Fidelity Requests Guidance Regarding Upfront Payments on Swaps

On February 20, 2014, representatives of Fidelity Investments ("Fidelity")¹ met with you to discuss the tax treatment of upfront payments on swaps and the possibility that receipt of an upfront payment on a swap by a tax-exempt organization could give rise to unrelated business taxable income ("UBTI") as defined in sections 512 and 514 of the Internal Revenue Code.² Fidelity appreciates the willingness of the U.S. Treasury Department ("Treasury") and the Internal Revenue Service (the "Service") to meet with Fidelity and consider this issue, and Fidelity also appreciates the opportunity to submit this letter outlining its request for guidance. As discussed below, Fidelity respectfully recommends that Treasury and/or the Service issue guidance providing that receipt of an upfront payment on a swap does not give rise to UBTI provided that certain variation margin payment or collateral posting requirements are satisfied.

Tax-exempt organizations frequently use swaps in their investment portfolios, primarily as a risk management tool (e.g., to manage interest rate risk and/or credit risk in their fixed income portfolios), and, with appropriate structuring, have been able to do so for years without UBTI risk. For example, if a swap does not provide for any nonperiodic payments (and the tax exempt organization does not borrow to fund its swap payments), a tax-exempt organization can invest in the swap with no risk of generating UBTI.³ As discussed in more detail below, the swaps markets have changed significantly in recent years, prompted in particular by the Dodd-swaps markets have changed significantly in recent years, prompted in particular by the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") and the resulting advent of clearing of swaps through regulated clearinghouses.⁴ Similar changes have occurred in the non-cleared swaps markets as well.

Among the changes that have occurred with respect to both the cleared and non-cleared swaps markets is the standardization of swap terms, including coupon rates. The standardization of a swap's coupon rate often necessitates an upfront nonperiodic payment, which accounts for the difference between the standardized coupon rate and the market rate at the time of trade by equalizing the present value of the payment obligations under the swap. Under the notional principal contract regulations, a "significant" upfront payment is treated as a loan between the parties, which raises the concern that a tax-exempt organization that is the recipient of a "significant" upfront payment in these standardized markets (and thus the borrower under the deemed loan) can end up generating UBTI under the debt-financed property rules of section 514 of the Code. As discussed in more detail below, that type of "loan" does not implicate any of the policy considerations at which the UBTI rules in general, and the debt-financed property rules in particular, were aimed, and the whole of the swap contract (including the upfront payment) represents the type of ordinary and routine investment activity that tax-exempt organizations should be permitted to invest in without generating UBTI, provided that certain variation margin payment or collateral posting requirements are satisfied. Accordingly, Fidelity respectfully recommends that Treasury and/or the Service issue guidance providing that such an upfront payment cannot give rise to UBTI and thereby allow tax-exempt organizations to retain the broad access to the swaps markets they historically have enjoyed.

I. Standardization of the Swaps Markets and Proliferation of Upfront Payments

Enacted in 2010, Dodd-Frank grants regulatory oversight over swaps⁵ to the Commodity Futures Trading Commission (the "CFTC") and certain other U.S. regulators and instructs those regulators to impose certain requirements intended to decrease systemic risk and increase liquidity, efficiency and transparency in the swaps markets. As regulators have acted and continue to act on that authority and the swaps markets have responded and continue to respond to the new requirements, the menu of swaps available to investors and the costs associated with investing in those swaps have changed and will continue to change substantially.

Based on Dodd-Frank, the CFTC has authority to mandate the central clearing and exchange trading of swaps. Under the Commodity Exchange Act, as amended by Dodd-Frank (the "CEA"), certain swaps that are subject to the CEA and that have been made subject to mandatory clearing by the CFTC must be cleared with a derivatives clearing organization ("DCO" or "clearinghouse"), and a subset of those swaps is subject to trade execution requirements whereby those swaps must be executed through a designated contract market or on a swap execution facility.⁶ Only members of a clearinghouse can directly submit a swap for clearing at a clearinghouse, and thus most swap investors (i.e., those that are not members of a clearinghouse) clear their swaps, and access the applicable clearinghouse, through a clearing member (the investor's Futures Commission Merchant or "FCM"). To enter into a cleared swap, a prospective swap investor generally finds a broker willing to enter into the desired trade (i.e., willing to take the other side of the swap) and enters a swap trade with that broker. The two swap participants (i.e., the swap investor and the broker) then bring the swap to the clearinghouse through their respective FCMs, at which point the trade will be broken into two parts and the swap investor and the broker each "face-off" with the clearinghouse (i.e., the clearinghouse becomes the party to whom each party makes payments and from whom each party receives payments) through its respective FCM.

 

 

Two such requirements are that all cleared swap participants must pay/receive variation margin and must post initial margin to the clearinghouse. Variation margin protects the parties (i.e., the swap participants and the clearinghouse) from exposure to the day-to-day fair market value of the swap. If a swap appreciates, the in-the-money party would be exposed to the risk that the clearinghouse (or FCM to whom it looks for payment) will default, in which case the in-the-money party will not receive the benefit of that appreciation. Similarly, the clearinghouse would be exposed to the risk that the out-of-the-money party on the other side of the swap will default. The variation margin requirement reduces this risk by providing for the parties to make/receive payments on a daily basis such that, at a given point in time during the life of a swap, the in-the-money party will have received, and the out-of-the-money party will have paid, a net amount of variation margin equal to the current fair market value of the swap.⁸

Initial margin, on the other hand, is an amount that each swap participant must post upon entry into a swap in order to protect the clearinghouse with respect to the potential future exposure that could arise from changes in the value of the swap during the time that it takes to close out and replace the position if a swap participant defaults. The amount of initial margin required for cleared swaps is calculated by the clearinghouse based on internal models that take into account a variety of risk factors. While the variation margin requirement described above is quite similar to the collateral posting requirement that many swap participants have historically been subject to with respect to bilateral/non-cleared swaps, swap participants generally have not been subject to initial margin or similar requirements. The initial margin requirement generally makes cleared swaps more costly than bilateral swaps, as cleared swaps come with what is effectively an additional restriction on the use of a portion of the swap participant's capital.⁹ As will be discussed shortly, this cost is an important factor in the way that the swaps markets are evolving under the new regulatory regime.

One significant consequence of Dodd-Frank and central clearing has been that more and more swaps are trading with standardized terms, meaning that start date, end date and coupon rates (among other terms) are pre-determined and consistent among swap participants (as opposed to being subject to negotiation between two counterparties to a particular swap). One aspect of this standardization is that except in rare cases where the standardized coupon rate equals the market rate at the time of trade, an upfront payment is required to equalize the present value of the payment obligations under the swap contract.¹⁰ These upfront payments are the subject of this letter. An example of such an upfront payment is illustrated below.

Example 1. X enters a cleared interest rate swap with a term of 5 years and a notional value of $100 million. X is the fixed rate payer (and floating rate receiver) on the swap. The standardized fixed rate on the swap is 0.8% and the standardized floating rate is 3-month LIBOR. Payments are made annually on the last day of the year. The market rate for the party paying the fixed rate in that type of swap at the time the swap is entered is 0.55%. Because X is agreeing to pay an above-market rate, X receives an upfront payment of $1,229,637, which equals the present value¹¹ of the five off-market payments of $250,000¹² that X has committed to pay over the term of the swap.¹³

Although Dodd-Frank and the CFTC do not specifically mandate that cleared swaps have standardized terms, they effectively made standardization of cleared swaps (and thus upfront payments) inevitable. A primary reason for this inevitability relates to the fact that the only way that a swap participant can exit a cleared swap prior to maturity is by entering into an offsetting swap trade. As offset is the only method of closing out positions, exits are both facilitated and more cost-efficient when swap terms are standardized, and therefore it is economically rational for the market to evolve to standardization, as has been the case for years in the futures contract markets. A swap investor that wants to exit a cleared swap has to find a broker willing to enter a new swap trade in which the swap investor takes the opposite and offsetting position to its original swap (and the broker takes the other side of that swap), enter that swap and then bring that swap to the clearinghouse where the original swap is cleared. If (and only if) the terms of those two swaps are identical, the investor's positions in those offsetting swaps will be netted to zero and terminated, thereby compressing the investor's portfolio. Similarly, if the broker with whom the investor entered the second swap holds an offsetting swap of its own, then the broker's position in those two swaps will be netted to zero and the broker's portfolio will be compressed.

The initial margin requirements mentioned above create a significant cost to the investor and/or broker if this netting is not achieved (and thus a significant incentive to achieve netting), because if entry into the offsetting swap creates a new swap that is going to remain outstanding in the applicable party's portfolio, then that party is going to be required to post additional initial margin in respect of that new swap while also maintaining its initial margin posting in respect of its existing swaps.¹⁴ If instead the offsetting swaps are identical and therefore can be netted, then that party will not be required to post initial margin in respect of the new swap and will receive back the initial margin posted in respect of the existing swap that is being offset.

If the investor's original swap has standardized terms, it would be far more likely that there will be a broker with existing positions in that standardized swap that is willing to enter into an offsetting swap that will achieve netting (and a reduction, rather than an increase in initial margin) for both parties. Otherwise, the investor would be faced with two unappealing choices. The investor could attempt to convince a broker to enter the swap that is perfectly offsetting for the investor but triggers a new line item and thus additional initial margin requirements for the broker. Alternatively, the investor could enter into a swap that is not perfectly offsetting for the investor and thus triggers a new line item and additional initial margin requirements for the investor. Either approach would entail additional cost for the investor, as the investor would either bear the initial margin costs directly in the latter case or would have to compensate the broker for its initial margin costs in the former case. For this reason, cleared swaps have generally become standardized, as was understood and expected when Dodd-Frank was enacted, and again this standardization leads to upfront payments.

A tax-exempt (or other) investor that wants to avoid the standardization associated with cleared swaps without potentially encountering the initial-margin-related issues just described could, to a limited extent and on a temporary basis, turn to the bilateral non-cleared swaps markets and look to negotiate on-market terms (and thus no upfront payment) with a counterparty that will not require initial margin. An investor may, in fact, have no choice but to turn to bilateral non-cleared swaps markets for swap-types for which clearing is not yet available. Bilateral, non-cleared, on-market swaps are exactly the type of swap that tax-exempt investors have historically invested in without UBTI risk. However, an investor that wants to invest in those types of swaps is now going to face a number of challenges and limitations. First, the universe of swap-types that remain eligible for bilateral non-cleared trading is already limited (e.g., over 90% of interest rate swaps are already subject to mandatory clearing)¹⁵ and will continue to shrink. Second, even non-cleared swaps are becoming standardized with increasing frequency. For example, credit default swaps (including single-name credit default swaps that are not yet subject to mandatory clearing) have common documentation and standardized terms (including coupon rates, which are currently set at either 100 or 500 basis points).¹⁶ As is true for cleared swaps, upfront payments on such swaps will become increasingly prevalent as non-cleared swaps continue to become standardized.

Non-cleared swaps are becoming standardized with increasing frequency for a number of reasons. First, standardization of non-cleared swaps produces desirable consistency for transacting parties.¹⁷ Second, standardization brings similar benefits to the non-cleared markets as are being achieved in the cleared space (namely reduced risk and increased efficiency and liquidity). Third, standardization of non-cleared swaps helps prepare those markets for the margin requirements, and eventual clearing mandates, that are expected to be imposed on those types of swaps.

Dodd-Frank specifically requires the CFTC and other U.S. regulators to adopt margin requirements for non-cleared swaps.¹⁸ Although these margin requirements have not yet been finalized, it is expected, based on an international framework published in September 2013, that these rules will impose initial and variation margin requirements.¹⁹ As with cleared swaps, the margin requirements would be intended to reduce credit risk, and thus systemic risk, with respect to swaps. Initial margin requirements for non-cleared swaps are expected to be set at levels exceeding the initial margin requirements for cleared swaps specifically to encourage swap participants to clear, and thus standardize, their swaps.²⁰ Once these requirements are in place, the non-cleared swaps market is expected to become narrower as more and more swaps are voluntarily cleared to avoid the additional costs.

As should be clear, the increased volume and cost-effectiveness of standardized swaps is dictated by regulatory and market forces outside the control of tax-exempt organizations, and similarly the necessity of an upfront payment on a standardized swap is outside the control of the parties to the swap. Subsequent sections of this letter describe the specific rules that govern whether a particular activity gives rise to UBTI and the policies underlying those rules and then evaluate whether the receipt and deployment of an upfront payment on a swap ought to be viewed as the type of activity that gives rise to UBTI as a matter of a tax policy/theory (and concludes that it should not). But, before turning to that analysis, it should be noted here that a conclusion that receipt of an upfront payment on a standardized swap by a tax-exempt organization can give rise to UBTI would produce results counter to the purposes of the regulatory regime just discussed. Tax-exempt investors, which have long used swaps as an ordinary and routine portfolio management tool to manage credit and interest rate risk, would be discouraged from trading the cleared, standardized swaps that the new regulatory regime is seeking to encourage as the more desirable form of swap investing from a risk, liquidity, efficiency and transparency perspective. Tax-exempt investors instead be would be pushed toward the shrinking non-cleared, non-standardized swaps markets. Fortunately, once one considers the UBTI rules and their underlying policies and the economics surrounding receipt/deployment of upfront payments in this context, one sees that these upfront payments should not be viewed as giving rise to UBTI and that a UBTI exemption not only would achieve consistency with the desires of the CFTC and other regulators to incentivize investors to use cleared, standardized swaps, but would also represent sound tax policy.

Treasury has already issued two regulatory amendments addressing potential issues that certain taxpayers faced with respect to cleared swaps following the passage and implementation of Dodd-Frank, both of which serve to limit the tax impact of the changes to swaps. In both cases, the potential issues were presented at least in part by the increased presence of upfront/nonperiodic payments prompted by the regulatory changes discussed above and the potential treatment of those upfront/nonperiodic payments as loans under the notional principal contract regulations. Presumably, after considering the particular rules at issue and the associated underlying tax policies, Treasury determined that it was appropriate to issue the regulations limiting the tax impact of Dodd-Frank and the deemed loan rule.

The first such amendment addressed the fact that U.S. shareholders of a controlled foreign corporation ("CFC") could face a potential income inclusion under section 956 if the CFC made an upfront payment to a U.S. person in connection with a swap and an obligation of that U.S. person created by that upfront payment was deemed to constitute United States property. Responding to concerns about this issue in the post-Dodd-Frank markets where standardized swaps are prevalent, Treasury issued regulations providing that an obligation of a U.S. person created by an upfront payment on a cleared swap does not constitute United States property for this purpose regardless of whether the upfront payment is treated as a loan under the notional principal contract regulations, provided that certain requirements are satisfied.²¹

The second such amendment addressed the fact that the assignment of a swap is treated as a taxable event for the non-assigning counterparty under certain circumstances and the termination payment made between the assigner and assignee is generally treated as a nonperiodic payment (and thus potentially a deemed loan). Responding to concerns about these issues in the post-Dodd-Frank markets where one dealer/clearinghouse may assign a swap to another dealer/clearinghouse, Treasury issued regulations providing that an assignment from one dealer/clearinghouse to another dealer/clearinghouse is not a taxable event for the non-assigning counterparty (under certain circumstances), and that the termination payment made between the assignor dealer/clearinghouse and the assignee dealer/clearinghouse is not treated as a deemed loan for either the assignee or the non-assigning counterparties.²²

Both of these regulatory amendments provided welcome relief for the otherwise impacted classes of taxpayers. Fidelity believes that the UBTI issue discussed herein is worthy of similar attention and relief.

II. Notional Principal Contract Regulations/Deemed Loan Rule

Before turning to a discussion of the UBTI rules and the economics surrounding receipt and deployment of upfront payments, it is worthwhile to review the notional principal contract regulations and the deemed loan rule mentioned above. Under Treasury Regulations section 1.446-3(g)(4), a notional principal contract with a "significant"²³ nonperiodic payment is treated as two separate transactions: (i) an on-market level payment swap and (ii) a loan. If the "significant" nonperiodic payment is made at the beginning of the swap (i.e., an upfront payment), then the loan transaction is one in which the payor of the upfront payment is deemed to have loaned the amount of the upfront payment to the payee and the payee is deemed to repay the loan in periodic installments. The time value/interest component of the loan is treated as interest for all purposes of the Code and is generally determined using the discount rate (or rates) that were actually used to determine the upfront payment.

Example 2. The facts are the same as in Example 1.²⁴ Assuming that the $1,229,637 upfront payment received by X is considered "significant",²⁵ the contract is accounted for as:

III. The UBTI Rules

The analysis of whether receipt and deployment of an upfront payment on a swap ought to be treated as the type of transaction that can give rise to UBTI begins with a review of the general scope of the UBTI rules, the types of income that are specifically included in UBTI (including, in particular, income from debt-financed property), the types of income that are specifically excluded from UBTI (including, in particular, income from various ordinary and routine investment activities), and the policy considerations underlying those rules. The economics surrounding the receipt and deployment of an upfront payment can then be evaluated in light of those considerations.

Sections 511-514 of the Code impose a tax on the UBTI of a tax-exempt organization. For this purpose, UBTI is generally the gross income derived by a tax-exempt organization from any trade or business regularly carried on by it that is not substantially related to the exercise or performance of its exempt function, less certain allowable deductions directly connected to that trade or business.

Prior to the enactment of the UBTI rules, tax-exempt organizations could earn income from operations unrelated to their exempt purpose tax-free so long as the net profits were later used to further the organization's exempt purpose. Congress' primary goal in enacting the UBTI rules in the Revenue Act of 1950 (the "1950 Act") was to prevent tax-exempt organizations from unfairly competing with their taxable competitors by expanding their operations with the tax-free profits from businesses unrelated to the organization's exempt purpose.²⁶ Congress also sought to prevent tax-exempt organizations from trading on their tax-exempt status in connection with acquisitions of businesses/assets. As explained by Congress, "[t]he problem at which the tax on unrelated business income is directed here is similarly that of unfair competition. The tax-free status of [these] organizations enables them to use their profits tax-free to expand operations, while their competitors can expand only with the profits remaining after taxes. Also, a number of examples have arisen where these organizations have, in effect, used their tax exemption to buy an ordinary business."²⁷

This goal of preventing tax-exempt organizations from trading on their tax-exemption and/or generating an unfair competitive advantage in expanding their operations also led to inclusion in UBTI of income earned on debt-financed property. Such income is included in UBTI, and thus subject to tax, under section 514 of the Code.²⁸ For this purpose, debt-financed property is any property held to produce income and with respect to which there is acquisition indebtedness. Acquisition indebtedness is defined as the unpaid amount of indebtedness incurred (i) in acquiring or improving property, (ii) before the acquisition or improvement of property if the indebtedness would not have been incurred but for the acquisition or improvement, or (iii) after the acquisition or improvement of property if the indebtedness would not have been incurred but for the acquisition or improvement and the incurrence of indebtedness was reasonably foreseeable at the time of acquisition of improvement.

Much of the current debt-financed property rules of section 514, including the primary aspects of the debt-financed property rules that are at issue herein, were enacted as part of the Tax Reform Act of 1969 (the "1969 Act"). The debt-financed property rules added by the 1969 Act were a response to the Clay Brown Supreme Court Decision,²⁹ which upheld a type of transaction in which a tax-exempt organization leveraged its exempt status to acquire a business on credit without contributing much, if anything, to the transaction other than its tax-exemption. In the typical "Clay Brown" transaction, a corporate business was sold to a tax-exempt organization, often at a mark-up, and the tax-exempt organization made a small or no down payment while agreeing to pay the balance of the purchase price out of profits from the property. The tax-exempt organization then liquidated the corporation and leased the business assets back to the seller, who had formed a new corporation to operate the business. The newly formed corporation paid a large portion of its business profits as "rent" to the tax-exempt organization, which then paid most of those receipts as installment payments on the initial purchase price. In this way, a taxable business was able to realize increased after-tax income and the tax-exempt organization was able to acquire ownership of a business without the investment of its own funds.³⁰ The debt-financed property rules added by the 1969 Act provide for the tax-exempt organization participating in a "Clay Brown" transaction to be subject to tax on all or a portion of the profits/"rental" income generated on the property until the purchase price is fully paid, and more generally provide for a tax-exempt organization to be subject to tax on all or a portion of the income generated on businesses and investments acquired with borrowed funds until the applicable loan is fully repaid.³¹

While the debt-financed property rules generally cause all or a portion of the income derived by a tax-exempt organization on investments made with borrowed funds to be treated as UBTI because of the policy considerations discussed above, income earned on ordinary and routine passive investments (that do not constitute debt-financed property) is generally excluded from UBTI because it does not implicate any of the policy considerations discussed above and, more generally, because passive investment income has always been considered an appropriate source of tax-exempt income for tax-exempt organizations.³² When the UBTI rules were first enacted under the 1950 Act, dividends, interest, royalties, rents and gains from the sale of leased property were excluded from UBTI. The legislative history to the 1950 Act stated that the "committee believes that such 'passive' income should not be taxed . . . because investments producing incomes of these types have long been recognized as proper for [tax-exempt] organizations."³³ Since that time, Congress, Treasury and the Service have periodically expanded the scope of the investment income exclusions as new investment-types have become more commonplace so as to ensure that various investment activities that became ordinary and routine (including certain investment activities that have a debt-like component) do not give rise to UBTI.

One of the earlier expansions of the investment income exclusions occurred in 1976 when gains from the lapse or termination of options to buy or sell securities in connection with a tax-exempt organization's investment activities were excluded from UBTI by statute.³⁴ Congress reasoned that "[t]axing such income is inconsistent with the generally tax-free treatment accorded to exempt organizations' income from investment activities."³⁵

In 1978, the UBTI rules were further modernized to provide that income from securities lending, including income earned on the investment of collateral, was excluded from UBTI first by Revenue Ruling 78-88 and then by statute.³⁶ In the securities lending arrangements specifically contemplated by the revenue ruling, a tax-exempt organization lent securities to a brokerage house. In addition to receiving amounts equal to the dividends or interest that the organization otherwise would have derived from the securities on loan, the tax-exempt organization was compensated for the loan either (i) in the form of a pre-determined premium paid by the brokerage house or (ii) by being permitted to invest, and keep the return on, collateral posted by the brokerage house.³⁷ The ruling notes that the legislative history of the UBTI rules "indicates that Congress does not intend for ordinary or routine investment activities of a [tax-exempt organization] in connection with its securities portfolio to be treated as the conduct of a trade or business for purposes of [the UBTI rules]", and concludes that the securities lending arrangements described therein were ordinary and routine investment activities that should not produce UBTI.

Revenue Ruling 78-88 also concludes that the debt-financed property rules do not apply to the collateral arrangement. Although the tax-exempt organization was the lender (not the borrower) of the securities under the applicable securities lending arrangements, the tax-exempt organization was receiving collateral that it was free to invest and could have been viewed as borrowing the collateral, in which case the return that was generated on the collateral could have been viewed as income from debt-financed property and thus UBTI. A tax-exempt organization participating in that type of securities lending transaction was, after all, getting access to funds that it was obligated to return (i.e., the collateral), was generating a return on those funds and was effectively compensating the brokerage house for its forbearance of those funds (by allowing the brokerage house to use the securities lent). In concluding that receipt of the collateral does not implicate the UBTI rules, the ruling states that "[a]lthough the organization has the obligation to return the collateral, it has not incurred indebtedness for the purpose of making additional investments. Rather, the collateral is posted to secure the broker's obligation to deliver identical securities, and the organization is allowed to retain the income from investment of the collateral as compensation for entering into the transaction." The subsequent codification of these results (i.e., the statutory exclusion from UBTI of income from securities lending arrangements such as those described in current section 514(c)(8) of the Code) affirms the ruling's conclusion and effectively affirms its reasoning.

In 1992, two more additions were made to the list of investment income-types excluded from UBTI under Treasury Regulations section 1.512(b)-1(a). First, income from notional principal contracts was added and thus specifically excluded from UBTI. Second, "other substantially similar income from ordinary and routine investments to the extent determined by the Commissioner" was added, thereby giving the Commissioner explicit authority to issue rulings excluding other types of investment income from UBTI.³⁸ The preamble to the regulations indicates that the amendments were based on the fact that "the legislative history indicates that Congress intended to exclude investment income from UBTI".³⁹ The preamble also indicates that for purposes of defining the scope of investments that the Commissioner has the authority to exclude from UBTI, "[t]he Service and the Treasury Department intend the phrase ordinary and routine in this context to mean investments which are ordinarily and routinely engaged in by investors in capital, commodity, and similar financial markets."⁴⁰

The foregoing summary of the scope and intent of the UBTI rules does not, by itself, offer a direct and definitive answer to the question of whether or not the bifurcation of a swap involving a significant upfront payment into an on-market swap and a loan under the notional principal contract regulations ought to cause a tax-exempt organization that is the borrower under the "loan" to end up with debt-financed property and thus UBTI. It does provide a framework for evaluating the issue, however. Based on the foregoing, it is entirely clear that income from ordinary and routine passive investments made by tax-exempt organizations is intended to be excluded from UBTI; that swaps are considered an ordinary and routine passive investment; and that swap income is excluded from UBTI. It is also clear that the universe of investment activities the income from which is excluded from UBTI is intended to evolve and expand so as to ensure that tax-exempt organizations have access to investment activities that become ordinary and routine as investment markets and practices change without risk of generating UBTI. In light of the regulatory and market changes discussed above, Fidelity believes that investing in a cleared or non-cleared swap with an upfront payment (and the associated variation margin payment or collateral posting requirements) is now an ordinary and routine investment of this kind and that any and all income derived from this type of investment (including, in particular, income generated on the deployment of the upfront payment) ought to be excluded from UBTI.

The further modernization of the UBTI rules that Fidelity requests could be accomplished by revenue ruling or regulatory amendment. The simplest path may be for the Service to issue a revenue ruling pursuant to the authority given to the Commissioner under Treasury Regulations section 1.512(b)-1(a). Given the evolution and standardization of the swaps markets described above, cleared and non-cleared swaps with upfront payments are now undeniably investments "ordinarily and routinely engaged in by investors in capital, commodity, and similar financial markets". Such swaps are therefore exactly the type of investment activity contemplated by Treasury Regulations section 1.512(b)-1(a). Alternatively, if Treasury believes that a regulatory change is required or appropriate, Treasury could amend the applicable regulations to provide for a similar result (as was done in the context of section 956 and 1001 as described above).

In light of the rulings referenced above on securities lending and short sales, the presence of a debt-like component within an investment activity should not be a barrier to either form of relief. The determination of whether Treasury or the Service ought to grant relief should be based on an evaluation of whether the economics surrounding the receipt and deployment of an upfront payment represent the type of economics that the investment income exclusions ought to exempt or whether these economics implicate a tax policy consideration that should override a potential investment income exclusion (and in particular, whether receiving an upfront payment on a swap offers a tax-exempt investor the opportunity to trade on its tax-exemption and/or generate an unfair competitive advantage in expanding its operations). For the reasons described below, we believe that the economics surrounding an upfront payment support the conclusion that receipt and deployment of an upfront payment should not give rise to UBTI when certain conditions are satisfied.

IV. Economics/Analysis for Cleared Swaps

Coupon payments are periodic payments made or received on coupon payment dates over the life of the swap (generally quarterly, semi-annually or annually). On an interest rate swap, the coupon payments would be the fixed and floating rate payments made over the life of the swap. For example, the 0.8% * $100 million annual fixed payments and the 3-month LIBOR * $100 million annual floating payments in Example 1 above are coupon payments.

An upfront payment is a payment made on settlement date of the swap in circumstances where the actual coupon rates on the swap are different from the market coupon rates at the time of trade. The upfront payment is made by the party that is "in-the-money" at the time of trade (i.e., the party who is making below-market payments or receiving above-market payments) to the clearinghouse and from the clearinghouse to the "out-of-the-money" party in order to make the "out-of-the-money" party whole for the off-market rate and equalize the present value of the payment obligations under the contract. The $1,229,637 payment in Example 1 above is an upfront payment.

An initial variation margin payment⁴² is a payment made by a party receiving an upfront payment, and received by a party making an upfront payment, to reduce credit risk associated with the upfront payment and the initial value of the swap.⁴³ A party making an upfront payment has credit risk because if the clearinghouse were to default, that party would not receive the full benefit it paid for (i.e., the benefit of making below-market payments or receiving above-market payments over the term of the swap).⁴⁴ To reduce this credit risk, the party receiving the upfront payment makes an initial variation margin payment to the clearinghouse and the clearinghouse makes an initial variation margin payment to the party making the upfront payment. The amount of the initial variation margin payment is equal to the amount of the upfront payment, adjusted for changes in value between the time of trade and the time the initial variation margin payment is determined. For example, in Example 1, X received an upfront payment of $1,229,637and X makes an initial variation margin payment of $1,229,637 (adjusted for any changes in value as just described).

Daily variation margin payments are made in an amount equal to the daily change in fair market value of the contract in order to manage credit risk. A daily variation margin payment is made by the party that experienced a decline in the value of the contract to the clearinghouse and by the clearinghouse to the party who experienced an increase in value so as to ensure that the party who is "in-the-money" at a particular point in time has generally received cash equal to the present value of the contract. In this way, the credit risk is minimized.

Price alignment interest ("PAI") is overnight interest paid (typically at the overnight federal funds rate) on total/net initial variation margin and daily variation margin outstanding. The party receiving a variation margin payment is free to invest, and keep the return on, those funds. In order to make the party paying that variation margin whole for forbearing the use of those funds, the party holding net variation margin pays to the clearinghouse, and the party that has paid net variation margin receives from the clearinghouse, this daily interest.

Example 3. Assume the same facts as Example 1, except that the fixed rate on the swap is equal to the market rate of 0.55% so there is no upfront payment or initial variation margin payment. The swap is a 5-year 0.55%-to-3-month-LIBOR swap with a notional value of $100 million. Payments are made on the last day of the year. X is the fixed rate payer (and floating rate receiver) on the swap. Assume also that X is a tax-exempt organization.

In this case, the two types of income that X could generate directly on the swap, namely periodic coupon payments and a termination payment, are clearly excluded from UBTI. A periodic payment received on a cleared swap is excluded from UBTI under Treasury Regulations section 1.512(b)-1(a), which as noted above excludes income from notional principal contracts. A termination payment received would be excluded from UBTI under section 512(b)(5) of the Code which excludes gains from the sale, exchange or other disposition of investment property.

The remaining items of income left to consider with respect to a cleared swap without an upfront payment relate to income potentially earned with respect to daily variation margin.

As noted above, as the value of the swap changes, X will make or receive daily variation margin payments equal to the change in fair market value of the swap. A daily variation margin payment itself is not an item of income, but rather is the equivalent of a posting of collateral. X, however, likely will generate some income associated with the daily variation margin whether X is the payer of daily variation margin or the recipient of daily variation margin. If the value of the swap moves against X (i.e., X is out-of-the-money on the swap), then X will pay daily variation margin and will receive PAI on its net variation margin balance outstanding. PAI received would be excluded from UBTI either as interest or as income from a notional principal contract.⁴⁵ If the value of the swap moves in X's favor (i.e., X is in-the-money on the swap), then X will receive daily variation margin that X is free to invest. Any income earned on the investment of the daily variation margin would be excluded from UBTI under the reasoning of Revenue Ruling 78-88, which, as discussed above, excludes income generated on collateral received in connection with a securities lending arrangement from UBTI.

Example 4. Assume the same facts as Example 3, except that 3-month LIBOR increases to 0.65% on day 2 of the swap and remains at 0.65% for the remaining term of the swap.

In this case, the increase in the 3-month LIBOR rate causes the value of the swap (i.e., the net present value of potential future cash flows) to move in X's favor and X receives a daily variation margin payment of $491,855 on day 2 of the swap based on the change in value of the swap.⁴⁶ X is free to invest that cash and keep the return. As additional days pass and future payment dates approach, the value of the swap increases for X. X consequently receives additional daily variation margin payments that it is free to invest. As noted above, this variation margin serves to reduce the risk that X will not receive future periodic payments if the clearinghouse were to default and thus acts as a form of collateral. When the first periodic payment of $100,000 is received by X at the end of year 1, the remaining value of the swap declines by an equal or similar amount (since the value of the swap then represents the present value of four, rather than five, potential future payments)⁴⁷ and X makes an equivalent variation margin payment. At the end of year 1, X thus holds $393,584 of net variation margin (i.e., the present value, at that point, of four potential future $100,000 payments). Similar events occur in years 2-5, with the result that X will receive five $100,000 coupon payments over the term of the swap (since 3-month LIBOR remained at 0.65% after day 2) and will repay all of the variation margin received. These economic results are summarized on an annual basis in the table below.⁴⁸ (X also pays daily PAI on the outstanding variation margin, which is not shown in the table).

                       Year 1      Year 2      Year 3      Year 4      Year 5

First, any upfront payment received by a tax-exempt organization is immediately returned in the form of an offsetting payment of initial variation margin.⁴⁹ Accordingly, a tax-exempt organization cannot enter into an off-market cleared swap in order to get access to loan proceeds as any such proceeds will be immediately deployed in the form of initial variation margin.

Second, although the tax-exempt organization will generate income on the embedded loan proceeds in the form of PAI on the initial variation margin posted, the tax-exempt organization is not incurring the "indebtedness" in an attempt to generate a net profit on those loan proceeds. The presence of the upfront payment, the initial variation margin payment and the associated cash flows are intended to be an economic wash that nets the parties back to the economics of an on-market swap (the income from which is clearly not UBTI, as described above). In fact, the discount rate(s) used in the present value calculation that determines the amount of the upfront payment is generally the rate(s) at which PAI is paid on the variation margin, such that (as of the time of trade) the income earned on the upfront payment (i.e., the PAI received on the initial variation margin payment made with the upfront payment proceeds) is expected to offset the implied interest paid on the deemed loan.⁵⁰

Example 5. Assume that the facts are the same as Example 1,⁵¹ except that 3-month LIBOR remains at 0.55% for the entire term of the swap. Assume also that X is a tax-exempt organization. X receives the upfront payment of $1,229,637 and immediately pays an offsetting amount of initial variation margin. Over the term of the swap, X makes five annual net coupon payments of $250,000 and receives total daily variation margin payments of $1,229,637 (i.e., receives back its initial variation margin paid) as shown in the following table.

                       Year 1      Year 2      Year 3      Year 4      Year 5

From a tax perspective, as indicated in Example 2, the transaction is accounted for as (i) an on-market 0.55%-to-LIBOR swap and (ii) a loan of $1,229,637 that X repays by way of five annual level payments of $250,000. Those two components are accounted for as shown in the tables below, with X recognizing no net swap income/deduction on the on-market swap and X recognizing interest deductions from the loan in the amounts shown in the "Time Value (Interest) Component" column. X also recognizes as income the PAI received (not depicted in the table). As mentioned above, under these circumstances, the PAI would generally equal and thereby offset the interest deductions from the loan. Note that the principal balances and principal payments/amortization on the loan are equal and offsetting to the variation margin balances and payments shown in the preceding table, reflecting again the notion that the economics surrounding the receipt and deployment of the upfront payment are intended to be an economic wash not just at the time of trade but over the term of the swap.⁵²

                         On-Market 0.55%-to-LIBOR swap

One consideration is that, because PAI is generally paid based on a floating rate (typically the overnight federal funds rate) the overnight interest that a tax-exempt organization receives on the outstanding variation margin balance originally paid with the proceeds of the upfront payment over the life of the swap may differ from the interest implied in determining the upfront payment (because, to state the obvious, the implied interest is fixed at the outset of the swap). In that way, the tax-exempt organization may end up earning more or less income on the deployment of the upfront payment than it pays in implied interest embedded in the off-market payments. This possibility (or even likelihood) does not seem worthy of triggering the UBTI rules. Because the tax-exempt organization must immediately return the upfront payment in the form of initial variation margin, the organization has no discretion with respect to the use of the funds. A tax-exempt organization would not be entering into the off-market swap with a view toward receiving the upfront payment and "investing" it in variation margin so as to speculate on the potential fluctuation of the overnight federal funds rate. It is not entering into the off-market swap in order to trade on its tax-exemption nor will it benefit from an unfair competitive advantage that it can use to expand its operations by possibly deriving some income on "borrowed" funds solely through a favorable fluctuation in the overnight interest rates. Rather, the tax-exempt organization is attempting to invest effectively in an on-market swap, which has long been viewed as the type of ordinary and routine investment activity that a tax-exempt organization can engage in without generating UBTI. As explained earlier, the economics surrounding the receipt and deployment of the upfront payment are intended to equalize the present value of the payments and replicate an on-market swap, and any net income earned on the deployment of the upfront payment based on a favorable fluctuation in the overnight PAI rate should be viewed as the type of passive investment income from an ordinary and routine investment activity that is excluded from UBTI.⁵³

The other consideration if rates move is that, if the value of the swap moves in favor of the tax-exempt organization who received the upfront payment (and paid the initial variation margin), that organization will receive a daily variation margin payment thereby reducing the outstanding variation margin balance associated with the swap to an amount that's lower than the outstanding principal balance of the deemed loan. This may appear to present a scenario in which the tax-exempt organization could end up with unfettered access to some or all of the deemed loan proceeds. In other words, under these circumstances it may seem that some or all of the initial variation margin payment made by the tax-exempt organization to offset the upfront payment is returned to the tax-exempt organization prior to a principal payment being made on the deemed loan. This scenario should not implicate the UBTI rules. At the time that the tax-exempt organization enters the swap, it does not know that the value is going to move in its favor and it would not be entering into the swap in order to trade on its tax exemption or to generate an unfair competitive advantage by expanding its operations with loan proceeds that it would only receive unfettered access to if the swap value subsequently fluctuates in its favor. Moreover, if the value of the swap does end up moving in favor of the tax-exempt organization, a careful consideration of the economics reveals that the tax-exempt organization's receipt of daily variation margin payments attributable to favorable fluctuations in the value of the swap are akin to daily variation margin payments that would have been received if the tax-exempt organization had entered into the on-market version of the swap (without an upfront payment) and similar market movements occurred. As discussed above, daily variation margin payments on on-market swaps (without upfront payments), like in Example 4, are properly viewed as not giving rise to UBTI in light of the reasoning in Revenue Ruling 78-88, and daily variation margin payments on off-market swaps (with upfront payments) should be similarly viewed as not giving rise to UBTI.

Example 6. Assume that the facts are the same as Example 5,⁵⁴ except that on day 2 of the swap, 3-month LIBOR increases to 0.65% and remains at 0.65% for the remaining term of the swap.

As in Example 4, where X entered into an on-market 0.55%-to-LIBOR swap and LIBOR increased to 0.65% on day 2 and remained at 0.65% for the remaining term of the swap, the increase in LIBOR causes the value of the 0.8%-to-LIBOR swap to increase from X's perspective, and as a result X receives a daily variation margin payment. The precise impact of the increase in LIBOR on the valuation of, and variation margin movements with respect to, the 0.8%-to-LIBOR swap depends on the discount rate(s) used for purposes of the valuation. If one assumes (as was assumed in Example 4), that the value of the swap (and thus the variation margin outstanding) at a given point equals the present value of the potential future payments determined based on the difference between then-current LIBOR and the fixed rate and discounted in all cases using the same 0.55% discount rate as was used to determine the $1,229,637 upfront payment, then the day 2 change in LIBOR should have the exact same economic impact on the off-market 0.8%-to-LIBOR swap in this Example 6 as it had on-market 0.55%-to-LIBOR swap in Example 4.

Under those circumstances, X receives a daily variation margin payment of $491,855 on day 2 of the 0.8%-to-LIBOR swap in this Example 6 based on the increase in swap value caused by the change in LIBOR,⁵⁵ and X is free to invest that cash and keep the return. X received this exact same daily variation margin payment in Example 4, where X entered the on-market 0.55%-to-LIBOR swap and LIBOR increased to 0.65% on day 2. As a result of the daily variation margin payment received by X in this case, X's total/net variation margin outstanding at the end of day 2 is reduced to $737,782, and, at the end of year 1, X's variation margin outstanding is down to $591,840. Thus, as of the end of year 1, X's variation margin outstanding is $394,560 less than the $986,400 principal balance on the deemed loan, and thus X has $394,560 that it is free to invest at the end of year 1, just as X did at the same point in Example 4 where X entered the on-market version of the swap. In fact, if you compare the cash flows and tax consequences in this example (shown in the tables below) to the cash flows and tax consequences in Example 5 (where X entered into the same swap but interest rates remained constant) and Example 4 (where X entered into an at market 0.55%-to-3-month LIBOR swap and LIBOR fluctuated to 0.65%), you see that the cash flows and the tax consequences in Example 4 are equal to the difference between the cash flows in this Example 6 and the cash flows in Example 5.⁵⁶ Given the economic comparability, the receipt of daily variation margin payments by a tax-exempt organization following a favorable change in swap value should be just as non-problematic from a UBTI perspective on a swap with respect to which it received an upfront payment (e.g., this Example 6) as it is on an on-market swap with respect to which there was no upfront payment (e.g., Example 4).

                       Year 1      Year 2      Year 3      Year 4      Year 5

                         Off-Market 0.8%-to-LIBOR swap

Based on the foregoing, there is nothing in the economics surrounding the receipt and deployment of an upfront payment on a cleared swap that implicates any of the tax considerations at which the UBTI rules were aimed. A tax-exempt organization cannot enter into an off-market cleared swap in order to get access to loan proceeds, as any such proceeds will be immediately deployed in the form of an offsetting amount of initial variation margin. Although the tax-exempt organization will generate income on that variation margin (i.e., on the embedded "loan" proceeds) in the form of PAI, the tax-exempt organization is not incurring the "indebtedness" in an attempt to generate a net profit on those loan proceeds. The presence of the upfront payment, the initial variation margin payment and the associated cash flows are generally an economic wash that nets the parties back to the economics of an on-market swap (the income from which is clearly not UBTI, as described above), and when understood in this way, it is evident that upfront payments on cleared swaps should not be treated as implicating the UBTI rules.

V. Economics/Analysis for Non-Cleared Swaps Subject to Margin Requirements

Non-cleared swaps are not yet subject to margin requirements, but, as discussed in Section I of this letter, Dodd-Frank specifically requires the CFTC and other regulators to adopt margin requirements for non-cleared swaps and, based on an international framework published in September 2013,⁶¹ it is anticipated that when these requirements are adopted they will require counterparties to non-cleared swaps to exchange variation margin.⁶²

The cash flows on a non-cleared swap subject to margin requirements would be essentially the same as the cash flows described with respect to cleared swaps in Section IV.A of this letter except that the cash flows would be exchanged directly between the counterparties instead of with a clearinghouse/FCM. In particular, a party receiving an upfront payment would be required to pay, and a party making an upfront payment would be entitled to receive, an initial variation margin payment to reduce credit risk with respect to the initial value of the swap, with the amount of the initial variation margin payment being equal to the amount of the upfront payment, adjusted for changes in value between the time of trade and the time the initial variation margin payment is determined. In addition, the parties would exchange daily variation payments equal to the change in fair market value of the swap so as to ensure that the party who is "in-the-money" at a particular point in time has generally received, and the party who is "out-of-the-money" at that point in time has generally paid, cash equal to the present value of the contract.

With this construct in place, all of the economic considerations discussed above with respect to cleared swaps would also apply to non-cleared swaps that are subject to margin requirements and there would be nothing in the economics surrounding the receipt and deployment of an upfront payment on such a swap that implicates any of the tax considerations at which the UBTI rules were aimed. A tax-exempt organization could not enter into an off-market non-cleared swap in order to get access to loan proceeds as any such proceeds would be immediately returned in the form of an offsetting amount of initial variation margin. Although the tax-exempt organization would generate income on that variation margin (i.e., on the embedded loan proceeds) in the form of PAI (which is expected to be a component of the margin requirements for non-cleared swaps), the tax-exempt organization would not be incurring the indebtedness in an attempt to generate a net profit on those loan proceeds. The presence of the upfront payment, the initial variation margin payment and the associated cash flows would generally be an economic wash that nets the parties back to the economics of an on-market swap (the income from which is clearly not UBTI, as described above).

VI. Economics/Analysis for Collateralized Non-Cleared Swaps

Until margin requirements for non-cleared swaps take effect, the cash flows on non-cleared swaps are somewhat different from the cash flows on cleared swaps.

As with cleared swaps, non-cleared swaps involve coupon payments, i.e., periodic payments made or received on coupon payment dates over the life of the swap (generally quarterly, semi-annually or annually). On non-cleared swaps, the coupon payments (and the other cash flows to be discussed) are exchanged between the counterparties directly instead of with a clearinghouse/FCM.

As with cleared swaps, a non-cleared swap with coupon rates that differ from the market coupon rates at the time of trade will involve an upfront payment made on the settlement date of the swap. As noted above, upfront payments occur and will continue to occur on non-cleared swaps with increasing frequency as non-cleared swaps become increasingly standardized.

Unlike cleared swaps, counterparties currently do not exchange initial variation margin or daily variation margin. Instead, credit risk with respect to the current value of a non-cleared swap is typically minimized by collateral requirements.

A party receiving an upfront payment on a non-cleared swap is generally required, pursuant to the Credit Support Index to the ISDA Master Agreement governing the swap, to post collateral to reduce credit risk associated with the upfront payment and the initial value of the swap. The value of the initial collateral posted generally equals the amount of the upfront payment, adjusted for changes in value between the time of trade and the time the initial collateral requirement is determined. On a daily basis over the term of the swap, additional collateral is posted or outstanding collateral is recalled in an amount generally equal to the daily change in value of the swap so as to ensure that the amount of collateral outstanding at a given point in time is generally equal to the present value of the swap at that point in time.

The collateral requirements that currently apply to non-cleared swaps are thus similar to the variation margin requirements that apply to cleared swaps (and that will eventually apply to non-cleared swaps). There are three noteworthy differences, however. First, many non-cleared swap investors are permitted to satisfy their collateral requirements by posting securities in-kind (e.g., high quality government debt or, in some cases, high quality corporate debt and/or certain equities). Second, the return on the collateral posted belongs to the party posting the collateral. The in-the-money party does not receive access to the collateral and thus does not have to pay (and the out-of-the-money party does not receive) PAI.⁶³ Third, a party's collateral requirements are often subject to minimum transfer amount thresholds under the terms of the applicable bilateral swap agreement. As a result, (i) a party may not be required to post collateral at all if the value of its total swap exposure to a particular counterparty is below a certain threshold; (ii) daily changes in value may not lead to the posting of additional collateral or the recall of outstanding collateral unless and until the change in value reaches a particular threshold; and (iii) the value of collateral required to be posted may be rounded off to values above or below the actual value of the swap exposure.⁶⁴

Example 7. Assume that, as in Examples 5 and 6, X, a tax-exempt organization, enters into a 5 year 0.8%-to-3-month LIBOR interest rate swap with a notional value of $100 million at a time when the market rate for the party paying the fixed rate is 0.55%. Assume that, as in Examples 5 and 6, X receives an upfront payment of $1,2229,637, but assume that in this case the swap is a non-cleared swap that is subject to collateral requirements.⁶⁵ Depending on the terms of X's swap agreements, X may be required to post collateral with a value of $1,229,637 if X's swap agreements do not provide for any minimum transfer amounts or if the minimum transfer amount provisions are not implicated under these facts. Another possibility is that X may be required to post collateral with a value of, for example, $1.2 or $1.3 million if X's swap agreements provide for collateral requirements to be rounded off. A third possibility is that X may be required to post no collateral if X's swap agreements provide for a minimum transfer amount threshold that exceeds the $1,229,637 swap value.⁶⁶ Any amount of collateral that X is required to post may be eligible to be posted in cash, in high quality government debt, in high quality corporate debt and/or certain equities depending on the terms of the collateral arrangement.

Based on the foregoing, Fidelity acknowledges that the economics surrounding the receipt and deployment of an upfront payment on a non-cleared swap that is subject to collateral requirements do not present as clear-cut a case for a UBTI exemption as an upfront payment on a cleared swap does or an upfront payment on a non-cleared swap that is subject to margin requirements would. Minimum transfer amount thresholds offer some investors the opportunity to derive immediate unfettered access to some or all of the upfront payment/deemed loan proceeds to the extent that amount is below the minimum transfer amount thresholds. In addition, to the extent that an investor does have to post and maintain collateral, the investor may have flexibility to post the collateral in the form of a sufficient range of security-types that enables the investor to attempt to produce a return on the collateral that surpasses the implied interest on the embedded loan associated with the upfront payment.

Nevertheless, Fidelity believes that upfront payments on non-cleared swaps that are subject to collateral requirements should not be treated as implicating the UBTI rules. The initial and ongoing collateral requirements on non-cleared swaps provide for limitations on the use of the upfront payment/deemed loan proceeds and the ability of a tax-exempt organization to incur indebtedness embedded in a non-cleared swap transaction in an attempt to generate a net profit on those borrowed funds. Although minimum transfer amount thresholds and flexibility with respect to eligible collateral-types could offer certain tax-exempt organizations an opportunity to actively seek some profit from an embedded loan, such allowances arise when they are regarded as de minimis from an economic perspective, and they should be viewed as similarly de minimis from a UBTI perspective.

The ability of a tax-exempt organization to generate a net return on an upfront payment (whether enabled by a minimum transfer amount threshold or the range of eligible collateral-types) does not seem any more prone to abuse than the ability of a tax-exempt organization, as described in Revenue Ruling 78-88, to lend securities in exchange for temporary access to, and the opportunity to generate a return on, collateral without UBTI risk. Any return that a tax-exempt organization can derive out of the flexibility offered by minimum transfer amount thresholds or eligible collateral provisions should be viewed as the product of negotiations between the parties and compensation for entering into an ordinary and routine investment (i.e., a swap trade) and exempted from UBTI. The additional latitude that this aspect of the requested relief would offer seems particularly appropriate given that tax-exempt organizations are simply attempting to maintain similar access to swaps they've historically had and the only change is that such swaps are becoming standardized due to forces and considerations outside of the control of the tax-exempt organizations. Furthermore, given that this aspect of the relief would be necessarily temporary in that, as discussed elsewhere in the letter, non-cleared swaps will eventually be subject to margin requirements (and potentially mandatory clearing), this additional latitude seems even more appropriate.

If, notwithstanding the above, Treasury and the Service do not believe it is appropriate to grant UBTI relief with respect to non-cleared swaps that are subject to a minimum transfer amount thresholds and/or a broad range of eligible collateral-types, Fidelity encourages Treasury and the Service to grant more limited relief with respect to non-cleared swaps that are subject to collateral requirements without minimum transfer amount thresholds and with a narrowly defined class of eligible collateral (e.g., cash or high quality government debt). This would allow tax-exempt organizations whose standard swap documentation already satisfies those requirements or who modify their standard terms to satisfy those requirements to invest in the current non-cleared swaps markets without the UBTI risk associated with upfront payments. The economics surrounding the receipt and deployment of an upfront payment on a non-cleared swap of this type would be analogous to the economics surrounding the receipt and deployment of an upfront payment on a cleared swap or a non-cleared swap subject to margin requirements.

VII. Conclusion

The standardization of the cleared and non-cleared swaps markets and the associated proliferation of upfront payments prompted by the regulatory changes mandated by Dodd-Frank raise a difficult issue for tax-exempt organizations that have long used swaps as an ordinary and routine portfolio management tool to manage interest rate risk and/or credit risk in their investment portfolios without UBTI risk. A tax-exempt organization that receives an upfront payment on a swap has to confront the concern that that upfront payment may be treated as a loan under the notional principal contract regulations and thus may give rise to UBTI under the debt-financed property rules. In the absence of guidance from Treasury or the Service, this UBTI concern will discourage tax-exempt organizations from investing in the standardized swaps that the new regulatory regime is seeking to encourage as the more desirable form of swap investing, and would push tax-exempt organizations toward the shrinking (and eventually more expensive) non-cleared, non-standardized swaps markets and the very type of swap that regulators are trying to discourage. This is particularly unfortunate given that the type of upfront payment in question does not implicate the policy considerations at which the UBTI rules in general, and the debt-financed property rules in particular, were aimed and the whole of the swap contract (including the upfront payment) represents the type of ordinary and routine investment activity that tax-exempt organizations should be permitted to invest in without generating UBTI.

A review of the UBTI rules and the underlying policy and history shows that income from ordinary and routine passive investments (including swaps) made by tax-exempt organizations is intended to be excluded from UBTI. It also demonstrates that the universe of investment activities the income from which is excluded from UBTI is intended to evolve and expand so as to ensure that tax-exempt organizations have free access to investment activities that become ordinary and routine as investment markets and practices change. Further, the presence of a debt-like component within an investment activity is not necessarily a barrier to a UBTI exclusion. Given the evolution and standardization of the swaps markets described above, cleared and non-cleared swaps with upfront payments are now clearly investments "ordinarily and routinely engaged in by investors in capital, commodity, and similar financial markets"⁶⁷ and thus exactly the type of investment activity that should be excluded from UBTI.

The foregoing review of the economics surrounding the receipt and deployment of an upfront payment on a swap that is subject to variation margin requirements (both cleared and non-cleared) indicates the economic similarity between an on-market swap (the income from which is clearly excluded from UBTI) and an off-market swap with an upfront payment. The variation margin requirements ensure that receipt of such an upfront payment does not implicate a tax policy consideration that should trigger the UBTI rules. Receipt of an upfront payment on a swap that is subject to variation margin requirements does not offer a tax-exempt organization the opportunity to trade on its tax-exemption and/or to generate an unfair competitive advantage in expanding its operations. A tax-exempt organization cannot enter into an off-market cleared swap in order to get access to loan proceeds, as any such proceeds will be immediately returned in the form of an offsetting amount of initial variation margin. Although the tax-exempt organization will generate income on that variation margin (i.e., on the embedded loan proceeds) in the form of PAI, the tax-exempt organization is not incurring the "indebtedness" in an attempt to generate a net profit on those loan proceeds. The presence of the upfront payment, the initial variation margin payment and the associated cash flows are generally an economic wash that nets the parties back to the economics of an on-market swap (the income from which is clearly not UBTI). Similarly, non-cleared swaps, which are not yet subject to margin requirements but are subject to collateral maintenance requirements, should be viewed as providing for comparable economic results.

In light of this analysis, Fidelity urges Treasury and/or the Service to issue guidance providing that receipt of an upfront payment on a swap cleared with a clearinghouse and subject to variation margin requirements does not give rise to UBTI.⁶⁸

Furthermore, Fidelity urges Treasury and/or the Service to extend that guidance to provide that receipt of an upfront payment on a non-cleared swap that is subject to variation margin requirements similarly does not give rise to UBTI. As discussed above, although margin requirements do not yet apply to non-cleared swaps, it is just a matter of time. Dodd-Frank requires regulators to impose margin requirements on non-cleared swaps and regulators have already established a framework for those requirements.

Lastly, Fidelity urges Treasury and/or the Service to extend that guidance further to provide that receipt of an upfront payment on a non-cleared swap that is subject to collateral requirements does not give rise to UBTI. Fidelity recommends that that guidance include upfront payments on non-cleared swaps with collateral requirements that include minimum transfer amount thresholds and/or a range of acceptable forms of collateral (i.e., cash, high quality government debt, high quality, corporate debt and/or equities). However, if Treasury and the Service do not believe it is appropriate to grant UBTI relief that is that broad, Fidelity would encourage Treasury and the Service to grant more limited relief with respect to non-cleared swaps that are subject to collateral requirements without minimum transfer amount thresholds and with a narrowly defined class of eligible collateral (e.g., cash or high quality government debt).

The relief requested could be provided in the form of a revenue ruling issued by the Service pursuant to the authority given to the Commissioner under Treasury Regulations section 1.512(b)-1(a) to exclude from UBTI "other substantially similar income from ordinary and routine investments to the extent determined by the Commissioner". Alternatively, the relief requested could be provided in the form of a regulatory amendment made by Treasury, as was done in the context of sections 956 and 1001 as described above.⁶⁹

This relief would reduce tax uncertainty and risk for tax-exempt organizations seeking to retain the broad access to swaps markets they have historically had as the swap markets move toward standardization, lower risk, and higher efficiency/transparency/liquidity as envisioned by Dodd-Frank. Fidelity urges Treasury and the Service to provide this relief as soon as practicable.

We thank Treasury and the Service for your consideration of this Letter. We would be pleased to provide any further information or respond to any questions that Treasury or the Service may have. If it would be helpful to discuss the content of this letter further, please contact Christopher DiJulia at 603-791-8157 or Jessica Reif Caplan at 617-563-4412.

² Unless otherwise indicated, all section references herein are to the Internal Revenue Code of 1986, as amended (the "Code").

³See, e.g., Treas. Reg. section 1.512(b)-1(a)(1) (providing that income from notional principal contracts is not UBTI). A tax-exempt organization could also in vest in a swap with a nonperiodic payment and not be at risk of generating UBTI depending on the timing, direction and (at least arguably) the size of the nonperiodic payment, generating UBTI depending on the timing, direction and (at least arguably) the size of the nonperiodic payment.

⁴ Pub. L. No. 111-203, 124 Stat. 1376 (2010).

⁵ Dodd-Frank also impacts other types of derivatives but this letter focuses on swaps because of the issue addressed herein. The definition of "swap" for purposes of Dodd-Frank is broader than the definition of "notional principal contract" under Treasury Regulations section 1.446-3 and includes interest rate swaps, currency swaps, equity swaps of various types, credit default swaps and swaps on other commodities. 7 U.S.C. § 1a(47).

⁶ 7 U.S.C. § 2(h).

⁷ Clearinghouses already clear a number of swap-types that are not yet subject to mandatory clearing.

⁸ Variation margin is discussed in more detail in section IV of this letter.

⁹ As outlined further below, non-cleared swaps will soon be more expensive than cleared swaps (and more expensive than historic non-cleared, bilateral swaps).

¹⁰ One example of a standardized product that has developed in this space is the Market Agreed Coupon interest rate swap contract ("MAC"). The MAC rates are determined by the Securities Industry and Financial Markets Association ("SIFMA") and the International Swaps and Derivatives Association ("ISDA"). MACs have standardized terms, including the coupon rates, which are announced approximately 6.5 months prior to the start date of the swap. Because the fixed rate is set in advance of the start date of the swap, it highly is unlikely that the fixed rate will equal the market rate on the start date of the swap, and thus a party entering a MAC contract on the start date of the swap will almost certainly be required to make/receive an upfront payment to account for the difference in rates. A MAC contract can also be entered into on a forward basis between the date that the fixed rate is announced and the start date on the swap, but even under those circumstances an upfront payment is almost certainly going to be required at the time of trade to account for the differential at that point between the fixed rate and applicable forward rates, and that payment will be treated as an upfront payment on the swap if/when the swap commences. See Treas. Reg. 1.446-3(g)(3).

¹¹ For purposes of this example, a discount rate of 0.55% was used in the present value calculation.

¹² The five off-market payments of $250,000 referenced here are the difference between the five annual payments of $800,000 (0.8% fixed rate times $100 million notional) that X has committed to pay and the five annual payments of $550,000 (0.55% market rate times $100 million notional) that X would have committed to pay if the swap had "on-market" terms (i.e., if the fixed rate on the swap were the market rate).

¹³ X is also required to post initial margin (not to be confused with the upfront payment of $1,229,637) and to pay variation margin.

¹⁴ In addition, that party is going to have to account for the upfront payment that will almost certainly be paid/received on that swap given that the original swap (and thus the offsetting swap) will almost certainly have embedded value at the time of trade. If entry into the offsetting swap nets to zero with an existing swap position, then the "upfront payment on the offsetting swap" is logically accounted for as a termination payment on the existing swap position.

¹⁵ Currently any fixed-to-floating interest rate swap or basis swap with a tenor of 28 days to 50 years and denominated in U.S. dollars (USD), euros (EUR) or British pounds (GBP) is subject to mandatory clearing, while any fixed-to-floating interest rate swap or basis swap with a tenor of 28 days to 30 years and denominated in Japanese yen (JPY) is also subject to mandatory clearing. In addition, the clearing mandate also covers forward rate agreements denominated in USD, EUR, GBP, and JPY and overnight index swaps denominated in USD, EUR, and GBP of varying tenors. Thus, while it is currently possible to structure an interest rate swap in such a way that it would not be mandated for clearing, executing an on-market bilateral interest rate swap denominated in one of the four aforementioned currencies would be difficult to do and any executing broker would likely charge a premium to do so.

¹⁶ Note that credit default swaps do not fall within the current definition of "notional principal contract" and thus are not necessarily subject to the rules applicable to significant upfront payments on notional principal contracts referenced above and discussed in more detail below. Although proposed regulations have been issued that would define "notional principal contract" to include credit default swaps, those proposed regulations have not yet been finalized and timing rules providing for how nonperiodic payments on a credit default swap (which unlike a standard notional principal contract has an uncertain term as a credit event could trigger a termination of the swap at any time) should be accounted for have not been proposed.

¹⁷ As some practitioners have noted, it is reasonable to expect that the non-cleared swap market will continue to adopt conventions, such as predetermined coupons, used by cleared swaps in order accommodate parties transacting in both markets. Parties to the swaps prefer the consistency across products as it results in more streamlined portfolios. Nijenhuis, Erika, "New Tax Issues Arising From the Dodd-Frank Act and Related Changes to Market Practice for Derivatives", Columbia Journal of Tax Law, Vol. 2.1 (January 2011) at 38.

¹⁸ 7 U.S.C. § 6s(e)(2).

¹⁹See Basel Committee on Banking Supervision and International Organization of Securities Commissions, Margin Requirements for Non-Centrally Cleared Derivatives (Sept. 2013) available at http://www.bis.org/publ/bcbs261.pdf.; see also Davis Polk, An Asset Manager's Guide to Swap Trading in the New Regulatory World, (March 11, 2013) at http://www.davispolk.com/files/uploads/An_Asset_Managers_Guide_to_Swap_Trading.pdf, page 16.

²⁰See id.

²¹See Treas. Reg. section 1.956-2T(b)(1)(xi). Treasury and the Service also noted they would each continue to study whether and under what circumstances broader relief would be appropriate. T.D. 9589.

²²See Treas. Reg. section 1.1001-4. Treasury and the Service also noted they would each continue to study whether and under what circumstances broader relief would be appropriate. T.D. 9639.

²³ There is little guidance on how to determine whether a nonperiodic payment is "significant". The regulations do not provide a bright-line test. They offer two examples illustrating one fact pattern in which a nonperiodic payment is "significant" and one fact pattern in which a nonperiodic payment is not "significant". In each example, the determination of "significance" is made by comparing the amount of the nonperiodic payment to the present value of all fixed payments on the contract (including the nonperiodic payment). In one example, the nonperiodic payment is not "significant" where the amount of the nonperiodic payment is equal to 10% of the present value of all fixed payments on the contract. In the other example, the nonperiodic payment is "significant" where the amount of the nonperiodic payment is equal to 40% of the present value of all fixed payments on the contract. See Treas. Reg. section 1.446-3(g)(6), Examples (2)-(3).

²⁴ As a reminder, the swap is a 5 year 0.8%-to-3-month LIBOR interest rate swap with a notional value of $100 million. Payments are made annually on the last day of the year. X is the fixed rate payer (and floating rate receiver) on the swap. The market rate for the party paying the fixed rate in that type of swap at the time the swap is entered is 0.55%. Because X is agreeing to pay an above-market rate, X receives an upfront payment of $1,229,637.

²⁵ The upfront payment amounts to approximately 45.45% of the present value of all fixed payments on the contract and thus appears to be "significant" by comparison to the two examples described in note 23 above.

²⁶ Joint Committee on Taxation, Historical Development and Present Law of the Federal Tax Exemption for Charities and other Tax-Exempt Organizations (JCX-29-05), April 19, 2005, (hereafter, the "2005 JCX Report") at 100.

²⁷ H. Rpt. No. 2319, 81st Cong., 2d Sess. 36 (1950). See also S. Rep. No. 2375, 81st Cong., 2d Sess. 28 (1950).

²⁸ The UBTI produced by a debt-financed property for a given year is generally equal to the total gross income derived from the property during the year times the average acquisition indebtedness with respect to the property for that year divided by the average amount of the adjusted basis in the property during the period of the year during which it is held by the tax-exempt organization. The organization is also allowed to take certain deductions with respect to the debt-financed property against that income. See Section 514(a).

²⁹Commissioner v. Clay B. Brown, 380 U.S. 563 (1965).

³⁰See Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1969 (JCS-16-70), December 3, 1970, at 62; 2005 JCX Report at 103.

³¹ Prior to the 1969 Act, the debt-financed property rules were limited to a provision enacted under the 1950 Act which treated certain rental income from real property as UBTI to the extent that the rental property was acquired with borrowed money. The rule was meant to address a particular practice whereby a tax-exempt organization would borrow money to acquire real estate and then lease the property back to the seller under a long-term lease while servicing the loan with the tax-free rental income from the lease (with the tax-exempt organization profiting in part to the extent of the difference between the rents received and the loan repayments). This provision served similar purposes as described above (i.e., to prevent tax-exempt organizations from trading on their tax-exemption and/or generating an unfair competitive advantage in expanding their operations). It also resulted from Congressional concern that these types of debt-financed sale-leaseback transactions could result in tax-exempt organizations owning the bulk of the commercial and industrial real estate in the country, which would potentially drastically lower the rental income included in the corporate and individual tax bases. See 2005 JCX report at 12-13, 103; H. Rpt. No. 2319, 81st Cong., 2d Sess.

³²See, e.g., T.D. 8423 ("The legislative history indicates that Congress intended to exclude investment income from UBTI.").

³³ H. Rpt. No. 2319, 81st Cong., 2d Sess.

³⁴ Currently, section 512(b)(5).

³⁵ S. Rept. No. 1172, 94th Cong., 2d Sess.

³⁶See Section 512(b)(1); Section 512(a)(5); Section 514(c)(8).

³⁷ Initial collateral posted was generally equal to the value of the securities lent, and was adjusted daily as the value of the securities changed.

³⁸ Treas. Reg. 1.512(b)-1(a)(1) currently states: "Dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), annuities, income from notional principal contracts (as defined in Treasury Regulations 26 CFR 1.863-7 or regulations issued under section 446), other substantially similar income from ordinary and routine investments to the extent determined by the Commissioner, and all deductions directly connected with any of the foregoing items of income shall be excluded in computing unrelated business taxable income."

³⁹ T.D. 8423.

⁴⁰Id. Other types of investment income also have been determined to not constitute UBTI. For example, the Service has ruled that income from short sales of publicly traded stock is not UBTI, notwithstanding the fact that a tax-exempt organization participating in a short sale transaction is borrowing stock and potentially generating a return on it. In that case, the Service based its conclusion on a Supreme Court ruling that short sales created an obligation, but not indebtedness, for purposes of the predecessor of section 163. See Rev. Rul. 95-8. The Service has also ruled privately that income from futures contracts is not UBTI. See, e.g., PLR 8110164.

⁴¹ As discussed above, initial margin is also generally required on cleared swaps to protect the clearinghouse with respect to the potential future exposure that could arise from changes in the value of the swap during the time that it takes to close out and replace the position if a swap participant defaults. Initial variation margin discussed below should not be confused with initial margin. In addition, credit default swaps would potentially involve credit event payments.

⁴² Initial variation margin payments and daily variation margin payments are listed here (and discussed elsewhere in this letter) as two different types of payments for consistency with the terminology used in the preamble to the 956 regulations mentioned above. See T.D. 9589. Alternatively, both types of payments could be referred to collectively as variation margin payments. In that case, what is referred to herein as an "initial variation margin payment" would be the first variation margin payment made on a swap with an upfront payment.

⁴³ For purposes of this letter, margin is being described and considered as it relates to a particular trade even though in practice margin could be net across multiple trades with the same clearinghouse. That said, economically the margin requirements still apply on a swap-by-swap basis and therefore this letter logically considers the cash flows on a per trade basis. Note that margin was considered similarly in the context of the section 956 relief with respect to initial variation margin. T.D. 9589.

⁴⁴ Similarly, the clearinghouse has credit risk to the party to whom it pays the upfront payment.

⁴⁵ Interest is excluded from UBTI under section 512(b)(1) and Treasury Regulations section 1.512(b)-1(a)), and, as noted above, income from a notional principal contract is excluded from UBTI under Treasury Regulations section 1.512(b)-1(a).

⁴⁶ The $491,855 is the present value of 5 potential future payments of $100,000. This example and all subsequent examples assume that the value of the swap at a given point is equal to the present value of the potential future payments determined based on the difference between the then-current 3-month LIBOR and the fixed rate and discounted (excepted as otherwise noted) using a 0.55% discount rate. This assumption is made for simplicity. In actuality, the valuation and discounting would be done based on interest rate curves, but the principles/concepts illustrated by the example would be applicable.

⁴⁷ More generally, since a portion of the variation margin received during year 1 by X on the swap was received to reduce X's credit risk with respect to that potential future periodic payment, logically the actual receipt of that periodic payment would lead to a payment by X of variation margin (effectively returning the margin received to secure that payment).

⁴⁸ Because the results are shown on an annual basis, the daily variation margin payment of $491,855 received on day 2 of the swap is not specifically shown in the table. As noted, X would have received that $491,855 on day 2 and then would have received additional daily variation margin payments throughout the remainder of year 1 (totaling $1,729) as payments dates approached and present value increased. When the first periodic payment of $100,000 was received by X, the value of the swap would have declined by $100,000, and X would have made a daily variation margin payment of $100,000, leaving X with the $393,584 of variation margin shown at the end of year 1.

⁴⁹ As noted above, the amount of the initial variation margin payment may differ slightly from the amount of the upfront payment due to changes in value between the time of trade and the time the initial variation margin payment is determined.

⁵⁰ For a general discussion of discount rates, see Clive Davidson, "OIS discounting dilemma for the buy-side", Risk Magazine, Feb. 22, 2013.

⁵¹ As a reminder, the swap is a 5 year 0.8%-to-3-month LIBOR interest rate swap with a notional value of $100 million. Payments are made annually on the last day of the year. X is the fixed rate payer (and floating rate receiver) on the swap.

⁵² Again, the numbers in the example are simplified. Variation margin payments and PAI payments are made on a daily basis whereas the numbers in the example are reflected on an annual basis. Although the actual calculations may be more complicated than what is shown in this example, the rate used to calculate PAI is generally also used to determine the amount of the upfront payment and that determination is made so as to provide for a general offset of the income earned on the upfront payment and the "interest" embedded in the off-market payments over the term of the swap, as depicted in this example. Note that the notional principal contract regulations determine the deemed loan and the associated tax accounting based on the rate or rates used to determine the upfront payment so as to attempt to accurately reflect the true economics embedded in the transaction. If the true economics embedded in the transaction are an economic wash between the income earned on the upfront payment and the interest embedded in the off-market payments, then it would seem that the tax rules should be reflecting that as well.

⁵³ As noted above, income earned on collateral is clearly excluded from UBTI in the securities lending context. The type of income discussed here seems even less concerning from a UBTI perspective than income earned on collateral in the securities lending context. In the securities lending context, the securities lender entered the transaction knowing that it was going to receive temporary access to collateral which it was free to invest how it chose. Any return on that investment was viewed as part of the compensation for entering into an ordinary and routine investment activity and thus not UBTI. In this case, the potential return in question is similarly part of the potential compensation for entering into an ordinary and routine investment activity, but in this case the tax-exempt organization cannot choose how the collateral/variation margin is invested and any return is limited to a favorable fluctuation in the overnight PAI rate, further limiting any possibility for abuse from a UBTI perspective.

⁵⁴ As a reminder, the swap is a 5 year 0.8%-to-3-month LIBOR interest rate swap with a notional value of $100 million. Payments are made annually on the last day of the year. X is the fixed rate payer (and floating rate receiver) on the swap. X receives an upfront payment of $1,229,637 and makes an initial variation margin payment of $1,229,637.

⁵⁵ This is based on a determination that the value of the swap on day 2 would be approximately $737,782 (i.e., the present value of the potential future payments determined based on the difference between then-current LIBOR and the 0.80% fixed rate). The change in value from $1,229,637 to $737,782 would result in a daily variation margin payment of $491,855 to X.

⁵⁶ For example, in year 1 in Example 5 (where X entered into the same swap but interest rates remained constant), X actually paid a net coupon payment of $250,000, received $243,237 in net daily variation margin payments, and recognized $0 of swap income and $6,763 of interest deduction. In year 1 in this Example 6, X actually paid a net coupon payment of $150,000, received $637,797 in net daily variation margin payments, and recognized $100,000 of swap income and $6,763 of interest deduction. So, in year 1, the fluctuation in interest rates caused X to make $100,000 less of coupon payments, receive $395,560 of additional daily variation margin payments and recognize $100,000 more of swap income. Those differences between Example 5 and Example 6 are exactly equal to the results in Example 4 (where X entered into the on-market version of the swap and the same interest rate fluctuation occurred) in that in year 1 in Example 4, X received a net coupon payment of $100,000 and $394,560 in net daily variation margin payments and recognized $100,000 of swap income.

⁵⁷ In this case, the value of the off-market 0.8%-to-LIBOR swap on day 2 would be approximately $735,594 (i.e., the present value of the potential future payments determined based on the difference between the-current LIBOR and the 0.8% fixed rate). The change in value from $1,229,637 to $735,594 would result in a daily variation margin payment of $494,043 to X. The value of the on-market 0.55%-to-LIBOR swap on day 2 would be approximately $490,396. The change in value from $0 to $490,396 would result in a daily variation margin payment of $490,396 to X. The reason for the difference is that whereas in the on-market 0.55%-to-LIBOR swap the initial value is $0 and the change in value is simply the present value of 5 potential future payments of $100,000 discounted at 0.65%, in the off-market 0.8%-to-LIBOR swap the initial value is the present value of 5 potential future payments of $250,000 discounted at 0.65% and the day 2 value is the present value of 5 potential future payments of $150,000 discounted at 0.65%. For the off-market swap, the differential in value does not reduce to simply the present value of potential future payments of $100,000 discounted at 0.65% (which would equal the $490,396 change from the on-market swap). It also includes the difference between five potential future payments of $250,000 discounted at 0.55% and those same five potential future payments of $250,000 discounted at 0.65% (with that difference equaling the $3,646). For simplicity, these calculations ignore the impact that the lapse of 1 day would have on the present value calculations.

⁵⁸ The net swap income on the two swaps and, in the case of the off-market 0.8%-to-LIBOR swap, the interest deductions associated with the deemed loan are unaffected by this change in discount rate and thus are the same as shown in Example 4 for the on-market 0.55%-to-LIBOR swap and in Example 6 for the off-market 0.8%-to-LIBOR swap.

⁵⁹ Example 6 describes a scenario in which a change in rates could result in a tax-exempt organization receiving a larger daily variation margin payment on the off-market version of the swap than it would have received on the on-market version. In different circumstances, a change in rates could result in a tax-exempt organization receiving a smaller daily variation margin payment on the off-market version of the swap than it would have received on the on-market version. For example, assume a tax-exempt organization agrees to be the fixed rate receiver and floating rate payer on a 5 year 0.3%-to-LIBOR interest rate swap at a time when the market rate was 0.55% and receives an upfront payment of $1,229,637. If LIBOR (and the discount rate used to value the swap) subsequently declines to 0.45% , the tax-exempt organization would receive a smaller daily variation margin payment on the off-market 0.3%-to-LIBOR swap than it would have on an on-market 0.55%-to-LIBOR swap.

⁶⁰ Similar to what was discussed in note 53 above and the accompanying text, any income earned on the investment of these daily variation margin payments seems even less concerning from a UBTI perspective than income earned on collateral in the securities lending context, which is clearly excluded from UBTI. In the securities lending context, the securities lender entered the transaction knowing that it was going to receive temporary access to collateral which it was free to invest how it chose. Any return on that investment was viewed as part of the compensation for entering into an ordinary and routine investment activity and thus not UBTI. In this case, the possibility that the value of the swap will fluctuate in favor of a tax-exempt organization that invests in the swap and result in that organization getting access to cash which it is free to invest is similarly part of the potential compensation for entering into an ordinary and routine investment activity. In this case, however, the tax-exempt organization cannot know that it will receive access to this cash at the time of investment, further limiting any possibility for abuse from a UBTI perspective.

⁶¹See Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions, "Margin Requirements for Non-Centrally Cleared Derivatives", September 2013 at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD423.pdf.

⁶² As noted in Section I, counterparties would also be required to post initial margin, with initial margin levels set at levels exceeding initial margin requirements for cleared swaps to encourage swap participants to clear their swaps.

⁶³ As discussed above, PAI is overnight interest paid/received on total/net initial variation margin and daily variation margin outstanding on a cleared swap (or a non-cleared swap that is subject to margin requirements). Variation margin requirements reduce credit risk by causing the out-of-the-money party to have paid, and the in-the-money party to have received, a net amount of cash (variation margin) equal to the present value of the contract. The in-the-money party is free to invest, and keep the return on, those funds. In order to make the out-of-the-money whole for forbearing the use of those funds, the in-the-money party pays and the out-of-the-money party receives PAI. On a collateralized non-cleared swap, the out-of-money party retains ownership of the collateral and the return on the collateral, so there is no need for PAI to compensate the out-of-the-money party for forbearing use of funds.

⁶⁴ The possibility of minimum transfer amounts is the reason the term "generally" was used multiple times in the preceding paragraph.

⁶⁵ In actuality, the initial value of the non-cleared version of the swap and the amount of the upfront payment on the non-cleared swap is likely to be slightly different from the initial value of the cleared swap and the amount of the upfront payment on the cleared swap because the present value calculation would be slightly different. In the case of a cleared swap, the present value calculations would use the same rate as is used to calculate PAI. In the case of a non-cleared swap, the present value calculations would be subject to the negotiation of the parties but would generally reflect the return that the recipient could expect to generate on the upfront payment received (i.e., the rate of return that the recipient could expect to generate on the securities eligible to be posted as collateral). In each case, the calculation is intended to provide for an economic wash between the return on the upfront payment and the implied interest on the deemed loan. For simplicity, the example assumes that present value calculation and thus the upfront payment are the same in the cleared examples and this non-cleared example.

⁶⁶ A minimum transfer amount threshold would more typically be $100,000, $500,000 or $1 million depending on the size and credit worthiness of the investor, but a threshold above $1.2 million is possible. Note again that the minimum transfer amount threshold would typically be measured with respect to the investor's total net exposure on swaps with the same counterparty.

⁶⁷See Treas. Reg. section 1.512(b)-1(a).

⁶⁸ Treasury and/or the Service could specifically provide, as was done in the section 956 context, that the party that receives the upfront payment be required by the end of the business day on which the upfront payment is made to make a payment of initial variation margin that is equal (before taking into account any change in value of the contract between the time the contract is entered into and the time at which the initial variation margin payment is determined) to the amount of the upfront payment. We note that we would view this formulation to cover a payment with respect to an option or a forward contract to enter into a swap, which payment generally becomes a nonperiodic payment on the swap (and thus potentially subject to the deemed loan rules) if and when the swap is entered into, provided that a payment of initial variation margin is required to be made when the payment on the option or forward is received. We would welcome clarification on the matter, however. By way of example, a payment at the outset of a forward-starting MAC contract, discussed above in note 10, would not become a nonperiodic payment on the swap until the effective date of the swap (when the forward contract is settled into the swap) but an initial variation margin payment will be made/received at the time the forward contract is entered and daily variation margin will be exchanged during the term of the forward (and the swap, once the forward is settled into the swap).

⁶⁹ Fidelity would also be open to requesting a private letter ruling if the Service preferred to address these issues in that manner, although Fidelity understands that other parties are interested in similar guidance/relief and the private letter ruling process may not be the most efficient route for all concerned.