Tax News
The Tax Treatment of Credit Default Swaps is Finally Clarified
September 26, 2011
One of the major frustrations I’ve had with the taxation of derivative instruments, such as swaps, is the unsettled state of the pertinent law, including some basic issues like characterization for tax purposes and related definitions. Until now, the tax characterization of Credit Default Swaps (CDS) represented some of the more striking examples of this type of a problem. If I have to summarize the issue, the major problem with figuring out how to tax CDS was that they do not fit too well in any of the closely related categories of instruments for which there is already published guidance: notional principal contracts (NPC), options, guarantees and insurance.  In other words, there are no rules that expressly address the taxation of CDS and there was no indicative guidance whether CDS should be taxed within the framework of one of the four categories enumerated above. To make matters worse, contrary to some other derivative instruments, CDS could be settled in cash or physically by delivering the reference obligation.  Depending on the type of settlement one could have at least theoretically made a stronger case to tax a CDS in one category of instrument over the other, say as an option instead of an NPC.

 In 2004 the IRS issued Notice 2004-52 where it ruminated over the proper characterization and taxation of CDS. The IRS basically outlined the different approaches to characterizing CDS, which in essence encompassed treating the CDS either as a NPC, option, guarantee, insurance, or not analogizing it to anything at all but taxing it depending on an analysis of the various elements of the CDS transaction, including the nature of the reference obligation and whether a party to the CDS provides financial services to customers. The Notice sought comments regarding the most suitable of these approaches. The NYSBA and a few others provided notable comments soon after the Notice. Since then there hasn’t been much on this front until now. Treasury recently issued Prop. Reg. § 1.446-3 (REG-111283-11 September 16, 2011) where it basically took the position that CDS should be taxed as NPCs. It further appears that this treatment is irrespective of whether the CDS is physically or cash settled as long as the swap meets the “2 or more payment” rule of Treas. Reg. § 1.446-3(c)(1).   In addition, the Proposed Regulations clarify some other facets of the taxation of swaps, such as clarifying what contracts will be subject to Section 1256 mark-to-market post Dodd-Frank and what contracts won’t. The Proposed Regulations provide that NPCs will fall outside Section 1256. Thus, it is now relatively clear that a derivative contract that falls both within the purview of 1256 and NPC will be taxes as an NPC even if traded on or subject to the rules of a qualified board or exchange.  I would venture to say that this guidance was long due and is surely welcomed by most practitioners.
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Tags: cds, credit default swaps, proposed regulation 1.446-3, Section 1256, section 446, swaps