Copyright © 2011 Tax Analysts
Tax Notes Today

JULY 22, 2011, FRIDAY

DEPARTMENT: News, Commentary, and Analysis; News Stories   

CITE: 2011 TNT 141-1

LENGTH: 778 words

HEADLINE: #1 2011 TNT 141-1 PROPOSED REGS ADDRESS DERIVATIVE CONTRACT ASSIGNMENT AFTER DODD-FRANK. (Section 1001 -- Gain or Loss) (Release Date: JULY 21, 2011) (Doc 2011-15928)

CODE: Section 1001 -- Gain or Loss

ABSTRACT: In temporary and proposed regulations under section 1001 issued July 21, Treasury determined that assignments of derivative contracts by dealers to other dealers or clearinghouses are not taxable events if they meet certain criteria that industry commentators had requested.

SUMMARY: Published by Tax Analysts(R)
 
In temporary and proposed regulations under section 1001 issued July 21, Treasury determined that assignments of derivative contracts by dealers to other dealers or clearinghouses are not taxable events if they meet certain criteria that industry commentators had requested.
 
The new regulations resolve questions generated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203), which bars banks from engaging in certain derivative transactions, including some swaps. As a result, banks will need to transfer their customers' derivative portfolios to an affiliated entity for servicing. Alternatively, swap customers may decide to transfer their swaps to a clearinghouse in order to benefit from the clearing process. Foreign swap dealers that received exemptions from U.S. commodities and securities laws -- repealed by Dodd-Frank -- when they entered derivative contracts with U.S. customers may also elect to transfer portfolios to U.S. affiliates in order to comply with the swap registration rules in Dodd-Frank.
 
Before the clarifications provided in the new regulations, it was unclear whether such assignments were taxable events for the non-assigning counterparty to a derivative contract because the prior regulations treated the assignment as nontaxable only if the assignment was between dealers and the contract permitted substitution.

AUTHOR: Sapirie, Marie
Tax Analysts

GEOGRAPHIC: United States

REFERENCES: Subject Area:
 Financial institution tax issues

TEXT:

Release Date: JULY 21, 2011
 
Published by Tax Analysts(R)
 
In temporary and proposed regulations under section 1001 issued July 21, Treasury determined that assignments of derivative contracts by dealers to other dealers or clearinghouses are not taxable events if they meet certain criteria that industry commentators had requested.
 
The new regulations resolve questions generated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203), which bars banks from engaging in certain derivative transactions, including some swaps. As a result, banks will need to transfer their customers' derivative portfolios to an affiliated entity for servicing. Alternatively, swap customers may decide to transfer their swaps to a clearinghouse in order to benefit from the clearing process. Foreign swap dealers that received exemptions from U.S. commodities and securities laws -- repealed by Dodd-Frank -- when they entered derivative contracts with U.S. customers may also elect to transfer portfolios to U.S. affiliates in order to comply with the swap registration rules in Dodd-Frank. (For the proposed regulations (REG-109006-11), see Doc 2011-15860. For the temporary regulations (T.D. 9538), see Doc 2011-15858.)
 
Before the clarifications provided in the new regulations, it was unclear whether such assignments were taxable events for the non-assigning counterparty to a derivative contract because the prior regulations treated the assignment as nontaxable only if the assignment was between dealers and the contract permitted substitution.
 
Practitioners were pleased with the regulations. "I think these are terrific regulations. They address a broad range of circumstances where taxpayers might want to change the counterparty to derivative contracts in ways that would be consistent with Congress's goals in passing Dodd-Frank and they eliminate some obstacles to those transfers," said Erika W. Nijenhuis, a partner at Cleary Gottlieb Steen & Hamilton LLP.
 
Stephen Land, a partner at Linklaters LLP, said the most helpful feature of the regulations is the clarification that even if the non-assigning party has to consent to an assignment to another dealer or to a clearinghouse, there is no recognition of gain or loss. However, he identified several anomalies in the regulations.
 
First, he questioned the purpose of the requirement that the contract permit assignment. He argued that there is no legal difference between a counterparty that has to consent to an assignment under the terms of the derivative contract and a counterparty that has to consent to a contractual change before an assignment is allowed, except that under the new regulations the former assignment is not taxable and the second is taxable.
 
Second, Land observed that the regulations limit the universe of assignors and assignees to dealers and clearinghouses. This limitation "is probably going to cover substantially all cases, but I can't think of any good tax policy answer if one of the assigning parties were not dealers," he said. By preserving the requirement that the assignor and assignee be a dealer or a clearinghouse, the proposed regs may create some situations in which an assignment that is in other respects identical to one that would not be taxable under the regulations is actually taxable. "It's hard to see the rationale" for that rule, he said.
 
Standard swap documentation prohibits the transfer of a swap "without the prior written consent of the other party," so that swaps entered into under such documentation can be assigned tax-free under the new regulations if the counterparty consents and the regulations' other conditions are satisfied.
 
Nijenhuis noted that the old rules under section 1001 applied only to notional principal contracts, while the new regulations broaden the scope of the rules to derivatives generally. She said the change was a positive development.
 
Nijenhuis also said that the regulations apply only if the terms of the derivative are not changed in a way that would otherwise result in a taxable exchange, so that caution should be observed in renegotiating any significant terms of the derivative in connection with the assignment.
 
The temporary regulations are effective on the date of publication in the Federal Register. Viva Hammer, a principal at KPMG LLP, said that "the IRS is treating these regulations as not being a 'rule,' and so the Administrative Procedure Act and certain other procedural requirements do not apply."