REG-111283-11

This document contains proposed amendments to the Income Tax Regulations (26 CFR 1) under sections 1256 and 446 of the Code. Section 1256(b)(2)(B) was added to the Code by section 1601 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law No. 111-203, §1601, 124 Stat. 1376, 2223 (2010)) (the Dodd-Frank Act). Section 1256(b)(2)(B) provides that certain swaps and similar agreements are not subject to section 1256 of the Code. These proposed regulations provide guidance on the category of swaps and similar agreements that are within the scope of section 1256(b)(2)(B). These proposed regulations also revise the definition and scope of a notional principal contract under §1.446-3 of the Income Tax Regulations.

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, nonequity 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” as defined in section 1256(g)(7).

Section 1601 of the Dodd-Frank Act added section 1256(b)(2)(B), which excludes swaps and similar agreements from the definition of a section 1256 contract. Section 1256(b)(2)(B) provides that the term “section 1256 contract” shall not include—

Congress enacted section 1256(b)(2)(B) to resolve uncertainty under section 1256 for swap contracts that are traded on regulated exchanges. The specific uncertainty addressed by the enactment of section 1256(b)(2)(B) was described in the Conference Report:

H.R. Conf. Rep. No. 111-517, at 879 (2010). Section 1256(b)(2)(B) 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 contract.

Congress incorporated into section 1256(b)(2)(B) a list of swaps that parallels the list of swaps included under the definition of a notional principal contract in §1.446-3(c) with the addition of credit default swaps. The parallel language suggests that Congress was attempting to harmonize the category of swaps excluded under section 1256(b)(2)(B) 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 the Dodd-Frank Act. Accordingly, §1.1256(b)-1(a) of the proposed regulations provides that a section 1256 contract does not include a contract that qualifies as a notional principal contract as defined in proposed §1.446-3(c). As discussed herein, the proposed regulations under §1.446-3 also expressly provide that a credit default swap is a notional principal contract.

Section 1256(b)(2)(B) 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” or would instead be treated as a nonequity option under section 1256(g)(3). Since an option on a notional principal contract is closely connected with the underlying contract, the Treasury Department and the IRS believe that such an option should be treated as a similar agreement within the meaning of section 1256(b)(2)(B). Accordingly, §1.1256(b)-1(a) of the proposed regulations also provides that a section 1256 contract does not include an option on any contract that is a notional principal contract defined in §1.446-3(c) of the proposed regulations.

The proposed regulations provide an ordering rule for a contract that trades as a futures contract regulated by the Commodity Futures Trading Commission (CFTC), but that also meets the definition of a notional principal contract. The Treasury Department and the IRS believe that such a contract is not a commodity futures contract of the kind envisioned by Congress when it enacted section 1256. Accordingly, §1.1256(b)-1(a) of the proposed regulations provides 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 as defined in §1.446-3(c) of the proposed regulations.

Section 1256(g)(1) defines a regulated futures contract as “a contract (A) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (B) which is traded on or subject to the rules of a qualified board or exchange.” The apparent breadth of section 1256(g)(1) has raised questions in the past as to whether a contract other than a futures contract can be a regulated futures contract. The Treasury Department and the IRS have historically limited the scope of a regulated futures contract to those futures contracts that have the characteristics of traditional futures contracts. Under the Dodd-Frank Act, a “designated contract market” may trade both futures contracts and swap contracts, although there will be specific reporting rules for swap contracts. In order to properly limit section 1256 to futures contracts that trade on designated contract markets, §1.1256(b)-1(b) of the proposed regulations provides that a regulated futures contract is a section 1256 contract only if the contract is a futures contract that is not required to be reported as a swap under the Commodity Exchange Act (7 U.S.C. 1) (the CEA). The reporting provisions for swaps under the CEA will not be effective until the CFTC has published final rules implementing such provisions. It is anticipated that swap reporting rules will be in effect before these regulations are finalized. If, however, these proposed income tax regulations are finalized before the swap reporting provisions become effective, the Treasury Department and the IRS will evaluate whether the provisions of §1.1256(b)-1(b) need to be adjusted.

Questions have also been raised as to whether the requirement that a regulated futures contract be “traded on or subject to the rules of” a qualified board or exchange includes off-exchange transactions such as an exchange of a futures contract for a cash commodity, or an exchange of a futures contract for a swap, that are carried out subject to the rules of a CFTC designated contract market. The phrase “traded on or subject to the rules of” appears to have originated under the CEA. Section 4(a) of the CEA provides, in part, that it is unlawful to engage in any transaction in, or in connection with, a commodity futures contract unless such transaction is conducted on or subject to the rules of a board of trade which has been designated as a contract market and such contract is executed or consummated by or through a contract market. Section 5(d) of the CEA, as amended by section 735 of the Dodd-Frank Act, provides that the rules of a designated contract market may authorize, for bona fide business purposes, transfer trades or office trades, or an exchange of (i) futures in connection with a cash commodity transaction, (ii) futures for cash commodities, or (iii) futures for swaps. As such, the Treasury Department and the IRS believe that a futures contract that results from one of these transactions is a regulated futures contract under section 1256(g)(1) because the contract is traded subject to the rules of a designated contract market.

Section 1256(g)(7)(C) provides that a qualified board or exchange includes any other exchange, board of trade, or other market which the Secretary determines has rules adequate to carry out the purposes of section 1256. Section 1.1256(g)-1(a) of the proposed regulations specifies that such determinations are only made through published guidance in the Federal Register or in the Internal Revenue Bulletin.

Since section 1256(g)(7) was adopted, the Treasury Department and the IRS have issued determinations for six entities, all of them foreign futures exchanges. See Rev. Rul. 2010-3, 2010-3 I.R.B. 272 (London International Financial Futures and Options Exchange), Rev. Rul. 2009-24, 2009-36 I.R.B. 306 (ICE Futures Canada), Rev. Rul. 2009-4, 2009-5 I.R.B. 408 (Dubai Mercantile Exchange), Rev. Rul. 2007-26, 2007-1 C.B. 970 (ICE Futures), Rev. Rul. 86-7, 1986-1 C.B. 295 (The Mercantile Division of the Montreal Exchange), and Rev. Rul. 85-72, 1985-1 C.B. 286 (International Futures Exchange (Bermuda)). The IRS has followed a two step process for making each of the six qualified board or exchange determinations under section 1256(g)(7). See §601.601(d)(2)(ii)(b).

In the first step, the exchange submitted a private letter ruling to the IRS requesting a determination that the exchange is a qualified board or exchange within the meaning of section 1256(g)(7)(C). Once the IRS determined that the exchange had rules sufficient to carry out the purposes of section 1256, the Treasury Department and the IRS published a revenue ruling announcing that the named exchange was a qualified board or exchange. The revenue rulings apply to commodity futures contracts and futures contract options of the type described under the CEA that are entered into on the named exchange. The revenue ruling does not apply to contracts that are entered into on another exchange that is affiliated with the named exchange.

In determining whether a foreign exchange is a qualified board or exchange under section 1256(g)(7)(C), the Treasury Department and the IRS have looked to whether the exchange received a CFTC “direct access” no-action relief letter permitting the exchange to make its electronic trading and matching system available in the United States, notwithstanding that the exchange was not designated as a contract market pursuant to section 5 of the CEA. Section 738 of the Dodd-Frank Act, however, provides the CFTC with authority to adopt rules and regulations that require registration of a foreign board of trade that provides United States participants direct access to the foreign board of trade’s electronic trading system. In formulating these rules and regulations, the CFTC is directed to consider whether comparable supervision and regulation exists in the foreign board of trade’s home country. Pursuant to section 738, the CFTC has proposed a registration system to replace the direct access no-action letter process. Under the proposed registration system, a foreign board of trade operating pursuant to an existing direct access no-action relief letter must apply through a limited application process for an “Order of Registration” which will replace the foreign board of trade’s existing direct access no-action letter. Many of the proposed requirements for and conditions applied to a foreign board of trade’s registration will be based upon those applicable to the foreign board of trade’s currently granted direct access no-action relief letter.

The IRS has conditioned a foreign exchange’s qualified board or exchange status under section 1256(g)(7)(C) on the exchange continuing to satisfy all CFTC conditions necessary to retain its direct access no-action relief letter. Consequently, if the CFTC adopts the proposed registration system, an exchange that has previously received a qualified board or exchange determination under section 1256(g)(7)(C) must obtain a CFTC Order of Registration in order to maintain its qualified board or exchange status. The IRS will continue to evaluate the CFTC’s rules in this regard to determine if any changes to the IRS’s section 1256(g)(7)(C) guidance process are warranted.

In 1993, the IRS promulgated §1.446-3(c) which defines a notional principal contract as a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. Questions have arisen as to the proper interpretation of this requirement. Sections 1.446-3(c)(1)(i) and (ii) of the proposed regulations expressly provide that a notional principal contract requires one party to make two or more payments to a counterparty. For this purpose, the fixing of an amount is treated as a payment, even if the actual payment reflecting that amount is to be made at a later date. Thus, for example, a contract that provides for a settlement payment referenced to the appreciation or depreciation on a specified number of shares of common stock, adjusted for actual dividends paid during the term of the contract, is treated as a contract with more than one payment with respect to that leg of the contract.

In Notice 2004-52, 2004-2 C.B. 168, the Treasury Department and the IRS described four possible characterizations of a credit default swap. See §601.601(d)(2)(ii)(b). These proposed regulations resolve this uncertainty by adding credit default swaps to the list of swaps categorized as notional principal contracts governed by the rules of §1.446-3.

Since the time that the §1.446-3 regulations were promulgated, markets have developed for contracts based on non-financial indices. Many of these contracts are structured as swaps, and payments are calculated based on indices such as temperature, precipitation, snowfall, or frost. For example, payments made under a weather derivative may be based on heating degree days and cooling degree days. As a technical matter, a weather-related swap currently is not a notional principal contract because a weather index does not qualify as a “specified index” under §1.446-3(c)(2) of the current regulations, which generally require that such index be a financial index.

The Treasury Department and the IRS believe that swaps on non-financial indices should be treated as notional principal contracts. Accordingly, §1.446-3(c)(2)(ii) of the proposed regulations expands a specified index to include non-financial indices that are comprised of any objectively determinable information that is not within the control of any of the parties to the contract and is not unique to one of the parties’ circumstances, and that cannot be reasonably expected to front-load or back-load payments accruing under the contract.

Section 1.446-3(c)(1)(ii) currently provides that a contract described in section 1256(b) and a futures contract are not notional principal contracts. In order to remove the circularity that would otherwise exist between excluded contracts under §1.446-3(c)(1)(ii) and proposed §1.1256(b)-1, a contract described in section 1256(b) and a futures contract have been deleted from excluded contracts under proposed §1.446-3(c)(1)(iv).

The definition of a notional principal contract in §1.446-3(c) of the proposed regulations is intended to be the operative definition for all Federal income tax purposes, except where a different or more limited definition is specifically prescribed. Thus, the regulations under sections 512, 863, 954, and 988 have been amended to reference the definition of a notional principal contract in §1.446-3(c).

These regulations are proposed to apply to contracts entered into on or after the date the final regulations are published in the Federal Register.

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It has also 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 the regulation does not impose a collection of information on small entitles, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business.

Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The Treasury Department and IRS invite comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available at www.regulations.gov or upon request.

A public hearing has been scheduled for January 19, 2012, beginning at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington, DC. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit written or electronic comments by December 15, 2011 and an outline of the topics to be discussed and the time to be devoted to each topic (a signed original and eight (8) copies) by December 14, 2011. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

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

Par. 2. Section 1.446-3 is amended by:

1. Revising the entries for the table of contents in §1.446-3(a) for paragraphs (c) and (j).

2. Revising paragraphs (c)(1), (c)(2), and (c)(3).

3. Adding and reserving paragraph (c)(5).

4. Adding paragraph (c)(6).

5. Adding two sentences to the end of paragraph (j).

The revisions and additions read as follows: