Wednesday, June 16, 2010
This article examines an array of new tax questions that have arisen, or are about to arise, as a result of changes in market practice and the legal rules governing credit default swaps (“CDS”) and other over-the-counter derivative financial instruments (“swaps”). The principal changes in market practice are that the terms of conventional CDS contracts, including the coupon payments on such CDS, have been standardized, and that certain CDS contracts are now cleared on regulated clearinghouses. The changes to the regulatory laws governing CDS and other swaps are still a work in process, but will almost certainly require such clearing and it appears typically will also require cleared swaps to be traded on exchanges regulated by the Commodity Futures Trading Commission or the Securities & Exchange Commission or on other regulated markets.
The first tax question addressed by this article is whether the clearing of swaps on regulated clearinghouses and/or the trading of swaps on regulated exchanges causes such swaps to become “§ 1256 contracts” required to be marked to market on an annual basis, or should do so. Gain or loss from a § 1256 contract generally is treated by statute as 60% long-term capital gain/loss and 40% short-term capital gain/loss. Section 1256 today applies only to a limited class of financial products specifically designated as such by Congress. In view of the broad definition of “§ 1256 contract,” however, it appears that it could be relatively easy to bring a swap within the scope of § 1256, if desired, but hard to take it out. Section 1256 treatment for swaps would clearly be disadvantageous for many taxpayers. It could also, however, be quite advantageous for others, as a result of the favorable tax rules for long-term capital gains. This article concludes that swaps should not as a policy matter be treated as § 1256 contracts, whether or not they are cleared or QBE-traded, unless and until Congress affirmatively provides for § 1256 treatment.
The article then turns to the question of how a large initial payment on a CDS – a fact pattern that is common for CDS and other swaps that have “standardized” coupons, whether or not they are cleared through a regulated clearinghouse – should be taxed, and in particular whether under current law such a payment can give rise to a debt obligation between the parties. This part of the article identifies a multitude of questions that would have to be answered before a taxpayer could ascertain with confidence whether indebtedness arises and if so what its terms might be. The article also discusses the special payment and collateral arrangements involved in clearing swaps, and argues in that context that deemed dividend rules of § 956 should not apply to upfront payments made on cleared swaps generally.
Because current law is undeniably unclear with respect to both of these issues, it is highly desirable that clarification be forthcoming from official sources, whether through regulatory guidance or legislation, so that financial reform legislation does not open the door to tax whipsaws and arbitrage. The article suggests a number of ways that either legislative amendments or regulatory guidance could address these issues.