US Government Issues New Guidance On Financial 'Swap' Transactions

by Mike Godfrey, Tax-News.com, Washington

01 March 2004

Last week, the Treasury Department and the Internal Revenue Service issued proposed regulations regarding the taxation of contingent non-periodic payments relating to ‘notional principal contracts’ (NPCs), normally referred to by the financial and derivatives markets as ‘swap’ transactions.

Existing regulations state that the income or deduction for a nonperiodic payment must be recognized by a party to the NPC in an economic manner over the full term of the NPC. The existing regulations implement this principle for fixed non-periodic payments, but do not contain any explicit rules or examples for significant contingent non-periodic payments, which are included in some NPCs.

Some taxpayers have taken the position that, regardless of economic expectations, a party to a NPC need not recognize any income with respect to a contingent non-periodic payment before the amount of the payment is finally fixed (a “wait and see” approach). Such a wait-and-see approach generally postpones the recognition of taxable income and may let a taxpayer choose to enjoy winning positions as sources of capital gain but to garner ordinary deductions from any losers.

The proposed regulations set forth a pair of more economic methods of accounting for significant contingent non-periodic payments. First, a generally applicable method requires a taxpayer to estimate the amount of any contingent future payment and, on the basis of that estimate, to recognize an appropriate portion in the each taxable year.

Additional estimations must take place every year, and the taxpayer must include or deduct a 'true-up' adjustment each year to the extent that the more up-to-date estimate indicates that prior accruals were wrong.

Second, for most NPCs, the taxpayer may instead elect to mark the NPCs to market. That is, the taxpayer may choose to recognize income or deduction at the end of each year, based on the extent to which the NPCs changed in value during the year. Because many taxpayers are already required to mark their derivative positions to market for financial statement purposes, taxpayers should find this method particularly easy to use, says the Treasury.

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