An Overview of the Taxation of Cross-Border Hedging and Notional Principal Contracts Involving CFCs

Notional principal contracts typically employ swaps and other reciprocal arrangements that provide for payments at specified intervals by a party to a counterparty calculated by reference to a specified index applied to a notional principal amount, for which the counterparty promises to pay similar amounts.

Treasury Regulation Sections 1.446-3(c)(1)(i) and 1.863-7(a)(1) define a “notional principal contract” as a financial instrument providing “for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal contract amount in exchange for specified consideration or a promise to pay similar amounts.” Interest rate swaps, currency swaps, interest rate caps, interest rate floors and other similar agreements are notional principal contracts under this definition. For example, suppose that DC, a U.S. corporation, enters into an interest swap contract with FC, an unrelated foreign corporation. Under the contract, DC must pay FC fixed rate dollar amounts, and FC must pay DC floating rate dollar amounts, each of which is determined solely by reference to a notional dollar denominated amount that is specified in the contract. This contract constitutes a notional principal contract. See Treas. Reg. Section 1.863-7(d), Ex.

U.S. individuals and businesses often use specified investment strategies to shield themselves from significant market or industry risks. In the cross-border context, many of these activities are housed in a controlled foreign corporation (“CFC”). Periodic and nonperiodic payments made or received with respect to a notional principal contract is typically taxed Section 446 of the Internal Revenue Code and its regulations. When cross-border hedging transactions are done through a CFC housing a notional principal contract, there are no specific blanket provisions of the Internal Revenue Code that tax these activities. Shareholders of a CFC involved in the hedging process could be subject to GILTI (“Net Controlled Foreign Corporation CFC Tested Income (“NCTI”), effective for tax years beginning after December 31, 2025). Cross-border hedging transactions involving CFCs that house a notional principal contract can under Subpart F, specifically as foreign personal holding company income. The first major category of foreign personal holding company is “foreign personal holding company income. Foreign personal holding company income includes most types of passive income, such as interest, dividends, rents, annuities, royalties and gains from the sale of stock, securities or other property that produces interest, dividends, rents, annuities or royalties. See IRC Sections 854(c)(1)(A) and (c)(1)(B)(i).

The definition of “foreign personal holding company income” includes net income from notional principal contracts. See IRC Section 954(c)(1)(F); H.R. Rep. No. 148, 105th Cong., 1st Sess. 543 (1997). Sometimes income from cross-border notional principal contracts involves currency gains. Income from foreign currency gains is a component of foreign personal holding company income for Subpart F purposes. For Subpart F purposes, the excess of foreign currency gains over foreign currency losses (as defined in Section 988(b)) attributable to any Section 988 transaction is classified as Subpart F income. Foreign currency gain is defined for purposes of Section 988 as gain from a Section 988 transaction to the extent such gain does not exceed gain realized by reason of changes in exchange rates on or after the booking date and before the payment date. See IRC Section 988(b)(1).

Conclusion

This article is intended to provide a very basic understanding regarding the taxation of cross-border hedging and notional principal contracts involving CFCs. This is an extremely complicated subject, especially if the U.S. investor has a significant number of transactions. Any U.S. investor that is involved in cross-border hedging transactions such consult with a qualified international tax attorney to discuss planning options and ensure that the transactions are properly reported on U.S. information and tax returns.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.