The Total Return Swap Business Expands to Bank Loans

When the Exotic Embraces the Mundane:The Total Return Swap Business Expands to Bank LoansBank loans to rated or publicly traded corporations appear to be the lowliest of financial products.The bank loan business is barely profitable for the financial institutions making the loans. Indeed,those loans often are offered as loss-leader products to potential borrowers. 1 Nonetheless,secondary market trading in bank loans has grown significantly recently and the threat of securitieslaw regulation of the trading is again being raised. 2 Hedge funds are big players in the bank loanmarket, frequently as part of credit arbitrage strategies designed to capture spreads in the creditderivative market. Many of the hedge funds trading in that market have become increasingly activein the bank loan origination process to diminish legal basis risk 3 between the obligations referencedin the credit derivative market and the actual bank loans.As this Alert will explain, when the hedge fund has taken the position that its activities are notsubject to U.S. federal income tax, tension can arise between the amount of the hedge fund’sinvolvement in the loan origination process and that tax position. The consequences to the hedgefund of being engaged in a trade or business in the United States include a 35 percent net incometax on those activities 4 and the imposition of a 30 percent branch profits tax. 5 Also, under a statutory“force of attraction” rule, income not previously subject to U.S. taxation could also become subject toU.S. taxation. 6 Accordingly, the stakes are substantial.We will use the following typical revolving loan as an illustration throughout this article. Assume thata U.S. bank (Bank A) has made a loan to XYZ, a rated U.S. corporate borrower, pursuant to whichXYZ is paying interest on the outstanding bank loan at the London Interbank Offer Rate (LIBOR)plus 40 basis points (0.4 percent or 40 bps) per annum on any amounts drawn down. It will pay a 15bps fee per annum on any unused commitment. The loan has a maximum five- year term and amaximum face amount of $ 100 million. To the extent that any amounts are drawn and repaid byXYZ, XYZ remains free to again borrow those amounts. A private entity taxable as a corporation forU.S. purposes that is organized under the laws of the Cayman Islands (the Hedge Fund) 7 desires toacquire a two-year economic exposure to 80 percent of that loan and commitment. The Hedge Fundis managed by a group of traders located in New York operating in partnership form, although thefund maintains its own offices in the Cayman Islands.As noted above, many hedge funds are not interested in being exposed to the economics of theloan only to earn the 40 bps spread to LIBOR. It should be noted that the 40 bps spread over LIBORbeing paid by XYZ barely (if at all) compensates the lender for taking on the credit risk of XYZ. Afterthe Hedge Fund acquires synthetic exposure to this loan, as described below, it could wait to see ifcredit spreads contract to the point that it can acquire a credit default swap (CDS) 8 on XYZCorporation for less than for 40 bps per annum. Another strategy would be for the Hedge Fund tosynthetically short sell the XYZ bank debt. In any event, our inquiry focuses on the total return swap(TRS) between Bank A and the Hedge Fund and not any corresponding trade.ALBANYAMSTERDAMATLANTABOCA RATONBOSTONCHICAGODALLASDELAWAREDENVERFORT LAUDERDALELOS ANGELESMIAMIMILAN *NEW JERSEYNEW YORKORANGE COUNTYORLANDOPHILADELPHIAPHOENIXROME *SILICON VALLEYTALLAHASSEETOKYO **TYSONS CORNERWASHINGTON, DCWEST PALM BEACHZURICHGreenberg Traurig, LLP____________________www.gtlaw.com

I. Operation of a Typical TRS on a Bank LoanMany of the hedge funds engaged in these types of arbitrage strategies will not acquire a bank loan directly.Instead, the hedge fund will acquire a synthetic exposure to the loan through derivatives. Bank A and theHedge Fund enter into a two-year TRS regarding 80 percent of the funded and unfunded amounts of thebank loan. 9 During the term of the TRS, Bank A pays 80 percent of the interest and commitment fees that itreceives on the loan to the Hedge Fund. In exchange, the Hedge Fund agrees to pay the product of (x)LIBOR plus a spread and (y) 80 percent of the outstanding drawn amount by XYZ, on the loan made byBank A. Also, the Hedge Fund would either make an upfront swap payment to Bank A or place collateralwith Bank A, equal to a percentage of the amounts drawn on the loan, to secure its obligations. 10 Thecollateral requirements will change over time as the amounts drawn on the loan change as well for changesin the value of the loan itself. Under the TRS, at the end of two years, Bank A will pay an amount equal tothe appreciation in 80 percent of the bank loan to the Hedge Fund. The loan could appreciate if, forexample, the credit quality of XYZ improves during this period. Conversely, if the value of the bank loan atthe end of the term of the TRS is less than its initial value, the Hedge Fund will pay that diminution in valueto Bank A. Thus, the Hedge Fund is economically exposed to 80 percent of the risk and reward on the loan.At least two independent companies provide pricing for bank loans and quotes from those companies arecommonly used to ascertain the value of bank loans. 11The bank loan TRS does not provide the Hedge Fund with any direct rights against XYZ regarding any ofthe covenants and representations made by XYZ nor does it require Bank A to actually hold the loan. Forexample, if the bank loan contains coverage tests (asset to liabilities or income to expenses), the HedgeFund would not be entitled to send out any notices of default or otherwise deal directly with the borrower.Those rights are left with Bank A. If XYZ is placed into bankruptcy receivership, the Hedge Fund would not,by virtue of the TRS transaction, be entitled to receive reports from XYZ or otherwise exercise any rights of adebt holder in the bankruptcy. In general, any of those events would trigger an acceleration and, therefore,settlement of the TRS or a mark-to- market of relative obligations. Also, the obligations of Bank A to theHedge Fund are not secured by the underlying bank loan. It is common for the swap confirmation to containan indemnity provision under which the Hedge Fund is required to indemnify Bank A against any costs orexpenses incurred regarding the underlying loan.It is also worth noting that recent innovations in this market have included the development of portfolioswaps. In those swaps, the financial institution, Bank A, will enter into a supplement under which it willprovide the Hedge Fund with derivative exposure to a number of loans that it has made to corporateborrowers. The supplement may relate to loans to be made as well as loans already held by Bank A (andmight provide Bank A with discretion, within predetermined guidelines, to add loans meeting certain criteriato the swap with the Hedge Fund).Greenberg Traurig, LLP

II.The TRS as an NPC for Federal Tax PurposesSeveral U.S. tax regulations contain a definition of a swap or notional principal contract (also known as aswap). The general definition (and the definition in the source rules, which is, for purposes of this article,identical) reads:A notional principal contract is a financial instrument that provides for the payment of amounts by oneparty to another at specified intervals calculated by reference to a specified index upon a notionalprincipal amount in exchange for specified consideration or a promise to pay similar amounts. 12Objective financial information is defined as objectively determinable financial information that is not withinthe control of any of the parties to the swap. 13 Objective financial information does not include the value ofthe stock of one of the parties to the swap or its dividends, profits, and so forth.An issue exists whether a bank loan that is extended by one of the parties to the swap (Bank A in ourexample) is objective financial information. That issue is posed because Bank A negotiated the loan, has theright to accept or reject requests for draw-downs, and is otherwise servicing the loan. The performance ofthe loan, however, is not within the control of Bank A; its value will totally depend on the performance of theborrower — something not within the control of Bank A. Accordingly, a strong argument exists that the loanperformance should be considered objective financial information within the meaning of the regulationdefining swaps.The TRS between the Hedge Fund and Bank A appears to meet the literal definition of a swap. Although thenotional amount will vary over the life of the swap with draws on the loan itself, that changing notionalamount affects both parties equally. Specifically, as the loan amount fluctuates, the notional amount onwhich the payments made by Hedge Fund are calculated likewise fluctuates. Conversely, because Bank A isrequired to pay an amount equal to all interest and fees received on the underlying bank loan, the notionalamount applicable to Bank A’s payments fluctuates in a like manner. Both parties are making payments atspecified intervals. Applicable regulations specifically permit a contract with a notional amount that variesover the life of the contract to be taxed as a swap, provided that the variance is based on objective financialinformation. 14 Since any variance will relate to actions by a third-party borrower, that requirement should besatisfied. 15 The loan itself is “notional” inasmuch as the swap does not convey any direct ownership rightsregarding the loan. As noted above, the swap does not allow the Hedge Fund to vote on matters submittedto creditors nor does it require a collateral deposit equal to the full amount loaned by Bank A.A. Issues as to NPC QualificationEven assuming the form of the swap meets the criteria for a “notional principal contract,” the question ariseswhether a “total return” derivative regarding an asset could constitute a transfer of tax ownership of the assetto the “long” counterparty. 16 Most practitioners view that issue as particularly acute when the underlyingasset is nonfungible property, which might include a privately originated bank loan. As long as thereferenced asset does not secure the swap, substantial arguments can be made that a total return swapregarding a nonfungible asset can be structured in such a manner as to avoid a transfer of tax ownership.The major feature of a bank loan TRS that raises an issue to whether that contract should be a taxed as aswap is whether it would be considered to have a different notional amount for Bank A (which includespayments on unfunded amounts) and for the Hedge Fund (whose notional is only the drawn amounts). Evenif unused commitment fees are not interest for tax purposes, 17 they are earned in connection with the loanGreenberg Traurig, LLP

and collecting and disbursing dividends received on the stock. The issue was whether the trust wasengaged in a trade or business within the United States so as to treat the beneficiary of the trust as soengaged. 27 The court stated that those activities do not constitute the conduct of a trade or business “nomatter how large the estate or extended the work.” 28 In contrast to those (and other similar) cases, inInverworld Inc. v. Comm’r, a Mexican corporation engaged in the financial services business received clientfunds in the United States, placed those funds with third parties, and executed stock trades in the UnitedStates on behalf of clients. On those facts, the foreign corporation was considered to be engaged in theconduct of a trade or business in the United States.A regulation proposed in 1998 (and still in proposed form as of the date hereof) makes clear that theprinciples of the above cases and the investment safe harbor apply to derivative transactions. 29 Thatregulation states that nondealer transactions in derivatives do not constitute the conduct of a trade orbusiness in the United States. Nondealer derivative transactions include interest rate swaps and equityswaps, as well as derivatives in a “note, bond, debenture or other evidence of indebtedness.” 30 A bank loanTRS should be within that definition and, provided that the Hedge Fund is not acting as a derivatives dealers(which is very unlikely), that proposed regulation offers additional support for the conclusion that proprietaryinvestment activities (whether actual or synthetic) are not trade or business activities. In at least one privateletter ruling, the IRS concluded that a taxpayer whose U.S. activities included procuring interest rate swapsas hedges of debt investing was not engaged in the conduct of a trade or business in the United States. 31We have postulated that the Hedge Fund is not engaged in the conduct of a U.S. trade or business byreason of its activities apart from entering into the TRS on the bank loan. The swap is a proprietary positionentered into for profit in the same way that any other security transaction would be acquired. Even assumingthat the Hedge Fund is managed and controlled from within the United States by a U.S.-based investmentmanager, 32 the well-established case law briefly described above unambiguously establishes that theacquisition and management of proprietary investment activities within the United States does not rise to thelevel of the conduct of a trade or business in the United States. The Hedge Fund, in contrast to the facts inInverworld, is not acquiring the position in the United States on behalf of another person. Accordingly, it issubstantially unlikely that the swap activities in and of themselves would change this result. Thus, the HedgeFund should not be subject to net income taxation by reason of entering into the swap with Bank A.B. Source Income TaxationCorporations that earn specified types of income “from sources within the United States” not in connectionwith the conduct of a trade or business within the United States are subject to a flat 30 percent withholdingtax. 33 U.S.-source income includes some types of interest 34 and “other fixed or determinable annual orperiodical gains, profits and income” (so- called FDAP income). FDAP income includes “all income includedin gross income under section 61” 35 unless specifically excluded and swap income is not excluded. Apartfrom currency swaps (which are separately sourced), income from a swap generally is sourced “byreference to the residence of the taxpayer as determined under section 988(a)(3)(B)(i).” 36 Under that section,a corporation organized under the laws of a country other than the United States is treated as a foreignperson. If a swap is entered into in connection with the conduct of a U.S. trade or business, however, theincome from the swap is treated as U.S.-source and is treated as income that is effectively connected. 37Swap income, whether in the form of periodic or nonperiodic payments, is FDAP income under the definitioncontained in applicable Treasury regulations. Income from a bank loan swap, however, should be sourced tothe residence of the recipient of the income which, in our case, is a non-U.S. person. Accordingly, since asGreenberg Traurig, LLP

analyzed above the swap should not be considered to be acquired in the conduct of a U.S. trade orbusiness, that income should not be considered to be U.S.-source income. Thus, any such income shouldnot be subject to U.S.-source-based withholding taxation.IV. Substance Over Form?It is axiomatic that the form of a transaction will not determine its federal income tax consequences if thesubstance of the transaction does not comport with that form. 38 In case of a TRS entered into with respect toa bank loan, the most likely recharacterization of the arrangement would be that the Hedge Fund is theowner of the loan itself and that Bank A is acting as an agent of the Hedge Fund in holding and servicing theloan. In that case, the Hedge Fund would not be considered to receive income from a swap, but insteadwould be considered to receive U.S.-source interest income on the loan itself. The tax consequences of thatrecharacterization will depend on whether the Hedge Fund is engaged in the trade or business of lending orsimply being an investor or trader in debt instruments.The leading case in which a cross-border relationship not cast as an agency was treated as such for federalincome tax purposes is Inverworld. 39 Although the deemed agent in Inverworld was a wholly ownedsubsidiary of the deemed principal, the court analyzed the issue as though the parties were not related. Inthat case, the U.S. subsidiary, on behalf of the deemed principal and its clients: (i) used guidelines providedby the foreign corporation to determine which U.S. financial products to purchase, (ii) performed brokerageservices, and (iii) generated client statements and effected currency exchange transactions. Those activities,conducted on a continual basis over several years, were sufficient for the court to find that the U.S.subsidiary was acting as an agent of the foreign corporation.The issue as to whether a TRS will be respected as a swap is not unique to the bank loan area. It alsoarises in connection with collateralized debt offerings and lending by off-shore distressed opportunity funds.In those contexts, professional firms and financial institutions have identified a number of factors that wouldmake an agency recharacterization more likely to be found. Many hedge funds follow guidelines based onthose criteria to avoid the consequences of being considered to be engaged in the conduct of trade orbusiness in the United States. It is important to note that no single factor should be determinative.• Does the total return recipient (the Hedge Fund) receive a fee from the borrower for an extension ofcredit?• Does the total return recipient (the Hedge Fund) participate in the negotiation of the underlying bankloan?• Does the total return recipient have communication with the corporate bank loan borrower (other thannormal due diligence)?• Does the total return recipient hold itself out as being in the business of extending credit, that is, does theHedge Fund actively solicit customers/borrowers?• Is the total return recipient obligated to enter into the TRS before the total return payer has extended theunderlying bank loan?• Does the total return recipient have any rights with respect to the underlying bank loan documents,including, for example, with respect to the enforcement thereof or amendments thereto?• Is the TRS entered into substantially at the same time that the total return payer extends the bank loan?Greenberg Traurig, LLP

• Does the initial notional amount of the TRS represent the initial principal amount (as opposed to the thenfairmarket value) of the underlying bank loan?• Does a substantial portion of the total return recipient’s activities consist of entering into TRSs over debtinstruments?• Is the duration of the TRS the same as the stated term of the underlying bank loan?• Does the TRS cover the entire principal amount of the bank loan rather than only a percentage thereof?• Is the TRS part of a significant number of similar transactions involving extensions of credit to U.S.borrowers?• Does the Hedge Fund place collateral with Bank A that is equal to the full notional amount of the swap?• Does the swap require Bank A to actually hold the bank loan?To the extent the factors enumerated above are present (the questions are answered in the affirmative), thatmay tend to support an argument that Bank A should be considered to be an agent of the Hedge Fund inholding the bank loan. Courts have held that acts of unrelated agents can result in the foreign principal beingtreated as engaged in the conduct of a trade or business in the United States. 40 As analyzed in thesucceeding sections, however, even if the Hedge Fund is considered to hold a direct interest in the loan, itmay not result in any net adverse federal income tax consequences to the Hedge Fund. That happy resultstems from the conclusion that even if Bank A is acting as an agent of the Hedge Fund, it should remainunlikely that the Hedge Fund would be considered to be engaged in the conduct of a U.S. trade or businessor would be subject to withholding tax -- provided that the Hedge Fund is considered a secondary marketpurchaser and not the originator of the loan.V. Consequences if Hedge Fund Owns Bank LoanAs discussed above, there are two bases on which a foreign corporation can be subjected to U.S. taxation,net income taxation on the ground that it is engaged in the conduct of a trade or business in the UnitedStates or source-based taxation if it is not. Unless the Hedge Fund (total return recipient) engages in bankloan TRSs on a regular and continuous basis, and meets a substantial number of the other factorsenumerated above, it is unlikely that even directly acquiring interests in bank loans in the manner positedwould amount to a U.S. trade or business. Concomitantly, regarding withholding tax, the portfolio interestexception should exempt any interest income from taxation in the hands of the Hedge Fund.A. Net Income TaxationIf the form of the TRS is not respected and the swap is instead treated as an ownership interest in theunderlying loan itself, the question becomes whether the activities of the Hedge Fund regarding theunderlying loan are sufficient to amount to the conduct of a trade or business in the United States. Theresolution of that ultimate issue depends on two subsidiary issues: (i) whether the bank loan activities areprotected from trade or business status by reason of either of the securities trading safe harbors and (ii)whether, if they are not so protected, they are so sporadic so as not to constitute the conduct of a financingbusiness in the United States.Greenberg Traurig, LLP

1. The general securities trading safe harbor. Section 864(b)(2)(A)(i)provides that a taxpayer is not engaged in a trade or business in the United States by virtue of trading insecurities through an independent agent. That exception applies only if the foreign person does not maintainan office in the United States through which these transactions are carried out. 41 Applicable regulationsmake clear that the term “securities” as used in this exception includes “any note, bond, debenture, or otherevidence of indebtedness or any evidence of an interest in or right to subscribe for or purchase any of theforegoing.” 42 An independent agent is a person of independent status, acting in the ordinary course of itstrade or business in that capacity. 43 A foreign corporation is not considered to have an office in the UnitedStates “merely because a person controlling that corporation has an office . . . from which generalsupervision and control over policies of the foreign corporation are exercised.” 44 If, however, the day-to- dayU.S. trading of the foreign corporation is conducted through a U.S. office, that office will be attributed to theforeign corporation. 45In appropriate cases, the independent agent trading safe harbor may offer a basis for concluding that ahedge fund that acquires an interest in a bank loan should not be considered to be engaged in the conductof a trade or business in the United States. The bank loan itself should be considered to be a security. BankA, the loan originator, should be considered to be an independent agent of the Hedge Fund in those casesin which Bank A originated the loan without any involvement of the Hedge Fund. When the Hedge Fund wasnot involved in negotiating the loan, the issue as to whether the Hedge Fund should be considered to haveoriginated the loan in the ordinary course of a financing business should not be present. 46 Perhaps the mostdifficult hurdle that the Hedge Fund will encounter in attempting to take advantage of the general safe harboris asserting that the office of its U.S.-based manager should not be imputed to it. As noted, that conclusioncan be established only if the Hedge Fund manager does not conduct the day- to-day business of the fundfrom its U.S. office. In practice, that may be difficult to sustain if the manager actively manages the HedgeFund’s activities from its U.S. office. As analyzed below, however, that fact will not preclude the Hedge Fundfrom taking advantage of the “trading for its own account” exception.2. The proprietary trading safe harbor.Foreign persons who are not dealers in securities may trade in securities through their own employees in theUnited States or through a U.S. agent (independent or not) without being considered to be engaged in aU.S. trade or business. 47 In contrast to the general exception, for nondealers there is no requirement thatthose activities be conducted through an office outside of the United States. 48 Section 475(c)(1) defines theterm “dealer in securities” to include a taxpayer who regularly purchases securities from or sells securities tocustomers in the ordinary course of a trade or business. 49 Applicable regulations parenthetically treat theorigination of loans in the same manner as the purchase of loans. 50 In all cases, however, a person cannotbe a dealer in securities unless it purchases securities from, or holds securities for sale to, customers. 51Even if loan origination can be considered to be a purchase of a debt instrument, the point at which loanorigination rises to the level of a financing business rather than mere trading in securities is unclear at best. 52If the Hedge Fund is not involved with the origination of the bank loans (using the criteria enumeratedabove), it should have a strong position that the proprietary trading safe harbor precludes a finding that it isengaged in the conduct of a U.S. trade or business with respect to bank loans. The fact that the HedgeFund’s activities were conducted by an investment manager located in the United States is irrelevant to thedetermination of whether the fund is engaged in a trade or business under this safe harbor. The acquisitionGreenberg Traurig, LLP

of an interest in a bank loan should be treated as an acquisition of a “security.” The Hedge Fund is unlikelyto be treated as a dealer in securities because it is neither buying from, nor selling to, customers.Accordingly, unless the activities rise to the conduct of a financing business (and not the trading ofsecurities), the Hedge Fund should not be considered to have generated a taxable nexus to the UnitedStates.3. Banking, financing and similar activities.Treas. reg. section 1.864-4(c)(5)(i) provides that a foreign corporation is engaged in a banking, financing, orsimilar business in the United States if, inter alia, it is engaged at any point during the tax year in one ormore of six “financing functions” in the United States, including making loans to the public. In Pasquel v.Comm’r, 53 a Mexican national entered into a transaction that had elements of being both a loan and a jointventure with a U.S. corporation. The U.S. corporation acquired two boats with funds supplied by the Mexicannational, resold the boats, and split the substantial profits with the Mexican national. The court held that,regardless of whether the transaction was a loan or a joint venture, a single transaction was an insufficientbasis for concluding that the Mexican national was engaged in a trade or business in the United States. Incontrast, in Inverworld, a Mexican financial institution that regularly engaged in five of the six enumeratedfinancing functions on a regular basis over a number of years was found to be engaged in the conduct of abanking or financing business in the United States. Although the IRS had issued a public ruling in 1973concluding that a captive foreign finance company was engaged in a financing business in the UnitedStates, it subsequently revoked the ruling because it did not apply the law to the facts. 54 Accordingly, there isno existing tax authority on the vast gray area between the two extremes represented by Pasquel andInverworld.In addition to the question of whether lending constitutes a trade or business when conducted by a foreigncorporation, the question whether lending constitutes a business for a domestic taxpayer has tax relevanceand has been extensively litigated. 55 As in the cross-border area, lending businesses have been found whenthe lending activities are frequent and continuous and conducted over a number of years. For example, ataxpayer who made eight or nine loans over a four-year period was held not to be in the lending business. 56Conversely, a person who made more than 100 loans over a five-year period was considered to be engagedin the lending business. 57 That case law supports the conclusion that sporadic lending activities do notconstitute a trade or business. 58Several of the factors enumerated could assist in an analysis of whether the activities of the Hedge Fund areregular and continuous enough to amount to the conduct of a trade or business. Although untested, it isworth noting that Treas. reg. section 1.864- 4(c)(5)(i) contains a limitation specifying that the loans must bemade “to the public” in the United States for lending to constitute a trade or business. In no event will aHedge Fund be willing to acquire bank debt from a wide array of borrowers that would constitute the “public”in the commonly accepted definition of that word. 59 Instead, at least in the author’s experience, hedge fundsare very selective about which corporations they will take exposure to. In this context, a portfolio swap maypresent greater risk of net U.S. taxation to a Hedge Fund than a one- off swap or several one-off swaps. Theheightened risk stems from the fact that there is a pattern of loan origination sometimes obligating theHedge Fund to take a credit that meets defined parameters without a veto right. In that case, the economicdefeasance engaged in by Bank A could more readily be imputed to the Hedge Fund as lending. In the vastmajority of cases, however, the Hedge Fund activities will not be substantial enough to amount to theconduct of a financing business in the United States.Greenberg Traurig, LLP

Footnotes1Remarks attributed to Steven Chazen, chief financial officer, Occidental Petroleum Corp., in Spiro, “The New ‘Attention’,” Investment Dealers Digest,(July 28, 2003) p. 36; see also Sapsford, “Banks Give Wall Street a Run for Its Money,” The Wall Street Journal, Jan. 5, 2004.2See Tunick, “The Loan Market’s Biggest Bugaboo: Could Bank Loans Be Reclassified as Securities?” Investment Dealers Digest, Dec. 6, 2004, p. 7.3As used in this report, legal basis risk means there is a risk that a default could occur on the bank debt that is actually held but there is no correspondingdefault on the debt instrument referenced in the credit derivative because the legal terms of the referenced loan differ from the terms specified asapplicable to the bank loan itself.4Section 882(a). The tax can be imposed on gross income if no tax return is filed. Section 882(c)(2). Section references are to the Internal RevenueCode of 1986, as amended, or the regulations thereunder, except as otherwise noted.5Section 884.6Section 864(c)(3).7For purposes of this article, unless otherwise noted, we will assume that the hedge funds under consideration are properly treated as corporations forU.S. tax purposes.8For purposes of this article, it is assumed that the credit default swap (CDS) is a notional principal contract within the meaning of Treas. reg. sections1.446-3(c)(1) and 1.863-7(a)(1). Of course, other characterizations of a CDS are possible for federal income tax purposes. See Kayle, “The FederalIncome Tax Consequences of Credit Derivative Transactions,” reprinted in Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, JointVentures, Financings, Reorganizations and Restructurings 2002 (Practicing Law Institute), vol. 15, p. 913; Miller, “Characterization of Credit DerivativeTransactions Affects Their Tax Treatment,” 3 Journal of Taxation of Financial Products 31 (Winter 2002).9Total return swaps with respect to stock are usually referred to as equity swaps. See Treas. reg. section 1.263(g)- 4(c)(ex. 7).10 In the author’s experience, swap market participants are indifferent between structuring collateral payments as upfront swap payments or as collateral.Apart from tax considerations, the economic consequences of the payments essentially are the same. In general, the amount of the required deposit willvary with amount drawn down on the revolving loan by XYZ.11 Dealers use Markit Loans (formerly known as Loan X) and Loan Pricing Servicing to place bids for bank loans and the quotes provided on theseservices are frequently used to obtain pricing for bank loans.12 Treas. reg. sections 1.446-3(c)(1), 863-7(a)(1).13 Treas. reg. section 1.446-3(c)(4)(ii).14 Treas. reg. section 1.446-3(c)(3).15 Treas. reg. section 1.446-3(c)(4)(ii).16 See, e.g., Rev. Rul. 2003-7, 2003-5 IRB 963, Doc 2003-1634, 2003 TNT 12-13.17 See Rev. Rul. 2004-52, 2004-22 IRB 973, Doc 2004-9837, 2004 TNT 89-23 (annual credit card fees are not interest, even if treated as such for financialaccounting purposes).18 A sale-repurchase transaction is taxed as a secured lending. See, e.g., Nebraska Dep’t of Revenue v. Lowenstein, 513 U.S. 123 (1994), and authoritiescited therein.19 See Webb, “Tax Management International Forum Discusses Tax Implications of Repo Transactions and Investments in Asset-Backed Securities,”Daily Tax Report, Oct. 25, 2002, p. J-1.20 See section 1058(b)(3); prop. Treas. reg. section 1.1058-1(b)(3).21 See Grodt & McKay Realty Inc. v. Comm’r, 77 T.C. 1221 (1981) at 1237; TAM 8643002; Watts Copy Systems, 67 T.C.M. 2480, Doc 94-3397, 94 TNT60-7 (1994); United Surgical Steel Co., 87 T.C. 1417 (1986); Sundance Ranches Inc. v. Comm’r, T.C. Memo. 1988-535; Hydrometals Inc. v. Comm’r,485 F.2d 1236 (1972).22 Rev. Rul. 88-3, 1988-1 C.B. 268; Treas. reg. section 1.864-2(e); Inverworld v. Comm’r, T.C. Memo. 1996-301, Doc 96-18802, 96 TNT 127-14.23 50 T.C. 145 (1968), aff’d 429 F.2d 1209 (2d Cir. 1970).24 50 T.C. at 153.25 265 F.2d 40 (9th Cir. 1959), aff’g 16 T.C.M. 724.26 35 T.C.M. 1362 (1974).27 See section 875.28 35 T.C.M. at 1363; see also Scottish Am. Inv. Co. Ltd. v. Comm’r, 12 T.C. 49 (1949).29 Prop. Treas. reg. section 1.864(b)-1.30 Prop. Treas. reg. section 1.864(b)-1(b)(2).31 LTR 9204015 (Oct. 24, 1991); see also 1997 FSA (Lexis) 334 (Nov. 25, 1997).32 See section 864(c)(4)(B). See Treas. reg. section 1.864-6 for rules relating to when foreign-source income is attributable to an office located in theUnited States.33 Section 881(a).34 In practice, the exemption for portfolio interest provide by section 882(c) overwhelms the general rule and U.S.-source interest is rarely subject tosource-based taxation.35 Treas. reg. section 1.1441-1(b)(1); see also Treas. reg. section 1.1441-1(b)(2).36 Treas. reg. section 1.863-7(b)(1).37 Treas. reg. section 1.863-7(b)(3).Greenberg Traurig, LLP