Taxes, IRS, Interest Rate

Is the IRS out to get you? Are there unresolved questions about your eligibility or status that are preventing you from moving forward? Have you been contacted recently, only to be asked for more documentation or information? Have you had to retain legal counsel to sort through all the new requirements? If you have experienced similar problems, you are not alone. Millions of Americans are coming to terms with their own frustrating IRS experiences. Some law makers even want to advance a new IRS tax, to help pay for regulating the IRS! But let’s not get ahead of ourselves. There’s already enough going on with Interest Rate Swaps.

Interest Rate Swaps have never been so simple and yet so fraught with questions and compliance issues. Many market participants are experiencing this right now as they go back into the market for the first time in years, concerned about rising interest rates. Others had inked their deals long ago, only to find that their bank needs new information to document their old swaps. The common theme linking transactions past and present is Dodd Frank. At the same time it seeks to regulate the market going forward, it intends to rewrite and re-document the past. That means you’ll have to deal with the IRS if you ever want another IRS deal (and in some cases, even if you don’t). Here’s why:

Eligibility. Market participants have struggled for years to determine whether a derivative user has the necessary sophistication to enter a transaction and be bound by its contractual obligations. In writing the Eligible Contract Participant (ECP) rules, the CFTC has settled on a financial proxy for sophistication, imposing asset or net worth tests along with an understanding of whether a trade is a hedge of commercial risk or a speculative transaction. Most entities who have transacted before will find that their ECP status is straightforward and not in question. However, at the margins, banks and borrowers now struggle with a labyrinth of rules, poring over borrower financial statements to understand which assets are “invested on a discretionary basis,” or scrutinizing formation documents to determine ownership structure and the relationship of a would-be swap guarantor to the business (who must now also be an ECP). This part of the transaction process has never been more intense, but parties who want to get it right are finding it takes time to sort out the details and find the necessary comfort to move ahead.

Current status. Are you a protocol adherent? Do you need to be? Did you think you were done, having done just one? Eligibility to transact an IRS is one thing, but your ability to do so will depend on who your counterparty is and whether or not you need to be a protocol adherent to transact. For anyone dealing with a swap dealer (SD) or Major Swap Participant (MSP), the rules require them to make new representations to you, and gather certain new data from you, none of which was contemplated in your original ISDA documents. Since it would be impractical and more costly to amend all the ISDAs one at a time, several Dodd Frank protocols have been established to facilitate mass amendments. The Dodd Frank ISDA August 2012 Protocol dealt with business conduct standards, and is now required as of May 1st to transact with a SD or MSP (unless bilateral amendment was agreed to). If you completed this protocol, you should promptly move on to the next one, the ISDA March 2013 Protocol, with a compliance date of July 1st. This protocol covers portfolio reconciliation, Swap Trading Relationship documentation, and opting out of central clearing, if eligible. Once again, SDs and MSPs will be unable to trade with you July 1st if you are not an adherent (or without bilateral amendment). If you have a pending IRS, you will want to get the protocol(s) done now to avoid any trading delays or disruptions.

New information on old swaps. Whether you call it a CFTC Interim Compliant Identifier (“CICI”) or in future-state jargon, a Legal Entity Identifier (“LEI”), you are talking about a unique number that identifies every market participant who will enter into a new IRS, or who has already entered into one. CICIs or LEIs require a onetime registration to obtain your number, and an annual recertification to “maintain” such number. Every new transaction done since April 10th has needed an LEI, which is required to be reported to a swap data repository (SDR) along with transaction details. Since reporting to an SDR is phased by entity type, in some cases LEIs will first be reported to an SDR beginning July 1st. But the requirement extends back in time to existing deals that were active on or after April 25, 2011, even if since matured or terminated. This is why you have been or will be contacted by your relationship bank, for your existing deal(s), asking you to obtain and report your LEI, or in some cases asking you for permission for the bank to obtain one on your behalf. Whether you intend to do a new IRS under your existing entity or not, an LEI should be obtained if your transaction is within the timing criteria.

It’s hard enough to decipher the new IRS rules, especially if your last time in the market was long before the financial crisis. But it’s even harder if you don’t know where to turn for help. If you have Dodd Frank questions, Chatham has answers, or we’ll know someone who does! Give us a call or drop us an email!