Par. 2. Section 1.446-3 is amended by: 1. Revising the entries for the table of contents in § 1.446-3(a) for paragraphs (c) and (j). 2. Revising paragraphs (c)(1), (c)(2), and (c)(3). 3. Adding and reserving paragraph (c)(5). 4. Adding paragraph (c)(6). 5. Adding two sentences to the end of paragraph (j). The revisions and additions read as follows:
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(c) Definitions and scope.
(1) Notional principal contract.
(i) In general.
(ii) Payment defined.
(iii) Included contracts.
(A) Special rule for credit default swaps.
(B) Special rule for nonfunctional currency notional principal contracts.
(iv) Excluded contracts.
(v) Transactions within section 475.
(vi) Transactions within section 988.
(2) Specified index.
(i) Specified financial index.
(ii) Specified non-financial index.
(3) Notional principal amount.
(4) Special definitions.
(i) Related person and party to the contract.
(ii) Objective financial information.
(iii) Dealer in notional principal contracts.
(5) [Reserved]
(6) Examples.
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(j) Effective/applicability date.
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(c) Definitions and scope —(1) Notional principal contract —(i) In general. A notional principal contract is a financial instrument that requires one party to make two or more payments to the counterparty at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts. An agreement between a taxpayer and a qualified business unit (as defined in section 989(a)) of the taxpayer, or among qualified business units of the same taxpayer, is not a notional principal contract because a taxpayer cannot enter into a contract with itself.
(ii) Payment defined. For purposes of paragraph (c)(1)(i) of this section, a payment includes an amount that is fixed on one date and paid or otherwise taken into account on a later date. Thus, for example, a contract that provides for a settlement payment referenced to the appreciation or depreciation on a specified number of shares of common stock, adjusted for actual dividends paid during the term of the contract, is treated as a contract with more than one payment with respect to that leg of the contract. See Example 2 of this paragraph (c).
(iii) Included contracts. Notional principal contracts governed by this section include contracts commonly referred to as interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, credit default swaps, weather-related swaps, and similar agreements that satisfy the requirements of paragraph (c)(1)(i). A collar is not itself a notional principal contract, but a cap and a floor that comprise a collar may be treated as a single notional principal contract under paragraph (f)(2)(v)(C) of this section. A contract may be a notional principal contract governed by this section even though the term of the contract is subject to termination or extension. Each confirmation under a master agreement to enter into an agreement covered by this section is treated as a separate notional principal contract (or as more than one notional principal contract if the confirmation creates more than one notional principal contract). Notwithstanding the rule under paragraph (c)(3) of this section—
(A) Special rule for credit default swaps. A credit default swap contract that permits or requires the delivery of specified debt instruments in satisfaction of one leg of the contract is a notional principal contract if it otherwise satisfies the requirements of paragraph (c)(1)(i) of this section.
(B) Special rule for nonfunctional currency notional principal contracts. A notional principal contract that permits or requires the delivery of specified currency in satisfaction of one or both legs of the contract but that otherwise qualifies as a nonfunctional currency notional principal contract under § 1.988-1(a)(2)(iii)(B) is a notional principal contract.
(iv) Excluded contracts. A forward contract, an option, and a guarantee are not notional principal contracts. An instrument or contract that constitutes indebtedness under general Federal income tax law is not a notional principal contract. An option or forward contract that entitles or obligates a person to enter into a notional principal contract is not a notional principal contract, but payments made under such an option or forward contract may be governed by paragraph (g)(3) of this section.
(v) Transactions within section 475. To the extent that the rules provided in paragraphs (e) and (f) of this section are inconsistent with the rules that apply to any notional principal contract that is governed by section 475 and the regulations thereunder, the rules of section 475 and the regulations thereunder govern.
(vi) Transactions within section 988. To the extent that the rules provided in this section are inconsistent with the rules that apply to any notional principal contract that is also a section 988 transaction or that is integrated with other property or debt pursuant to section 988(d), the rules of section 988 and the regulations thereunder govern. The rules of § 1.446-3(g)(4) are not considered to be inconsistent with the rules of section 988. See § 1.988-2(e)(3)(iv).
(2) Specified index. A specified index may be either a specified financial index or a specified non-financial index.
(i) Specified financial index. A specified financial index is—
(A) A fixed rate, price, or amount;
(B) A fixed rate, price, or amount applicable in one or more specified periods followed by one or more different fixed rates, prices, or amounts applicable in other periods;
(C) An index that is based on objective financial information (as defined in paragraph (c)(4)(ii) of this section); and
(D) An interest rate index that is regularly used in normal lending transactions between a party to the contract and unrelated persons.
(ii) Specified non-financial index. A specified non-financial index is any objectively determinable information that—
(A) Is not within the control of any of the parties to the contract and is not unique to one of the parties' circumstances;
(B) Is not financial information; and
(C) Cannot be reasonably expected to front-load or back-load payments accruing under the contract.
(3) Notional principal amount. For purposes of this section, a notional principal amount is any specified amount of money or property that, when multiplied by either a specified financial index or a specified non-financial index, measures a party's rights and obligations under the contract, but is not borrowed, loaned, or sold between the parties as part of the contract. The notional principal amount may vary over the term of the contract, provided that it is set in advance or varies based on objective financial information (as defined in paragraph (c)(4)(ii) of this section). If a notional principal contract references a notional principal amount that varies, or that references a different notional principal amount for each party, and a principal purpose for entering into the contract is to avoid the application of the rules in this section, the Commissioner may recharacterize the contract according to its substance, including by separating the contract into a series of notional principal contracts for purposes of applying the rules of this section or by treating the contract, in whole or in part, as a loan.
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(5) [Reserved]
(6) Examples. The following examples illustrate the application of paragraph (c) of this section.
Example 1. Forward rate agreement.
(i) On January 1, 2012, A enters into a contract with unrelated counterparty B under which on December 31, 2013, A will pay or receive from B, as the case may be, an amount determined by subtracting 6% multiplied by a notional amount of $10 million from 3 month LIBOR on December 31, 2013 multiplied by the same notional amount ((3 month LIBOR × $10,000,000)−(6% × $10,000,000)). The contract provides for no other payments.
(ii) Because this contract provides for a single net payment between A and B determined by interest rates in effect on the settlement date of the contract, the contract is not a notional principal contract defined in § 1.446-3(c)(1)(i).
Example 2. Equity total return contract with dividend adjustments.
(i) On January 1, 2012, A enters into a contract with unrelated counterparty B under which on December 31, 2013, A will receive from B an amount equal to the appreciation (if any) on a notional amount of 1 million shares of XYZ common stock, plus any dividends or other distributions that are paid on 1 million shares of XYZ common stock during the term of the contract. In return, on December 31, 2013 A will pay B an amount equal to any depreciation on 1 million shares of XYZ common stock, and an amount equal to 3 month LIBOR multiplied by the notional value of 1 million shares of XYZ stock on January 1, 2012 compounded over the term of the contract. All payments are netted such that A and B are only liable for the net payment due under the contract on December 31, 2013.
(ii) Because both legs of this contract provide for payments that become fixed during the term of the contract (the dividend payments and the LIBOR-based payments), each leg of the contract is treated as providing for more than one payment. In addition, since the indices referenced in the contract are specified indices described in paragraph (c)(2)(i) of this section, and the 1 million shares of XYZ common stock are a notional principal amount described in paragraph (c)(3) of this section, the contract is a notional principal contract defined in § 1.446-3(c)(1)(i).
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(j) Effective/applicability date. * * * The rules of paragraph (c) of this section apply to notional principal contracts entered into on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register . Section 1.446-3(c) as contained in 26 CFR part 1 revised April 1, 2011, continues to apply to notional principal contracts entered into before the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register .