Swaps Tax Treatment Confusion Cleared Up With Fin Reg

July 22, 2010 | By: Robert A. Green, CPA

Forbes

The “Restoring American Financial Stability Act of 2010” — also known as “Fin Reg” — signed into law on July 21 moves many derivative contractors from the private marketplace to clearing on futures exchanges. In Section 1601 of the bill, Congress makes it crystal clear this movement isn’t like trading and it doesn’t afford these derivatives contracts the regulated futures contract tax treatment in Section 1256.

Swap contracts – a form of credit insurance – were at the center of the credit crisis. AIG wrote far too many of these swap contracts (pocketing the premium) and lacked sufficient capital to cover its eventual credit losses at the height of the financial panic. Regulators lacked transparency since swaps were private derivatives contracts. 

Fin Reg addresses these problems by moving many derivative swap contracts into clearing on futures exchanges to provide market-based transparency of pricing and terms and normal exchanged-based margin and leverage rules. However, in moving to futures exchanges, Congress did not want to reward swap contracts with the lower 60/40 treatment in Section 1256. 

The new law amends Section 1256 to broaden the list of contracts that are barred from the definition. Section 1256 contracts include: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. Under pre-Act law, the term Section 1256 contract doesn’t include securities futures contracts or options on such a contract unless the contract or option is a dealer securities futures contract. 

Law change
For tax years beginning after July 21, 2010 all of the following also are excepted from the definition of a Section 1256 contract: 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. (Code Sec. 1256(b), as amended by Act Sec. 1601. You can find Section 1601 – Title XVI – Section 1256 Contracts on the last pages of the bill.) 

The Conference Report says the change addresses the recharacterization of income as a result of increased exchange trading of derivatives contracts by clarifying that Code Sec. 1256 doesn’t apply to certain derivatives contracts transacted on exchanges. 

Leading tax attorney for investment-management businesses Roger Lorence emailed me, stating that “Swaps were not 60/40 under prior law. The new law clarifies that their status is not 60/40. Leading experts have expressed their views that there was confusion in the marketplace about the treatment of swaps cleared by clearing arms of exchanges, although the swap contracts themselves were not traded on a qualified board or exchange (traded on a QBE is a requirement for 60/40 treatment). There is a difference between clearing and trading — trading means a designated contract market for that contract has been approved by the CFTC and swaps are not eligible for designation as a contract market (there can’t be trading in a swap). No contract that legitimately is 60/40 now loses 60/40 under this bill. The amendment is designed to foreclose aggressive taxpayers from taking the position that swaps are 60/40.”

Thanks Roger, this clarifies my question about traders gaining a new opportunity to trade these derivatives contracts – they don’t get this opportunity. They can gain from the transparency on the exchange clearing. 

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