Treasury And IRS Request Information On Credit Default Swaps

by Mike Godfrey, Tax-News.com, Washington

21 July 2004

In an attempt to clarify the tax treatment of financial transactions known as credit default swaps, the US Treasury Department and the Internal Revenue Service on Monday issued a Notice requesting information on these particular financial instruments.

The government’s action comes in response to requests by taxpayer and industry groups for guidance on the tax treatment of credit default swaps, particularly in relation to payments from US individuals to foreign individuals.

"This is an important market that has grown very rapidly and continues to evolve," stated Acting Assistant Secretary for Tax Policy Gregory Jenner.

"We understand the need for guidance in this area. The purpose of this Notice is to ask for the information that we need in order to be able to provide the kind of specific and comprehensive guidance taxpayers have requested," he concluded.

A credit default swap is a specific kind of counterparty agreement which allows the transfer of third party credit risk from one party to the other.

One party in the swap is a lender and faces credit risk from a third party, and the counterparty in the credit default swap agrees to insure this risk in exchange for regular periodic payments.

If the third party defaults, the party providing insurance will have to purchase from the insured party the defaulted asset. In turn, the insurer pays the insured the remaining interest on the debt, as well as the principal.

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