IRS regulations on upfront payments under certain notional principal contracts

11 Jun

The Internal Revenue Service has released temporary and proposed regulations relating to the treatment of upfront payments pursuant to certain notional principal contracts. The regulations provide that certain obligations of U.S. persons arising from upfront payments by controlled foreign corporations (CFC) pursuant to clearinghouse contracts do not constitute “United States property”.

Internal Revenue Code section 956 requires an income inclusion by “U.S. shareholders” (most 10% shareholders) of a controlled foreign corporation that invests earnings in “U.S. property”. Such an investment is viewed as the equivalent of a dividend. U.S. property generally includes an obligation of a U.S. person, other than obligations of a domestic corporation that is neither a U.S. shareholder of the CFC, nor an affiliate.

When a notional principal contract (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 Internal Revenue Service may treat any nonperiodic payment in connection with an NPC, whether or not significant, as a loan.

If a party to an NPC makes below-market periodic payments or receives above-market periodic payments, 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. Swaps cleared through a U.S.-registered clearinghouse generally are required to have standardized coupons (100 or 500 basis points), and thus are typically off-market, requiring an upfront payment.

The second party (the ultimate recipient of the upfront payment) is required to make a payment of “initial variation margin” to the U.S.-registered clearinghouse. The margin may not equal the amount of the first party’s upfront payment, due to either: (1) netting of the second party’s other transactions; or (2) changes in the value of the contract. Otherwise, the two payments are intended to correspond.

In addition to initial variation margin, U.S.-registered clearinghouses require each party to a cleared contract to provide daily variation margin (mark-to-market or maintenance margin), in an amount equal to the change in the fair market value of the contract.

Unless the first party and the second party are clearing members of the clearinghouse, the payments will be made to or through each party’s clearing member, which may be an affiliate of that party. Hence, there is a risk that an upfront payment otherwise could constitute an investment in U.S. property, triggering current taxation to the clearing member or to the ultimate recipient.

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. This statute regulates swap dealers and major swap participants, and imposes clearing and trade execution requirements.

The 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 NPCs. The payment must be made by a CFC that is a dealer in securities or commodities. Also: (1) the upfront payment must be required under a contract that is cleared by a derivatives clearing organization or a registered clearing agency;
(2) the CFC must make the upfront payment to or through a U.S. person that is a clearing member, or directly to the clearing agency if the CFC is a clearing member;
(3) the upfront payment must be made, directly or indirectly, to the counterparty to the contract;
(4) the counterparty must be required to pay initial variation margin that is equal (before taking into account any change in the value of the contract) to the amount of the upfront payment made by the CFC; and
(5) the initial variation margin must be paid, directly or indirectly, to the CFC.

The new exception currently is limited to cleared contracts. The Service and the Treasury continue to study whether it would be appropriate to extend the exception to contracts that are not cleared by a U.S.-registered clearinghouse, but that otherwise meet the above criteria.

The regulations apply to payments made on or after May 11, 2012. However, taxpayers may apply the regulations retroactively.


James Cantillon Ross

Attorney at law

(LL.M. Taxation)

Bars of California, New York and Quebec

mail: 230 Cook Street # 23019 RPO, Victoria V8V 4Z8

(not admitted in British Columbia)

tel/fax 206 338 4456 cantilon@




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