Scope of Notational Principal Contract Exclusion from UBTI Clarified in Proposed Regs

This post is a heads up for exempt organizations that invest in nontraditional investments such as interest rate swaps and other notational principal contracts (NPCs). Income from NPCs is excluded from UBTI by Treas. Reg. §1.512(b)-1(a), which includes income from NPCs with other passive investment income such as dividends, interest, and annuities.

Note: Section 512(b)(1) lists five categories of passive income that are excluded from UBTI: dividends, interest, payments with respect to securities loans, amounts received or accrued as consideration for entering into agreements to make loans, and annuities. Although income from NPCs is not specifically mentioned in §512(b)(1), Treas. Reg. §1.512(b)-1(a)(1) does expressly identify income from NPCs as excludable passive investment income.

 What Are Notational Principal Contracts?

 An NPC is a financial agreement calling for the exchange of payments between two parties, at least one of which periodically pays amounts calculated by applying a rate determined by reference to a specified index to a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.

 What Amendments Are Proposed?

 The proposed amendment to Treas. Reg. 1.512(b)-1(a)(1) is a conforming amendment to proposed amendments to Treas. Reg. §§1.1256(b)-1(a) and 1.446-3(c). Section 1256 provides special income tax treatment for section 1256 contracts, such as regulated futures contracts, that are marked to market and traded on a qualified board or exchange. Gain or loss on section 1256 contracts is generally treated as 60% long-term and 40% short-term capital gain or loss. Current §1256(b)(2)(B), added by the Dodd-Frank Act of 2010, provides that various types of swaps and similar contracts are not treated as section1256 contracts. The excluded contracts are almost identical to those listed as notational principal contracts under present Treas. Reg. §1.446-3(c), which discusses the recognition of income from NPCs that is necessary clearly to reflect income under §446.

 To resolve some uncertainties regarding the treatment of swaps that are traded on regulated exchanges, Proposed Treas. Reg. §1.1256(b)-1(a) provides that notational principal contracts described in Treas. Reg. §1.446-3(c) are excluded from treatment as section 1245 contracts. In turn, Proposed Treas. Reg. §1.446-3(c) clarifies some questions about NPCs and allows additional types of contracts to be classified as NPCs. For example, the proposed regulation provides that one party to a NPC must make a minimum of two payments to the other contracting party. The proposed regulation also includes as NPCs credit default swaps and swaps based on non-financial indices, such as weather-related swaps. Under the current regulation, a specified index includes only financial indices.

 What Is the Current Status of the Proposed Regulations?

 A public hearing about the proposed regulations was conducted on January 19, 2012, with 13 in attendance and one speaker.

Tax Court: An Exempt Organization Subject to the UBIT is Still an Exempt Organization

To those not accustomed to dealing with subchapter F of the Code (pertaining to exempt organizations) it may seem contradictory that so-called exempt organizations are subject to the unrelated business income tax. And the UBIT is not the only tax that may apply to exempt organizations. Charitable organizations which are private foundations are taxed on their net investment income and are subject to a series of excise taxes designed to curb particular behaviors susceptible to abuse. Thus, exempt organizations, which are not subject to the regular income tax imposed under §§1 and 11, are distinguished from for-profit companies that must pay income taxes. For convenience, we refer to them as exempt organizations, even though we know that they may be liable for the UBIT or other specialized taxes.

 Section 501 expressly recognizes that concept of tax-exempt organizations being subject to taxation. Exemption from taxation is provided under §501(a) for organizations described in §501(c), §501(d), and §401(a). These organizations are charities and 28 other categories of organizations described in §501(c), religious and apostolic organizations described in §501(d), and qualified retirement plans described in §401(a).

 Section 501(b) states that an organization exempt from taxation under §501(a) is subject to tax as provided in parts II (taxes on private foundations), III (the UBIT), and VI (taxes on political organizations) of subchapter F. Notwithstanding parts II, III, and VI of subchapter F, however, such an organization is “considered an organization exempt from income taxes for purposes of any law referring to organizations exempt from income taxes.”

 The Tax Court recently considered this seemingly straightforward Code provision in Research Corporation v. Commissioner, 138 T.C. No. 7 (2012).  Continue reading

Social Welfare Organization Derived UBTI from Members-Only Beach Club and Parking Lots

In Ocean Pines Association, Inc. v. Commissioner, the Court of Appeals for the Fourth Circuit held that a tax-exempt social welfare organization conducted an unrelated business when it operated two parking lots and a beach club limited to members only. The case was not complex, and the outcome was predictable. The court’s opinion, however, illustrates a classic analysis of the distinction between related and unrelated businesses under the UBIT.  Continue reading