[Federal Register Volume 77, Number 92 (Friday, May 11, 2012)]
[Rules and Regulations]
[Pages 27612-27615]
From the Federal Register Online via the Government Publishing 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