U.S. Taxation of Notional Principal Contracts (Portfolio 189)

Be a trusted advisor to your clients with Bloomberg Tax Portfolios. In this portfolio, Premier tax experts review the U.S. federal income taxation of notional principal contracts, including the interaction of its tax treatment with other financial-related provisions (including, mark-to-market rules, straddles, hedges, short sale, constructive sale and ownership issues, and capitalization issues), with other domestic-related provisions (including, consolidated return, partnership, personal holding company, tax-exempt provisions, foundation excise tax, publicly traded partnerships), with other inbound international tax provisions (U.S. source FDAP and withholding tax, treaty characterization, “effectively connected” character, and foreign government income), with other outbound international tax provisions (Subpart F, Section 956, Passive Foreign Investment Company, and foreign tax credit provisions), and certain reporting obligations

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Our Portfolios are written by leading tax professionals who set the standard as leaders in their fields. The U.S. Taxation of Notional Principal Contracts portfolio was authored by the following attorneys.
Christopher (Chris) Ocasal

Christopher (Chris) Ocasal is a principal with Ernst & Young's Financial Services group. Mr. Ocasal has extensive experience in advising clients with regard to their international tax issues and has substantial expertise with financial institutions and products. Mr. Ocasal has worked with major U.S. multinationals with significant international operations and major foreign multinationals with significant U.S. operations. He advises on structuring joint ventures, domestic and international reorganizations, mergers and acquisitions, financial products, foreign currency transnational anti-deferral regimes, withholding tax issues, foreign tax credit planning, and U.S. tax treaties. Before joining Ernst & Young, Mr. Ocasal was a partner with Sutherland, Asbill & Brennan and a principal at PricewaterhouseCoopers LLP Washington National Tax Services office. Mr. Ocasal received a J.D. from George Washington University Law School and an LL.M. from Georgetown University. He is a member of the New York, Virginia, and District of Columbia bars. Mr. Ocasal is also the author of 931 T.M., U.S. Income Taxation of International Insurance Activities.


Credentials /

Christopher (Chris) Ocasal: J.D. from George Washington University Law School; LL.M. from Georgetown University; Member of the New York, Virginia, and District of Columbia bars;  Author of 931 T.M., U.S. Income Taxation of International Insurance Activities.

Chip Harter

Chip Harter is a principal in the PricewaterhouseCoopers LLP Washington National Tax Practice. His practice focuses on domestic and cross-border tax issues arising with respect to financing transactions and financial instruments. He advises financial institutions, multinational corporations and investment funds, and, as a senior technical review partner within PwC's National Tax office, he participates in the review of the tax provisions of financial institutions and multinational corporations. Mr. Harter joined PricewaterhouseCoopers in 1999 after having practiced tax law with Baker & McKenzie for 18 years. From 1989 through 1994, he was an Adjunct Professor of Taxation in the Graduate Tax Program of IIT Chicago-Kent College of Law. Mr. Harter earned a J.D. from the University of Chicago Law School in 1980, where he was Comments and Articles Editor of the University of Chicago Law Review, and he graduated magna cum laude from Harvard College in 1977. Following law school, Mr. Harter clerked for The Honorable Thomas R. McMillen, United States District Judge for the Northern District of Illinois.



Credentials / 

Chip Harter:  J.D. from the University of Chicago Law School in 1980; Comments and Articles Editor of the University of Chicago Law Review;  Graduated magna cum laude from Harvard College 


Table of Contents

Portfolio 189-1st: U.S. Taxation of Notional Principal Contracts

Portfolio Description


Technical Advisors


Detailed Analysis

I. Notional Principal Contracts: History, Types, and Comparison to Other Financial Arrangements

A. History

B. International Swap Dealers Association (ISDA)

C. Derivative Clearing Houses and Exchanges

D. Types of NPCs

1. Generally

2. Interest Rate Swaps

3. Interest Rate Caps, Interest Rate Floors, and Collars

4. Equity Swaps

5. Commodity Swaps

6. Total Return Swaps

7. Credit Default Swaps

E. Comparison to Other Financial Instruments and Derivatives

1. Swaps Compared to Futures and Forward Contracts

2. Caps and Floors Compared to Options

3. CDSs Compared to Put Options

4. CDSs Compared to Letters of Credit and Guarantees

5. CDSs Compared to Insurance

II. Timing of Income/Deductions from § 446 NPCs

A. Before the § 446 Regulations

B. “Notional Principal Contracts” — Defined

1. Definition Under 1993 § 446 Regulations

2. Definition Under 2011 Proposed Regulations

3. Definition Under 2012 Amendments to the Commodity Exchange Act

4. Excluded Contracts

a. Excluded Contracts Under 1993 § 446 Regulations

b. Excluded Contracts Under 2011 Proposed Regulations

5. Specified Index

a. Specified Index Under 1993 § 446 Regulations

b. Specified Index Under 2011 Proposed Regulations

6. Notional Principal Amount

a. Notional Principal Amount Under 1993 § 446 Regulations

b. Notional Principal Amount Under 2011 Proposed Regulations

C. Timing and Measurement

1. Periodic Payments

a. Periodic Payment — Defined

b. Periodic Payments — Recognition Rules

2. Nonperiodic Payments

a. Nonperiodic Payments — Defined

b. Nonperiodic Payments — Recognition Rules

(1) Generally

(2) Swaps

(a) General Rules for Swaps

(b) Alternative Methods for Swaps

(i) Prepaid Swaps

(ii) Other Swaps

(3) Caps & Floors

(a) General Rules of Caps & Floors

(b) Alternative Methods for Caps & Floors that Hedge Debt

(i) Prepaid Caps or Floors

(ii) Other Caps or Floors

(c) Additional Methods

(d) Contingent Nonperiodic Payments

(i) Notice 2001-44

(ii) Rev. Rul. 2002-30 and Notice 2002-35

(iii) Prop. Regs. § 1.446-3(g)(6)

(A) Projected Contingent Nonperiodic Payment Amount

(B) Level Payment Amortization

(C) Significant Nonperiodic Payment

(D) Redetermination of Projected Payment Amount and Level Payment Amortization

(E) Mark-to-Market Election

(F) Effective Date

3. Termination Payments

a. Termination Payments — Defined

b. Termination Payments — Recognition Rules

D. Anti-Avoidance and Anti-Abuse Provisions

1. General Rules

2. Hedging of a § 446 NPC

3. Constructive Loans: Significant Nonperiodic Payments

a. Swaps

b. Caps & Floors

c. Economic Substance

III. Character of Payments

A. Periodic and Nonperiodic Payments

B. Termination Payments

1. Termination by Assignment or Exchange

a. General Rule

b. Section 475's Mark-to-Market Rules

c. Intercompany Consolidated Group Items

2. Termination by Extinguishment

a. After the Taxpayer Relief Act of 1997

b. Before the Taxpayer Relief Act of 1997

c. Contingent Nonperiodic Payments

IV. Source of Income from § 863 NPCs

A. Background

B. Scope of Regulations

C. Section 863 NPC

1. Section 863 Definition

2. Sourcing Income from § 863 NPCs

a. General Rule

b. Qualified Business Units Exception

c. Effectively Connected Income Exception

d. Global Dealing Activities

e. FDAP Exception?

V. Timing of Income/Deductions from § 988 NPCs

A. Background

B. Nonfunctional Currency NPCs

1. Section 988 Definition

2. Amount and Timing

a. Generally

b. At-Market Currency Swap Contracts

(1) Definition

(2) Swap Principal Amount

(a) Defined

(b) Amount and Timing of Exchange Gain or Loss

(3) Periodic Interim Payments

(a) Defined

(b) Amount and Timing of Exchange Gain or Loss

(4) Termination Payments

c. Off-Market Currency Swap Contracts

(1) Definition

(2) Amount and Time

(3) Scope

d. Hyperinflationary Currency Swap Contracts

(1) Definition

(2) Exchange Gain or Loss

(3) Scope

3. Anti-Abuse Rules

a. Clear Reflection of Income

b. Clearly Stated Terms

c. Significant Swap Premiums

d. Substance over Form

4. Character of Exchange Gain or Loss

5. Source of Exchange Gain or Loss

a. General Rules

b. Residence

VI. Miscellaneous Issues with Respect to NPCs

A. Interaction with Other Financial-Related Tax Provisions

1. Mark-To-Marketing NPCs

a. Section 475

b. Section 1256

(1) Generally

(2) Scope of Swaps Excluded by § 1256(b)(2)(B)

(a) NPCs and Credit Default Swaps

(b) Option on an NPC

(c) Ordering Rule for CFTC Contracts

(d) Regulated Futures Contracts

2. Straddles Rules

a. Section 1092

b. Section 263

3. Hedge Accounting Under § § 446, 1221, 1275, and 988

4. Short Sales

5. Constructive Sale Under § 1259

6. Constructive Ownership

a. Common Law

b. Section 1260

7. Section 263 Capitalization Rules

B. Interaction with Other Domestic Rules

1. Consolidated Return Rules

2. Partnership

a. Investment Partnerships

b. Section 752 Regulations

3. Personal Holding Company

4. Unrelated Business Taxable Income

5. Foundation Excise Tax

6. Publicly Traded Partnerships

C. Taxation of U.S. Activities of Foreign Persons

1. U.S. Withholding Under § § 1441 and 1442

2. U.S. Tax Under § 871(m)

a. Generally

b. Specified Notional Principal Contracts, Payments Made on or Before December 31, 2013

c. Specified Notional Principal Contracts, Payments Made on or After January 1, 2014

(1) Generally

(2) Long Party Is “In The Market” on Same Day Parties Price or Terminate NPC

(3) Underlying Security Is Not Regularly Traded on a Qualified Exchange

(4) Short Party Posts the Underlying Security as Collateral

(5) Term of the NPC Has Fewer than 90 Days

(6) Long Party Controls the Short Party's Hedge

(7) Notional Principal Amount on Certain Publicly Traded Underlying Security

(8) NPC Entered Into on or After the Announcement of a Special Dividend and Before Ex-Dividend Date

d. Tax and Withholding Obligations

3. Treaty Characterization

4. Effectively Connected Income with the Conduct of a Trade or Business in the United States

a. Trade or Business in the United States

b. Effectively Connected Income

c. Swaps as U.S. Real Property Interests Under § 897

5. Income from Foreign Governments

D. Taxation of Foreign Activities of U.S. Persons

1. Subpart F

2. Section 956

3. Passive Foreign Investment Company

4. Foreign Tax Credit Computation

a. Separate Categories

b. Expenses Allocation Rules

c. Economic Substance

E. Reporting Requirements

1. Reporting Requirements Under § 1461

2. Reporting Requirements Under § 6041

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Preamble 1991 Proposed Regulations

Worksheet 2 Preamble 1993 Final Regulations

Worksheet 3 Preamble 2004 Proposed Regulations (69 Fed. Reg. 8886 (2/26/04))

Worksheet 4 Preamble to 2011 Proposed Regulations (76 Fed. Reg. 57684 (9/16/11))

Worksheet 5 Joint Committee Report on Section 871(m)