Tax Treatment for Swaps
September 21, 2012
By Robert A. Green, CPA and Mark Feldman, JD
A growing trend for traders is to get involved with swap transactions. In general, tax treatment for swaps is ordinary gain or loss, but some financial instruments partially including swaps may qualify for lower 60/40 tax rates in Section 1256. The CME Group just announced new "swap futures" and tax attorneys feel they probably don't qualify for Section 1256 treatment.
What exactly is a swap? According to Investopedia “A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time.” Classic swaps involve bonds and/or currencies, swapping interest rate and currency cash flows. For example, a global business often uses swap transactions to cushion risk exposure outside their main business activities. Derivatives are meant to smooth balance sheets, but in 2008 they contributed to the banking and markets crisis.
In general, the IRS treats swap contracts as Notional Principal Contracts (NPCs). Therefore, they receive ordinary gain or loss treatment and are subject to accrual accounting, which means mark-to-market accounting (realized and unrealized gains and losses at year-end). Read more on the IRS site.
Hedge funds often take one side of a swap transaction with corporations and banks. Retail traders rarely have that type of access to the swaps marketplace. But they’re gaining exposure to a bevy of new exchange-traded derivative products, including options on swaps, swap futures, and ETFs consisting partially of swaps. All of these choices are great, but they muddy the waters on tax treatment.
As we pointed out in our blog about the Dodd-Frank Financial Regulation bill enacted in July 2010, Congress reined in the privately traded swaps marketplace by requiring certain derivative transactions to be cleared on futures exchanges, with posting of collateral and compliance oversight. Congress and the IRS specifically addressed taxation, stating that although swaps would be cleared on futures exchanges, they still had ordinary gain or loss treatment, not lower Section 1256 60/40 tax rates as many hoped the rule change meant. The Dodd-Frank legislation said contracts must be subject to price discovery on a qualified board or exchange to qualify as Section 1256 contracts. But most swap contracts are privately arranged; there isn't price discovery on a qualified board of exchange.
Back in March 2011, our blog covered ETF tax and regulatory issues, including tax treatment for options on ETFs. Since then a few clients have asked us about these instruments, where swaps are a minor or major component of the underlying ETF. We make a case for treating options on commodities ETFs as Section 1256 contracts, but only if the commodities ETFs are taxed as partnerships (PTP) or grantor trusts. If an ETF is taxed as a corporation (which often is the case for foreign ETFs and for ETFs holding securities which are RICs—Registered Investment Companies), then an option on the ETF is treated as an option on a single security, and therefore fails Section 1256 treatment.
Important update: As explained in our March 2011 blog, securities ETFs are organized as RICs. Some tax attorneys make a case for treating options on broad-based securities ETFs as Section 1256 contracts, and options on narrow-based securities ETFs as securities. Other tax attorneys consider all options on RICs of any kind to be securities. See the debate in the blog. At this point, the majority view is that all options on securities ETFs are treated as securities. We've always stated that tax treatment for options on ETFs was unclear as the IRS has not issued guidance on this subject. We now suggest a more conservative tax posture calling for all options on securities ETFs to be treated as securities. We'll have a blog update on options on ETFs soon.
What happens if an underlying commodities ETF contains a material amount of swap transactions? Does that taint the option on that commodities ETF from using the more tax-beneficial Section 1256 treatment? Yes it may; see more below.
Swaps were excluded from Section 1256
In 2010, Section 1256 was amended to exclude “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.” We have received questions from clients as whether all swaps (for example, real estate index swaps) are excluded from Section 1256 because of the words “or similar agreement.”
There is nothing definitive on this issue. However, in its preamble to proposed regulations dealing with Section 1256, the IRS writes:
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 §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 §1.446-3(c), rather than with the contracts defined as “swaps” under section 721 of the Dodd-Frank Act. Accordingly, § 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 §1.446-3(c).
Basically, if the IRS is correct, then a real estate index swap should be excluded from 1256 treatment because it’s considered a notional principal contract under Regulation §1.446-3(c). We believe the IRS view is a correct interpretation of the statute and should be followed.
Options on Swaps
In the Preamble, the IRS also takes the position that an option on a notional principal contract doesn’t qualify for 1256 treatment. This view is harder to fit into the language of Section 1256, though the IRS reasoning is sound.
Proposed regulations aren't binding until they are made final. Nevertheless, they are statements of current IRS thinking, so taxpayers taking a contrary position could be challenged. We strongly recommend following the IRS by excluding all “notional principal contracts” (such as real estate index swaps) from Section 1256. We also recommend following the IRS proposal with regard to options on swaps, even though it’s not clear whether Section 1256 requires this conclusion.
Options on ETFs Consisting of Swaps and other Securities:
Often, ETFs consist of both swaps and other securities. See, for example, http://www.proshares.com/funds/uyg_daily_holdings.html?show=all. What is the tax treatment of such ETFs? As discussed in our March blog, income generated while holding the ETFs passes through to the holders. If, for example, 25% of the ETF’s income passed through on a Schedule K-1 is generated by Section 1256 contracts, then 25% of the income will be subject to Section 1256. If the ETF is treated as a partnership, then the gain on the sale of the ETF will not get Section 1256 treatment because the ETF itself is still a security.
What happens if you purchase an option on such an ETF? Is it treated as an option on a broad-based securities index with Section 1256 treatment, or does the presence of swaps mean it surely fails to qualify for Section 1256 treatment? We believe it probably fails Section 1256 treatment.
Given the fact that options on swaps are not clearly covered by Section 1256 and are discussed only in proposed regulations that are non-binding, there might be an opening to be lenient where the swaps constitute a minority of the ETF. This is an area where a tax opinion from our tax attorney would be a good idea to avoid penalties if you’re later challenged by the IRS.
According to Reuters, CME Group Inc. “is planning to offer a new suite of futures tied to interest rate swaps later this year, as the giant exchange operator seeks to take advantage of a regulatory push for more of the $400 trillion over-the-counter swaps market to move into clearinghouses and onto regulated trading platforms.”
This begs the following tax question: Will these swap futures contracts be taxed like other "regulated futures contracts" (RFCs) traded on U.S. futures exchanges, which are listed in Section 1256, or will they be subject to ordinary gain or loss treatment like swap NPC contracts in general? Does the IRS's proposed regulations on swaps specifically exclude swap futures from Section 1256 tax treatment? According to our research, swap futures probably won't have Section 1256 treatment.
According to Investopedia, “The primary difference between options and futures is that options give the holder the right to buy or sell the underlying asset at expiration, while the holder of a futures contract is obligated to fulfill the terms of his/her contract."
The Preamble to the regs states: “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, §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 §1.446-3(c) of the proposed regulations.”
The same reasoning should apply to forward contracts on swaps; we assume these are at least as closely connected with the swap as is an option on a swap.
Since the Treasury is basing its position on interpreting what constitutes a “similar agreement” under 1256(b)(2)(B), this interpretation may be made by a court even before Treasury finalizes the regulations. Therefore, we believe it's risky to use 1256 treatment.
The proposed regulations provide that a regulated futures contract is a section 1256 contract only if it's not required to be reported to the Commodity Futures Trading Commission as a swap under the new DFA definition (prop. reg. section 1.1256(b)-1(b)). That means reportable swaps wouldn't be marked to market under section 1256. This would limit section 1256 blended rates to futures contracts that aren't included in the DFA definition.
We are not sure yet whether a swap future is required to be reported to the Commodity Futures Trading Commission as a swap under the new DFA Definition. The open question is do swap futures contracts have economic terms that are identical to swaps?
Where to report swap transactions
In general, swaps are ordinary gain or loss treatment reported on line 21 “Other Income” of Form 1040 like the default treatment for forex in Section 988. That also means summary reporting is allowed, unlike securities trades which must be reported line by line or trade by trade on Form 8949. Unlike with forex (Section 988), swaps contracts are subject to accrual accounting — reporting both realized and unrealized gains and losses.
Unlike with forex, you cannot file an opt-out election to treat swaps as capital gains or losses. If you have trader tax status (business treatment), you can use Form 4797 Part II (ordinary gain or loss) instead of line 21 of Form 1040.
Our tax attorney Roger D. Lorence, JD LLM also says the following. "In some cases a swap is a leg in a straddle. In that case, Form 6781 would be required. If a client is big enough as a commodities trader, they could have a mixed straddle account election, although this seems unlikely to me because just the software and IT maintenance is costly. In other cases, identified mixed straddles and identified straddles would be in a client's trading. Form 6781 would be familiar to many clients because they are already filing it for their 1256 trading."
For additional reading, see a good article from Rothstein Kass IRS Proposes Regulations Addressing Credit Default Swaps and Other Derivatives (Nov. 2011). This article nicely differentiates between most swaps and Bullet Swaps. Most swaps are NPCs with ordinary gain or loss treatment, and they do not qualify for Section 1256 treatment. But Bullet Swaps are different; they may have capital gain or loss treatment. However, it appears that proposed regulations will treat the single payment under the bullet swap as requiring periodic accrual of underlying amounts as ordinary income. The article also covers credit default swaps and all other types of swaps, too. Excerpts:
*”The character of a NPC’s unscheduled termination payment is generally capital in nature. However, since many NPCs are marked to market for tax purposes, the opportunity for long-term capital gain treatment is limited.
*The IRS has issued proposed regulations that treat a futures contract that may otherwise be a §1256 contract, trading on a “qualified board of exchange” that has a system of marking to market, instead as a NPC, if the contract meets the Commodity Futures Trading Commission’s definition of a swap subject to CFTC reporting. Further, if the contract meets the tax code’s definition of a NPC and a §1256 contract, the proposed regulations treat the contract as a NPC. Lastly, the proposed regulation clarify that listed options on NPCs ( i.e., swaptions) will not be classified as §1256 contracts.
*The longstanding tax definition of NPC has excluded certain instruments, such as forwards, as they call for a single settlement payment between the parties. Swaps that call for multiple payments between the parties may be treated as a NPC while single payment (bullet) swaps are currently excluded from the timing and character rules applicable to NPCs, i.e., capital gain or loss at termination. In the proposed regulations, the Treasury takes a novel approach of the term “payment” to bifurcate a payment into components, whereby the fixing of the amount to be paid is deemed a payment. For example, a total return equity swap that calculates dividends and interest quarterly for a single settlement payment at the end of the swap term will be treated as a NPC with multiple payments and not as a forward/bullet swap. As the U.S. Department of the Treasury (the “Treasury”) continues to maintain that payments pursuant to the swap, including final settlement, are not to be treated as termination payments, it appears that the proposed regulations will treat the single payment under the bullet swap as requiring periodic accrual of underlying amounts as ordinary income.”
If you hear the term “swap” in any of the instruments you trade, figure you probably will have ordinary gain or loss treatment, with the accrual method and summary reporting. Remember, even if it clears on a futures exchange, it’s probably not allowed to have Section 1256 treatment. We don't think the new CME swap futures are included in Section 1256, either.
In general, if you want Section 1256 treatment, it’s best to read our content and check with our tax attorney.
Posted 8 hours, 42 minutes ago on September 21, 2012
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