Credit Default Swaps
Credit default swaps are also under study by the IRS. They raise difficult US tax issues.
The agency published a list of questions in late July that it has about them and asked for input from the public. It will eventually publish guidance.
A credit default swap is an arrangement where a company that is concerned about the creditworthiness of a counterparty to a contract buys something like insurance or a guarantee against a default. The purchaser might pay a lump-sum premium at the start. It might make periodic payments over time. If a default occurs, then it receives either a payment for the loss in contract value caused by the default or it receives a replacement instrument that will give it the value it originally expected.
Among the questions the IRS has are whether a US withholding tax or insurance excise tax should be collected on the premium payments by a US purchaser of a credit default swap to a foreign seller and the timing of when payments in either direction under the swap can be deducted and when they have to be reported as income. Most of the issues have to do with cross-border swaps. For example, another question is whether foreign suppliers of such swaps are considered engaged in a trade or business in the US; that might subject them to taxes as if they were US residents.
The IRS described the various theories that have been advanced for analyzing credit default swaps in late July in Notice 2004-52.