C. Special Character Rules
Special character rules apply to a total return swap which contains a reference obligation denominated in a foreign currency. If the total return swap requires payment to be made or received in or determined by reference to the value of “nonfunctional currency”, gains and losses attributable to foreign currency (from exchange rate fluctuations) are generally treated as ordinary in character. “Functional currency” is the currency of the economic environment in which a significant part of the activities of a business unit is conducted and which is used by the unit in keeping its books and records. For US persons, the functional currency is usually the US dollar. Accordingly, where the reference debt instrument is denominated in non-functional currency, the gain or loss attributable to the foreign currency will be accounted for separately from the total return swap gain or loss and the foreign currency gain or loss will be ordinary in character.
XI. Source Rules
Determining the source of income from a total return swap is necessary, amongst other reasons, in order to determine whether a withholding obligation exists. The source of income is generally determined by reference to the residence of the income recipient. For instance, if the payer in a total return swap makes a net payment to a non-US receiver, the payment would be considered a source outside the US and thus no withholding obligation will exist. In contrast, if the receiver is a US resident and the payer a non-US resident, the payment would be considered a US source and not subject to withholding tax, as the receiver is already subject to US taxation. If the income is effectively connected to the conduct of a US trade or business (i.e the total return swap was entered into in connection with that business), the income is generally considered a US source.
The source of foreign currency gain or loss on a total return swap where the payments are denominated in or determined by reference to a foreign currency is determined by reference to the residence of the taxpayer upon whose books the gain or loss is reflected. The foreign currency gain or loss is treated separately from the gain or loss of the underlying transactions (the total return swap). US withholding rules can be quite complex. Fortunately, the issue of withholding is resolved by an applicable tax treaty for most taxpayers.
XII. Constructive Sales Rules
If the payer in a total return swap owns the underlying reference obligation, the question arises as to whether the payer has constructively disposed of the reference asset and this realized a taxable event.
A constructive sale is a transaction that offsets an “appreciated financial position” and has the effect of substantially eliminating the taxpayer’s risk of loss and chance for further gain on the position. An appreciated financial position is defined as any position with respect to any stock, debt instrument, or partnership interest if there would be a gain if such a position were sold, assigned, or otherwise terminated at fair market value. However, an appreciated financial position does not include positions that are marked-to-market (e.g, inventories of dealers in securities) or any position with regard to “straight debt”. Straight debt is debt that unconditionally entitles the holder to receive a specified principal amount, provides for interest payable based on a fixed or variable rate, and is not convertible into stock of the issuer or any related person.
Constructive sale transactions include short sales, offsetting notional principal contracts, futures or forwards contracts, or similar transactions with respect to the same or substantially identical property. For purposes of the constructive sale rules, an offsetting notional principal contract is defined as an agreement which requires a payment (or provides credit) for all or substantially all of the investment yield (including appreciation) on the position for a specified period and provides reimbursement for (or receives credit for) all or substantially all of any decline in the value of such property. Thus, the payer in a total return swap who owns the underlying reference obligation will not trigger the constructive sale rules if the reference asset is straight debt or the swap agreement does not cover all of the economic risk relating to the debt instrument.