US end-users risk tax hit in move to daily settled swaps

Changing treatment of variation margin could benefit banks, but hurt clients

Capital question: "US tax lawyers are debating the issue. It's… extremely sensitive," says a tax specialist

Changing the treatment of margin on cleared swaps could leave derivatives end-users with a bigger tax bill, setting up a fresh trade-off for the planned move. The margin change promises to cut bank capital requirements dramatically, but on top of the tax question, it also risks upsetting hedge accounting arrangements.

The changes, which have seen all four of the big swaps clearing houses seek supporting legal opinions in recent months, would see daily margin posting as the settlement of a trade, rather than as collateral. This is how the futures market has functioned for decades, and if cleared swaps follow suit it would cut a bank's exposure and capital under the terms of the leverage ratio. The latest question is whether it would also present their customers with a tax hike.

"It would be a fundamental change and an effective doubling in rates, depending on the nature of the derivative and how long term it is. US tax lawyers are debating the issue. It's an open question and extremely sensitive," says a tax specialist at one US law firm.

Large numbers of end-user taxpayers might suddenly have to revisit where they're going to use cleared swaps
Second US-based lawyer

A second US-based lawyer warns there is potential for "a radical change in the tax treatment of derivatives. Large numbers of end-user taxpayers might suddenly have to revisit where they're going to use cleared swaps."

The cloud hangs over end-users of derivatives specifically, because they are taxed as payments accrue, rather than when the value of a trade changes – the latter approach applies for banks. For end-users, the US tax system currently distinguishes between payments made on a swap and collateral exchanged on a swap. Coupon payments and upfront payments at origination and termination are treated as payments on a swap, accrued over its life and taxed on an amortising basis. Variation margin is treated as collateral and is not subject to tax, although price alignment interest (PAI) – a payment from the margin receiver to the payer – is taxed as interest on that collateral.

Possible scenarios

This could change if the margin stops being treated as collateral. In one scenario, the trade would become subject to additional income tax; in another, it would attract more capital gains tax.

The first scenario would see coupons and upfront payments continue to be treated as they are currently, subject to income tax. But the variation margin would also become subject to income tax since it would be treated as settlement of the swap on a daily basis.

PAI would no longer be regarded as interest on collateral for tax purposes, because the variation margin will have ceased to be characterised as collateral. That would require clearing members, which sit between end-users and clearing houses – and have to differentiate coupon, margin, upfront and PAI payments – to stop classifying it as interest, creating a book-keeping headache as it would then need to be bundled into the formula for calculating daily payment of variation margin.

The second scenario would see variation margin becoming subject to capital gains tax; the argument being that the swap would have a rolling term of one business day. Coupons and upfront payments would continue to be subject to income tax, but if the swap itself is settled and replaced every day, then each of its final settlement payments would arguably result in a capital gain or loss. Variation margin, including PAI, would then be subject to capital gains tax.

The market doesn't want the US Internal Revenue Service to say it triggers a tax event. It would be a reporting nightmare
Tax specialist at a US law firm

The tax lawyer says non-corporate taxpayers, including funds in which US individuals invest, are entitled to preferential rates for long-term capital gains – a rate of 20% for derivatives with terms of greater than a year, for example – but short-term capital gains are taxed at the same rate as ordinary income. Cutting the term of the derivative to a single day would see the rate almost double to 39.6%.

"No end-user now treats the passing back and forth of collateral as a tax event on the underlying derivative. The market doesn't want the US Internal Revenue Service (IRS) to say it triggers a tax event. It would be a reporting nightmare and would fundamentally change how people treat derivatives for US tax purposes," the lawyer says.

According to a second US lawyer, the timing of income or loss will also be of concern to taxpayers as the ability to deduct capital losses from tax could be limited. This might also lead to an increase in tax, since gains would be taxable, but capital losses could not be deducted unless a taxpayer had other offsetting gains.

Of course, another possible outcome is that there is no change to the tax status of a cleared swap, and the second lawyer can see merit in both sides of the argument: "The fact the changes are being made in order to alter the regulatory capital treatment tends to point towards regarding the payments as if they are truly payments for tax purposes. On the other hand, there is a very long tax history in the area of cleared transactions of treating variation margin as collateral."

This long history could save daily settled cleared swaps. Mark Howe, a Washington-based tax partner at Cadwalader, Wickersham & Taft, points to Title V of the Economic Recovery Tax Act of 1981, which established that treating variation margin as income in a futures contract would be inappropriate, absent specific legislation.

"The tax issues raised by this regulatory and documentary change are similar to the tax issues that US tax lawyers had to address for the treatment of variation margin for futures, and in that case there was a consensus that variation margin did not trigger a tax event," says Howe.

Big savings under leverage ratio

The industry has already invested a lot of time and energy in the planned margin changes, and until recently it seemed sure of its ground. In December 2015, the Securities Industry and Financial Markets Association (Sifma) wrote to US regulators, telling them to expect cuts of two-thirds in the exposure numbers reported by banks for their cleared swaps under the leverage ratio.

In an emailed statement, Sifma said it is "aware of the pending changes to the rules dealing with variation margin by the CME and LCH.Clearnet, and is currently evaluating the US federal income tax consequences, if any, of those changes".

One New York-based head of over-the-counter clearing at a large US bank says the tax code is complex and often requires interpretation, creating a challenge for end-users: "For a clearer, ultimately the tax onus would wind up being on our clients, so it's less of a direct consideration for us. If they have to move something out of an interest line and into a cashflow line then systems will need to be rewired. If the daily payment of interest is not viewed as interest any more and instead is a cashflow within the contract, how will that be treated from a tax perspective?"

After taxpayers have sought advice from legal counsel on the correct tax position, if there is still uncertainty, the US government may need to step in to reflect any changes necessary in the tax code. This process is fraught with difficulties, warns the second lawyer, not least because officials may be wary of embarking on time-consuming modification of the tax code if those changes are later made redundant by a reworking of the leverage ratio, which is itself under review.

One of the changes being considered by the Basel Committee on Banking Supervision is a change to the methodology used to calculate exposure - the denominator of the ratio. The decades-old current exposure method (CEM), which limits netting and risk mitigation- could be replaced by the brand new, more sensitive, standardised approach to counterparty credit risk (SA-CCR).

Clearing banks say daily settlement would be less of a benefit under SA-CCR, because it would do away with the CEM's system of maturity buckets and notional multipliers – the exposure-reducing power of settlement arises because a daily margin payment would instantly pull any swap out of the longer-dated buckets, where the multipliers are larger, and place it in the shortest bucket. The SA-CCR takes into account the actual maturity of the underlying transaction instead.

The second lawyer says: "If the US Treasury was convinced to issue guidance, that process could take some time. So they might think why should they spend time on it if the leverage ratio is due to be changed? But it's up in the air whether the leverage ratio will be changed."

I would not expect the move to daily settlement to make any difference in the UK
Charles Yorke, Allen & Overy

The Bank of England supports changes to the leverage ratio's treatment of initial margin, but the US Federal Reserve has been sitting on the fence so far, despite repeated calls from the US House Committee on Agriculture for changes to be made.

What of the tax implications in other jurisdictions? In the UK, a special code for taxing swap transactions operates and applies to any company, financial or otherwise, says Isaac Zailer, head of tax at law firm Herbert Smith Freehills. It subjects profit and loss on trades to income tax rather than capital gains tax. He does not think daily settlement would create significant tax leakage for banks or their end-user clients in the UK.

Charles Yorke, a partner at law firm Allen & Overy's London tax group, agrees: "In the UK, banks and corporates are subject to corporation tax on income from their derivatives on a fair-value basis. The tax charge arises in real time as fair value moves. You don't wait until settlement of the swap. I would not expect the move to daily settlement to make any difference in the UK."

Four derivatives-clearing houses have sought legal opinions to back up the treatment of daily variation margin as settlement. But, aside from tax considerations, arcane accounting rules may also undermine the move. Settling a swap on a daily basis could make it a less effective hedge, principally because of PAI not being present in the hedged item, while banks could also see inefficiencies in hedge accounting if legacy trades have to be de-recognised and re-established.

The International Swaps and Derivatives Association says it is working with LCH.Clearnet and the ‘big four' accounting firms on the accounting treatment of daily settled swaps, but it is not considering tax implications at this time.

The US Treasury and the IRS did not respond to requests for comment by press time.