|November 15, 2013|
Previously published on November 11, 2013
On November 5, 2013, the Internal Revenue Service (IRS) issued final regulations relating to the transfer or assignment of certain derivative contracts. The final regulations, which are provided as Treas. Reg. § 1.1001-4, address:
- Whether a transfer or assignment of certain derivative contracts is treated as a deemed exchange under Treas. Reg. § 1.1001-1(a); and
- Whether such transfers are subject to the embedded loans rules under Treas. Reg. § 1.446-3(g)(4).
The final regulations finalize existing temporary regulations that provide an exception to sale or exchange treatment to a non-assigning party in the case of the assignment of derivative contracts between dealers or clearinghouses. In addition, the final regulations expand on the temporary regulations by clarifying that any payment made between a transferor and a transferee of a swap contract does not result in an embedded loan under the section 446 regulations.
Treas. Reg. § 1.1001-1(a) requires the recognition of gain or loss realized from the exchange of property for other property differing materially either in kind or in extent. The final regulations finalize, without material change, temporary regulations providing that a transfer or assignment of a derivative contract by a party to the contract generally is not required to be treated by the non-assigning counterparty as a deemed exchange of the original contract under Treas. Reg. § 1.1001-1(a) that would give rise to the recognition of gain or loss for the non-assigning counterparty if (1) both parties in the transfer or assignment are either a dealer or a clearinghouse, (2) the terms of the derivative contract permit the transfer or assignment, and (3) the terms of the derivative contract are not otherwise materially modified.
Treas. Reg. § 1.446-3(g)(4) requires certain derivative contracts with significant non-periodic payments be treated as two separate transactions consisting of (1) an on-market, level-payment contract, and (2) a loan. The final regulations provide that any payment between the transferor and the transferee of a derivative contract will not give rise to this embedded loan rule of Treas. Reg. § 1.446-3(g)(4), and the resulting bifurcated treatment. The IRS said that it would be inconsistent for an embedded loan to result from such a payment in a situation where the general rule under Treas. Reg. § 1.1001-4(a) treats the transfer or assignment of a notional principal contract as a non-taxable event.