ISDA March 2013 Dodd-Frank Protocol (AKA Dodd-Frank Protocol 2.0)

24 Pages·2013·0.64 MB·English

JUNE 2013
VOL 14, NO 10
TAX • REGULATION • FINANCE
FINANCIAL PRODUCTS REPORT
THE 7% SOLUTION: STRUCTURED DIVIDEND RECEIVED
DEDUCTION TRANSACTIONS FACE INTERNAL REVENUE SERVICE
AUDIT SCRUTINY
ISDA MARCH 2013 DODD-FRANK
PROTOCOL (A.K.A. DODD-FRANK MARK LEEDS received deduction or ing piece of authority
PROTOCOL 2.0) . . . . . . . . . . . . . . . .9
Azam H. Aziz, Geoffrey B. Goldman, THIS ARTICLE EXAMINES RECENTLY “DRD,” currently lowers because it analyzes certain
Donna M. Parisi and James Larsen RELEASED AUDIT GUIDANCE FROM THE the effective tax rate on Code § 1258 conversion
INTERNAL REVENUE SERVICE CHAL-
intercorporate dividends to transaction issues and does
THE EUROPEAN ALTERNATIVE LENGING THE RIGHT OF CORPORATE
INVESTMENT FUND MANAGERS 7%.2 Recently, the Internal not directly address DRD
DIRECTIVE—A NON-EU FUND TAXPAYERS TO CLAIM DIVIDEND
MANAGER’S PERSPECTIVE . . . . .14 RECEIVED DEDUCTIONS IN VARIOUS Revenue Service (“IRS”) issues. In the front end of
Jeremy C. Jennings-Mares, Jay G. Baris
and Afia Fening TRANSACTIONS. released three separate the transaction, a parent cor-
I pieces of audit guidance in poration (“Parent”) that
CFTC STAFF PROVIDES
INFORMAL RELIEF FOR t appears that a 7% effec- which the IRS challenged filed a consolidated federal
SECURITIZATION VEHICLES
FROM COMPLIANCE WITH NEW tive tax rate can have the right of corporate tax- income tax return with a
SWAP CLEARING RULES . . . . . . .19
addictive properties to cor- payers to claim DRDs in corporation that had losses
Richard L. Fried
porate taxpayers much in various transactions. In the (“Subsidiary”) purchased
IN RECENT NEWS . . . . . . . . . . . . .22
the same way that the 7% same way that the literary 80% of the common stock
Zsuzsanna Kadar
cocaine solution had to version of Dr. Sigmund of a newly-formed corpo-
Sherlock Holmes in Freud sought to keep ration called “Special Pur-
Nicholas Meyer’s 1974 Holmes away from his 7% pose Vehicle” or SPV. A
novel entitled, The Seven Per- solution, the IRS appears to financial institution
cent Solution.Specifically, Sec- be on a similar mission (“Bank”) purchased the
tion 243(c)(1) of the against corporate taxpayers remaining 20% of the SPV
Internal Revenue Code of that have structured into common stock. Bank also
1986, as amended (the their 7% solution. This arti- purchased a substantial
“Code”) provides corporate cle describes and analyzes amount of SPV preferred
taxpayers who hold at least these developments. stock.3 The SPV preferred
20% of the outstanding stock was stock described in
FIELD ATTORNEY ADVICE
stock of a U.S. corporation, Code § 1504(a)(4), some-
20131701F (RELEASE DATE
determined by voting power APRIL 26, 2013) times referred to as “plain
and value, with a deduction vanilla preferred.” The plain
equal to 80% of the amount FAA 20131701F addressed vanilla preferred stock did
of dividends received on the financial plumbing not affect whether Parent
such stock.1This deduction, behind a DRD structured and SPV were members of
referred to as the dividend transaction. It’s an interest- the same affiliated group eli-
JUNE2013
DERIVATIVES
EDITORIAL ADVISORY BOARD
EDITOR-IN-CHIEF Lawrence Lokken
Mark H. Leeds U. OF FLORIDA COLLEGE OF LAW
gible to file a consolidated federal 5-year due date of the note issued by [email protected] GAINESVILLE
income tax return.4 Parent sold a call SPV to Subsidiary in exchange for the GREENBERG TRAURIG LLP Roger D. Lorence
NEW YORK CITY SADIS & GOLDBERG, L.L.P
option to Bank which would allow cash loan. In general, Subsidiary could MANAGING EDITOR NEW YORK CITY
Michael Bisaccio John F. Marshall, Ph.D.
Bank to purchase the 80% of the SPV satisfy its obligations under the loan
michael.bisaccio@ MARSHALL, TUCKER & ASSOC.
common stock held by Parent. from SPV by delivering the bonds that thomsonreuters.com PORT JEFFERSON
Gregory May
it would receive from Euro Interna-
The Transactions Among the Parties ADVERTISING SALES FRESHFIELDS BRUCKHAUS
tional, instead of repaying such loan in Terry Storholm, Manager DERINGER
NEW YORK CITY
WG&L Journals Advertising
SPV then lent the monies that it cash. Thus, if the reference bonds fell Robert H. Scarborough
610 Opperman Drive
received as capital contributions to Sub- in value, SPV (and ultimately, Bank, Eagan, MN 55123 FRESHFIELDS BRUCKHAUS
DERINGER,
sidiary, as more fully described below. who owned substantially all of SPV Phone: [phone] NEW YORK CITY
Fax: [phone] Perry J. Shwachman
The FAA recites that SPV did not through the plain vanilla preferred
terry.storholm@ SIDLEY AUSTIN LLP
expect to incur a tax liability on the stock8) would bear this loss. For this thomsonreuters.com CHICAGO
Lewis R. Steinberg
interest accrued or paid on this loan reason, the loan from SPV to Sub-
CONTRIBUTORS UBS SECURITIES LLC
because SPV believed that it could shel- sidiary was referred to as a “credit AND ADVISORS NEW YORK CITY
Vincent Aquilino
Robert Uhl
ter its income with Subsidiary’s pre- linked note.” UNGARETTI & HARRIS
DELOITTE & TOUCHE LLP
existing losses. If SPV and Subsidiary The prepaid forward contract CHICAGO WILTON, CONN.
Micah Bloomfield
had been members of the same affili- between Subsidiary and Euro Interna- COUNTRY
STROOCK & STROOCK & LAVAN CORRESPONDENTS
ated group filing a consolidated federal tional had a feature that, in the absence LL,P Argentina
NEW YORK CITY Patricia Lopez Aufranc
income tax return, this result would of a default on a bond in the portfo- Jeffrey Bryant MARVAL, O’FARRELL & MAIRAL,
have occurred.5The FAA states that in lio, ensured that Subsidiary would earn SCHOOL OF ACCOUNTANCY, BUENOIS AIRES
WICHITA STATE UNIVERSITY Australia
separate advice the IRS had concluded a profit on the transaction. Specifically, WICHITA, KANSAS Tony Rumble
that the fact that Parent granted a call all interest paid on the portfolio dur- Stevie D. Conlon SSYADVINNEGYSFACTORY LTD,
option on the SPV stock to Bank pre- ing the duration of the forward con- ARLINGTON HEIGHTS, IL Germany
Robert N. Gordon Dr. Stephan Eilers
vented SPV and Subsidiary from being tract was to be invested in additional TWENTY-FIRST SECURITIES Holger Häuselmann
considered part of the same affiliated bonds that would be delivered to Sub- CNOEWRP YOORRAKT ICOINTY DFREERSIHNFGIEELRDS BRUCKHAUS
group.6 sidiary at the termination of the for- Peter H. Huang COLOGNE/FRANKFURT
India
Subsidiary used the loan proceeds ward contract. Accordingly, if the UNIVERSITY OF COLORADO J.D. Agarwal, Chairman
LAW SCHOOL INDIAN INSTITUTE OF FINANCE
that it received from SPV to prepay its forward contract was respected as such BOULDER, CO NEW DELHI
obligations under a forward contract and the bond portfolio remained val- Thomas A. Humphreys ILtiasaly Curran, Esq.
MORRISON & FOERSTER LLP
with a non-U.S. subsidiary of Sub- ued at par, Subsidiary could expect a NEW YORK CITY UGHI & NUNZIATE
ROME
sidiary (“Euro International”). The pre- gain on its position equal to all inter- Ira Kawaller Japan
KAWALLER & CO., Kenju Watanabe
paid forward contract required Euro est that accrued on the bonds during BROOKLYN SKADDEN, ARPS, SLATE, MEAGHER
International to deliver a portfolio of the duration of the contract. Kevin Keyes & FLOM, NEW YORK CITY
high grade corporate bonds to Sub- Given that Subsidiary would not FRIED, FRANK, HARRIS, SHRIVER & Takuhide Mitsui
JACOBSON MITSUI, YASUDA, WANI & MAEDA
sidiary.7The delivery date under the for- receive current payments on the for- WASHINGTON, D.C. TOKYO
ward contract corresponded to the ward contract with Euro International, Derivatives Financial Products Report (ISSN 1536-397X) (TDVN) is published monthly
by Warren, Gorham & Lamont, division of Thomson Reuters/WG&L, 195 Broadway
a mechanism was needed to provide New York, NY 10007. Copyright © 2013 Thomson Reuters/WG&L. All rights reserved.
No part of this newsletter may be reproduced in any form or incorporated into any
1 sThhaer edheotldeermr hinoladtsi oant loefa swt h2e0t%h eorf tah ec oourptsotraantde- Subsidiary with cash flow to make inter- oinwfonremr.a tRioenq ureesttrsie vtoal rseypstreomdu cwei thmoautet rtiahle sheoxpulrde sbs ew arditdterne sspeedr mtois sCioonp oyrf igthhte Ccloepayraringchet
ing stock of a U.S. corporation is made without est payments on the credit linked note. Center, 222 Rosewood Drive, Danvers, MA 01923, [phone], fax (978) 750-
considering stock described in Code § 4470 or 4744. Requests to publish material or to incorporate material into computer-
1504(a)(4). Accordingly, Subsidiary and Parent tizreibdu tdioatna, bsahsoeus ldo rb aen ayd odtrheessre edl etcot rTohnoicm fosormn , Roeru ftoerr so, t1h1e7r Ethaastn Sintedviveindsu aAl voern iunete, rVnaalhl adlilsa-,
2 35% (the maximum corporate tax rate) x 20% = entered into an unusual 5-year interest NY 10595, [phone]. Annual subscription price: Print $485; Checkpoint (elec-
tronic version, one user) $630.
7%.
3 It appears that the preferred stock issued to rate swap. Under this swap, Parent Subscriptions: 1-800-323-8724.
Bank bore a fixed rate. made periodic payments to Subsidiary Editorial inquiries: Contact Michael Bisaccio, One New York Plaza,New York, NY
4 See Code § 1504(a)(4). 10004, [phone]; email: [email protected].
equal to the product of the par amount
5 See Treasury Regulation § 1.1502-11(a). This publication is sold with the understanding that the publisher is not engaged in
of the credit linked note and the rendering legal, accounting, or other professional advice or services. If such advice or
6 See Treasury Regulation § 1.1502-4(b)(2). services are sought, the services of a lawyer, accountant or other professional should
7 It was unclear as to whether the bonds deliver- LIBOR-based interest rate thereon. be obtained.
able under the prepaid forward contract could In response to IRS Circular 230 requirements, Thomson Reuters advises that any dis-
be fixed rate bonds, floating rate bonds or both. These payments were equal to the pay- cussions of federal tax issues in its publications and products, or in third-party publica-
tions and products on its platforms, are not intended to be used and may not in fact be
The forward contract specified only that the ments that Subsidiary needed to make used to avoid any penalties under the Internal Revenue Code, or to promote, market,
bonds had to have a yield at least equal to U.S. or recommend any transaction or subject addressed therein.
dollar LIBOR. interest payments on the credit linked POSTMASTER: send address changes to Derivatives Report, 117 East Stevens Avenue,
8 The plain vanilla preferred stock likely constitut- note it issued to SPV. The timing of Valhalla, NY 10595.
ed the overwhelming majority of the capitaliza-
tion of SPV. As a result, any losses would be these payments also matched the tim-
borne by Bank as the holder of such stock. ing of the interest payments under the
2
DERIVATIVES
credit linked note. In exchange for this ror interest rate swap were identical The author speculates that the use
stream of payments, Subsidiary was with the swap between Euro Finance of the capital losses possessed by Sub-
required to make a single payment to and SPV except, under this last swap, sidiary was at the heart of the trans-
Parent equal to a fixed rate per annum Euro Finance received the fixed rate leg action. Within the Parent consolidated
(and compounded at a LIBOR-based and paid the floating rate leg. Assum- federal income tax return, Subsidiary’s
rate) at the maturity of the swap. Sub- ing that the plain vanilla preferred stock interest deduction should have been
sidiary would be able to satisfy this issued by SPV to Bank bore a fixed matched by the interest income earned
delayed delivery obligation when it interest rate, the swaps among Bank, by SPV, making these items a wash.
received payment from Euro Interna- Euro Finance and SPV had the effect The recognition of the interest income
tional under the forward contract. of converting this yield to a floating rate by SPV would have generated earnings
to Bank. and profits within SPV, allowing SPV
After the transaction had been run- to treat distributions made on the pre-
SECTION 243(C)(1) OF THE ning for some time (presumably about ferred stock taxable as a dividend.10
INTERNAL REVENUE CODE 5 years), Bank exercised its call option Bank claimed an 80% DRD on such
OF 1986, AS AMENDED,
to buy the 80% of the SPV common dividends. Through the initial interest
PROVIDES CORPORATE
stock that it did not own. The exercise rate swap between Parent and Sub-
TAXPAYERS WHO HOLD AT
of the call option corresponded with sidiary, Parent effectively lent the cash
LEAST 20% OF THE
the delivery of the bonds under the pre- in respect of the interest payments on
OUTSTANDING STOCK OF A
paid forward contract between SPV the credit linked note to Subsidiary.
U.S. CORPORATION,
and Subsidiary. Presumably, at this time, When Subsidiary recognized the
DETERMINED BY VOTING
all of the swaps terminated as well. income (under the prepaid forward
POWER AND VALUE, WITH
contract) necessary to repay this loan,
A DEDUCTION EQUAL TO
Federal Income Tax Reporting on the
80% OF THE AMOUNT OF Subsidiary was able to shelter this
Transaction
DIVIDENDS RECEIVED ON income from federal income tax
SUCH STOCK. Although there was some ambiguity in through the use of its capital losses.
the reporting of the transactions Thus, if the transaction had worked
described above, the taxpayers appear as planned, it would have accom-
Parent entered into a 5-year fixed- to have reported the transactions as fol- plished the Herculean task of gener-
to-floating interest rate swap with Euro lows: ating a capital gain without any
International. The notional amount of speculation on the price of an asset
this swap was equal to the principal 1. Subsidiary deducted the interest that would be treated as a capital asset
amount of the credit linked note. Under accrued on the credit linked note in Subsidiary’s hands.
this swap, Parent paid the product of that it issued to SPV. As an aside here, it is the view of the
the notional amount and a fixed inter- 2. Subsidiary did not include any author that the need for this type of
est rate. In exchange for these pay- income attributable to the appre- planning appears to be patently unfair.
ments, Euro International paid the ciation in its position under the To the author, it remains a mystery as
product of a floating rate and the same forward contract. There is a sug- to why corporate taxpayers should not
notional amount. gestion that Subsidiary either sold be permitted to use capital losses to
SPV then entered into a third 5-year its position under the forward shelter ordinary income. For individu-
fixed-to-floating interest rate swap with contract shortly prior to settle- als, the reason is clear: long-term cap-
another non-U.S. subsidiary of Parent ment or, at settlement, the bonds ital gains are tax-preferenced items and
(“Euro Finance”). Again, the notional that it received at that time. Upon individuals should be required to “ring-
amount of this swap was equal to the whichever of these events fence” capital losses against capital
principal amount of the credit linked occurred, Subsidiary claimed to gains. But given that there is no tax pref-
note. Under this swap, Euro Finance recognize a capital gain that it erence for capital gains recognized by
paid the product of the notional sheltered with existing capital corporations, there does not appear to
amount and a fixed interest rate. In losses. a tax policy justification for the limita-
exchange for these payments, SPV paid 3. All of the swaps were treated as tion on the use of capital losses by cor-
the product of a floating rate and the notional principal contracts and porations.
same notional amount. Euro Finance income and expense was accrued
entered into a mirror interest rate swap under the regulations applicable 9 See Treas. Reg. § 1.446-3(c).
with Bank. All of the terms of the mir- to such contracts.9 10 See Code § 316(a).
3
VOL. 14 NO. 10
DERIVATIVES
JUNE2013
The IRS Attack on the Tax Reporting for
the Transactions under the credit linked note and the pre- incurred on positions within a straddle
paid forward contract were offsetting to the extent that deductions exceed
The IRS did not challenge the charac- positions with respect to the high grade income from the property comprising
terization of the prepaid forward con- bonds referenced in each position, even the straddle.12Instead, these amounts
tract between Subsidiary and Euro though there was not a complete over- are capitalized into the straddle posi-
International as a forward contract for lap between the two reference portfo- tions. The IRS, under this rule, denied
federal income tax purposes. The IRS lios. Subsidiary an interest deduction for
further recognized that the bonds to the interest paid on the credit linked
TO THE AUTHOR, IT
be delivered to Subsidiary by Euro note and for accruals on the swap with
REMAINS A MYSTERY AS TO
International would have a basis equal Parent. The denial of the deductions
WHY CORPORATE
to the upfront payment made by Sub- to Subsidiary, however, should not have
TAXPAYERS SHOULD NOT
sidiary and that, ordinarily, any gain rec- affected whether SPV had income or
BE PERMITTED TO USE
ognized by Subsidiary on the whether SPV had sufficient earnings
CAPITAL LOSSES TO
disposition of either the forward con- and profits to support the treatment of
SHELTER ORDINARY
tract or the bonds would be capital gain. distributions on the SPV preferred
INCOME. GIVEN THAT
Importantly, the IRS did not assert that THERE IS NO TAX stock as dividends. This determination
there was an embedded time value of PREFERENCE FOR CAPITAL would have increased the income of the
money element that should be taxed on GAINS RECOGNIZED BY Parent group for each year of the trans-
a current or deferred basis to Sub- CORPORATIONS, THERE action until the straddle was unwound
sidiary. The IRS did, however, find a DOES NOT APPEAR TO A in 2011.
basis to challenge the character of the TAX POLICY JUSTIFICATION
gain recognized by Subsidiary as capi- FOR THE LIMITATION ON Application of the Conversion
tal gain. THE USE OF CAPITAL Transaction Rules. Code § 1258(a)
LOSSES BY CORPORATIONS.
provides that gain from the disposition
Application of the Straddle Rules. of a capital asset which is recognized
The IRS asserted that Subsidiary’s posi- Interestingly, the IRS also asserted on the disposition or termination of
tions under the prepaid forward con- that a straddle existed between Sub- any position which is held as part of a
tract and the credit linked note sidiary’s position under the interest rate “conversion transaction” can be treated
constituted a straddle within the mean- swap with Parent and the prepaid for- in whole or in part as ordinary income.
ing of Code § 1092(c). A straddle exists ward contract. Since Subsidiary prepaid A conversion transaction is defined to
when a taxpayer holds offsetting posi- its obligations under the forward con- include a transaction that satisfies two
tions in personal property, including tract, a fixed discount rate must have tests:
debt instruments (such as the bonds to been used to determine the prepay-
be delivered to Subsidiary under the ment. Under the swap between Sub- 1. Substantially all of the taxpayer’s
forward contract). Under proposed sidiary and Parent, Subsidiary received expected return is attributable to
Treasury Regulations, the IRS treats floating rate payments. From these the time value of the taxpayer’s
positions in debt instruments (such as facts, the IRS found that if interest rates net investment in the transaction;
the credit linked note issued by Sub- fell and the value of the position under and
sidiary) as part of a straddle when one the swap fell, Subsidiary would have a 2. It constitutes one of the follow-
or more payments are linked to the more valuable position under the for- ing types of transactions:
value of personal property.11Since the ward contract. Vice versa, if interest a. the holding of property and
credit linkage under the credit linked rates rose and Subsidiary’s position the entering into a substantially
note and debt instruments to be deliv- under the forward contract fell in value, contemporaneous contract to
ered under the prepaid forward con- its position under the interest rate swap sell property at a price deter-
tract were “substantially similar,” the would have increased in value. The fact mined in accordance with that
IRS found that Subsidiary’s positions that the IRS had already found a strad- contract;
dle involving the forward contract did b. a straddle; or
11 Prop. Treas. Reg. § 1.1092(d)-1(d).
not prevent the finding of a second c. a transaction that is marketed
12 Code § 263(g).
13 Code § 1258(c). Conversion transactions straddle involving the same position. or sold as producing capital
include any other transaction identified by the When the straddle rules apply, a tax- gains from a transaction that
IRS in regulations, but no such transactions
have been designated by the IRS as such. Code payer is not entitled to deductions for meets the first test stated
§ 1258(c)(2)(D). interest and other carrying charges above.13
4
DERIVATIVES
CHIEF COUNSEL ADVICE 201320014
The legislative history accompany- (RELEASE DATE MAY 17, 2013) It received collateral deposits from
ing the enactment of Code § 1258 elab- clients and counterparties. The tax-
orates on the first requirement: In contrast to the bilateral transaction payer was required to pay interest on
between unrelated parties encountered such collateral deposits. The taxpayer
In a conversion transaction, the tax-
in FAA 20131701F, the IRS chose to was required to, and in fact did, invest
payer is in the economic position of a
challenge the availability of a DRD in the collateral deposits in high grade liq-
lender – he has an expectation of a
a solely related party transaction in uid assets. The taxpayer earned more
return from the transaction which in
substance is in the nature of interest CCA 201320014. In an unusually eru- interest on the investments than it was
and he undertakes no significant risks dite evaluation of an operational required to pay to its clients (such
other than those typical of a lender. restructuring to obtain a DRD, the IRS excess, the “Spread”). The taxpayer’s
internal documents stated that the
A taxpayer’s net investment in a con-
IN AN UNUSUALLY
impetus for the transactions described
version transaction “generally will be
ERUDITE EVALUATION OF
below was a desire to undertake a trans-
the aggregate amount invested by the AN OPERATIONAL
action that would decrease the amount
taxpayer in the conversion transaction RESTRUCTURING TO
of federal income tax that it earned on
less any amount received by the tax- OBTAIN A DRD, THE IRS
the Spread.
payer for entering into any position held FOUND THAT A SERIES OF
TRANSACTIONS
as part of the conversion transaction.” Transaction Steps
ADMITTEDLY UNDERTAKEN
Accordingly, in order for any transac-
Simplified, the taxpayer undertook a
FOR THE PURPOSE OF
tion to be treated as a conversion trans-
CONVERTING INTEREST nine step restructuring plan involving
action, it must provide the taxpayer with INCOME TO DIVIDEND the following steps:
a return that is akin to the yield that a
INCOME ELIGIBLE FOR THE
lender would receive and not pose risks DRD WOULD NOT BE 1. What appear to be different
greater than those that a lender would RESPECTED FOR FEDERAL branches of a first tier subsidiary
normally bear. INCOME TAX PURPOSES. of the taxpayer (for example, the
The IRS held that the straddle rela- U.S. branch and the London
tionship between the prepaid forward found that a series of transactions branch) exchanged client collat-
contract and the credit linked note admittedly undertaken for the purpose eral for cash collateral pursuant to
caused the two positions to be consid- of converting interest income to divi- a securities lending agreement.
ered a “conversion transaction” in Sub- dend income eligible for the DRD 2. The branch that received the cash
sidiary’s hands. The IRS held that would not be respected for federal collateral transferred the cash to
Subsidiary did not earn its return from income tax purposes. In this highly the taxpayer.
structured transaction, from the out- 3. The taxpayer transferred the cash
a speculative position in the portfolio
set, the parties knew and intended that to a CFC (“FSub-1”) for common
of bonds referenced in the prepaid
a U.S. shareholder of a controlled for- and preferred stock in FSub-1.
forward contract because any loss on
eign corporation (a “CFC”) would be 4. FSub-1 transferred the cash
the portfolio could be passed through
required to dispose of stock in the cor- received from the taxpayer to a
to SPV under the credit linked note14
poration that paid the DRD eligible regulated investment company
and Subsidiary’s return was “econom-
income prior to the last day of the (“RIC”) in exchange for RIC
ically linked to the interest earned on
CFC’s taxable year in order to prevent stock.
those securities.” Since the IRS found
the DRD eligible income from being 5. The RIC invested the cash
that a straddle existed and Subsidiary’s
recharacterized as subpart F income received from FSub-1 in high
return was attributable to the time value
that would not carry out a DRD. The grade liquid debt instruments.
of money, the IRS held that the con-
analysis contained in the CCA hinges 6. Prior to the end of FSub-1’s tax
version transaction rules caused the
on the fact that the parties knew and year, FSub-1 distributed the cash
gain on the settlement of the forward
executed these transactions for the sole that it received from RIC (net of
contract transaction to be ordinary purpose of enhancing the after-tax expenses) to the taxpayer.
income and not capital gain. Accord- return on the interest income from the 7. FSub-1 then terminated its inter-
ingly, the IRS sought to prevent Sub- federal income tax rechacterterization. est in the RIC and RIC liquidated.
sidiary from using its capital losses The taxpayer involved in the trans-
14 The IRS referred to the positions under the pre-
against the gain recognized on the for- actions described CCA 201320014 was paid forward contract and the credit linked
ward contract settlement. a U.S. bulge-bracket investment bank. notes as “nearly identical.”
5
VOL. 14 NO. 10
DERIVATIVES
JUNE2013
8. Parent sold all of its FSub-1 stock investment of the Customer Funds by payer undertook a “liquidity test” in
to a domestic partnership. the amount of the section 245 DRD.” which the structure was unwound and
9. FSub-1 liquidated. As more fully described below, the IRS reconstituted on the same day to ensure
refused to accept this business purpose that the structure would not inhibit the
The CCA does not make clear as a valid non-tax business purpose. taxpayer from accessing the client
whether FSub-1 was newly-formed funds. The IRS cited to this fact that
pursuant to the transactions described CODE § 246(C)(4) the transactions actually had a delete-
above. The Advice does state, however, PROVIDES THAT FOR rious non-tax effect and that the only
that FSub-1 did not possess any dedi- PURPOSES OF reason that the taxpayer implemented
cated employees. It does appear, how- MAINTAINING THE the transactions was to obtain a DRD.
ever, that employees of other taxpayer REQUIRED HOLDING The IRS also discounted any benefit
affiliates were dual-hatted as FSub-1 PERIOD FOR DRD that the taxpayer could receive with
ELIGIBILITY, A TAXPAYER’S
employees. It further does not appear respect to asset management, given the
HOLDING PERIOD WILL BE
that FSub-1 was subject to any non-U.S. taxpayer’s professed expertise in this
REDUCED FOR PERIODS
taxes on the income that it received area. Thus, in the view of the IRS the
WHEN “UNDER
from RIC. substance of the transaction did not
REGULATIONS PRESCRIBED
comport with its form.
Tax Reporting of the Nine Step BY THE SECRETARY, A
Next, the IRS directly considered
Transaction TAXPAYER HAS
whether the transactions should be
DIMINISHED HIS RISK OF
The RIC did not pay any federal income considered to be within the intent of
LOSS BY HOLDING ONE OR
tax on the interest income and capital MORE OTHER POSITIONS Congress in enacting and refining the
gains that it earned by claiming a divi- WITH RESPECT TO DRD rules. The IRS cited legislative
dend paid deduction. The dividend SUBSTANTIALLY SIMILAR OR history almost 100 years old for the
paid deduction is available only in lim- RELATED PROPERTY.” proposition that a DRD only applies
ited circumstances to certain specified “when ‘the issuing corporation has
corporations, but was available to the already been taxed on the earnings’ and
The IRS Challenges to the Taxpayer’s
RIC.15Even though FSub-1 was a CFC Reporting of the Transactions the dividends remain in corporate solu-
and the taxpayer would have had to tion.” The IRS also analyzed the income
include the income paid to FSub-1 as The IRS began its attack on the tax- earned by the RIC and found that the
subpart F income and not as a dividend payer’s claim of a DRD with respect “RIC received no dividends that would
if taxpayer had held the FSub-1 stock to the distributions that FSub-1 made qualify for a DRD if RIC were allowed
at year end, taxpayer took the position to Parent with a discussion of the sub- a DRD, and therefore none of RIC’s
that since it disposed of the stock of stance versus form doctrine. The IRS distributions were eligible for the
FSub-1 to another U.S. taxpayer prior stated that the “routing of the invest- DRD.” This conclusion was reinforced
to the end of FSub-1’s tax year, the ment and investment returns through by the fact that, under Code § 881(e),
DRD rules applied.16Under applicable FSub-1 and RIC did not serve a mean- the RIC was not required to withhold
rules, even though FSub-1 was a non- ingful business purpose” and such steps U.S. federal income tax on distributions
U.S. corporation, dividends paid by were a “contrivance to avoid U.S. fed- made to FSub-1 because the distribu-
FSub-1 were eligible for the DRD in eral income tax.” In support of this tions retained their character as with-
full because 100% of the income of conclusion, the IRS noted that the tax- holding tax-free interest even when
FSub-1 was derived from U.S. sources.17 payer planned to terminate its direct distributed in the form of a RIC cor-
We note that as a technical matter, ownership of FSub-1 prior to FSub- porate dividend. The IRS acknowl-
the IRS did not dispute that this report- 1’s tax year for the purpose of avoid- edged that the taxpayer would dispute
ing was consistent with the literal pro- ing a subpart F inclusion. The IRS these legislative purposes on the ground
visions of the Code. The taxpayer further cited to the fact that the re-rout- that the statute is clear on its face and
defended its reporting position on the ing of the monies through the struc- does not impose a requirement that tax
basis that the transactions were under- ture did not enable the taxpayer to be imposed on the corporate earnings
taken “to increase its return on the enhance the pretax return on the invest- in order for a distribution to constitute
ments. In fact, the “significant costs” a DRD eligible dividend.
15 See Code § 852(b)(2)(D). of the transactions actually reduced To the author, the IRS found itself
16 See Code § 951(a). the pretax return. The transactions also on its firmest footing for disallowing
17 Code § 245(a)(5)(B). raised regulatory concerns. The tax- the DRD when it analyzed the subpart
6
DERIVATIVES
F aspects of the transactions. In this viewed as evidence that Parent did not “under regulations prescribed by the
section of the CCA, the IRS concluded lose control of the funds even while Secretary, a taxpayer has diminished
that the transactions should not be they were held by RIC. Accordingly, the his risk of loss by holding one or more
respected in the form in which they IRS found that insertion of FSub-1 and other positions with respect to sub-
were undertaken. While the taxpayer RIC into the transactions did not pos- stantially similar or related property.”
correctly determined that there would sess an independent business purpose. Treasury Regulation § 1.246-5(c)(1)(ii)
not be a subpart F inclusion if it dis- FSub-1 did not retain any profit on the provides that when a taxpayer is hold-
posed of the FSub-1 stock prior to the transaction and its activities were ing more than 20 stocks and defeases
end of the tax year of FSub-1, the IRS directed by employee of the taxpayer. risk through shorting an index (or a
countered that this provision: The combination of these factors led like transaction), the taxpayer’s hold-
the IRS to assert that it could success- ing period for the stock will be sus-
[I]s not a tool for tax avoidance; rather,
fully challenge the involvement of RIC pended only if the two positions
it is a necessary rule to prevent both
the current and former shareholders and FSub-1 in the transactions. “substantially overlap.” If the two
from being subject to tax with respect Lastly, the IRS made two additional positions do not substantially overlap,
to the same amount of the CFC’s sub- attacks on the taxpayer’s reporting of however, the Regulations also contain
part F income.
the transactions. First, the IRS two anti-abuse rules, either of which
A court could concur with the IRS asserted that the subpart F inclusion, will toll the taxpayer’s holding period
on this point in light of the facts that not the DRD rules, should apply even if they apply.
taxpayer transferred the stock of FSub- though the taxpayer disposed of the
1 to a related partnership in a transac- stock of FSub-1 prior to the end of
A CORPORATE HOLDER OF
tion that was intended from the outset FSub-1’s tax year. This argument was STOCK IS ENTITLED TO A
of the initial acquisition of the stock based on the fact that the taxpayer DRD ONLY IF IT MEETS
and was undertaken solely for the pur- continued to possess the ability to CERTAIN HOLDING PERIOD
pose of enabling the taxpayer to claim control the stock following the dis- REQUIREMENTS WITH
a DRD. The IRS’s underlying point is position to the related partnership. RESPECT TO THE STOCK.
that the subpart F inclusion rules were Second, the IRS asserted that the use
not intended to allow a former U.S. of the statutes in the manner in which
shareholder to achieve a better result they were used was contrary to the Treasury Regulation § 1.246-
by transferring its interest to a related intent of the statutes. As a result, the 5(c)(1)(vi) sets forth an anti-abuse
party than holding the interest. taxpayer should not be entitled to rule pursuant to which, even if a tax-
The IRS rounded out its challenges directly plan into such results for a tax payer passes the “substantial over-
to the taxpayer’s claim by asserting that avoidance purpose. lap” rules of Treasury Regulation §
it could apply the step transaction doc- 1.246-5(1)(ii), will toll the taxpayer’s
FIELD ATTORNEY ADVICE 20131902F
trine to challenge the availability of the holding period if: (1) changes in the
(RELEASE DATE MAY 10, 2013)
DRD to the taxpayer. A full discussion value of the position or the stocks
of the step transaction doctrine is A corporate holder of stock is enti- reflected in the position are reason-
beyond the scope of this article. For tled to a DRD only if it meets certain ably expected virtually to track
our purposes, it suffices to note that holding period requirements with (directly or inversely) changes in the
the IRS found that the routing of funds respect to the stock. Specifically, with value of the taxpayer’s stock holdings,
through RIC and FSub-1 would have respect to common stock, the shareholder or any portion of such holdings and
been “fruitless” without the comple- must hold the stock for at least 46 days other positions of the taxpayer; and
tion of the subsequent steps, includ- during the 91 day period beginning on (2) the position is held or acquired as
ing the planned disposition of the the date that is 45 days before the ex- part of a plan a principal purpose of
FSub-1 stock prior to the year-end of dividend date; and with respect to pre- which is to obtain tax savings (includ-
FSub-1. The IRS found that the pur- ferred stock, is at least 91 days during ing deferral) the value of which is sig-
pose of the transaction was not to cre- the 181 day period beginning on the nificantly in excess of the expected
ate a RIC or transfer ownership of the date that is 90 days before the ex-div- pre-tax economic profits from the
assets, but to “have FSub-1 distribute idend date.18 Code § 246(c)(4) pro- plan.19This anti-abuse rule addresses
RIC dividends to [the taxpayer] and to vides that for purposes of maintaining the potential avoidance of the sub-
have [the taxpayer] dispose of its shares the required holding period for DRD
in FSub-1 just before the end of FSub- eligibility, a taxpayer’s holding period 18 Code § 246(c)(1), (2).
1’s tax year.” The liquidity test was will be reduced for periods when 19 See T.D. 8590 (Mar. 20, 1995).
7
VOL. 14 NO. 10
DERIVATIVES
JUNE2013
stantial overlap test by acquiring stock apply when the taxpayer owns an conceded that the options qualified as
that is not formally reflected in a short interest in an entity that holds stock, substantially similar or related prop-
index position, but that is compara- with respect to which the taxpayer has erty for purposes of the DRD rules.
ble to, or highly correlated with, such entered into an offsetting position in As a result, there is no discussion in
stock. Thus, the taxpayer must hold a the hedge.
the FAA as to the substantial overlap
position in stock and also hold (or Proposed regulations contained an
standard or the anti-abuse rules dis-
benefit from) a contra position, which example for the related-party anti-abuse
cussed above.
would then be tested to determine if rule which was deleted in the final reg-
The sole issue addressed in the
it offsets the taxpayer’s long stock ulations for reasons that are not entirely
ruling was whether the DRD man-
holdings. Furthermore, such contra clear. The deleted example offered the
dated holding period for the sub-
position must “virtually” track the following guidance:
value of the stockholdings (a high sidiaries could be tolled by offsetting
On January 1, 1993, L Corporation
threshold), and be acquired or held as positions held by the corporate par-
purchased for $100,000 a basket of pre-
part of a plan, a principal purposeof ferred stocks of companies in the util- ent. The IRS cited to Treasury Regu-
which is to obtain tax savings signif- ity industry. Also on January 1, 1993, lation § 1.246-5(c)(6) for the
icantly in excess of the expected pre- L causes R Corporation, a wholly- proposition that positions held by
owned subsidiary of L Corporation, to
tax economic profits from the plan. related parties are treated as held by
sell short $100,000 worth of utility
Treasury Regulation § 1.246-5(c)(6) index RFCs. Changes in the fair mar- the corporate shareholder “if the
provides that positions held in related ket value of the basket of preferred positions are held with a view to
party or pass-through structures “with stocks are reasonably expected to
avoiding the application of [the DRD
a view towards avoiding this section approximate changes in the utility
index. For purposes of section rules].” The FAA then concludes that
(the holding period requirement)” can
246(c)(4)(C), the basket of preferred the risk mitigation purpose of the
be re-characterized as diminishing risk
stocks of the utility companies held by
holding of the options is such a pur-
of loss. Specifically, the Regulation pro- L Corporation is substantially similar
pose and the holding period for the
vides that: or related to the RFCs on the utility
index held by its subsidiary, R Corpo- stock portfolio is tolled. As a result,
Positions held by a party related to the ration. In addition, changes in the fair
the taxpayer was denied the DRD.
taxpayer within the meaning of sec- market values of the positions (the
The concessions made by the tax-
tions 267(b) or 707(b)(1) are treated as basket of preferred stocks and the
positions held by the taxpayer if the short position in a RFC on the utility payer in FAA 20131920F make the
positions are held with a view to avoid- index) vary inversely. Thus, L Corpo- issuance of the guidance somewhat
ing the application of this section or § ration is treated as having diminished
curious.21 The related party hedge
1.1092(d)-2. In addition, a taxpayer is its risk of loss on the basket of pre-
treated as diminishing its risk of loss ferred stocks for purposes of section issue addressed in the FAA is not a
20
by holding substantially similar or 246(c)(4)(C). controversial one or one that seem-
related property if the taxpayer holds
ingly needed much, if any, interpreta-
an interest in, or is the beneficiary of, In FAA 20131920F, a wholly-
a pass-through entity, intermediary, or tion. The real issue seems to be
owned subsidiary of a common par-
other arrangement with a view to whether the portfolio bore a relation-
ent corporation (“X”) included in a
avoiding the application of this section
ship to the S&P500 options either
or § 1.1092(d)-2. consolidated federal income tax
under the mechanical 20 stock test or
return, held a portfolio of dividend-
This anti-abuse rule addresses sit- paying stocks. These stocks paid div- the anti-abuse rules. But these issues
uations in which a taxpayer owns stock idends and X, on its consolidated were conceded by the taxpayer for
directly and also owns an interest in federal income tax return, claimed purposes of the Advice. One cannot
a related person or pass-through entity DRDs. During the years at issue, X help but wonder if the question asked
that holds offsetting short positions entered into a series of put and call by the Field Auditor was really the
with respect to its long stock posi- options on the S&P 500 index. X con- question at issue. n
tions. Furthermore, this rule can also ceded that its purpose in entering into
the option transactions was to “miti- MARK LEEDS ([email protected]; (212) 506-
20 See, Prop. Treas. Reg. § 1.246-5(d), Ex. 8 (FI- gate the risk of holding a portion of 2499) is a tax partner with the New York office of
22-92 (5/27/1993)). Mayer Brown and the editor-in-chief of Derivatives:’
its equity portfolio.” X also stated that
21 At least one other commentator has observed Financial Products Report.Mark will be speaking on
“tax considerations were not sought,
that this FAA is a case of strange facts making these developments at the Institute of International
strange law. See Anthony Tuths, letter to the asked about or addressed in the estab- Bankers 2013 Annual Tax Seminar in New York on
Editor, Tax Notes Today (May 28, 2013). lishment of the option program.” X June 17, 2013.
8
DERIVATIVES
ISDA MARCH 2013 DODD-FRANK PROTOCOL (A.K.A. DODD-
FRANK PROTOCOL 2.0)
AZAM H. AZIZ, GEOFFREY All parties automatically agree to not mandatory and market participants
B. GOLDMAN, DONNA M.
Schedules 1 and 2 of the Supplement can elect to address these regulatory
PARISI AND JAMES
LARSEN after they exchange questionnaires. requirements with their swap dealers on
THIS ARTICLE EXAMINES THE INTERNATIONAL SWAPS Schedule 3 is mandatory for swap deal- a bilateral basis. As a practical matter,
AND DERIVATIVES ASSOCIATION’S RECENTLY PUB- ers, major swap participants and finan- however, given the volume of docu-
LISHED MARCH 2013 DODD-FRANK PROTOCOL.
cial entities and Schedule 4 is ments that swap dealers will need to
O
n March 22, 2013, ISDA published mandatory for “CFTC Swap Enti- amend before the Adherence Deadline,
the March 2013 Dodd-Frank Pro- ties,” which is defined as registered it is not likely that market participants
tocol1 (the “Protocol” or “Protocol swap dealers, major swap participants will have time to bilaterally renegotiate
2.0”), which is designed to facilitate and persons that in good faith expect their trading documentation. Market
compliance with certain CFTC rules to shortly register as such.4 All other participants also have the option to do
parties have the option to agree to nothing, but this will likely result in a
relating to clearing, portfolio reconcil-
Schedules 3 and 4. When both parties disruption of new trading activity fol-
iation and swap trading relationship
documentation.2The current deadline have agreed to the same Schedules, lowing the Adherence Deadline. Note
then the relevant Schedules are deemed that ISDA’s August 2012 Dodd-Frank
for compliance with these rules is July
incorporated into the swap trading doc- Protocol5 (“Protocol 1.0”) addresses
1, 2013 and failure to complete Proto-
umentation between the parties. Sched- an entirely separate set of CFTC rules
col 2.0 or enter into a substantially sim-
ules 3 and 4 will only be effective on and completing that protocol does not
ilar bilateral amendment addressing
July 1, 2013 unless the CFTC again impact the requirement to complete
these requirements by the Adherence
delays the compliance date of the rules, Protocol 2.0. There will likely be addi-
Deadline will likely result in swap deal-
in which case the later date will be the tional protocols published to address
ers becoming unable or unwilling to
effective date. None of the Schedules additional CFTC and SEC rulemakings.
enter into new swaps.3This article pro-
will be effective unless one of the par-
vides an overview of the Protocol’s Confirmation, Portfolio Reconciliation,
ties is a registered swap dealer or major
structure and a summary of changes Portfolio Compression, and Swap Trading
swap participant. The parties can also
Relationship Documentation
that the Protocol will make to existing
use Protocol 2.0 to enter into a deemed Requirements for Swap Dealers
agreements between Protocol partici-
2002 ISDA Master Agreement.
pants.
On August 27, 2012, the CFTC adopted
The operative provisions of the Pro- WHY IS PROTOCOL 2.0 NECESSARY?
final regulations setting forth require-
tocol are found in the four schedules
Protocol 2.0 addresses a number of ments for swap confirmation, swap
that comprise the ISDA March 2013
CFTC rules that are briefly described trading relationship documentation
DF Supplement:
below. The Protocol is generally an (“STRD”) and portfolio reconciliation
efficient, industry wide solution to for swap dealers. The CFTC has indi-
• Schedule 1 provides definitions;
bring trading documentation into com- cated that non-US swap dealers may not
• Schedule 2 covers a variety of
pliance with these regulations, but it is be required to comply with the STRD
CFTC rules, including, among
1 The full text of the ISDA March 2013 DF subject to the same rules and can also use the
other things, confirmations, clear-
Protocol Agreement, the ISDA March 2013 DF Protocol.
ing, and the end-user clearing Supplement and the ISDA March 2013 DF 3 The list of registered swap dealers can be
Protocol Questionnaire, can be found at: found at: http://www.nfa.futures.org/NFA-
exception;
http://www2.isda.org/dodd-frank-documenta- swaps-information/SD-MSP-registry.HTML.
• Schedule 3 provides a set of tion-initiative/. 4 For further information regarding the terms
agreements intended to address 2 CFTC, Final Rule, Confirmation, Portfolio “swap dealer” and “major swap participant”
Reconciliation, Portfolio Compression, and please refer to our publication on this topic,
the documentation requirements Swap Trading Relationship Documentation available at: http://www.shearman.com/swap-
dealer-major-swap-participant-and-eligible-con-
of the CFTC’s risk valuation and Requirements for Swap Dealers and Major tract-participant-sec-and-cftc-adopt-entity-defini-
Swap Participants, 77 Fed. Reg. 55904 (Sept.
dispute resolution regulations; 11, 2012). CFTC, Final Rule, Clearing tion-rules-07-13-2012/.
5 Despite sharing a similar format and adherence
• Schedule 4 provides a set of Requirement Determination Under Section 2(h) mechanic, Protocol 2.0 and Protocol 1.0
of the CEA, 77 Fed. Reg. 74284 (Dec. 13,
agreements intended to address 2012) and CFTC, Final Rule, End-user Exception atidodnrse sasn de ncotimreplyl edtiinffge roennet wseiltl si no fn oC FwTaCy rseagtuislafy-
the documentation requirements to the Clearing Requirement for Swaps, 77 Fed. the requirements of the other. Information on
Reg. 42559 (July 19, 2012). This publication Protocol 1.0 can be found at: http://www2
of the CFTC’s portfolio reconcili- will focus on the use of the Protocol by swap .isda.org/functional-areas/protocol-manage-
ation regulations. dealers, although major swap participants are ment/protocol/8.
9
VOL. 14 NO. 10
DERIVATIVES
JUNE2013
rules when transacting swaps with non- party meets the statutory conditions ily negotiated, many market partici-
US persons, but the applicability of required for an exception from a pants that do not currently have an
these rules to transactions involving mandatory clearing requirement. ISDA Master Agreement in place may
non-US persons is currently in a state Portfolio Reconciliation Rules: Swap prefer to negotiate their own agree-
of flux, pending the release of the dealers and major swap participants ment rather than enter into the default
CFTC’s final cross-border guidance.6 are required to reconcile swap portfo- ISDA March 2013 DF Protocol Mas-
Swap Confirmation Rules: The swap lios with other swap dealers or major ter Agreement.
confirmation rules require swap deal- swap participants with varying fre-
ers and major swap participants to exe- quency, depending upon the size of the
PROTOCOL 2.0 IS
cute confirmations of all swap particular portfolio. Discrepancies in
GENERALLY AN EFFICIENT,
transactions in which their counter- material terms identified as part of a
INDUSTRY WIDE SOLUTION
party is another swap dealer or major portfolio reconciliation process must
TO BRING TRADING
swap participant on the first business be resolved immediately and discrep-
DOCUMENTATION INTO
day following the execution date. For ancies in valuation must be resolved
COMPLIANCE WITH THESE
swap transactions with other types of within one business day. For swap port- REGULATIONS, BUT IT IS
counterparties, swap dealers and major folios involving a counterparty that is NOT MANDATORY AND
swap participants must send an not a swap dealer or major swap par- MARKET PARTICIPANTS
acknowledgement of the transaction ticipant, swap dealers and major swap CAN ELECT TO ADDRESS
on the first business day following the participants must establish written poli- THESE REGULATORY
execution date, and would be required cies and procedures to perform port- REQUIREMENTS WITH
to have policies and procedures in place folio reconciliation and to resolve any THEIR SWAP DEALERS ON
to confirm the swap transaction on the identified discrepancies in the material A BILATERAL BASIS.
first business day following the execu- terms or valuation of swaps in a timely
tion date for financial entities, and on fashion.
Mandatory Clearing
the second business day for all other
ISDA March 2013 DF Protocol Master
counterparties. On December 13, 2012, the Federal
Agreement
Swap Trading Relationship Documen- Register published the CFTC’s first
tation Rules: The STRD rules require The Protocol gives parties the option clearing determination for “plain
swap dealers and major swap partici- to elect to enter into a deemed 2002 vanilla” fixed for floating interest rate
pants to document all terms govern- ISDA Master Agreement to govern swaps, forward rate agreements and
ing their trading relationship in swaps (defined to include excluded FX basis swaps in US dollars, Euro, Ster-
writing, including terms related to swaps and forwards) that are not (i) ling or Yen, and CDX and iTraxx index
credit support arrangements, swap val- governed by an existing master agree- credit default swaps. The CFTC is phas-
uation methodologies, and limitation ment or (ii) agreed by the parties to be ing in compliance with this clearing
of termination rights if a party cleared on a derivatives clearing orga- requirement by dividing market par-
becomes subject to a special resolu- nization. The deemed 2002 ISDA Mas- ticipants into three categories and
tion regime. Swap dealers and major ter Agreement has certain requiring the most active market par-
swap participants are also required to predetermined elections made to its ticipants to begin clearing first. The
document certain information related schedule. The ISDA will be governed three categories of market participants
to clearing of their swaps and the by New York law, multiple payment are “Category 1 Entities,” “Category 2
qualifications of their counterparties transaction netting will be applicable Entities,” and “Category 3 Entities”. In
to invoke the end-user clearing excep- for FX Transactions and Currency combination with Protocol 1.0, Proto-
tion. Such information must be suffi- Option Transactions only, and if the col 2.0 permits swap dealers to obtain
cient to provide the swap dealer or parties have completed Protocol 1.0, the necessary representations about
major swap participant with a reason- then this agreement will be supple- when their counterparties become sub-
able basis to believe that its counter- mented per the terms of that protocol. ject to this mandatory clearing require-
Where no ISDA Master Agreement ment.
6 For further information regarding the CFTC’s is currently in place, this deemed ISDA Category 1 Entities include swap
cross-border guidance please refer to our publi-
permits the parties to satisfy certain dealers, major swap participants and
cation on this topic, available at: http://www
.shearman.com/cftc-issues-final-exemptive- portions of the STRD rules. However, active funds, and these entities were
order-temporarily-limiting-cross-border-applica-
tion-of-the-swaps-provisions-of-the-dodd-frank- because ISDA Master Agreements required to begin clearing swaps with
act-12-28-2012/. tend to be highly customized and heav- other Category 1 Entities on March 11,
10