LUMP-SUM PAYMENTS ON INTEREST RATE AND CURRENCY SWAP CONTRACTS MUST BE AMORTIZED OVER THE LIFE OF THE CONTRACT, IRS SAYS.

In Notice 89-21, the Service takes the position that lump-sum payments with respect to notional principal contracts that require future payments must be taken into income over the life of the contract. The Service stated that taking the entire lump-sum payment into income when it is received or deferring the entire amount of the payment to the termination of the contract does not clearly reflect income and is an impermissible accounting method. The Service stated that the accounting method prescribed in the Schulde and AAA cases does not clearly reflect income in the case of notional principal contracts.

The Service indicated that regulations will be issued under sections 61,446(b), 451, 461, and 988 providing specific rules regarding the "manner in which a taxpayer must amortize or take into account over the life of a notional principal contract payment made or received with respect to the contract." The Service added that the specific rules for amortizing payments made or received under various notional principal contracts will generally be prospective. The Service also noted that a mark-to-market system for dealers in notional principal contracts is under consideration.

In the case of lump-sum payments with respect to notional principal contracts entered into, or assigned, prior to the effective date of the regulations (including contracts entered into prior to the publication of this notice), the payments must be amortized over the life of the contract using a reasonable method to clearly reflect income. The Service stated that it will accept any reasonable method of amortization that takes the payments under the notional principal contract into account over the life of the contract until the regulations are effective.

Finally, Notice 89-22 provides that no inference should be drawn as to the proper treatment of transactions that are not properly characterized as notional principal contracts -- for example, transactions that are in substance loans or payments under insurance or annuity contracts.

Notice 89-22 serves as an administrative pronouncement under regulations section 1.6661-3(b)(2). For further information, contact Scott D. Feldstein of the Office of Assistant Chief Counsel (Financial Institutions and Products) at (202) 566-3516. For requests on obtaining consent to change a method of accounting for notional principal contracts, contact Pam Lowe of the Office of Assistant Chief Counsel (Income Tax and Accounting) at (202) 566-4481.

This notice provides guidance with respect to the federal income tax treatment of lump-sum payments received in connection with interest rate and currency swap contracts, interest rate cap contracts, and similar financial products ("notional principal contracts").

Under section 446(b) of the Internal Revenue Code, if a taxpayer's method of accounting does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary, does clearly reflect income. The Commissioner has broad authority to determine whether a method of accounting for a particular item of income or expense clearly reflects income. See RCA Corporation v. United States, 664 F.2d 881, 886 (2d Cir. 1981), cert. denied, 457 U.S. 1133 (1982).

In the case of a payment received during one taxable year with respect to a notional principal contract where such payment relates to the obligation to make a payment or payments in other taxable years under the contract, a method of accounting that properly recognizes such payment over the life of the contract clearly reflects income. Moreover, including the entire amount of such payment in income when it is received or deferring the entire amount of such payment to the termination of the contract does not clearly reflect income and is an impermissible method of accounting. The method of accounting prescribed in cases such as Schlude v. Commissioner, 372 U.S. 128 (1963), and American Automobile Association v. United States, 367 U.S. 687, (1961) does not clearly reflect income in the case of notional principal products.

Regulations will be issued under sections 61, 446(b), 451, 461, and 988 providing specific rules regarding the manner in which a taxpayer must amortize or take into account over the life of a notional principal contract payments made or received with respect to the contract. The regulations will provide similar rules governing the treatment of payments made or received in connection with the assignment of the right to receive future payments under a notional principal contract in the absence of a corresponding assumption of the obligations to make payments under the contract. The specific rules for the manner of amortization of payments made or received with respect to various types of notional principal contracts will generally be prospective. A mark-to-market system for dealers in notional principal contracts is also under consideration.

In the case of lump-sum payments made or received with respect to notional principal contracts entered into, or assignments made, prior to the effective date of the regulations (including contracts entered into prior to the publication of this notice), a method of accounting used by a taxpayer is a method that clearly reflects income only if the payments are taken into account over the life of the contract using a reasonable method of amortization. For contracts entered into prior to the effective date of the regulations, the Commissioner will generally treat a method of accounting as clearly reflecting income if it takes such payments into account over the life of the contract under a reasonable amortization method, whether or not the method satisfies the specific rules in the forthcoming regulations.

Taxpayers that have adopted a method of accounting that is inconsistent with the preceding paragraph of this notice must obtain the consent of the Commissioner and change to an acceptable method of accounting. A revenue procedure will be published shortly describing (1) the procedure for obtaining this consent, and (2) the manner in which a changing taxpayer must account for any adjustments under section 481. The revenue procedure will provide that notwithstanding any provision in Rev. Proc. 84-74, 1984-2 C.B. 736, the Service in examining a taxpayer's return may require that a method of accounting consistent with the preceding paragraph of this notice be adopted for the earliest year under examination, regardless of whether it was the taxpayer or the government that raised the issue and regardless of whether the issue was raised in the course of an examination or on a Form 3115 or otherwise.

No inference should be drawn from this notice as to the proper treatment of transactions that are not properly characterized as notional principal contracts, for instance, to the extent that such transactions are in substance properly characterized as loans. In addition, no inference should be drawn from this notice as to the characterization of a contract as an insurance contract or annuity contract or the proper treatment of payments made under insurance or annuity contracts.

This notice serves as an "administrative pronouncement" as that term is described in section 1.6661-3(b)(3) of the Income Tax Regulations and may be relied upon to the same extent as a revenue ruling or revenue procedure.

The principal author of this notice is Scott D. Feldstein of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information on the substantive rules relating to notional principal contracts contact Mr. Feldstein on (202) 566- 3516 (not a toll-free call). For further information on obtaining consent to change a method of accounting for notional principal contracts contact Pam Lowe of the Office of Assistant Chief Counsel (Income Tax and Accounting) on (202) 566-4481 (not a toll-free call).