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IRS issues temporary regulations related to notional principal contracts

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The IRS on May 8 issued temporary regulations under Treas. Reg. Sec. 1.446-3T (T.D. 9719), which provide that a notional principal contract (NPC) with one or more nonperiodic payments must generally be treated as two transactions with certain exceptions.

An NPC, defined under Treas. Reg. Sec. 1.446-3, is a financial instrument providing for payments by one party to another at specified intervals calculated by reference to a specified index on a notional principal amount, in exchange for specified consideration or a promise to pay similar amounts. An example of an NPC includes an interest rate swap that requires a party to pay a fixed interest rate (for example, 5%) on a quarterly basis on a notional principal amount (for example, $1,000) to a counterparty in exchange for the counterparty’s quarterly payment of a variable interest rate (for example, LIBOR) on the notional principal amount.

Three types of payment generally relate to an NPC: (i) periodic payments, (ii) nonperiodic payments and (iii) termination payments.

  1. Under Treas. Reg. Sec. 1.446-3(e), periodic payments are made or received at intervals of one year or less during the entire term of the contract, based on the specified index and the notional amount.  
  2. Under Treas. Reg. Sec. 1.446-3(h), a termination payment is made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of any party under an NPC.
  3. Under Treas. Reg. Sec. 1.446-3(f), a nonperiodic payment is made or received related to an NPC that isn’t a periodic payment or a termination payment. An example of a nonperiodic payment is an upfront payment for an off-market swap agreement.

Under the pre-existing Treas. Reg. Sec. 1.446-3(g)(4), a swap with “Significant Non-Periodic Payments” was treated as two separate transactions consisting of an on-market, level payment swap and a loan.

The newly issued Treas. Reg. Sec. 1.446-3T(g)(4) provides generally that an NPC 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 that must be accounted for by the parties independently of the swap.  

The new regulations provide two exceptions to this general rule. First, under Treas. Reg. Sec. 1.446-3T(g)(4)(ii)(A), the general rule doesn’t apply to an NPC if the term is one year or less. In determining a contract term, the IRS may treat two or more contracts as a single contract if a principal purpose of entering into the separate contracts is to qualify for the first exception.  

The second exception, found under Treas. Reg. Sec. 1.446-3T(g)(4)(ii)(B), doesn’t apply the general rule to NPCs subject to certain margin or collateral requirements.  

The newly issued regulations under Treas. Reg. Sec. 1.446-3T(g)(4)(i) apply to NPCs entered into on or after Nov. 4, 2015, and the newly issued regulations under Treas. Reg. Sec. 1.446-3T(g)(4)(ii) apply to NPCs entered into on or after May 8, 2015. Taxpayers may apply Treas. Reg. Sec. 1.446-3T(g)(4)(ii) to NPCs entered into before May 8, 2015.  

The regulations under Treas. Reg. Sec. 1.446-3T(g)(4) are set to expire on May 7, 2018.

Contacts
Andy Cordonnier
+1 202 521 1502
andy.cordonnier@us.gt.com

Jeff Borghino
+1 202 521 1532
jeff.borghino@us.gt.com

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