Tax News
Regs. 1.446-3T and 1.956-2T change the treatment of “embedded loan” swaps and the related Sec. 956 definition of US property
May 07, 2015
Administrative Actions
Treasury just pre-released RIN 1545-BM62 (1.446-3T and 1.956-2T introducing some changes to the application of the “embedded loan” rules and the definition of U.S. property for Sec. 956 purposes. This is not a topic that a typical private equity or hedge fund would face on a regular basis or would be familiar with, but for some participants that are more heavily involved in financial instrument derivative markets the new regulations may prove significant.

The regulations do several things, but most importantly, they change the embedded loan rule and provide an exception to the Sec. 956 definition of U.S. property for uncleared swaps that qualify for the full margin exception to the embedded loan rule.

What is an embedded loan swap? Until now, this was a swap with a significant upfront non-periodic payment.  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. If the upfront payment is significant as compared to the net present value of the fixed payments, then the swap is broken down in two contracts, an at-market payment swap and a loan. For federal income tax purposes the transaction had to be broken down into these two parts.

The problem was that the existing regulations did not provide any safe-harbor or bright line rule for determining “significant.” All the regulations provided was two examples which illustrated that 66.7% of net present value was significant while 9.1% was non-significant. This type of rule apparently was difficult to administer because one of the principal changes in the new regulations is the removal of the “significant” qualifier to the embedded loan rules. The rule now provides that except for contracts for which there is an explicit exception, the temporary regulations treat all notional principal contracts that have nonperiodic payments as having embedded loans. The new regulations provide two exceptions: one for short term NPCs and another for NPCs subject to prescribed margin or collateral requirements.

Why is this important? It is important because embedded loans can have material withholding, UBTI and other tax consequences. For example, a foreign swap participant that expected that would not be subject to withholding under current NPC rules may end up being subject to withholding on interest if he/she is not in a 0% withholding treaty jurisdiction or it does not qualify for the “portfolio interest” exception. On the other hand, an unaware tax-exempt investor could run into a UBTI problem due to the debt-financed rules. Lastly, the “embedded loan” classification may have an impact on the application of Sec. 1258.

Another element of the “embedded loan” rule involves Sec. 956. An “embedded loan” could be classified as an investment in U.S. property for Sec 956 purposes. This in turn could cause a deemed dividend from a CFC which could lead to unintended consequences. In 2012 Treasury published regulations providing that embedded loans arising from upfront payments on cleared contracts with respect to which full initial variation margin is posted are excluded from the definition of U.S. property.  Regretably, however, these regulations did not afford such an exception for uncleared contracts. The new regulations change this result for uncleared contracts with full margin or cash collateral.

The regulations could be found here.
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