Notional Principal Contracts; Swaps With Nonperiodic Payments, 26437-26442 [2015-11092]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 80, Number 89 (Friday, May 8, 2015)]
[Rules and Regulations]
[Pages 26437-26442]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-11092]



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Federal Register / Vol. 80, No. 89 / Friday, May 8, 2015 / Rules and 
Regulations

[[Page 26437]]



DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9719]
RIN 1545-BM62


Notional Principal Contracts; Swaps With Nonperiodic Payments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

-----------------------------------------------------------------------

SUMMARY: This document contains final and temporary regulations 
amending the treatment of nonperiodic payments made or received 
pursuant to certain notional principal contracts. These regulations 
provide that, subject to certain exceptions, a notional principal 
contract with a nonperiodic payment, regardless of whether it is 
significant, must be treated as two separate transactions consisting of 
one or more loans and an on-market, level payment swap. This document 
also contains temporary regulations regarding an exception from the 
definition of United States property. These regulations affect parties 
making and receiving payments under notional principal contracts, 
including United States shareholders of controlled foreign corporations 
and tax-exempt organizations. The text of the temporary regulations 
also serves as the text of the proposed regulations set forth in the 
notice of proposed rulemaking (REG-102656-15) on this subject in the 
Proposed Rules section in this issue of the Federal Register.

DATES: Effective Date. These regulations are effective on May 8, 2015.
    Applicability Date. For the dates of applicability, see Sec. Sec.  
1.446-3T(j)(2) and 1.956-2T(f).

FOR FURTHER INFORMATION CONTACT: Regarding the regulations under 
section 446, Alexa T. Dubert or Anna H. Kim at (202) 317-6895; 
regarding the regulations under section 956, Kristine A. Crabtree at 
(202) 317-6934 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

I. Embedded Loan Rule

    On October 14, 1993, the Treasury Department and the IRS published 
final regulations (TD 8491) under section 446(b) of the Internal 
Revenue Code (Code) in the Federal Register (58 FR 53125) relating to 
the timing of income, deduction, gain, or loss with respect to 
payments, including nonperiodic payments, made or received pursuant to 
a notional principal contract (NPC) (the 1993 Regulations). See Sec.  
1.446-3. Under the 1993 Regulations, when an NPC includes a 
``significant'' nonperiodic payment, the contract is generally treated 
as two separate transactions consisting of an on-market, level payment 
swap and a loan (the embedded loan rule). The loan must be accounted 
for by the parties to the contract separately from the swap. The time-
value component associated with the loan is recognized as interest for 
all purposes of the Code.
    A nonperiodic payment commonly arises when a party to an NPC makes 
below-market periodic payments or receives above-market periodic 
payments under the terms of the contract. A party making below-market 
periodic payments or receiving above-market periodic payments would 
also typically be required to make an upfront payment to the 
counterparty 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 in exchange for A receiving periodic 
on-market, floating-rate payments from B, then A typically will 
compensate B for receiving the below-market fixed rate payments by 
making an upfront payment at the outset of the interest rate swap 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.

II. Nonperiodic (Upfront) Payments Arising From the Standardization of 
Contract Terms

    The Dodd-Frank Wall Street Reform and Consumer Protection Act of 
2010, Public Law 111-203, 124 Stat. 1376, Title VII (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 
standardized swap contracts; (3) creates rigorous recordkeeping and 
real-time reporting regimes; and (4) enhances rulemaking and 
enforcement authority of various federal regulators with respect to 
entities and intermediaries within their jurisdiction. As part of 
implementing the Dodd-Frank Act, the Commodity Futures Trading 
Commission (CFTC) has mandated that certain swap contracts (cleared 
contracts), including swaps that are NPCs under Sec.  1.446-3, be 
cleared through U.S.-registered derivatives clearing organizations. The 
Securities and Exchange Commission (SEC) has not yet mandated clearing 
of any security-based swaps through clearing agencies (which, together 
with derivatives clearing organizations, are referred to herein as 
U.S.-registered clearinghouses).
    To facilitate clearing and exchange trading, cleared contracts 
generally have standardized terms, which often give rise to upfront 
payments. For example, a Market Agreed Coupon interest rate swap (MAC) 
has standardized terms, including a standardized coupon rate (or fixed 
rate). Because the fixed rate is set in advance, it is unlikely that 
the fixed rate will equal the market rate on the start date of the MAC. 
Consequently, except for the rare instance when the market rate for a 
particular MAC equals the fixed rate, a MAC with a standardized coupon 
rate will be off-market and will require an upfront payment to equalize 
the present value of the payment obligations under the contract.
    Certain over-the-counter markets in swap contracts not subject to 
clearing with U.S.-registered clearinghouses (uncleared contracts) also 
have voluntarily begun to adopt terms similar to the MAC, including 
pre-defined, market-agreed start and end dates, payment dates, and 
fixed coupons to achieve greater standardization of

[[Page 26438]]

contract terms. Similar to cleared contracts, these uncleared contracts 
are resulting in an increasing number of upfront payments.

III. Margin Requirements

    As part of establishing a risk-management framework, the SEC, CFTC, 
and certain other federal regulators (collectively, the Regulators) are 
required by the Dodd-Frank Act to propose and adopt collateral 
requirements for cleared contracts and certain uncleared contracts. 
These requirements are typically referred to as ``margin'' requirements 
in the context of contracts between entities that are regulated by the 
Regulators (regulated entities) and, in these temporary regulations, 
the term ``margin'' is used in the context of cleared and uncleared 
contracts between regulated entities and the term ``collateral'' is 
used in the context of uncleared contracts between unregulated 
entities.

A. Margin Requirements on Cleared Contracts

    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 in an amount that fully 
collateralizes the credit risk on the contract. Because credit risk 
starts at the inception of the contract and continues throughout the 
term of the contract, the requirement to exchange margin sufficient to 
fully collateralize credit risk begins when the parties enter into the 
contract. To ensure that credit risk on the contract is fully 
collateralized, the contract is marked to market on a daily basis 
(beginning on the day the contract is entered into) and margin is 
exchanged by the parties based on the mark-to-market value.
    For example, if A and B enter into a cleared off-market interest 
rate swap contract the terms of which require A to make periodic below-
market, fixed rate payments to B in exchange for A receiving periodic 
on-market, floating-rate payments from B, then A will make an upfront 
payment to the clearinghouse (to be passed on to B) 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. A has credit risk with respect to 
that payment because, if the clearinghouse (or A's clearing member) 
were to default, A may not receive the full benefit of receiving on-
market, floating rate payments in exchange for making below-market 
fixed rate payments for the term of the contract. When the U.S.-
registered clearinghouse makes the upfront payment to B, the U.S.-
registered clearinghouse similarly has credit risk with respect to B 
(or B's clearing member). To eliminate the credit risk to A and B, the 
parties are required to post margin. More specifically, B (the ultimate 
recipient of the upfront payment) is required to make a payment of 
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 (or substantially 
equal) to the amount of the upfront payment.\1\ After receiving B's 
initial variation margin payment, the U.S.-registered clearinghouse 
will pay the same amount to A.\2\ Consequently, A is fully 
collateralized on the exposure on the swap contract at the end of the 
day the upfront payment is made.
---------------------------------------------------------------------------

    \1\ The total amount of initial variation margin posted by B may 
not equal the amount of A's upfront payment due to either: (1) The 
netting of B's notional exposure to A, or to the U.S.-registered 
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 B's initial 
variation margin payment, as the case may be. However, on a 
transaction-by-transaction basis, the payment of initial variation 
margin by B should equal (or closely approximate) A's upfront 
payment when any daily variation margin is treated as separate from 
the initial variation margin posted on that day.
    \2\ In each case, unless A and B are clearing members of the 
U.S.-registered clearinghouse, the payment is made to or through 
each party's clearing member (that is, a futures commission 
merchant, broker, or dealer who is a member of the clearinghouse), 
which may be an affiliate of that party.
---------------------------------------------------------------------------

    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. Daily variation margin 
is a cash payment made on a daily or intra-day 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 (the mark-
to-market value). Thus, A and B will continue to mark to market the 
cleared contract and exchange daily variation margin based on those 
values on a daily basis for the entire term of the contract.

B. Margin Requirements on Uncleared Contracts Between Regulated 
Entities and the Exchange of Collateral on Uncleared Contracts Between 
Unregulated Entities

    The margin requirements proposed by the Regulators for uncleared 
contracts are expected to appropriately address the credit risk posed 
by a counterparty that is a regulated entity and the risks associated 
with an uncleared contract and are expected to be as stringent as those 
required for cleared contracts.\3\ In addition, unregulated entities 
that enter into uncleared contracts may exchange collateral sufficient 
to fully collateralize the mark-to-market exposure on the contract on a 
daily basis for the entire term of the contract (beginning on the day 
the contract is entered into).
---------------------------------------------------------------------------

    \3\ See Margin Requirements for Uncleared Swaps for Swap Dealers 
and Major Swap Participants, 79 FR 59898 (October 3, 2014); Basel 
Committee on Banking Supervision (BCBS) and the Board of the 
International Organization of Securities Commissions (IOSCO), Margin 
Requirements for Non-centrally Cleared Derivatives (September 2013).
---------------------------------------------------------------------------

IV. Other Recent Guidance and Comments Regarding the Embedded Loan Rule 
as Applied to Upfront Payments on Cleared and Uncleared Contracts

    The Dodd-Frank Act has led to significant changes in market 
practices for cleared and uncleared contracts, including the increased 
volume of cleared and uncleared contracts with upfront payments. Under 
the 1993 Regulations, the parties to an NPC with an upfront payment are 
required to determine whether the upfront payment is a significant 
nonperiodic payment. If the payment is significant, the embedded loan 
rule will apply. In addition, under the 1993 Regulations, for purposes 
of section 956 (regarding United States property), the Commissioner may 
treat any nonperiodic payment, whether or not significant, as one or 
more loans.
    On May 11, 2012, the Treasury Department and the IRS published 
temporary regulations under section 956 (TD 9589) in the Federal 
Register (77 FR 27612). On the same date, a notice of proposed 
rulemaking (REG-107548-11) by cross-reference to the temporary 
regulations was published in the Federal Register (77 FR 27669). These 
regulations excepted from the definition of United States property 
under section 956 certain obligations arising from upfront payments on 
cleared contracts with respect to which full initial variation margin 
is posted (the Section 956 Regulations). In response to the request for 
comments and, more generally, because of the growing number of upfront 
payments on cleared and uncleared contracts, the Treasury Department 
and the IRS have received several comment letters noting the 
potentially burdensome tax consequences associated with treating an 
upfront payment as one or more

[[Page 26439]]

loans. For example, the 1993 Regulations do not define what constitutes 
a ``significant'' nonperiodic payment. Instead, examples in the 1993 
Regulations illustrate contracts with and without significant 
nonperiodic payments and explain how to determine significance by 
comparing the nonperiodic payment to the present value of the total 
amount of payments due under the contract. Commenters have noted that 
the lack of a definition in the embedded loan rule for when such a 
payment is significant creates uncertainty and that taxpayers have 
developed different ways to determine ``significance'' for this 
purpose.
    In addition, commenters have argued that receiving an upfront 
payment and posting cash margin back to the payor of the upfront 
payment lacks the most important attribute of indebtedness because the 
recipient lacks discretion as to the payment's use. Commenters also 
have raised concerns of increased compliance burdens arising from 
withholding and information reporting resulting from the increasing 
number of upfront payments treated as loans. Commenters specifically 
cite the difficulty of satisfying information reporting on upfront 
payments arising from cleared contracts because a U.S-registered 
clearinghouse is interposed between the first party and second party 
once a contract is submitted and accepted for clearing.
    Commenters also have raised concerns that receipt by a tax-exempt 
organization of an upfront payment arising from entering into a 
standardized cleared or uncleared contract (the loan separated from the 
on-market swap under the embedded loan rule) may cause income earned on 
the tax-exempt organization's deployment of the upfront payment to 
constitute unrelated business taxable income under the debt-financed 
property rules of section 514. Finally, commenters have requested that 
the exception in the Section 956 Regulations be extended to uncleared 
contracts with upfront payments with respect to which full initial 
variation margin is posted.

Explanation of Provisions

    The text of these temporary regulations also serves as the text of 
the 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. The temporary regulations under section 446 simplify 
the embedded loan rule and provide two exceptions to that rule. The 
temporary regulations under section 956 provide an exception to the 
definition of United States property with respect to certain notional 
principal contracts subject to margin or collateral requirements as 
described in the temporary regulations under section 446.

I. Simplification of the Embedded Loan Rule

    Because excepting non-significant nonperiodic payments from the 
embedded loan rule is not functioning as a rule of administrative 
convenience as intended, these temporary regulations eliminate that 
exception. Instead, other than contracts for which there is an explicit 
exception, the temporary regulations treat all notional principal 
contracts that have nonperiodic payments as including one or more 
loans. The Treasury Department and the IRS have determined that, unless 
an exception applies, the economic loan that is inherent in a 
nonperiodic payment should be taxed as one or more loans, and that it 
is reasonable to require taxpayers to separate the loan or loans from 
an NPC in the case of any nonperiodic payment, regardless of the 
relative size of such payment. Taxpayers may implement this change upon 
publication in the Federal Register, but for those taxpayers that need 
additional time, the temporary regulations delay the applicability date 
of this rule until November 4, 2015.

II. Exceptions to the Embedded Loan Rule

    The temporary regulations provide two independent exceptions from 
the embedded loan rule. First, except for purposes of sections 514 and 
956, the temporary regulations provide an exception for a nonperiodic 
payment made under an NPC with a term of one year or less (short-term 
exception).
    Second, the temporary regulations provide an exception for certain 
NPCs with nonperiodic payments that are subject to prescribed margin or 
collateral requirements. The embedded loan rule is intended to address 
situations when one party to a contract provides cash to the 
counterparty and is compensated for that cash with a direct or indirect 
interest payment. The Treasury Department and the IRS have concluded, 
however, that the same concerns do not exist when a party pays or 
receives an upfront payment and must immediately collect or post an 
equivalent amount of cash margin or collateral. Accordingly, in those 
circumstances, the Treasury Department and the IRS have determined that 
the embedded loan rule should not apply to the upfront payment.
    In order to qualify for the exception, the regulations require both 
that the margin or collateral posted and collected be paid in cash and 
that the parties to the contract be required to post and collect margin 
or collateral in an amount that fully collateralizes the mark-to-market 
exposure on the contract (including the exposure on the nonperiodic 
payment) on a daily basis for the entire term of the contract. The 
mark-to-market exposure on a cleared contract will be fully 
collateralized only if the contract is subject to both initial 
variation margin in an amount equal to the nonperiodic payment (except 
for variances permitted by intraday price changes) and daily variation 
margin in an amount equal to the daily change in the fair market value 
of the contract, and on an uncleared contract if it is subject to 
equivalent margin or collateral requirements (full margin exception). A 
taxpayer may use the full margin exception without regard to whether 
the contract qualifies for the short-term exception.
    The Treasury Department and the IRS request comments on whether 
there are other circumstances in which the embedded loan rule should 
not apply. For example, there may be circumstances in which time value 
is appropriately accounted for under the contract because applying the 
embedded loan rule would not alter the tax consequences of the 
contract. In particular, the Treasury Department and the IRS request 
comments on whether it is necessary to require taxpayers to apply the 
embedded loan rule to NPCs with nonperiodic payments that are subject 
to mark-to-market accounting.
    Finally, the Treasury Department and the IRS request comments on 
all other aspects of the temporary and proposed rules, including but 
not limited to any anticipated effects on market participants' 
behavior, the applicability of the full margin exception only in cases 
in which cash margin is posted, or possible effects on the goal of the 
Dodd-Frank Act to encourage centralized clearing of swaps.

III. Exception to the Definition of United States Property

    The temporary regulations under section 956 provide an exception to 
the definition of United States property for certain obligations of 
United States persons arising from upfront payments made with respect 
to notional principal contracts that qualify for the full margin 
exception to the embedded loan rule in the temporary regulations under 
section 446. To qualify for the United States property exception, the 
upfront payment must be made by a controlled foreign corporation (as 
defined in section 957(a)) that is either a dealer in

[[Page 26440]]

securities under section 475(c)(1) or a dealer in commodities.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866, as 
supplemented by Executive Order 13653. 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, and because these regulations do not 
impose a collection of information on small entities, the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) does not apply. 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 authors of these regulations are Alexa T. Dubert and 
Anna H. Kim of the Office of Associate Chief Counsel (Financial 
Institutions and Products). However, other personnel from the Treasury 
Department and the IRS 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 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

0
Par. 2. Section 1.446-3 is amended by:
0
1. Revising paragraph (g)(4).
0
2. Revising paragraph (g)(6), Examples 2, 3 and 4.
0
3. Redesignating paragraph (j) as (j)(1) and revising the paragraph 
heading of paragraph (j)(1).
0
4. Adding paragraphs (j)(2) and (k).
    The revisions and addition to read as follows:


Sec.  1.446-3  Notional principal contracts.

* * * * *
    (g) * * *
    (4) [Reserved]. For further guidance, see Sec.  1.446-3T(g)(4).
* * * * *
    (6) * * *
    Example 2. [Reserved]. For further guidance, see Sec.  1.446-
3T(g)(6), Example 2.
    Example 3. [Reserved]. For further guidance, see Sec.  1.446-
3T(g)(6), Example 3.
    Example 4. [Reserved]. For further guidance, see Sec.  1.446-
3T(g)(6), Example 4.
* * * * *
    (j) Effective/applicability date--(1) * * *
    (2) [Reserved]. For further guidance, see Sec.  1.446-3T(j)(2).
    (k) [Reserved]. For further guidance, see Sec.  1.446-3(k).

0
Par. 3. Section 1.446-3T is added to read as follows:


Sec.  1.446-3T  Notional principal contracts (temporary).

    (a) through (g)(3) [Reserved]. For further guidance, see Sec.  
1.446-3(a) through (g)(3).
    (4) Notional principal contracts with nonperiodic payments--(i) 
General rule. Except as provided in paragraph (g)(4)(ii) of this 
section, a notional principal contract with one or more nonperiodic 
payments is treated as two separate transactions consisting of an on-
market, level payment swap and one or more loans. The loan(s) must be 
accounted for by the parties to the contract independently of the swap. 
The time value component associated with the loan(s) is not included in 
the net income or net deduction from the swap under Sec.  1.446-3(d), 
but it is recognized as interest for all purposes of the Internal 
Revenue Code. See paragraph (g)(6) Example 2 of this section.
    (ii) Exceptions--(A) Notional principal contract with a term of one 
year or less--(1) General rule. Except for purposes of sections 514 and 
956, paragraph (g)(4)(i) of this section does not apply to a notional 
principal contract if the term of the contract is one year or less. For 
purposes of this paragraph (g)(4)(ii)(A), the term of a notional 
principal contract is the stated term of the contract, inclusive of any 
extensions (optional or otherwise) provided for in the terms of the 
contract, without regard to whether any extension is unilateral, is 
subject to approval by one or both parties to the contract, or is based 
on the occurrence or non-occurrence of a specified event.
    (2) Anti-abuse rule. For purposes of determining the term of a 
contract under paragraph (g)(4)(ii)(A)(1) of this section, the 
Commissioner may treat two or more contracts as a single contract if a 
principal purpose of entering into separate contracts is to qualify for 
the exception set forth in paragraph (g)(4)(ii)(A)(1) of this section. 
A purpose may be a principal purpose even though it is outweighed by 
other purposes (taken together or separately).
    (B) Notional principal contract subject to margin or collateral 
requirements. Subject to the requirements in paragraph (g)(4)(ii)(C) of 
this section, paragraph (g)(4)(i) of this section does not apply to a 
notional principal contract if the contract is described in paragraph 
(g)(4)(ii)(B)(1) or (2) of this section. See Sec.  1.956-2T(b)(1)(xi) 
for a related exception under section 956.
    (1) The contract 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 by a clearing agency (as such term in 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, and the derivatives clearing organization or 
clearing agency requires the parties to the contract to post and 
collect margin or collateral to fully collateralize the mark-to-market 
exposure on the contract (including the exposure on the nonperiodic 
payment) on a daily basis for the entire term of the contract. The 
mark-to-market exposure on a contract will be fully collateralized only 
if the contract is subject to both initial variation margin in an 
amount equal to the nonperiodic payment (except for variances permitted 
by intraday price changes) and daily variation margin in an amount 
equal to the daily change in the fair market value of the contract. See 
paragraph (g)(6) Example 3 of this section.
    (2) The parties to the contract are required, pursuant to the terms 
of the contract or the requirements of a federal regulator, to post and 
collect margin or collateral to fully collateralize the mark-to-market 
exposure on the contract (including the exposure on the nonperiodic 
payment) on a daily basis for the entire term of the contract. The 
mark-to-market exposure on a contract will be fully collateralized only 
if the contract is subject to both initial variation margin or 
collateral in an amount equal to the nonperiodic payment (except for 
variances permitted by intraday price changes) and daily variation 
margin or collateral in an amount equal to the daily change in the fair 
market value of the contract. For purposes of this paragraph 
(g)(4)(ii)(B)(2), the term ``federal regulator'' means the Securities 
and Exchange Commission (SEC), Commodity Futures Trading Commission 
(CFTC), or a prudential

[[Page 26441]]

regulator, as defined in section 1a(39) of the Commodity Exchange Act 
(7 U.S.C. 1a), as amended by section 721 of the Dodd-Frank Act. See 
paragraph (g)(6) Example 4 of this section.
    (C) Limitations and special rules--(1) Cash requirement. A notional 
principal contract is described in paragraph (g)(4)(ii)(B) of this 
section only to the extent the parties post and collect margin or 
collateral to fully collateralize the mark-to-market exposure on the 
contract (including the exposure on the nonperiodic payment) by paying 
and receiving the required margin or collateral in cash. The term 
``cash'' includes U.S. dollars or cash in any currency in which payment 
obligations under the notional principal contract are denominated.
    (2) Excess margin or collateral. For purposes of paragraph 
(g)(4)(ii)(B)(2) of this section, if the amount of cash margin or 
collateral posted and collected is in excess of the amount necessary to 
fully collateralize the mark-to-market exposure on the contract 
(including the exposure on the nonperiodic payment) on a daily basis 
for the entire term of the contract, any excess is subject to the rule 
in paragraph (g)(4)(i) of this section.
    (3) Margin or collateral paid and received in cash and other 
property. If the parties to the contract post and collect both cash and 
other property to satisfy margin or collateral requirements to 
collateralize the mark-to-market exposure on the contract (including 
the exposure on the nonperiodic payment), any excess of the nonperiodic 
payment over the cash margin or collateral posted and collected is 
subject to the rule in paragraph (g)(4)(i) of this section.
    (5) [Reserved]. For further guidance, see Sec.  1.446-3(g)(5).
    (6) Examples through Example 1. [Reserved]. For further guidance, 
see Sec.  1.446-3(g)(6), Examples through Example 1.

    Example 2. Nonperiodic payment. (i) On January 1, 2016, 
unrelated parties M and N enter into an interest rate swap contract. 
Under the terms of the contract, N agrees to make five annual 
payments to M equal to LIBOR times a notional principal amount of 
$100 million. In return, M agrees to pay N 6% of $100 million 
annually, plus an upfront payment of $15,163,147 on January 1, 2016. 
At the time M and N enter into the contract, the rate for similar 
on-market swaps is LIBOR to 10%, and N provides M with information 
that the amount of the upfront payment was determined as the present 
value, at 10% compounded annually, of five annual payments from M to 
N of $4,000,000 (4% of $100,000,000). The contract does not require 
the parties to post and collect margin or collateral to 
collateralize the mark-to-market exposure on the contract on a daily 
basis for the entire term of the contract.
    (ii) The exceptions in paragraphs (g)(4)(ii)(A) and (B) of this 
section do not apply. Under paragraph (g)(4)(i) of this section, the 
transaction is recharacterized as consisting of both a $15,163,147 
loan from M to N that N repays in installments over the term of the 
contract and an interest rate swap between M and N in which M 
immediately pays the installment payments on the loan back to N as 
part of its fixed payments on the swap in exchange for the LIBOR 
payments by N.
    (iii) The upfront payment is recognized over the life of the 
contract by treating the $15,163,147 as a loan that will be repaid 
with level payments over five years. Assuming a constant yield to 
maturity and annual compounding at 10%, M and N account for the 
principal and interest on the loan as follows:


----------------------------------------------------------------------------------------------------------------
                                                                                 Interest          Principal
                                                           Level payment        component          component
----------------------------------------------------------------------------------------------------------------
2016...................................................         $4,000,000         $1,516,315         $2,483,685
2017...................................................          4,000,000          1,267,946          2,732,054
2018...................................................          4,000,000            994,741          3,005,259
2019...................................................          4,000,000            694,215          3,305,785
2020...................................................          4,000,000            363,636          3,636,364
                                                        --------------------------------------------------------
                                                                20,000,000          4,836,853         15,163,147
----------------------------------------------------------------------------------------------------------------

    (iv) M recognizes interest income, and N claims an interest 
deduction, each taxable year equal to the interest component of the 
deemed installment payments on the loan. These interest amounts are 
not included in the parties' net income or net deduction from the 
swap contract under Sec.  1.446-3(d). The principal components are 
needed only to compute the interest component of the level payment 
for the following period and do not otherwise affect the parties' 
net income or net deduction from this contract.
    (v) N also makes swap payments to M based on LIBOR and receives 
swap payments from M at a fixed rate that is equal to the sum of the 
stated fixed rate and the rate calculated by dividing the deemed 
level annual payments on the loan by the notional principal amount. 
Thus, the fixed rate on this swap is 10%, which is the sum of the 
stated rate of 6% and the rate calculated by dividing the annual 
loan payment of $4,000,000 by the notional principal amount of 
$100,000,000, or 4%. Using the methods provided in Sec.  1.446-
3(e)(2), the fixed swap payments from M to N of $10,000,000 (10% of 
$100,000,000) and the LIBOR swap payments from N to M are included 
in the parties' net income or net deduction from the contract for 
each taxable year.
    Example 3. Full margin--cleared contract. (i) A, a domestic 
corporation enters into an interest rate swap contract with 
unrelated counterparty B. The contract is required to be cleared and 
is accepted for clearing by a U.S.-registered derivatives clearing 
organization (DCO). The standardized terms of the contract provide 
that A, for a term of X years, will pay B a fixed coupon of 1% per 
year and receive a floating coupon on a notional principal amount of 
$Y. When A and B enter into the interest rate swap, the market 
coupon for similar interest rate swaps is 2% per year. The DCO 
requires A to make an upfront payment to compensate B for the below-
market annual coupon payments that B will receive, and A makes the 
upfront payment in cash. The DCO also requires B to post initial 
variation margin in an amount equal to the upfront payment and 
requires each party to post and collect daily variation margin in an 
amount equal to the change in the fair market value of the contract 
on a daily basis for the entire term of the contract. B posts the 
initial variation margin in U.S. dollars, and the parties post and 
collect daily variation margin in U.S. dollars.
    (ii) Because the contract is subject to initial variation margin 
in an amount equal to the upfront payment and daily variation margin 
in an amount equal to the change in the fair market value of the 
contract on a daily basis for the entire term of the contract, the 
contract is described in paragraph (g)(4)(ii)(B)(1) of this section 
and paragraph (g)(4)(i) of this section does not apply to the 
contract.
    Example 4. Full margin--uncleared contract. (i) On June 1, 2016, 
P, a domestic corporation, enters into an interest rate swap 
contract with an unrelated domestic counterparty, CP. Under the 
terms of the contract, CP agrees to make five annual payments to P 
equal to a specified contract rate of 3% times the notional amount 
of $10,000,000 plus an upfront payment of $1,878,030. In exchange, P 
agrees to make five annual payments to CP equal to the same notional 
amount times LIBOR. At the time the parties enter into the contract, 
the fixed rate for an on-market swap is 7.52%. The contract is not 
required to be cleared and is not accepted for clearing by a U.S.-
registered derivatives clearing organization. However, pursuant to 
the terms of the contract, P is obligated to post $1,878,030 as 
collateral with CP, and P and CP are obligated to post and collect 
collateral each business day in an amount equal to the daily change 
in the fair market value of the contract for the entire

[[Page 26442]]

term of the contract. All collateral on the contract is required to 
be in U.S. dollars.
    (ii) Because the contract is required to be collateralized in an 
amount equal to the upfront payment and changes in the fair market 
value of the contract on a daily basis for the entire term of the 
contract, the contract is described in paragraph (g)(4)(ii)(B)(2) of 
this section and paragraph (g)(4)(i) of this section does not apply 
to the contract.

    (h) through (j)(1) [Reserved]. For further guidance, see Sec.  
1.446-3(h) through (j)(1).
    (2) Application of Sec.  1.446-3T(g)(4). The rules provided in 
paragraph (g)(4)(i) of this section apply to notional principal 
contracts entered into on or after November 4, 2015. Taxpayers may 
apply the rules provided in paragraph (g)(4)(i) of this section to 
notional principal contracts entered into before November 4, 2015. The 
rules provided in paragraph (g)(4)(ii) of this section apply to 
notional principal contracts entered into on or after May 8, 2015. 
Taxpayers may apply the rules provided in paragraph (g)(4)(ii) of this 
section to notional principal contracts entered into before May 8, 
2015. For the rules that apply to notional principal contracts with 
nonperiodic payments entered into before the dates set forth in this 
paragraph (j)(2), see Sec.  1.446-3(g)(4) as contained in 26 CFR part 
1, revised April 1, 2015.
    (k) Expiration date. The applicability of paragraph (g)(4) of this 
section and paragraph (g)(6) Examples 2, 3 and 4 of this section 
expires May 7, 2018.

0
Par. 4. Section 1.956-2T is amended by revising paragraphs (b)(1)(xi), 
(f) and (g) to read as follows:


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

* * * * *
    (b) * * *
    (1) * * *
    (xi) An obligation of a United States person arising from a 
nonperiodic payment by a controlled foreign corporation (within the 
meaning of section 957(a)) with respect to a notional principal 
contract described in Sec.  1.446-3T(g)(4)(ii)(B)(1) or (2) if the 
following conditions are satisfied--
    (A) The controlled foreign corporation that makes the nonperiodic 
payment is either a dealer in securities (within the meaning of section 
475(c)(1)) or a dealer in commodities; and
    (B) The conditions set forth in Sec.  1.446-3T(g)(4)(ii)(C)(1) 
(relating to full margin or collateral in cash) are satisfied.
    (C) Examples. The following examples illustrate the application of 
this paragraph (b)(1)(xi):

    Example 1. Full margin--cleared contract. (i) A domestic 
corporation (U.S.C.) wholly owns a controlled foreign corporation 
(CFC) that is a dealer in securities under section 475(c)(1). CFC 
enters into an interest rate swap contract with unrelated 
counterparty B. The contract is required to be cleared and is 
accepted for clearing by a U.S.-registered derivatives clearing 
organization (DCO). CFC is not a member of the DCO. CFC uses a U.S. 
affiliate (CM), which is a member of the DCO, as its clearing member 
to submit the contract to be cleared. CM is a domestic corporation 
that is wholly owned by U.S.C.. The standardized terms of the 
contract provide that, for a term of X years, CFC will pay B a fixed 
coupon of 1% per year and receive a floating coupon on a notional 
principal amount of $Y. When CFC and B enter into the contract, the 
market coupon for similar interest rate swaps is 2% per year. The 
DCO requires CFC to make an upfront payment to compensate B for the 
below-market annual coupon payments that B will receive, and CFC 
makes the upfront payment in cash. CFC makes the upfront payment 
through CM to the DCO, which then makes the payment to B. The DCO 
also requires B to post initial variation margin in an amount equal 
to the upfront payment and requires each party to post and collect 
daily variation margin in an amount equal to the change in the fair 
market value of the contract on a daily basis for the entire term of 
the contract. B posts the initial variation margin in U.S. dollars, 
which is received by CFC (through DCO and CM), and the parties post 
and collect daily variation margin in U.S. dollars.
    (ii) Because the contract is subject to initial variation margin 
in an amount equal to the upfront payment and daily variation margin 
in an amount equal to the change in the fair market value of the 
contract on a daily basis for the entire term of the contract, the 
contract is described in Sec.  1.446-3T(g)(4)(ii)(B)(1). 
Furthermore, because the additional conditions set forth 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. Full margin--uncleared contract. (i) Assume the same 
facts as in Example 1, except for the following. CFC's counterparty 
to the contract is U.S.C., CM is not involved, and the contract is 
not required to be cleared and is not accepted for clearing by a 
U.S.-registered derivatives clearing organization. The contract 
requires CFC to make an upfront payment to compensate U.S.C. for the 
below-market annual coupon payments that U.S.C. will receive, and 
CFC makes the upfront payment in U.S. dollars. Pursuant to the 
requirements of a federal regulator, U.S.C. is obligated to post 
initial variation margin with CFC in an amount equal to CFC's 
upfront payment, and U.S.C. and CFC are obligated to post and 
collect daily variation margin in an amount equal to the change in 
the fair market value of the contract on a daily basis for the 
entire term of the contract. U.S.C. posts the initial variation 
margin in U.S. dollars, which is received by CFC, and the parties 
post and collect daily variation margin in U.S. dollars.
    (ii) Because the contract is subject to initial variation margin 
in an amount equal to the upfront payment and daily variation margin 
in an amount equal to the change in the fair market value of the 
contract on a daily basis for the entire term of the contract, the 
contract is described in Sec.  1.446-3T(g)(4)(ii)(B)(2). 
Furthermore, because the additional conditions set forth in this 
paragraph (b)(1)(xi) are satisfied, the obligation of U.S.C. arising 
from the upfront payment by CFC does not constitute United States 
property for purposes of section 956.
* * * * *
    (f) Effective/applicability date. Paragraph (b)(1)(xi) of this 
section applies to payments described in Sec.  1.956-2T(b)(1)(xi) made 
on or after May 8, 2015. Taxpayers may apply the rules of paragraph 
(b)(1)(xi) to payments made before May 8, 2015.
    (g) Expiration date. The applicability of paragraph (b)(1)(xi) of 
this section expires on May 7, 2018.

John M. Dalrymple,
Deputy Commissioner for Services and Enforcement.
    Approved: April 29, 2015.
Mark J. Mazur,
Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 2015-11092 Filed 5-7-15; 8:45 am]
 BILLING CODE 4830-01-P