Proposed Notional Principal Contract Regs. Address Contingent Payments and Character

In February 2004, the IRS released long-anticipated proposed regulations (Prop. Regs. Sec. 1.446-3; REG-166012-02), introducing a new regime of tax accounting for contingent nonperiodic payments under notional principal contracts (NPCs)also known as swaps. The proposed regulations would also prescribe new rules (Prop. Regs. Sec. 1.1234A-1) for addressing the character of payments made under an NPC, a forward contract and a type of derivative referred to as a bullet swap.

Timing Rules

Regs. Sec. 1.446-3 provides timing rules for three categories of payments made pursuant to NPCs: periodic, nonperiodic and termination. Nonperiodic payments (i.e., payments made under an NPCs terms, but not at intervals of a year or less) are recognized over the contracts term. However, the current regulations only address how to allocate fixed or noncontingent nonperiodic payments; they do not consider how to recognize contingent nonperiodic payments. The IRS solicited comments on how to treat contingent nonperiodic payments in 1993 (in the preamble to Regs. Sec. 1.446-3) and again in Notice 2001-44.

Absent IRS guidance, taxpayers typically accounted for NPC contingent nonperiodic payments only when a payment became fixed and determinable. In essence, they adopted a wait-and-see accounting method, deferring recognition until determining whether they would be making or receiving a payment and could definitively calculate its amount. In Rev. Rul. 2002-30, the IRS observed that the backloaded timing of tax consequences that resulted from this method could be problematic, especially when one party was deducting periodic payments as an ordinary expense, while the other was deferring capital recognition of the contingent payment.

Prop. Regs.

Prop. Regs. Sec. 1.446-3(g)(6)(ii) would disallow the wait-and-see method and require taxpayers to spread contingent nonperiodic payments over an NPCs term under a new noncontingent swap method. Under this method, taxpayers would estimate the contingent payments expected amount and take into account annually the projected contingent payments appropriate portions. They would also revise their payment projections annually and make certain adjustments annually to account for any differences between the projections and the revised amounts. Prop. Regs. Sec. 1.446-3(i) would also provide an elective mark-to-market regime, under certain conditions. The complicated proposed noncontingent swap method has been received cautiously by taxpayers that foresee compliance burdens if the rules are adopted in their current form.

Generally, the regulations are not proposed to be effective until 30 days after they are promulgated in final or temporary form. However, the preamble suggests that the wait-and-see method is not permissible for contingent nonperiodic payments on NPCs in effect after March 27, 2004, unless a taxpayer had already adopted that method for such items. This elicited requests from practitioners for prompt clarification about whether the wait-and-see method was a permissible accounting method for determining whether a taxpayer has established an accounting method. If it was not permissible, a taxpayer would have had to use the wait-and-see method to reflect contingent nonperiodic payments on NPCs on at least two returns, and many taxpayers would be precluded from adopting the method before March 27, 2004 if they had not already done so. The Service did not provide interim guidance, and many taxpayers were forced to take uncertain positions on returns filed in 2004.

Character Rules

As to the character of payments associated with NPCs, Prop. Regs. Sec. 1.1234A-1(a) would provide that all amounts accruing on the contract under its terms (both periodic and nonperiodic) are ordinary income or expense. Termination payments (i.e., payments to extinguish or terminate a partys rights and obligations under an NPC, but not including periodic or nonperiodic payments made at maturity of an NPC) on NPCs that are capital assets in a taxpayers hands would generate capital gain or loss. Prop. Regs. Sec. 1.1234A-1(c) would also mandate capital treatment for any gain or loss arising from settling obligations under a forward contract or bullet swap, which is economically similar to an NPC, but requires settling all payment obligations at contract maturity, rather than at specified intervals.

Observations

Although not immediately apparent, the timing and character rules set forth in the proposed regulations are integrally connected. The IRS appeared to be concerned that by clearly allowing taxpayers to claim capital treatment for termination payments, it was granting them a wide degree of latitude to selectively whipsaw the government. For example, a taxpayer with an NPC calling for a contingent backloaded payment could terminate the contract just prior to maturity if it were in a gain position and treat the resulting payment as capital gain. Alternatively, if the contract was in a loss position, the taxpayer could make payments according to the contracts terms and treat the resulting payments as ordinary expense.

The annual re-projection requirement, with resulting adjustments to current income and deduction amounts, attempts to address this concern. If recognition of contingent nonperiodic payments is deferred to maturity, the potential amounts subject to this type of character arbitrage are quite large. By requiring taxpayers to account for contingent nonperiodic payments during the NPCs term via annual projections, re-projections and adjustments, the noncontingent swap method attempts to limit the amounts that taxpayers can selectively characterize as ordinary or capital.

From David H. Shapiro, J.D., LL.M., Washington, DC