On Feb. 26, the Department of the Treasury issued proposed regulations (Reg. 166012-02) relating to the character and timing of payments made pursuant to notional principal contracts. Specifically, the proposed regulations relate to the inclusion into income or deduction of a contingent non-periodic payment provided for under a notional principal contract, such as certain credit default and certain total return swaps. If applied in its current form, the substance of the new tax accounting rules included in these proposed Treasury regulations would change the tax treatment of swap activities for many hedge funds.

Background

In 1989, the IRS issued Notice 89-21 to provide guidance with respect to the tax treatment of lump-sum payments received in connection with notional principal contracts. The notice stated that a method of accounting that properly recognizes a lump-sum payment over the life of the contract based on a reasonable amortization method clearly reflects income and indicated that regulations would be issued to provide specific rules regarding the manner in which a taxpayer must take into account, over the life of a notional principal contract, payments made or received with respect to the contract.

In 1993, the IRS published final regulations (the 1993 Treasury regulations) under Internal Revenue Code section 446(b) relating to the timing of income and deductions for amounts paid or received pursuant to notional principal contracts. The 1993 Treasury regulations divided payments made pursuant to notional principal contracts into three categories (periodic, non-periodic and termination payments), and the 1993 Treasury regulations provide timing regimes for each. With respect to non-periodic payments, the 1993 Treasury regulations provide that such payments generally must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract. Although the 1993 Treasury regulations do not distinguish between non-contingent and contingent non-periodic payments, the specific rules and examples in the 1993 Treasury regulations address only non-contingent non-periodic payments. The preamble to the 1993 Treasury regulations states, “the IRS expects to address contingent payments in future regulations.” In addition, neither the 1993 Treasury regulations nor any other section provides specific rules governing the tax character of the various types of notional principal contract payments.

In 2001, the IRS published Notice 2001-44, setting forth several alternatives for the appropriate method for the inclusion or deduction of contingent non-periodic payments made pursuant to notional principal contracts and the proper character treatment of payments made pursuant to a notional principal contract. Two of the alternatives did not require the current accrual of contingent payments, but at the same time those alternatives potentially restricted the ability of the taxpayer to claim current deductions.

General Overview of Proposed Regulations

The proposed regulations put forth two main themes. First, in the preamble to the proposed regulations, Treasury acknowledges that some taxpayers only take contingent non-periodic payments into account for purposes of calculating taxable income when the payment becomes fixed and determinable–the so-called “wait-and-see” method of accounting. The preamble goes on to assert that this wait-and-see method is “inconsistent” with the timing rules in the regulations as currently in place. Treasury also contends that the wait-and-see method is inconsistent with current rules in place for other contingent instruments, specifically contingent debt instruments, which are subject to the non-contingent bond method. The non-contingent bond method requires parties to the contingent instrument to forecast future cash flows and account for these forecasted amounts as a component of taxable income over the term of the contingent debt instrument.

Second, the proposed regulations call for new rules requiring that all non-periodic payments, both contingent and non-contingent, be included in taxable income over the term of the notional principal contract. Accordingly, the proposed regulations call for the implementation of a non-contingent swap method–similar to the non-contingent bond method and similar to one of the alternatives proposed in Notice 2001-44 but with periodic reforecasts of the contingent non-periodic payments. However, the proposed regulations do provide an alternative to these non-contingent swap rules provided that the taxpayer elects into a mark-to-market regime specifically with respect to all their notional principal contracts with non-periodic payments.

Treasury states that these rules would place the tax treatment of notional principal contracts structured with non-periodic payments on par with the tax treatment of similar notional principal contracts structured solely with periodic payments. The preamble also acknowledges the increased compliance burden placed on taxpayers as a result of these rules; however, Treasury dismisses these concerns, in part, because these rules will apply to complex instruments entered into by sophisticated investors who are able to make these calculations, if they are not already doing so for other purposes. Hedge funds may choose to avoid this complexity by employing the mark-to-market methodology for swaps. In addition, hedge funds with an IRC ?475 mark-to-market election in place should likely avoid this complexity.

The proposed regulations clarify that the character of both periodic and non-periodic payments, including any payments made at maturity of the notional principal contract, is ordinary. Meanwhile, any gain or loss upon early termination of the notional principal contract may qualify for capital gain treatment–keeping in mind any effect of these new rules. However, if a notional principal contract were impacted by the mechanical operation of these rules, the amount of capital gain (or loss) may be significantly reduced.

At present, these proposed regulations do not apply to “bullet swaps” or “prepaid forward

contracts.” For purposes of the proposed regulations, a bullet swap is defined as a financial instrument providing for the settlement of all of the parties’ obligations via a single payment (even if a net payment) at or near maturity that is measured by reference to a specified index on a notional principal amount. As a result, hedge funds engaging in these activities may not need to change their tax treatment for these instruments.

Effective Dates

In general, the regulations are proposed to apply prospectively to notional principal contracts entered into on or 30 days after the regulations become final. However, certain provisions of the preamble make it less clear as to how, or if, the final regulations may apply to notional principal contracts in effect at the time final regulations are issued. The preamble states that if a taxpayer has adopted a method of accounting for notional principal contracts with contingent non-periodic payments, the commissioner generally will not require a change in the accounting method until the taxpayer’s first tax year ending on or after 30 days after final regulations are published.

Interestingly however, the preamble distinguishes a taxpayer that has not adopted an accounting method with respect to notional principal contracts containing contingent non-periodic payments and who has such notional principal contracts in effect or enters into such notional principal contracts on or 30 days after the publication of these proposed regulations (i.e., beginning March 27). According to the preamble, such a taxpayer must adopt an accounting method that reasonably takes the contingent non-periodic payments into account over the life of the contract–although, at this time, it is not required that the specific methods in the proposed regulations be followed. Hedge funds should review whether they have adopted a method of accounting for their existing swap activity and any possible effect it may have on its tax reporting requirements. In addition, they should consider how these rules would affect their current and future activities for the types of swaps covered by these proposed regulations.

Howard Leventhal is co-national director of the firm’s asset management tax practice and a partner in Ernst & Young’s global hedge fund practice based in the New York financial services office. Joseph Bianco is a tax senior manager in Ernst & Young’s global hedge fund practice based in the firm’s New York financial services office.