[Federal Register Volume 76, Number 180 (Friday, September 16, 2011)]
[Proposed Rules]
[Pages 57684-57690]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2011-23665]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-111283-11]
RIN 1545-BK22


Swap Exclusion for Section 1256 Contracts

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that describe 
swaps and similar agreements that fall within the meaning of section 
1256(b)(2)(B) of the Internal Revenue Code (Code). This document also 
contains proposed regulations that revise the definition of a notional 
principal contract under Sec.  1.446-3 of the Income Tax Regulations. 
This document provides a notice of public hearing on these proposed 
regulations.

DATES: Written or electronic comments must be received by December 15, 
2011. Outlines of topics to be discussed at the public hearing 
scheduled for January 19, 2012, must be received by December 14, 2011.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-111283-11), Room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington DC 20044. Submissions may be hand delivered Monday through 
Friday, between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
111283-11), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit 
comments electronically via the Federal eRulemaking Portal at http://www.regulations.gov/ (IRS-REG-111283-11). The public hearing will be 
held in the Auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
K. Scott Brown (202) 622-7454; concerning submissions of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, Richard Hurst, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) under sections 1256 and 446 of the Code. 
Section 1256(b)(2)(B) was added to the Code by section 1601 of the 
Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. 111-
203, 1601, 124 Stat. 1376, 2223 (2010)) (the Dodd-Frank Act). Section 
1256(b)(2)(B) provides that certain swaps and similar agreements are 
not subject to section 1256 of the Code. These proposed regulations 
provide guidance on the category of swaps and similar agreements that 
are within the scope of section 1256(b)(2)(B). These proposed 
regulations also revise the definition

[[Page 57685]]

and scope of a notional principal contract under Sec.  1.446-3 of the 
Income Tax Regulations.

Explanation of Provisions

A. Section 1256(b)(2)(B) Language and Legislative History

    Section 1256 provides that contracts classified as section 1256 
contracts are marked to market and any gain or loss is generally 
treated as 60 percent long-term capital gain or loss and 40 percent 
short-term capital gain or loss. Section 1256(b)(1) defines the term 
``section 1256 contract'' as a regulated futures contract, foreign 
currency contract, nonequity option, dealer equity option, and dealer 
securities futures contract. With the exception of a foreign currency 
contract, a section 1256 contract must be traded on or subject to the 
rules of a ``qualified board or exchange'' as defined in section 
1256(g)(7).
    Section 1601 of the Dodd-Frank Act added section 1256(b)(2)(B), 
which excludes swaps and similar agreements from the definition of a 
section 1256 contract. Section 1256(b)(2)(B) provides that the term 
``section 1256 contract'' shall not include--

any interest rate swap, currency swap, basis swap, interest rate 
cap, interest rate floor, commodity swap, equity swap, equity index 
swap, credit default swap, or similar agreement.

    Congress enacted section 1256(b)(2)(B) to resolve uncertainty under 
section 1256 for swap contracts that are traded on regulated exchanges. 
The specific uncertainty addressed by the enactment of section 
1256(b)(2)(B) was described in the Conference Report:

    The title contains a provision to address the recharacterization 
of income as a result of increased exchange-trading of derivatives 
contracts by clarifying that section 1256 of the Internal Revenue 
Code does not apply to certain derivatives contracts transacted on 
exchanges.

H.R. Conf. Rep. No. 111-517, at 879 (2010).

    Section 1256(b)(2)(B) contemplates that a swap contract, even if 
traded on or subject to the rules of a qualified board or exchange, 
will not be a section 1256 contract.

B. Scope of Swaps Excluded by Section 1256(b)(2)(B)

1. Notional Principal Contracts and Credit Default Swaps
    Congress incorporated into section 1256(b)(2)(B) a list of swaps 
that parallels the list of swaps included under the definition of a 
notional principal contract in Sec.  1.446-3(c) with the addition of 
credit default swaps. The parallel language suggests that Congress was 
attempting to harmonize the category of swaps excluded under section 
1256(b)(2)(B) with swaps that qualify as notional principal contracts 
under Sec.  1.446-3(c), rather than with the contracts defined as 
``swaps'' under section 721 of the Dodd-Frank Act. Accordingly, Sec.  
1.1256(b)-1(a) of the proposed regulations provides that a section 1256 
contract does not include a contract that qualifies as a notional 
principal contract as defined in proposed Sec.  1.446-3(c). As 
discussed herein, the proposed regulations under Sec.  1.446-3 also 
expressly provide that a credit default swap is a notional principal 
contract.
2. Option on a Notional Principal Contract
    Section 1256(b)(2)(B) raises questions as to whether an option on a 
notional principal contract that is traded on a qualified board or 
exchange would constitute a ``similar agreement'' or would instead be 
treated as a nonequity option under section 1256(g)(3). Since an option 
on a notional principal contract is closely connected with the 
underlying contract, the Treasury Department and the IRS believe that 
such an option should be treated as a similar agreement within the 
meaning of section 1256(b)(2)(B). Accordingly, Sec.  1.1256(b)-1(a) of 
the proposed regulations also provides that a section 1256 contract 
does not include an option on any contract that is a notional principal 
contract defined in Sec.  1.446-3(c) of the proposed regulations.
3. Ordering Rule
    The proposed regulations provide an ordering rule for a contract 
that trades as a futures contract regulated by the Commodity Futures 
Trading Commission (CFTC), but that also meets the definition of a 
notional principal contract. The Treasury Department and the IRS 
believe that such a contract is not a commodity futures contract of the 
kind envisioned by Congress when it enacted section 1256. Accordingly, 
Sec.  1.1256(b)-1(a) of the proposed regulations provides that section 
1256 does not include any contract, or option on such contract, that is 
both a section 1256 contract and a notional principal contract as 
defined in Sec.  1.446-3(c) of the proposed regulations.

C. Definition of Regulated Futures Contract

    Section 1256(g)(1) defines a regulated futures contract as ``a 
contract (A) with respect to which the amount required to be deposited 
and the amount which may be withdrawn depends on a system of marking to 
market, and (B) which is traded on or subject to the rules of a 
qualified board or exchange.'' The apparent breadth of section 
1256(g)(1) has raised questions in the past as to whether a contract 
other than a futures contract can be a regulated futures contract. The 
Treasury Department and the IRS have historically limited the scope of 
a regulated futures contract to those futures contracts that have the 
characteristics of traditional futures contracts. Under the Dodd-Frank 
Act, a ``designated contract market'' may trade both futures contracts 
and swap contracts, although there will be specific reporting rules for 
swap contracts. In order to properly limit section 1256 to futures 
contracts that trade on designated contract markets, Sec.  1.1256(b)-
1(b) of the proposed regulations provides that a regulated futures 
contract is a section 1256 contract only if the contract is a futures 
contract that is not required to be reported as a swap under the 
Commodity Exchange Act (7 U.S.C. 1) (the CEA). The reporting provisions 
for swaps under the CEA will not be effective until the CFTC has 
published final rules implementing such provisions. It is anticipated 
that swap reporting rules will be in effect before these regulations 
are finalized. If, however, these proposed income tax regulations are 
finalized before the swap reporting provisions become effective, the 
Treasury Department and the IRS will evaluate whether the provisions of 
Sec.  1.1256(b)-1(b) need to be adjusted.
    Questions have also been raised as to whether the requirement that 
a regulated futures contract be ``traded on or subject to the rules 
of'' a qualified board or exchange includes off-exchange transactions 
such as an exchange of a futures contract for a cash commodity, or an 
exchange of a futures contract for a swap, that are carried out subject 
to the rules of a CFTC designated contract market. The phrase ``traded 
on or subject to the rules of'' appears to have originated under the 
CEA. Section 4(a) of the CEA provides, in part, that it is unlawful to 
engage in any transaction in, or in connection with, a commodity 
futures contract unless such transaction is conducted on or subject to 
the rules of a board of trade which has been designated as a contract 
market and such contract is executed or consummated by or through a 
contract market. Section 5(d) of the CEA, as amended by section 735 of 
the Dodd-Frank Act, provides that the rules of a designated contract 
market may authorize, for bona fide business purposes, transfer trades 
or office trades,

[[Page 57686]]

or an exchange of (i) Futures in connection with a cash commodity 
transaction, (ii) futures for cash commodities, or (iii) futures for 
swaps. As such, the Treasury Department and the IRS believe that a 
futures contract that results from one of these transactions is a 
regulated futures contract under section 1256(g)(1) because the 
contract is traded subject to the rules of a designated contract 
market.

D. Qualified Board or Exchange

    Section 1256(g)(7)(C) provides that a qualified board or exchange 
includes any other exchange, board of trade, or other market which the 
Secretary determines has rules adequate to carry out the purposes of 
section 1256. Section 1.1256(g)-1(a) of the proposed regulations 
specifies that such determinations are only made through published 
guidance in the Federal Register or in the Internal Revenue Bulletin.
    Since section 1256(g)(7) was adopted, the Treasury Department and 
the IRS have issued determinations for six entities, all of them 
foreign futures exchanges. See Rev. Rul. 2010-3 (2010-1 CB 272 (London 
International Financial Futures and Options Exchange)), Rev. Rul. 2009-
24 (2009-2 CB 306 (ICE Futures Canada)), Rev. Rul. 2009-4 (2009-1 CB 
408 (Dubai Mercantile Exchange)), Rev. Rul. 2007-26 (2007-1 CB 970 (ICE 
Futures)), Rev. Rul. 86-7 (1986-1 CB 295 (The Mercantile Division of 
the Montreal Exchange)), and Rev. Rul. 85-72 (1985-1 CB 286 
(International Futures Exchange (Bermuda))). The IRS has followed a two 
step process for making each of the six qualified board or exchange 
determinations under section 1256(g)(7). See Sec.  
601.601(d)(2)(ii)(b).
    In the first step, the exchange submitted a private letter ruling 
to the IRS requesting a determination that the exchange is a qualified 
board or exchange within the meaning of section 1256(g)(7)(C). Once the 
IRS determined that the exchange had rules sufficient to carry out the 
purposes of section 1256, the Treasury Department and the IRS published 
a revenue ruling announcing that the named exchange was a qualified 
board or exchange. The revenue rulings apply to commodity futures 
contracts and futures contract options of the type described under the 
CEA that are entered into on the named exchange. The revenue ruling 
does not apply to contracts that are entered into on another exchange 
that is affiliated with the named exchange.
    In determining whether a foreign exchange is a qualified board or 
exchange under section 1256(g)(7)(C), the Treasury Department and the 
IRS have looked to whether the exchange received a CFTC ``direct 
access'' no-action relief letter permitting the exchange to make its 
electronic trading and matching system available in the United States, 
notwithstanding that the exchange was not designated as a contract 
market pursuant to section 5 of the CEA. Section 738 of the Dodd-Frank 
Act, however, provides the CFTC with authority to adopt rules and 
regulations that require registration of a foreign board of trade that 
provides United States participants direct access to the foreign board 
of trade's electronic trading system. In formulating these rules and 
regulations, the CFTC is directed to consider whether comparable 
supervision and regulation exists in the foreign board of trade's home 
country. Pursuant to section 738, the CFTC has proposed a registration 
system to replace the direct access no-action letter process. Under the 
proposed registration system, a foreign board of trade operating 
pursuant to an existing direct access no-action relief letter must 
apply through a limited application process for an ``Order of 
Registration'' which will replace the foreign board of trade's existing 
direct access no-action letter. Many of the proposed requirements for 
and conditions applied to a foreign board of trade's registration will 
be based upon those applicable to the foreign board of trade's 
currently granted direct access no-action relief letter.
    The IRS has conditioned a foreign exchange's qualified board or 
exchange status under section 1256(g)(7)(C) on the exchange continuing 
to satisfy all CFTC conditions necessary to retain its direct access 
no-action relief letter. Consequently, if the CFTC adopts the proposed 
registration system, an exchange that has previously received a 
qualified board or exchange determination under section 1256(g)(7)(C) 
must obtain a CFTC Order of Registration in order to maintain its 
qualified board or exchange status. The IRS will continue to evaluate 
the CFTC's rules in this regard to determine if any changes to the 
IRS's section 1256(g)(7)(C) guidance process are warranted.

E. Definition and Scope of a Notional Principal Contract

1. Payments Under a Notional Principal Contract
    In 1993, the IRS promulgated Sec.  1.446-3(c) which defines a 
notional principal contract as a financial instrument that provides for 
the payment of amounts by one party to another at specified intervals 
calculated by reference to a specified index upon a notional principal 
amount in exchange for specified consideration or a promise to pay 
similar amounts. Questions have arisen as to the proper interpretation 
of this requirement. Sections 1.446-3(c)(1)(i) and (ii) of the proposed 
regulations expressly provide that a notional principal contract 
requires one party to make two or more payments to a counterparty. For 
this purpose, the fixing of an amount is treated as a payment, even if 
the actual payment reflecting that amount is to be made at a later 
date. Thus, for example, a contract that provides for a settlement 
payment referenced to the appreciation or depreciation on a specified 
number of shares of common stock, adjusted for actual dividends paid 
during the term of the contract, is treated as a contract with more 
than one payment with respect to that leg of the contract.
2. Credit Default Swaps
    In Notice 2004-52 (2004-2 CB 168), the Treasury Department and the 
IRS described four possible characterizations of a credit default swap. 
See Sec.  601.601(d)(2)(ii)(b). These proposed regulations resolve this 
uncertainty by adding credit default swaps to the list of swaps 
categorized as notional principal contracts governed by the rules of 
Sec.  1.446-3.
3. Weather-Related and Other Non-Financial Index Based Swaps
    Since the time that the Sec.  1.446-3 regulations were promulgated, 
markets have developed for contracts based on non-financial indices. 
Many of these contracts are structured as swaps, and payments are 
calculated based on indices such as temperature, precipitation, 
snowfall, or frost. For example, payments made under a weather 
derivative may be based on heating degree days and cooling degree days. 
As a technical matter, a weather-related swap currently is not a 
notional principal contract because a weather index does not qualify as 
a ``specified index'' under Sec.  1.446-3(c)(2) of the current 
regulations, which generally require that such index be a financial 
index.
    The Treasury Department and the IRS believe that swaps on non-
financial indices should be treated as notional principal contracts. 
Accordingly, Sec.  1.446-3(c)(2)(ii) of the proposed regulations 
expands a specified index to include non-financial indices that are 
comprised of any objectively determinable information that is not 
within the control of any of the parties

[[Page 57687]]

to the contract and is not unique to one of the parties' circumstances, 
and that cannot be reasonably expected to front-load or back-load 
payments accruing under the contract.
4. Excluded Contracts
    Section 1.446-3(c)(1)(ii) currently provides that a contract 
described in section 1256(b) and a futures contract are not notional 
principal contracts. In order to remove the circularity that would 
otherwise exist between excluded contracts under Sec.  1.446-
3(c)(1)(ii) and proposed Sec.  1.1256(b)-1, a contract described in 
section 1256(b) and a futures contract have been deleted from excluded 
contracts under proposed Sec.  1.446-3(c)(1)(iv).
5. Conforming Amendments
    The definition of a notional principal contract in Sec.  1.446-3(c) 
of the proposed regulations is intended to be the operative definition 
for all Federal income tax purposes, except where a different or more 
limited definition is specifically prescribed. Thus, the regulations 
under sections 512, 863, 954, and 988 have been amended to reference 
the definition of a notional principal contract in Sec.  1.446-3(c).

Proposed Effective/Applicability Date

    These regulations are proposed to apply to contracts entered into 
on or after the date the final regulations are published in the Federal 
Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulation does not impose a collection of information on small 
entitles, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The Treasury Department and IRS invite comments on the 
clarity of the proposed rules and how they can be made easier to 
understand. All comments will be available at http://www.regulations.gov or upon request.
    A public hearing has been scheduled for January 19, 2012, beginning 
at 10 a.m. in the Auditorium, Internal Revenue Building, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments by December 15, 2011 and an outline of the topics 
to be discussed and the time to be devoted to each topic (a signed 
original and eight (8) copies) by December 14, 2011. A period of 10 
minutes will be allotted to each person for making comments. An agenda 
showing the scheduling of the speakers will be prepared after the 
deadline for receiving outlines has passed. Copies of the agenda will 
be available free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is K. Scott 
Brown, Office of the Associate Chief Counsel (Financial Institutions 
and Products). However, other personnel from the IRS and Treasury 
Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *

    Par. 2. Section 1.446-3 is amended by:
    1. Revising the entries for the table of contents in Sec.  1.446-
3(a) for paragraphs (c) and (j).
    2. Revising paragraphs (c)(1), (c)(2), and (c)(3).
    3. Adding and reserving paragraph (c)(5).
    4. Adding paragraph (c)(6).
    5. Adding two sentences to the end of paragraph (j).
    The revisions and additions read as follows:


Sec.  1.446-3  Notional principal contracts.

* * * * *
    (c) Definitions and scope.
    (1) Notional principal contract.
    (i) In general.
    (ii) Payment defined.
    (iii) Included contracts.
    (A) Special rule for credit default swaps.
    (B) Special rule for nonfunctional currency notional principal 
contracts.
    (iv) Excluded contracts.
    (v) Transactions within section 475.
    (vi) Transactions within section 988.
    (2) Specified index.
    (i) Specified financial index.
    (ii) Specified non-financial index.
    (3) Notional principal amount.
    (4) Special definitions.
    (i) Related person and party to the contract.
    (ii) Objective financial information.
    (iii) Dealer in notional principal contracts.
    (5) [Reserved]
    (6) Examples.
* * * * *
    (j) Effective/applicability date.
* * * * *
    (c) Definitions and scope--(1) Notional principal contract--(i) In 
general. A notional principal contract is a financial instrument that 
requires one party to make two or more payments to the counterparty at 
specified intervals calculated by reference to a specified index upon a 
notional principal amount in exchange for specified consideration or a 
promise to pay similar amounts. An agreement between a taxpayer and a 
qualified business unit (as defined in section 989(a)) of the taxpayer, 
or among qualified business units of the same taxpayer, is not a 
notional principal contract because a taxpayer cannot enter into a 
contract with itself.
    (ii) Payment defined. For purposes of paragraph (c)(1)(i) of this 
section, a payment includes an amount that is fixed on one date and 
paid or otherwise taken into account on a later date. Thus, for 
example, a contract that provides for a settlement payment referenced 
to the appreciation or depreciation on a specified number of shares of 
common stock, adjusted for actual dividends paid during the term of the 
contract, is treated as a contract with more than one payment with 
respect to that leg of the contract. See Example 2 of this paragraph 
(c).
    (iii) Included contracts. Notional principal contracts governed by 
this section include contracts commonly

[[Page 57688]]

referred to as interest rate swaps, currency swaps, basis swaps, 
interest rate caps, interest rate floors, commodity swaps, equity 
swaps, equity index swaps, credit default swaps, weather-related swaps, 
and similar agreements that satisfy the requirements of paragraph 
(c)(1)(i). A collar is not itself a notional principal contract, but a 
cap and a floor that comprise a collar may be treated as a single 
notional principal contract under paragraph (f)(2)(v)(C) of this 
section. A contract may be a notional principal contract governed by 
this section even though the term of the contract is subject to 
termination or extension. Each confirmation under a master agreement to 
enter into an agreement covered by this section is treated as a 
separate notional principal contract (or as more than one notional 
principal contract if the confirmation creates more than one notional 
principal contract). Notwithstanding the rule under paragraph (c)(3) of 
this section--
    (A) Special rule for credit default swaps. A credit default swap 
contract that permits or requires the delivery of specified debt 
instruments in satisfaction of one leg of the contract is a notional 
principal contract if it otherwise satisfies the requirements of 
paragraph (c)(1)(i) of this section.
    (B) Special rule for nonfunctional currency notional principal 
contracts. A notional principal contract that permits or requires the 
delivery of specified currency in satisfaction of one or both legs of 
the contract but that otherwise qualifies as a nonfunctional currency 
notional principal contract under Sec.  1.988-1(a)(2)(iii)(B) is a 
notional principal contract.
    (iv) Excluded contracts. A forward contract, an option, and a 
guarantee are not notional principal contracts. An instrument or 
contract that constitutes indebtedness under general Federal income tax 
law is not a notional principal contract. An option or forward contract 
that entitles or obligates a person to enter into a notional principal 
contract is not a notional principal contract, but payments made under 
such an option or forward contract may be governed by paragraph (g)(3) 
of this section.
    (v) Transactions within section 475. To the extent that the rules 
provided in paragraphs (e) and (f) of this section are inconsistent 
with the rules that apply to any notional principal contract that is 
governed by section 475 and the regulations thereunder, the rules of 
section 475 and the regulations thereunder govern.
    (vi) Transactions within section 988. To the extent that the rules 
provided in this section are inconsistent with the rules that apply to 
any notional principal contract that is also a section 988 transaction 
or that is integrated with other property or debt pursuant to section 
988(d), the rules of section 988 and the regulations thereunder govern. 
The rules of Sec.  1.446-3(g)(4) are not considered to be inconsistent 
with the rules of section 988. See Sec.  1.988-2(e)(3)(iv).
    (2) Specified index. A specified index may be either a specified 
financial index or a specified non-financial index.
    (i) Specified financial index. A specified financial index is--
    (A) A fixed rate, price, or amount;
    (B) A fixed rate, price, or amount applicable in one or more 
specified periods followed by one or more different fixed rates, 
prices, or amounts applicable in other periods;
    (C) An index that is based on objective financial information (as 
defined in paragraph (c)(4)(ii) of this section); and
    (D) An interest rate index that is regularly used in normal lending 
transactions between a party to the contract and unrelated persons.
    (ii) Specified non-financial index. A specified non-financial index 
is any objectively determinable information that--
    (A) Is not within the control of any of the parties to the contract 
and is not unique to one of the parties' circumstances;
    (B) Is not financial information; and
    (C) Cannot be reasonably expected to front-load or back-load 
payments accruing under the contract.
    (3) Notional principal amount. For purposes of this section, a 
notional principal amount is any specified amount of money or property 
that, when multiplied by either a specified financial index or a 
specified non-financial index, measures a party's rights and 
obligations under the contract, but is not borrowed, loaned, or sold 
between the parties as part of the contract. The notional principal 
amount may vary over the term of the contract, provided that it is set 
in advance or varies based on objective financial information (as 
defined in paragraph (c)(4)(ii) of this section). If a notional 
principal contract references a notional principal amount that varies, 
or that references a different notional principal amount for each 
party, and a principal purpose for entering into the contract is to 
avoid the application of the rules in this section, the Commissioner 
may recharacterize the contract according to its substance, including 
by separating the contract into a series of notional principal 
contracts for purposes of applying the rules of this section or by 
treating the contract, in whole or in part, as a loan.
* * * * *
    (5) [Reserved]
    (6) Examples. The following examples illustrate the application of 
paragraph (c) of this section.

    Example 1. Forward rate agreement. (i) On January 1, 2012, A 
enters into a contract with unrelated counterparty B under which on 
December 31, 2013, A will pay or receive from B, as the case may be, 
an amount determined by subtracting 6% multiplied by a notional 
amount of $10 million from 3 month LIBOR on December 31, 2013 
multiplied by the same notional amount ((3 month LIBOR x 
$10,000,000)-(6% x $10,000,000)). The contract provides for no other 
payments.
    (ii) Because this contract provides for a single net payment 
between A and B determined by interest rates in effect on the 
settlement date of the contract, the contract is not a notional 
principal contract defined in Sec.  1.446-3(c)(1)(i).
    Example 2. Equity total return contract with dividend 
adjustments. (i) On January 1, 2012, A enters into a contract with 
unrelated counterparty B under which on December 31, 2013, A will 
receive from B an amount equal to the appreciation (if any) on a 
notional amount of 1 million shares of XYZ common stock, plus any 
dividends or other distributions that are paid on 1 million shares 
of XYZ common stock during the term of the contract. In return, on 
December 31, 2013 A will pay B an amount equal to any depreciation 
on 1 million shares of XYZ common stock, and an amount equal to 3 
month LIBOR multiplied by the notional value of 1 million shares of 
XYZ stock on January 1, 2012 compounded over the term of the 
contract. All payments are netted such that A and B are only liable 
for the net payment due under the contract on December 31, 2013.
    (ii) Because both legs of this contract provide for payments 
that become fixed during the term of the contract (the dividend 
payments and the LIBOR-based payments), each leg of the contract is 
treated as providing for more than one payment. In addition, since 
the indices referenced in the contract are specified indices 
described in paragraph (c)(2)(i) of this section, and the 1 million 
shares of XYZ common stock are a notional principal amount described 
in paragraph (c)(3) of this section, the contract is a notional 
principal contract defined in Sec.  1.446-3(c)(1)(i).
* * * * *
    (j) Effective/applicability date. * * * The rules of paragraph (c) 
of this section apply to notional principal contracts entered into on 
or after the date of publication of a Treasury decision adopting these 
rules as final regulations in the Federal Register. Section 1.446-3(c) 
as contained in 26 CFR part 1 revised April 1, 2011, continues to apply 
to notional principal contracts entered into before the date of

[[Page 57689]]

publication of a Treasury decision adopting these rules as final 
regulations in the Federal Register.
    Par. 3. Section 1.512(b)-(1) is amended by:
    1. Revising paragraph (a)(1).
    2. Adding two sentences to the end of paragraph (a)(3).
    The revision and addition read as follows:


Sec.  1.512(b)-1  Modifications.

* * * * *
    (a) Certain Investment Income--(1) In general. Dividends, interest, 
payments with respect to securities loans (as defined in section 
512(a)(5)), annuities, income from notional principal contracts (as 
defined in Sec.  1.446-3(c)), other substantially similar income from 
ordinary and routine investments to the extent determined by the 
Commissioner, and all deductions directly connected with any of the 
foregoing items of income shall be excluded in computing unrelated 
business taxable income.
* * * * *
    (3) * * * The rules of paragraph (a)(1) of this section apply to 
notional principal contracts as defined in Sec.  1.446-3(c) that are 
entered into on or after the date of publication of a Treasury decision 
adopting these rules as final regulations in the Federal Register. 
Section 1.512(b)-1(a)(1) as contained in 26 CFR part 1 revised April 1, 
2011, continues to apply to notional principal contracts entered into 
before the date of publication of a Treasury decision adopting these 
rules as final regulations in the Federal Register.
* * * * *
    Par. 4. Section 1.863-7 is amended by:
    1. Revising the third sentence and removing the fourth sentence of 
paragraph (a)(1).
    2. Adding two sentences to the end of paragraph (a)(2).
    The revision and addition read as follows:


Sec.  1.863-7  Allocation of income attributable to certain notional 
principal contracts under section 863(a).

    (a) Scope--(1) Introduction. * * * Notional principal contract 
income is income attributable to a notional principal contract as 
defined in Sec.  1.446-3(c). * * *
    (2) * * * The rules of this section apply to notional principal 
contracts as defined in Sec.  1.446-3(c) that are entered into on or 
after the date of publication of a Treasury decision adopting these 
rules as final regulations in the Federal Register. Section 1.863-7 as 
contained in 26 CFR part 1 revised April 1, 2011, continues to apply to 
notional principal contracts entered into before the date of 
publication of a Treasury decision adopting these rules as final 
regulations in the Federal Register.
* * * * *
    Par. 5. Section 1.954-2 is amended by:
    1. Revising paragraph (h)(3)(i).
    2. Adding paragraph (h)(3)(iii).
    The revision and addition read as follows:


Sec.  1.954-2  Foreign personal holding company income.

* * * * *
    (3) Notional principal contracts--(i) In general. Income equivalent 
to interest includes income from notional principal contracts (as 
defined in Sec.  1.446-3(c)) denominated in the functional currency of 
the taxpayer (or a qualified business unit of the taxpayer, as defined 
in section 989(a)), the value of which is determined solely by 
reference to interest rates or interest rate indices, to the extent 
that the income from such transactions accrues on or after August 14, 
1989.
* * * * *
    (iii) Effective/applicability date. The rules of paragraph (h)(3) 
of this section apply to notional principal contracts as defined in 
Sec.  1.446-3(c) that are entered into on or after the date of 
publication of a Treasury decision adopting these rules as final 
regulations in the Federal Register. Section 1.954-2(h)(3) as contained 
in 26 CFR part 1 revised April 1, 2011, continues to apply to notional 
principal contracts entered into before the date of publication of a 
Treasury decision adopting these rules as final regulations in the 
Federal Register.
* * * * *
    Par. 6. Section 1.988-1 is amended by:
    1. Revising paragraph (a)(2)(iii)(B)(2).
    2. Adding two sentences to the end of paragraph (a)(2)(iii)(C).
    The revision and addition read as follows:


Sec.  1.988-1  Certain definitions and special rules.

    (a) * * *
    (2) * * *
    (iii) * * *
    (B) * * *
    (2) Definition of notional principal contract. Generally, the term 
``notional principal contract'' means a contract defined in Sec.  
1.446-3(c). However, a ``notional principal contract'' shall only be 
considered as described in paragraph (a)(2)(iii)(B)(1) of this section 
if the underlying property to which the instrument ultimately relates 
is money (for example, functional currency), nonfunctional currency, or 
property the value of which is determined by reference to an interest 
rate. Thus, the term ``notional principal contract'' includes a 
currency swap as defined in Sec.  1.988-2(e)(2)(ii), but does not 
include a swap referenced to a commodity or equity index.
    (C) * * * The rules of this paragraph (a)(2)(iii) apply to notional 
principal contracts as defined in Sec.  1.446-3(c) that are entered 
into on or after the date of publication of a Treasury decision 
adopting these rules as final regulations in the Federal Register. 
Section 1.988-1(a)(2)(iii) as contained in 26 CFR part 1 revised April 
1, 2011, continues to apply to notional principal contracts entered 
into before the date of publication of a Treasury decision adopting 
these rules as final regulations in the Federal Register.
* * * * *
    Par. 7. Section 1.1256(b)-1 is added to read as follows:


Sec.  1.1256(b)-1  Section 1256 contract defined.

    (a) General rule. A section 1256 contract does not include any 
contract, or option on such contract, that is a notional principal 
contract as defined in Sec.  1.446-3(c). A contract that is defined as 
both a notional principal contract in Sec.  1.446-3(c) and as a section 
1256 contract in section 1256(b)(1) is treated as a notional principal 
contract and not as a section 1256 contract.
    (b) Regulated futures contract. A regulated futures contract is a 
section 1256 contract only if the contract is a futures contract--
    (1) With respect to which the amount required to be deposited and 
the amount which may be withdrawn depends on a system of marking to 
market;
    (2) That is traded on or subject to the rules of a qualified board 
or exchange; and
    (3) That is not required to be reported as a swap under the 
Commodity Exchange Act.
    (c) Effective/applicability date. The rules of this section apply 
to contracts entered into on or after the date the final regulations 
are published in the Federal Register.
    Par. 8. Section 1.1256(g)-1 is added to read as follows:


Sec.  1.1256(g)-1  Qualified board or exchange defined.

    (a) General rule. A qualified board or exchange means a national 
securities exchange registered with the Securities Exchange Commission, 
a domestic board of trade designated as a contract market by the 
Commodity Futures Trading Commission, or any other exchange, board of 
trade, or other

[[Page 57690]]

market for which the Secretary determines in published guidance in the 
Federal Register or in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii) of this chapter) that such market has rules adequate 
to carry out the purposes of section 1256.
    (b) Effective/applicability date. The rule of this section applies 
to taxable years ending on or after the date the final regulations are 
published in the Federal Register.

 Steven T. Miller,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2011-23665 Filed 9-15-11; 8:45 am]
BILLING CODE 4830-01-P