Tax Treatment of the Assignment of Derivative Positions: IRS and Treasury Issue Regulations Clarifying That Transfers of Derivative Positions Among Dealers or Clearinghouses Will Generally Not Be Taxable Events for Non-assigning Counterparties

Sullivan & Cromwell LLP - July 21, 2011

On July 21, 2011, the Internal Revenue Service and Treasury Department released temporary and proposed regulations (the “Temporary Regulations”) clarifying that the transfer of certain derivative positions among dealers or clearinghouses will generally not result in a taxable exchange for the non-assigning counterparty if the transfer is permitted by the terms of the derivative contract. For this purpose, a transfer will be deemed permitted by the terms of the derivative contract notwithstanding that the transfer requires counterparty consent.

Before today’s revisions, applicable treasury regulations (the “Former Regulations”) set out a more limited version of the rule set out in the Temporary Regulations that was only applicable to transfers of notional principal contracts among dealers in notional principal contracts. Additionally, it was not clear under the Former Regulations whether a transfer was permitted by the terms of the contract where the consent of the non-assigning counterparty was required to effect the transfer.

The Temporary Regulations apply to notional principal contracts and other derivatives, and the Temporary Regulations include within their scope transfers to and from a clearinghouse. Thus, the interposition of a clearinghouse between two counterparties to a derivative may not give rise to a taxable event.

The clarity provided by the Temporary Regulations may be particularly helpful in light of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which, according to the preamble to the Temporary Regulations (the “Preamble”), “in some cases will necessitate the movement of entire books of derivative contacts.” Dodd-Frank will also require, on a going-forward basis, that certain derivatives be cleared through clearinghouses.