New Tax Issues Arising from Derivatives Regulatory Reform

Abstract

This article addresses current (as of June 2010) and anticipated U.S. federal income tax issues arising from the clearing of swaps through regulated central counterparties. It makes suggestions for changes to the law in order to address those issues. It is believed that the article inspired the enactment of section 1256(b)(2)(B) of the Internal Revenue Code, which was enacted as section 1601 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The article examines an array of new U.S. federal income tax questions that arose as a result of changes in market practice and the legal rules governing credit default swaps and other over-the-counter derivative financial instruments (“swaps”). The first tax question addressed by the article is whether the clearing of swaps on regulated clearinghouses and/or the trading of swaps on regulated exchanges causes such swaps to become “section 1256 contracts” required to be marked to market on an annual basis, or should do so. Gain or loss from a section 1256 contract generally is treated for U.S. federal income tax purposes as 60 percent long-term capital gain/loss and 40 percent short-term capital gain/loss, which would be disadvantageous for many taxpayers but advantageous for others. The article then turns to the question of how a large initial payment on a swap – a fact pattern that is common for credit default and other swaps that have “standardized” coupons, whether or not they are cleared through a regulated clearinghouse – should be taxed, and in particular whether under current (as of June 2010) law such a payment can give rise to a debt obligation between the parties.

Part I of the article provides a brief overview of what a credit default swap is, the manner in which parties transact in swaps in the over-the-counter market, the tax treatment of notional principal contracts and options, respectively, and the basics of section 1256 treatment. Part I is intended as background for readers not already familiar with those instruments or tax rules. Part II of the article describes in broad strokes the proposals pending in Congress as of June 2010 to require clearing and/or exchange-trading of swaps (subsequently enacted by Dodd-Frank), and the manner in which credit default swaps were being cleared on ICE Trust U.S. and the Chicago Mercantile Exchange, the two U.S. clearinghouses for such swaps. Part II also discusses how the initial premium on a standard coupon credit default swap is priced. Part III then considers the section 1256 issue, and Part IV discusses the issues arising from large initial payments on standardized swaps, whether or not they are cleared or traded.

The article recommends several possible legislative solutions to the section 1256 issue, and regulatory guidance with respect to the deemed loan issue.

Keywords: tax, swap, credit default swap, CDS, Dodd-Frank, section 1256, deemed loan, central clearingparty, derivative, clearinghouse, mark-to-market, regulated futures contract

JEL Classification: K23, K34, G13, G23, H25