IRS Requests Comments On Accounting Methods For Contingent Nonperiodic Payments.

Notice 2001-44

I. PURPOSE

The IRS and the Treasury Department are soliciting comments on the appropriate method for the inclusion into income or deduction of contingent nonperiodic payments made pursuant to a notional principal contract and the treatment of such inclusions or deductions.

II. BACKGROUND

I. In General

Section 1.446-3 of the Income Tax Regulations provides rules on the timing of inclusion of income and deductions for amounts paid or received pursuant to notional principal contracts. T.D. 8491, 1993-2 C.B. 215. The regulations define a notional principal contract ("a NPC") as a "financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount, in exchange for specified consideration or a promise to pay similar amounts." Section 1.446-3(c)(1)(i). Payments made pursuant to NPCs are divided into three categories (periodic, nonperiodic, and termination payments), and the regulations provide separate timing regimes for each. However, no guidance is provided in the regulations for the timing of inclusion or deduction of contingent nonperiodic payments made under NPCs. In addition, neither section 1.446-3 nor any other section provides specific rules governing the character of the various types of payments that could be made pursuant to a NPC.

The lack of comprehensive guidance in this area of the law has created significant uncertainty for taxpayers. For some, this uncertainty adds a considerable burden to the tax compliance process, and may discourage certain taxpayers from entering into NPCs. Other taxpayers welcome the ability to pick and choose among various tax law theories as to the character and timing of NPC payments, but this can lead to a whipsaw of the government. Both result in lack of confidence in the tax system, and inefficiencies in the capital markets.

The IRS and Treasury have reviewed several methods for including into income or deducting contingent nonperiodic payments made pursuant to NPCs. In evaluating each method, the IRS and Treasury have considered the extent to which it reflects certain fundamental tax policy principles. These policy principles include: whether the method provides sufficient certainty as to the amount and timing of inclusions or deductions (certainty/clarity); whether the method is complex, and the compliance and administrability burden created by that complexity (administrability); whether the method creates or increases inconsistencies in the tax treatment of financial instruments with similar economic characteristics (neutrality); whether the method creates or increases inconsistencies in the tax treatment of different taxpayers entering into the same instruments (symmetry); whether the method accurately reflects the accretion or reduction in economic wealth in the period in which the taxpayer is measuring the tax consequence of being a party to the NPC (economic accuracy); and whether the method is flexible enough to readily accommodate new financial arrangements (flexibility). It is clear that these principles are frequently in conflict, and there is no method of accounting that would satisfy all the criteria. However, the examination of an accounting method in the light of these principles can highlight the strengths and weaknesses of the method and inform the rulemaking process.

The methods the IRS and Treasury are considering for the inclusion into income or deduction of contingent nonperiodic payments made pursuant to NPCs are described below under the following headings: the Noncontingent Swap Method; the Full Allocation Method; the Modified Full Allocation Method; and the Mark-to-Market Method. The IRS and Treasury are seeking comments on the relative merits of each of these methods, as well as suggestions as to other methods that may be superior to these methods with respect to the fundamental tax policy principles listed above. The IRS and Treasury are interested in what authority taxpayers believe exists for mandating any and each of these methods.

Although this Notice is addressing the timing issues regarding NPCs with a contingent component, the IRS and Treasury are aware that there must be some coordination between the existing NPC rules and any new applicable rules. The IRS and Treasury are interested in comments on the need to revise the current rules for NPCs and related instruments if new rules for contingent NPCs are introduced. The IRS and Treasury are also interested in whether taxpayers believe it is necessary to develop rules on a much wider range of instruments before any kind of rule is issued with respect to contingent NPCs, which are only one specific type of instrument, i.e., whether the proliferation of individualized rules is more harmful than helpful in this area.

The IRS and Treasury are interested in comments from taxpayers as to the appropriateness of special, simplified rules for short-term or standardized contracts, and what form the simplified rules should take. If taxpayers suggest that a simplified rule should be provided for certain contracts, the IRS and Treasury are interested in what kind of test should be used to determine whether the simplified rule applies.

In addition to reviewing methods for the timing of income and expense with respect to contingent nonperiodic payments, the IRS and Treasury are considering what the character should be for all types of payments made pursuant to NPCs. In the current tax law, the distinction between capital gain and ordinary income is significant in two ways. First, taxpayers cannot offset capital losses against ordinary income (with a small exception for individuals). One policy reason for the rule against offsetting of capital losses against ordinary income is that taxpayers are able to choose the timing of their sales or exchanges of capital assets much more easily than the timing of their ordinary income or loss ("cherry picking"). They could, therefore, sell their loss assets at a time when they are expecting large amounts of ordinary income while deferring recognition on their gain assets. Second, for individuals, long-term capital gains are taxed at lower rates than ordinary income.

In determining whether particular payments made pursuant to a NPC should most appropriately be characterized as capital or as ordinary, attention should be given to the goals of minimizing cherry picking of character results and consistent application of the policy rationale for the current capital gains preference. In addition, in the financial products area, it is particularly important to pay attention to the neutrality principle, i.e., consistent treatment of different instruments with similar economic characteristics. There is almost limitless flexibility in the design of derivatives, and tax rules that provide for differences in tax treatment that do not reflect economic differences may produce inappropriate tax consequences. For example, some taxpayers are permitted to treat certain payments received pursuant to forward and option contracts as capital. If these taxpayers entered into NPCs with the same economic characteristics as the options or forwards contracts, but did not receive the same tax character treatment, tax-advantaged products might develop to arbitrage the tax differences between the various instruments. The particular problem the IRS and Treasury face with regard to neutrality is that the existing rules for various financial instruments are so inconsistent with each other, that it is difficult to decide, when developing rules for new instruments that can mimic many types of instruments, which set of existing rules should be followed. The IRS and Treasury are interested in comments on how the neutrality principle can best be given consistent effect for complex financial instruments.

The IRS and Treasury invite comments on the appropriate policy considerations for making character designations for NPC payments, as well as the application of those principles illustrated by the examples in the Notice. The IRS and Treasury also seek comments on: the authority governing the character of NPC payments and whether and what legislative change may be necessary to rationalize the rules.

The IRS and Treasury are aware that the definition of NPC as provided in section 1.446-3 covers only one class of the possible notional principal contracts that are transacted in the marketplace. For example, a contract that provides for a single payment at maturity based on some notional amount and specified index may not be covered by the definition because there are no "payments" made at "specified intervals." Such a contract is sometimes called a "bullet swap." There may be little difference in economics between a NPC as defined in section 1.446-3 and a series of bullet swaps, yet the payments made under one are covered by the regulation, whereas the payments under the other may not. The IRS and Treasury seek comments on how the tax accounting methods described in this Notice, or other methods, could be made applicable to a broader group of contracts that serve similar purposes as NPCs. The IRS and Treasury also seek comments on the appropriate character of payments made pursuant to contracts similar to NPCs.

A. METHODS FOR DETERMINING THE TIMING OF PAYMENTS UNDER NPCS

1. THE NONCONTINGENT SWAP METHOD

          a. TIMING. The noncontingent swap ("NCS") method provides an

Under the NCS method, the cost of hedging the exposure to the contingent NPC payment is used as a proxy for the contingent payment itself. The cost of hedging the contingent payment under the NPC is the current price of a portfolio of financial assets that, if liquidated on December 31, 2002, will exactly cover the cost of the contingent payment. This approach has been chosen because if a party to a contingent NPC assumed the hedging cost, both counterparties would be in the same position as if the contingent future obligation were actually paid. This hedging cost is therefore deemed to be paid, for example, by A to B, in satisfaction of the contingent obligation (for purposes of making calculations under the NCS method). The NCS method then provides a mechanism for amortizing this deemed payment by A to B into B's income throughout the life of the swap. It should be noted that the hedge transaction need not be entered into by either A or B. The deemed hedge merely provides a computational mechanism for converting the contingent payment into a fixed payment. Further details regarding this illustration, with computations of the hedging cost and the amounts of deductions and income inclusions, are provided in the Appendix.

          c. POLICY CONSIDERATIONS. The NCS method has the policy

               (ii) The IRS and Treasury also request comments on the

          a. TIMING. Under the full allocation method, taxpayers would

          a. TIMING. Under this method, each party to a NPC would

          a. TIMING. Under this method, taxpayers would mark their

The IRS and Treasury are seeking comments on what kinds of record keeping and information reporting would be necessary for each and any of the methods of accounting for contingent NPCs that would enable the IRS to verify the inclusions and deductions of counterparties to contingent NPCs and minimize the compliance burdens for taxpayers. In particular, the IRS and Treasury are interested in the following:

1. Are there any special kinds of information necessary for the IRS to obtain from taxpayers in order to verify their tax return positions with respect to contingent NPCs?

2. If there are special kinds of information relating to tax return positions for contingent NPCs, how should that information be made available to the IRS? Is it sufficient for taxpayers to keep detailed books and records which an agent can request if necessary? Or should specific information be required to be reported with the tax return? If the information is reported with a tax return, what form should the reporting take?

3. Is there sufficient justification to require third party reporting with respect to any of the methods of accounting for NPCs, particularly for the NCS method and the mark-to-market method? Should counterparties who are dealers be required to report their marks to nondealer counterparties under the mark-to-market method?

4. If certain types of record keeping or information reporting are recommended in comments to the IRS and Treasury, what would be the appropriate penalties for failure to keep the required records or provide the information?

III. REQUEST FOR COMMENTS

Written comments are requested to be submitted no later than November 19, 2001, to CC:FIP (Notice 2001-44), room 4300, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Comments may be hand delivered between the hours of 8 a.m. and 5 p.m. to CC:FIP (Notice 2001-44), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the Internet by submitting comments directly to the IRS Internet site at http://www.irs.gov/tax_regs/regslist.html. All comments will be available for public inspection and copying.

DRAFTING INFORMATION

The principal authors of this notice are: Elizabeth Handler and Dale S. Collinson, Office of Associate Chief Counsel (Financial Institutions and Products), Internal Revenue Service; Viva Hammer, Office of the Tax Legislative Counsel, Office of Tax Policy, United States Department of the Treasury; and Matthew J. Eichner, Office of Tax Analysis, Office of Tax Policy, United States Department of the Treasury. However, other personnel from the IRS and Treasury Department participated in its development. For further information regarding this notice contact Viva Hammer on (202) 622-0869 or Dale Collinson at (202) 622-3900 (not toll free calls).

APPENDIX

The method described in Section II.B.1.b. is illustrated using the following example of a simple equity swap contract on a notional amount of 100 shares of XYZ stock, entered into on January 1, 2001 between A and B with the following terms:

 A pays B:

With this forward contract in place, A would be able to make the required payment to party B. ² However, the arrangement described thus far would involve A committing more funds to building the hedge than is absolutely necessary. A is required to pay B only the difference between the price of the shares on December 31, 2002 and the price of the shares on January 1, 2001, and not the entire value of the shares on December 31, 2002. For example, suppose that the price of the 100 XYZ shares has risen to $110,000 by expiration of the NPC. If this happens, A would be obligated to pay B $12,500. A would purchase the shares pursuant to the forward contract for $106,200, sell them for $110,000, and pay party B the $12,500 required under the terms of the swap. The remaining $97,500 in proceeds would belong to A. This $97,500 (the market price of the shares on January 1, 2001) would always remain in A's possession at maturity no matter how the value of XYZ stock changes through the life of the NPC. Therefore, simply entering into a forward contract for the purchase of the XYZ stock is not an exact hedge for A's commitment under the swap contract. To further refine the hedge, A could borrow the present value of $97,500, i.e., $84,966 on January 1, 2001. Borrowing this amount would mean that the cost of assembling the hedge would be ($92,547 - $84,966), or $7,582.

The net cash flow from these two transactions -- purchasing the forward contract and borrowing the present value of the current price of the 100 shares -- would always enable A to exactly make the payment due to B under the NPC on December 31, 2002, no less and no more. If the share price rises to $1,000 by December 31, 2002, A would sell the stock delivered in satisfaction of the forward contract for $100,000, pay $2,500 to B and repay the loan with the remaining $97,500. If, instead, the price were to fall to $935 by December 31, 2002, A would actually receive $4,000 from B which, in combination with the proceeds from selling the stock delivered under the forward contract for $93,500, would allow A to repay the loan balance of $97,500.

Once the present value of A's deemed hedge for the contingent payment is determined, this amount must be amortized into B's income. This can be done by deeming A to provide to B a zero coupon bond with a present value of $7,582. Such a bond has a face value, payable at maturity, of $8,700 (assuming again an annual rate of 7.00% and compounded semiannually).

The original issue discount (OID) is found by multiplying the present value of the bond at the beginning of each six month period by the periodic rate, 7.00%/2 or 3.50%:

 Period ending       OID                      Present Value of Bond

 Period                                                 Balance

 Period Ending       OID            Principal           Income

² The terms of the contract require B to make a payment to A if the XYZ stock decreases in value. Because forward pricing for investment property such as corporate stock always assumes an increase in price, the method would also assume at the outset that the contingent payment would be made by A to B.