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New Tax Issues Arising from Derivatives Regulatory Reform

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 over-the-counter derivative financial instruments (“swaps”). The changes to the regulatory laws governing swaps are still a work in process, but will almost certainly require both the clearing of most swaps through regulated central clearinghouses and the trading of those swaps on regulated markets such as an exchange. The first tax question addressed by this article is whether clearing and trading of swaps causes them to become “section 1256 contracts” required to be marked to market on an annual basis, or should do so. 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 “section 1256 contract,” however, it appears that it could be relatively easy to bring a swap within the scope of section 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 section 1256 contracts, whether or not they are cleared or exchange-traded, unless and until Congress affirmatively provides for section 1256 treatment. The article then turns to the question of how an initial payment on a swap – a fact pattern that is common for cleared swaps and other swaps that have “standardized” coupons – should be taxed, and in particular whether under current law such a payment can or should 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. 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.