On September 16, 2011, the IRS and Treasury Department issued proposed Treasury Regulations (Proposed Regulations) clarifying the treatment of credit default swaps (CDS) and other derivatives for tax purposes. The Proposed Regulations:

Classification of a swap as a notional principal contract can affect the timing or character of payments made under the swap. This classification also generally places a swap under the residence-based source rules for withholding tax purposes. Generally payments made by a US person to a non-US person under a notional principal contract are not subject to US withholding tax, unless certain special rules apply.

Before the release of the Proposed Regulations, there was uncertainty concerning the tax treatment of CDS. Although the Proposed Regulations clarify the treatment of CDS, they do not address:

The Proposed Regulations also address the treatment of swaps under IRC Section 1256, which generally requires taxpayers to mark to market annually certain exchange-traded and foreign currency contracts. Any gain or loss on these contracts is generally treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss. The Dodd-Frank Act added IRC Section 1256(b)(2)(B), which provides that specified swaps are not subject to the mark-to-market rules of IRC Section 1256 even if the swaps are traded on a regulated exchange. The Proposed Regulations clarify that the IRC Section 1256(b)(2)(B) exclusion applies to any swap or option on a swap, that is treated as a notional principal contract under Treasury Regulation Section 1.446-3(c).

The Proposed Regulations are not currently effective. If finalized in their current form, they will apply to swaps entered into on or after the date final Treasury Regulations are issued. A public hearing on the Proposed Regulations is scheduled for January 19, 2012.