n-04-52.pdf

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Part III - Administrative, Procedural, and Miscellaneous

Request for Information about Credit Default Swaps

Notice 2004-52

I. PURPOSE

This Notice requests further information regarding certain financial transactions
commonly known as credit default swaps in connection with the consideration by
Treasury and the IRS of taxpayer requests for specific guidance on the tax treatment of
credit default swaps.

II. BACKGROUND

A credit default swap (CDS) generally refers to a contractual arrangement in
which one party (the protection buyer) buys from a counterparty (the protection seller)
protection against default by a particular obligor (the reference entity) with respect to a
particular obligation (the reference obligation). Typically the protection buyer either
pays a single lump sum, or it pays periodical regular fees either until a defined credit
event occurs or until the maturity of the CDS if no credit event occurs. Following the
occurrence of a credit event, the protection seller typically either pays the protection
buyer an amount reflecting the reference obligation’s loss in value from the date the
CDS was established or purchases from the protection buyer at a pre-determined price
an obligation (the deliverable obligation) that is expected to approximate the post-credit-
event value of the reference obligation. Although certain standard contractual terms
and conditions may be used, the reference obligation, the deliverable obligation, the
credit events covered, and the protection seller’s obligation upon the occurrence of a
credit event are all matters of negotiation between the parties.

A large international market for CDSs has developed. Market participants
include commercial banks, broker-dealers, insurance companies, hedge funds, and
special-purpose securitization vehicles such as synthetic collateralized debt obligations.
Commercial banks may buy protection in order to manage credit risk associated with a
particular loan and may sell protection in order to acquire synthetic exposure to other
loans. Broker-dealers may buy and sell protection in the course of providing market
liquidity. Insurance companies may buy and sell protection both in the conduct of their
investment activities and in the conduct of their insurance activities. Hedge funds may
buy and sell protection in order to manage risk, speculate, or acquire synthetic
exposure. Securitization vehicles may sell protection in order to acquire synthetic
exposure.

Recent news reports suggest that market participants are considering the
creation of CDS indexes through which participants could buy and sell protection on a
defined basket of credit exposures on standardized terms.

Several market participants have requested specific guidance regarding the tax
treatment of CDSs. Treasury and the IRS recognize the significance of the CDS market
and are aware that the market is rapidly evolving. Treasury and the IRS believe that
CDSs deserve careful study so that appropriate guidance can be issued.

III. TAXPAYER REQUESTS FOR GUIDANCE

Several taxpayers and industry groups have requested guidance on the tax
treatment of CDSs and the taxpayers that enter into them. Among the questions they
have raised are:
• whether amounts paid by a U.S. protection buyer to a foreign protection seller
constitute income that is subject neither to withholding nor to the insurance-
premium excise tax;
• whether a protection seller could be considered to be engaged in a trade or
business within the United States by virtue of entering into CDS agreements;
• whether a CDS gives rise to:
o passive income for purposes of the passive foreign investment company
rules;
o qualifying income for purposes of the publicly traded partnership rules; or
o unrelated business taxable income; and
• the timing of recognition of income for the protection seller and expense for the
protection buyer.

The concerns raised relate particularly, although not exclusively, to the treatment
of payments from a protection buyer within the United States to a protection seller
outside the United States. In response to these taxpayer requests, Treasury and the
IRS are thoroughly analyzing all of the tax issues raised by CDSs and expect to issue
guidance.

Submissions generally have argued that the legal rights and obligations under a
CDS are sufficiently analogous to those in other types of existing financial transaction
that the tax treatment of the analogous transactions should govern the tax treatment of
a CDS for all purposes of the Code. See, e.g., Bank of America v. United States
, 680
F.2d 142, 149-50 (Ct. Cl. 1982) (commissions for bankers’ acceptances sourced for
foreign tax credit purposes in same manner as interest because predominant feature of
acceptance is substitution of credit and because interest is closest analogy in source
rules).

Some possible analogies for a CDS include a derivative financial instrument such
as a contingent option or notional principal contract, a financial guarantee or standby
letter of credit, and an insurance contract. A variety of theories have been advanced in
the existing literature both for and against these analogies. Other commentary
recommends an alternative to the analogue approach. Following is a brief survey of
some of the theories that have been advanced.

A CDS has been analogized to a contingent put option that the option buyer is
entitled to settle either for cash value or by physical exercise with respect to the
deliverable obligation following the occurrence of a credit event. Option premium
generally is not subject to withholding. Trading in such options may not give rise to a
“trade or business within the United States” pursuant to the securities-trading safe
harbor under section 864(b).

A CDS has been analogized to certain notional principal contracts providing for
contingent nonperiodic payments. Some commentators have argued that CDSs with
periodic payments, among other features, meet the definition of a notional principal
contract; however, commentators disagree about the scope of CDSs that may fall within
the definition of notional principal contract. Payments with respect to a notional
principal contract generally are not subject to withholding. Trading in such notional
principal contracts may not give rise to a trade or business within the United States.
Special timing rules may apply to notional principal contracts.

A CDS has been analogized to a guarantee. Guarantee fees have been
analogized to commissions for letters of credit, which are sourced in the same manner
as interest. See Centel Communications Co. v. Commissioner
, 920 F.2d 1335, 1343-
1344 (7th Cir. 1990) (citing Bank of America
). In addition, guaranteeing obligations and
issuing standby letters of credit from within the United States could constitute engaging
in a trade or business within the United States. Some commentators have distinguished
CDSs from guarantees on the basis that a credit event under a CDS requires
performance by the protection seller without regard to whether the protection buyer
sustains an actual loss. A relevant factor in this regard may be how much of the CDS
protection-buying market consists of persons who do not have or expect to be exposed
to credit risk.

A CDS has been analogized to a form of insurance. Insurance premiums paid to
a foreign person with respect to a U.S. risk are subject to excise tax. Moreover, insuring
risks from within the United States could constitute engaging in a trade or business
within the United States. Some commentators have distinguished CDSs from insurance
on the basis, as described above, that no actual loss need be sustained in order to give
rise to an obligation under a CDS. Some commentators have noted the Supreme
Court’s opinion in Helvering v. LeGierse
, 312 U.S. 531 (1941), that the essence of
insurance activity is the shifting and distribution of insurance risk. These commentators

have suggested that many protection sellers do not shift or distribute risk with respect to
CDSs in this way, and that it is not clear how a protection buyer could know how its
counterparty manages risk with respect to a particular CDS.

Some commentators have suggested consideration of an approach to determine
the tax treatment of CDSs other than classification by analogy to other types of financial
transaction. Instead, they have proposed that the tax treatment of payments with
respect to a CDS could be determined by analyzing various elements of the CDS
transaction, including the nature of the reference obligation and whether a party to the
CDS provides financial services to customers.

IV. REQUEST FOR COMMENTS

The foregoing brief overview indicates that the economic similarity of a CDS to
various financial transactions tends to blur the distinctions between possible analogies
and that the various analogies correspond to significantly different tax treatment.

Treasury and the IRS believe that additional information is needed in order to
respond to taxpayer requests for specific guidance regarding the appropriate tax
treatment of amounts paid and received with respect to a CDS. Treasury and the IRS
are particularly interested in information regarding:
• CDS contractual terms, both standard and negotiated, particularly with respect to
credit events, subrogation rights, security interests in collateral, and
collateralization requirements in general;
• CDS pricing, particularly with respect to guarantees, contingent options, and
insurance;
• operation of the CDS market, particularly with respect to price quotation and
dissemination;
• market practice regarding hedging, the management of basis risk, and the timing
of CDS transactions relative to the assumption and disposition of analogous
risks; and
• the regulatory capital, GAAP, and internal booking treatment of CDSs by various
market participants.

Treasury and the IRS also welcome any other information that market
participants believe may be relevant.

V. SUBMISSION OF COMMENTS

Taxpayers may submit written comments to: CC:ITA:RU (Notice 2004-52), Room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC
20044. Submissions may be hand delivered between the hours of 8 a.m. and 5 p.m. to
CC:ITA:RU (Notice 2004-52), Courier’s Desk, Internal Revenue Service, 1111

Constitution Avenue NW, Washington, DC. Alternatively, taxpayers may submit
comments electronically via the Internet by submitting comments electronically via the
following e-mail address: Notice.Comments@irscounsel.treas.gov
. Please include:
Notice 2004-52 in the subject line of any electronic communications.

DRAFTING INFORMATION

The principal authors of this Notice are Paul Epstein, Theodore Setzer, and
Steven Jensen of the Office of Associate Chief Counsel (International). For further
information regarding this Notice contact Mr. Epstein, Mr. Setzer, or Mr. Jensen at (202)
622-3870 (not a toll-free call).