Final Regs Clarify That Notional Principal Contracts Are Excluded From UBTI

 DEPARTMENT OF THE TREASURY

 ACTION: Final Rule.

 SUMMARY: This document contains final regulations relating to the taxation of tax-exempt organizations' unrelated business taxable income. The Service published proposed regulations on September 3, 1991 (56 FR 43571), to conform to 1978 statutory amendments regarding securities loans and to clarify that income from certain investments is not subject to unrelated business income tax. After receiving and considering public comments, the Service is finalizing the proposed regulations with modifications.

 EFFECTIVE DATE: These amendments are effective for income from notional principal contracts for amounts received after August 30, 1991. See "SUPPLEMENTARY INFORMATION" for further details.

 FOR FURTHER INFORMATION CONTACT: Regina L. Oldak, (202) 622-6080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

BACKGROUND

Although generally exempt from federal income taxation, an organization described in section 501(a) of the Internal Revenue Code of 1986 must pay tax on its unrelated business taxable income, as defined in section 512. Section 512(a)(1) defines unrelated business taxable income (UBTI) as generally meaning gross income from any unrelated trade or business (as defined in section 513) regularly carried on by the organization, less deductions that are directly connected with that trade or business, computed with the modifications provided in section 512(b).

 Section 512(b)(1) provides that "[t]here shall be excluded all dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), and annuities, and all deductions directly connected with such income." The legislative history indicates that Congress intended to exclude investment income from UBTI. See S. Rep. No. 81-2375, 81st Cong., 2d Sess. 30 (Aug. 22, 1950); H.R. Rep. No. 81-2319, 81st Cong., 2d Sess. 38 (June 23, 1950); and S. Rep. No. 94-1172, 94th Cong., 2d Sess. 3 (1976).

 In response to requests for clarification regarding whether income or expense derived from certain notional principal contracts is UBTI, the Service published a Notice of Proposed Rulemaking (NPRM) on September 3, 1991 (56 FR 43571). The NPRM proposed that the list of exclusions for dividends, interest, and annuities in section 1.512(b)-1(a) be expanded to also exclude from UBTI, to the extent determined by the Commissioner in a revenue ruling, substantially similar income from an exempt organization's ordinary and routine investments in connection with a securities portfolio. The NPRM also proposed that such substantially similar income be treated as gross investment income for purposes of sections 509(e) and 4940(c)(2). The preamble to the proposed regulations included the text of a revenue ruling proposed to be issued under the authority of the regulations. The proposed revenue ruling stated that, for purposes of sections 512(b), 509(e), and 4940(c)(2), income from interest rate swaps and currency swaps was determined by the Commissioner to be substantially similar income from ordinary and routine investments in connection with a securities portfolio.

 The NPRM also proposed to add payments with respect to securities loans (as defined in section 512(a)(5)) to the list of exclusions from UBTI in section 1.512(b)-1(a) in order to conform the regulations to the statute, which was amended by P.L. 98-345 (1978). No comments were received regarding this provision.

 A public hearing was held on December 6, 1991.

 Public comments received by the Service generally welcomed the guidance as an important step to clarify this area of the law, but suggested several modifications. Most of the comments suggested that the exclusion from UBTI should apply to all notional principal contracts, not just interest rate and currency swaps. Several comments requested that the Service expressly exclude from UBTI income from particular types of notional principal contracts, notably equity and commodity swaps. Some comments requested that the exclusions be provided in the regulations, rather than in revenue rulings. Some comments also requested that the regulations (or revenue ruling) define the term notional principal contract.

DISCUSSION OF FINAL REGULATIONS

 The final regulations amend the regulations under section 512(b)(1) to conform to and incorporate the 1978 statutory amendment regarding securities loans. In addition, the final regulations respond to public comments by eliminating the need for a revenue ruling and clarifying that section 512(b)(1) generally excludes not only dividends, interest, payments with respect to securities loans, and annuities, but also income from notional principal contracts. The final regulations also exclude other income from an exempt organization's ordinary and routine investments that the Commissioner determines to be substantially similar to dividends, interest, payments with respect to securities loans, annuities, and income from notional principal contracts. The final regulations further respond to public comments by clarifying that for purposes of this regulation, the term notional principal contract includes contracts defined in Treas. Reg. section 1.863-7 or regulations issued under section 446.

 The final regulations clarify that the new exclusions being added to section 1.512(b)-1(a) do not apply to exempt organizations that act as brokers or dealers (including organizations that make a market in derivative financial products, as described in Treas. Reg. section 1.954-2T(a)(4)(iii)(B)) and that none of the exclusions in section 1.512(b)-1(a) affects the exclusion from UBTI of certain gains or losses under section 512(b)(5). Thus, the regulations do not affect the treatment of any gain or loss from the extinguishment, assignment, or other disposition of any swap position. Generally, a non-dealer exempt organization's gain or loss from sales or other dispositions of non-inventory property would be excluded from UBTI under section 512(b)(5). The final regulations retain and restate the current regulations' limitations with respect to income from debt-financed property and interest and annuity income derived from controlled organizations.

 The final regulations also amend the regulations under sections 509(e) and 4940(c)(2), so that investment income that is excluded from UBTI under section 512(b)(1) is included in the gross investment income of a private foundation.

 One comment on the proposed regulations questioned whether, in order for an investment to be excluded as substantially similar income from ordinary and routine investments, the investment must be ordinary and routine for each exempt organization that engages in the transaction. The 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. In order to exclude an amount from UBTI, it is not necessary for an exempt organization to demonstrate that it ordinarily and routinely engages in such transactions.

 The fact that these regulations exclude certain income from UBTI is not intended to affect determinations under any relevant fiduciary standards of state or federal law.

DATES

 The effective dates of the rules of section 1.512(b)-1(a) that were in effect prior to this Treasury decision remain the same. The exclusion under section 1.512(b)-1(a)(1), and the inclusion under sections 1.509(a)-3(a)(3)(i) and 53.4940-1(d)(1), of income from notional principal contracts is effective for amounts received after August 30, 1991. However, an organization may apply the exclusion under section 1.512(b)-1(a)(1) of income from notional principal contracts prior to that date, provided that such amounts are treated consistently for all open taxable years. Furthermore, an organization that excludes from UBTI income from notional principal contracts under section 1.512(b)-1(a)(1) prior to that date must include that income in its gross investment income under sections 1.509(a)-3(a)(3)(i) and 53.4940-1(d)(1). Unless otherwise provided by the Commissioner, the exclusion under section 1.512(b)-1(a)(1), and the inclusion under sections 1.509(a)- 3(a)(3)(i) and 53.4940-1(d)(1), of income that the Commissioner determines to be substantially similar income from ordinary and routine investments is effective for amounts received after the date of the Commissioner's determination.

SPECIAL ANALYSES

 It has been determined that this rule is not a major rule as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It has also been determined that section 533(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and, therefore, a final Regulatory Flexibility Analysis is not required. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking for the regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

DRAFTING INFORMATION

 The principal author of these regulations is Regina L. Oldak, Office of Associate Chief Counsel (Employee Benefits and Exempt Organizations), Internal Revenue Service. However, personnel from other offices of the Service and the Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR 1.507-1 through 1.514(g)-1

 Foundations, Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 53

 Excise taxes, Foundations, Investments, Reporting and recordkeeping requirements, Trusts and trustees.

Treasury Decision 8423

AMENDMENT TO THE REGULATIONS

The amendments to 26 CFR parts 1 and 53 are as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority citation for part 1 continues to read in part:

Authority: 26 U.S.C. 7805 * *

Par. 2. In section 1.509(a)-3, paragraph (a)(3)(i) is amended by adding a new sentence at the end to read as follows:

SECTION 1.509(A)-3 BROADLY. PUBLICLY SUPPORTED ORGANIZATIONS.

(a) * * *

(3) * * *

(i) * * * For purposes of section 509(e), gross investment income includes the items of investment income described in section 1.512(b)-1(a).

* * * * *

Par. 3. In section 1.512(b)-1, paragraph (a) is revised to read as follows:

SECTION 1.512(b)-1 MODIFICATIONS.

* * * * *

(a) CERTAIN INVESTMENT INCOME -- (1) IN GENERAL. 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.

(2) LIMITATIONS. The exclusions under paragraph (a)(1) of this section do not apply to income derived from and deductions in connection with debt-financed property (as defined in section 514(b)). Moreover, the exclusions under paragraph (a)(1) of this section do not apply to gains or losses from the sale, exchange, or other disposition of any property, or to gains or losses from the lapse or termination of options to buy or sell securities. For rules regarding the treatment of these gains and losses, see section 512(b)(5) and section 1.512(b)-l(d). Furthermore, the exclusions under paragraph (a)(1) of this section do not apply to interest and annuities derived from and deductions in connection with controlled organizations. For rules regarding the treatment of such amounts, see section 512(b)(13) and section 1.512(b)-1(l). Finally, the exclusions under paragraph (a)(1) of this section of income from notional principal contracts and income that the Commissioner determines to be substantially similar income from ordinary and routine investments do not apply to income earned by brokers or dealers (including organizations that make a market in derivative financial products, as described in Treasury Regulations 26 CFR 1.954-2T(a)(4)(iii)(B)).

(3) EFFECTIVE DATES. The effective dates of the rules of paragraphs (a)(1) and (a)(2) of this section that were in effect prior to this Treasury decision remain the same. The exclusion under paragraph (a)(1) of this section of income from notional principal contracts is effective for amounts received after August 30, 1991. However, an organization may apply the exclusion under paragraph (a)(1) of this section of income from notional principal contracts prior to that date, provided that such amounts are treated consistently for all open taxable years. Unless otherwise provided by the Commissioner, the exclusion under paragraph (a)(1) of this section of income that the Commissioner determines to be substantially similar income from ordinary and routine investments is effective for amounts received after the date of the Commissioner's determination.

* * * * *

PART 53 -- FOUNDATION AND SIMILAR EXCISE TAXES

Par. 4. The general authority citation for part 53 is revised to read as follows:

Authority: 26 U.S.C. 7805.

Par. 5. In section 53.4940-1, paragraph (d)(1) is amended by adding a new sentence at the end to read as follows:

SECTION 53.4940-1 EXCISE TAX ON NET INVESTMENT INCOME.

* * * * *

(d) * * *

(1) * * * For purposes of paragraph (c) of this section, gross investment income also includes the items of investment income described in section 1.512(b)-1(a).

* * * * *