SERVICE ALTERS SUBPART F RULES: WILL TREAT INCOME FROM UNHEDGED NOTIONAL PRINCIPAL CONTRACTS AS INCOME EQUIVALENT TO INTEREST.

Notice 89-90

This Notice announces rules that will be incorporated in final regulations with respect to the treatment under section 954(c)(1)(E) of the Internal Revenue Code of income attributable to a notional principal contract (such as an interest rate swap agreement, an interest rate cap or floor agreement, or other similar contract) that is denominated in the functional currency of, and that is earned by, a qualified business unit (QBU), as defined in section 989(a) of the Code and the regulations hereunder. Section 951(a)(1)(A) of the Code requires that a United States shareholder of a controlled foreign corporation (CFC) include in its gross income its pro rata share of the CFC's subpart F income. Subpart F income is defined in section 952(a) to include foreign base company income, as determined under section 954. Section 952(a)(2). Section 954(a)(1) defines foreign base company income to include foreign personal holding company income, as determined under section 954(c). Section 954(c)(1)(E) provides that foreign personal holding company income includes any income equivalent to interest, including income from commitment fees (or similar amounts) for loans actually made. Section 1.954-2T(h)(1) of the Temporary Income Tax Regulations states that income equivalent to interest includes, but is not limited to, income derived from the following categories of transactions: (i) An investment, or series of integrated transactions which include an investment, in which the payments, net payments, cash flows, or return predominantly reflect the time value of money, and (ii) Transactions in which the payments or a predominant portion thereof are in substance for the use or forbearance of money, but are not generally treated as interest. The temporary regulations further state that income equivalent to interest does not include income attributable to notional principal contracts such as interest rate swaps, currency swaps, interest rate floor agreements, or similar contracts except to the extent that such contracts are part of an integrated transaction that gives rise to income equivalent to interest. Income derived from notional principal contracts by a person acting in its capacity as a regular dealer in such contracts are presumed, under this temporary regulations, not to be integrated with an investment. Notional principal contracts are generally used by taxpayers to manage interest rate risks. In substance, notional principal contracts generally affect the all-in cost of interest-bearing liabilities or the return on interest-bearing assets. The final regulations, when issued, will state that income attributable to a notional principal contract that is denominated in (or the value of which is determined by reference to) the functional currency of, and that is earned by, a QBU that is a party to the contract is income equivalent to interest under section 954(c)(1)(E) of the Code. This rule will apply regardless of whether the notional principal contract is integrated with an investment. Notional principal contracts denominated in (or the values of which are determined by reference to) a nonfunctional currency will generally be governed by sections 988 and 954(c)(1)(D). An exception will be provided where the notional principal contract is subject to the rules of section 1.861-9T(b)(6) of the Temporary Income Tax Regulations. In the case of a notional principal contract identified with a liability or liabilities, the notional principal contract will not generate income equivalent to interest includible in subpart F income because, under the rules of section 1.861-9T(b)(6) of the temporary regulations, this interest expense of the CFC will be reduced by the income or gain attributable to its notional principal contract. An exception to the general rule will also be provided for amounts received or accrued by a person acting in its capacity as a regular dealer in notional principal contracts. For purposes of this exception, amounts received or accrued by any person from a notional principal contract that is integrated with an asset shall not be treated as amounts received or accrued by a person acting in its capacity as a regular dealer in notional principal contracts. The rules described above, when incorporated in final regulations, will apply to all items of income received or accrued on or after the date of publication of this Notice in the Internal Revenue Bulletin. See, Notice 89-21, 1989-8 I.R.B. 23, for guidance about the proper method of accounting for payments made or received with respect to notional principal contracts. This document is an "administrative pronouncement" as that term is used in section 1.6661-3(b)(2) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or a revenue procedure. See Rev. Rul. 87-138, 1987-2 C.B. 287. DRAFTING INFORMATION. The principal authors of this Notice are Philip L. Garlett and Shannon M. Votava of the Office of the Associate Chief Counsel (International). For further information about this Notice, contact Philip Garlett or Shannon Votava at (202) 566-6645 (not a toll-free call), or write to the Internal Revenue Service, Office of the Associate Chief Counsel (International), 1111 Constitution Avenue, N.W., Washington, D.C. 20224, Attention: CC:INTL:Br2, Room 4712.