the time when the required margin 
is paid, requiring daily variation margin to be added to or subtracted 
from the second party's initial variation margin payment, as the case 
may be. However, on a transaction-by-transaction basis, the payment of 
initial variation margin by the second party should equal the first 
party's upfront payment when any daily variation margin is treated as 
separate from the initial variation margin posted on that day.
    After receiving the second party's initial variation margin 
payment, the U.S.-registered clearinghouse will pay the same amount to 
the first party. In each case, unless the first party and the second 
party are clearing members of the U.S.-registered clearinghouse, the 
payment will be made to or through each party's clearing member, which 
may be an affiliate of that party.
    Assume that D (a dealer under section 475) and C (a customer) enter 
into a contract that is accepted for clearing by a U.S.-registered 
clearinghouse, the terms of which require D to make below-market 
periodic payments to C. D is required under the contract to make an 
upfront payment of $25,000 to compensate C for the below-market coupon 
payments that C will receive. D (not a clearing member) makes that 
upfront payment to its clearing member, who then pays the U.S.-
registered clearinghouse an identical amount. The U.S.-registered 
clearinghouse in turn pays that amount to the clearing member for C, 
which makes the upfront payment to C. C, on the same business day, 
makes an initial variation margin payment of $25,000 to its clearing 
member, who then pays that amount to the U.S.-registered clearinghouse; 
the U.S.-registered clearinghouse makes the initial variation margin 
payment to D's clearing member; and D's clearing member makes the 
payment to D. Thus, the upfront payment from D is immediately offset by 
an initial variation margin payment in the same amount from C.
 (2) Daily Variation Margin Required To Account for Daily Market 
Fluctuation
    In addition to initial variation margin, U.S.-registered 
clearinghouses manage credit risk by requiring that each party to a 
cleared contract provide daily variation margin (also referred to as 
mark-to-market or maintenance margin). Daily variation margin is a cash 
margin payment made on a daily or intraday basis between the 
counterparties to a contract to protect against the risk of 
counterparty default. The rules of U.S.-registered clearinghouses 
generally require that daily variation margin be paid in an amount 
equal to the change in the fair market value of the contract.

Explanation of Provisions

    The text of these temporary regulations also serves as the text of 
the

[[Page 27614]]

proposed regulations set forth in the notice of proposed rulemaking on 
this subject in the Proposed Rules section of this issue of the Federal 
Register. These temporary regulations establish an exception to the 
definition of U.S. property for obligations of U.S. persons arising 
from upfront payments made with respect to certain cleared contracts 
that are properly classified as NPCs. The temporary regulations provide 
that obligations of U.S. persons arising from such upfront payments by 
a CFC that is a dealer in securities or commodities (within the meaning 
of section 475) do not constitute U.S. property for purposes of section 
956(a).
    To qualify for this exception: (1) The upfront payment must be 
required under a contract that is cleared by a derivatives clearing 
organization (as such term is defined in section 1a of the Commodity 
Exchange Act (7 U.S.C. 1a)) or a clearing agency (as such term is 
defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 
78c)) that is registered as a derivatives clearing organization under 
the Commodity Exchange Act or as a clearing agency under the Securities 
Exchange Act of 1934, respectively; (2) the CFC must make the upfront 
payment to or through a United States person that is a clearing member 
of the derivatives clearing organization or clearing agency, or 
directly to the derivatives clearing organization or clearing agency if 
the CFC is a clearing member of such derivatives clearing organization 
or clearing agency; (3) the upfront payment must be made, directly or 
indirectly, to the counterparty to the contract; (4) the counterparty 
to the contract must be required to make a payment in the nature of 
initial variation margin that is equal (before taking into account any 
change in the value of the contract between the time the contract is 
entered into and the time at which the payment is made) to the amount 
of the upfront payment made by the CFC; and (5) such payment in the 
nature of initial variation margin must be paid, directly or 
indirectly, to the CFC.
    The IRS and the Treasury Department do not believe that an 
obligation of a U.S. person created by an upfront payment resulting 
from a cleared contract that satisfies the requirements listed in this 
regulation is the type of transaction intended to be covered by section 
956, whether or not the payment is treated as a loan under the NPC 
rules under section 446. While the section 956 exception in these 
temporary regulations currently is limited to cleared contracts, the 
IRS and the Treasury Department continue to study, and request comments 
on, whether and under what circumstances it would be appropriate to 
extend the exception to contracts that are not cleared by a U.S.-
registered clearinghouse, but that would otherwise meet the criteria 
set forth in these temporary regulations.

Effective/Applicability Date

    These regulations apply to payments described in Sec.  1.956-
2T(b)(1)(xi) made on or after May 11, 2012. However, taxpayers may 
apply the rules of these regulations retroactively to payments made 
prior to May 11, 2012.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For the 
applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), 
refer to the cross-reference notice of proposed rulemaking published in 
the proposed rules section in this issue of the Federal Register. 
Pursuant to section 7805(f) of the Internal Revenue Code, these 
regulations have been submitted to the Chief Counsel for Advocacy of 
the Small Business Administration for comment on their impact on small 
entities.

Drafting Information

    The principal author of these regulations is Kristine A. Crabtree 
of the Office of Associate Chief Counsel (International). However, 
other personnel from the IRS and the Treasury Department participated 
in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding an 
entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.956-2T(b)(1)(xi) also issued under 26 U.S.C. 956(e). * 
* *

0
Par. 2. Section 1.956-2 is amended by adding a new paragraph (b)(1)(xi) 
to read as follows:


Sec.  1.956-2  Definition of United States property.

* * * * *
    (b) * * *
    (1) * * *
    (xi) [Reserved]. For further guidance, see Sec.  1.956-
2T(b)(1)(xi).
* * * * *

0
Par. 3. Section 1.956-2T is amended by:
0
1. Revising paragraphs (a) through (d)(1).
0
2. Adding new paragraphs (f) and (g).
    The revisions and additions read as follows:


Sec.  1.956-2T  Definition of United States property (temporary).

    (a) through (b)(1)(x) [Reserved]. For further guidance, see Sec.  
1.956-2(a) through (b)(1)(x).
    (xi) An obligation of a United States person arising from an 
upfront payment by a controlled foreign corporation (within the meaning 
of section 957(a)) with respect to a notional principal contract 
(within the meaning of Sec.  1.446-3(c)(1)) where the following 
conditions are satisfied--
    (A) The controlled foreign corporation that makes the upfront 
payment is a dealer in securities or commodities (within the meaning of 
section 475(c)(1) or (e)(1));
    (B) The upfront payment is required under a contract that is 
cleared by a derivatives clearing organization (as such term is defined 
in section 1a of the Commodity Exchange Act (7 U.S.C. 1a)) or a 
clearing agency (as such term is defined in section 3 of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c)) that is registered as a 
derivatives clearing organization under the Commodity Exchange Act or 
as a clearing agency under the Securities Exchange Act of 1934, 
respectively;
    (C) The controlled foreign corporation makes the upfront payment:
    (1) To or through a United States person that is a clearing member 
of a derivatives clearing organization or clearing agency, or
    (2) Directly to the derivatives clearing organization or clearing 
agency if the controlled foreign corporation is a clearing member of 
such derivatives clearing organization or clearing agency;
    (D) The upfront payment is made by the derivatives clearing 
organization or clearing agency, directly or indirectly, to the 
original counterparty to the contract;
    (E) The original counterparty to the contract that receives the 
upfront payment, as described in paragraph (b)(1)(xi)(D) of this 
section, is required by the derivatives clearing organization or 
clearing agency to make, by the end of the business day on which the 
upfront payment is made by the controlled foreign corporation, a 
payment in the nature of initial

[[Page 27615]]

variation margin that is equal (before taking into account any change 
in the value of the contract between the time the contract is entered 
into and the time at which the payment is made) to the amount of the 
upfront payment and such payment is made, directly or indirectly, to 
the derivatives clearing organization or clearing agency; and
    (F) The payment in the nature of initial variation margin is paid 
by the derivatives clearing organization or clearing agency, directly 
or indirectly, to the controlled foreign corporation.
    (G) Examples. The following examples illustrate the application of 
this paragraph (b)(1)(xi):

    Example 1. CFC is a controlled foreign corporation that is 
wholly owned by USP, a domestic corporation. CFC is a dealer in 
securities under section 475(c)(1). CFC enters into a credit default 
swap (that it treats as a notional principal contract for U.S. 
federal income tax purposes) with unrelated counterparty B. The 
credit default swap is accepted for clearing by a U.S.-registered 
derivatives clearing organization (DCO). CFC is not a member of DCO. 
CFC uses a U.S. affiliate (CM), which is a member of DCO, as its 
clearing member to submit the credit default swap to be cleared. CM 
is a domestic corporation that is wholly owned by USP. The 
standardized terms of the credit default swap provide that, for a 
term of X years, CFC will pay B a fixed coupon of 100 basis points 
per year on a notional amount of $Y. At the time CFC and B enter 
into the credit default swap, the market coupon for similar credit 
default swaps is 175 basis points per year. To compensate B for the 
below-market annual coupon payments that B will receive, the 
contract requires CFC to make an upfront payment through CM to DCO. 
DCO then makes the upfront payment to B through B's clearing member. 
DCO also requires B to post initial variation margin in an amount 
equal to the upfront payment. B pays the initial variation margin 
through its clearing member to DCO. DCO then pays the initial 
variation margin through CM to CFC. Because the conditions set out 
in this paragraph (b)(1)(xi) are satisfied, the obligation of CM 
arising from the upfront payment by CFC does not constitute United 
States property for purposes of section 956.
    Example 2. Assume the same facts as in Example 1, except that 
counterparty B is, like CM, a domestic corporation that is wholly 
owned by USP. Because the conditions set out in this paragraph 
(b)(1)(xi) are satisfied, the obligations of CM and B arising from 
the upfront payment by CFC do not constitute United States property 
for purposes of section 956.
    Example 3. Assume the same facts as in Example 2, except that 
CFC uses an unrelated person as its clearing member. Because the 
conditions set out in this paragraph (b)(1)(xi) are satisfied, the 
obligation of B arising from the upfront payment by CFC does not 
constitute United States property for purposes of section 956.

    (b)(2) through (d)(1) [Reserved]. For further guidance, see Sec.  
1.956-2(b)(2) through (d)(1).
* * * * *
    (f) Effective/applicability date. Paragraph (b)(1)(xi) applies to 
payments described in Sec.  1.956-2T(b)(1)(xi) made on or after May 11, 
2012. Taxpayers may apply the rules of paragraph (b)(1)(xi) to payments 
described in Sec.  1.956-2T(b)(1)(xi) made prior to May 11, 2012.
    (g) Expiration date. The applicability of paragraph (b)(1)(xi) 
expires on Friday, May 8, 2015.

Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
    Approved: May 1, 2012.
Emily S. McMahon,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2012-11329 Filed 5-10-12; 8:45 am]
BILLING CODE 4830-01-P