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.
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.