Obligations arising from certain upfront payments made by CFCs are not U.S. property

The IRS issued temporary regulations relating to the treatment of upfront payments made pursuant to certain notional principal contracts (NPCs) for U.S. federal income tax purposes (T.D. 9589). The temporary regulations establish an exception to the definition of U.S. property for obligations of U.S. persons arising from upfront payments made with respect to certain cleared contracts that are properly classified as NPCs. The temporary regulations provide that obligations of U.S. persons arising from such upfront payments by a controlled foreign corporation (CFC) that is a dealer in securities or commodities (within the meaning of Sec. 475) do not constitute U.S. property for purposes of Sec. 956(a).

To qualify for this exception:

(1) The upfront payment must be required under a contract that is cleared by a derivatives clearing organization or a clearing agency that is registered as a derivatives clearing organization under the Commodity Exchange Act or as a clearing agency under the Securities Exchange Act of 1934, respectively;
 
(2) The CFC must make the upfront payment to or through a U.S. person that is a clearing member of the derivatives clearing organization or clearing agency, or directly to the derivatives clearing organization or clearing agency if the CFC is a clearing member of the derivatives clearing organization or clearing agency;

(3) The upfront payment must be made, directly or indirectly, to the counterparty to the contract;

(4) The counterparty to the contract must be required to make a payment in the nature of initial variation margin that is equal (before taking into account any change in the value of the contract between the time the contract is entered into and the time at which the payment is made) to the amount of the upfront payment made by the CFC; and

(5) The payment in the nature of initial variation margin must be paid, directly or indirectly, to the CFC.

The IRS does not believe that an obligation of a U.S. person created by an upfront payment resulting from a cleared contract that satisfies the requirements listed in this regulation is the type of transaction intended to be covered by Sec. 956, whether or not the payment is treated as a loan under the NPC rules under Sec. 446. While the Sec. 956 exception in the temporary regulations currently is limited to cleared contracts, the IRS stated in the preamble to the regulations that it is continuing to study, and requesting comments on, whether and under what circumstances it would be appropriate to extend the exception to contracts that are not cleared by a U.S.-registered clearinghouse, but that would otherwise meet the criteria set forth in these temporary regulations.

These regulations apply to payments made on or after May 11, 2012. However, taxpayers may apply the rules of these regulations retroactively to payments made prior to May 11, 2012.

—Sally P. Schreiber (sschreiber@aicpa.org) is a JofA senior editor.