BANKERS WANT MODIFICATIONS TO NOTIONAL PRINCIPAL CONTRACT REGS.

Ames argues that an election to mark to market should override the timing rules of section 988 and that the regulations should not create two conceptually different safe harbors for nonperiodic payments made for swaps, caps, or floors. Ames also asserts that the assignment rule should be deleted because it deters economically motivated assignments and encourages tax-motivated assignments. She further states that the definition of notional principal contract should be expanded to cover currency swaps and contracts with more than one specified purpose.

The American Bankers Association hereby submits comments on the Proposed Regulations implementing Internal Revenue Code ("IRC") Section 446(b) ("Proposed Regulations" or "Regulations"). These Regulations relate to the timing of income and deductions with respect to notional principal contracts ("NPCs"). The American Bankers Association ("ABA") is the national trade and professional association for America's commercial banks of all sizes and types. Assets of ABA member banks are about 95 percent of the industry total. Our comments are directed solely to the impact of the proposed rules on commercial banks and their customers.

The ABA is pleased that the IRS has attempted to seek conformity in its definitions of NPCs for purposes of IRC Sections 446 and 863. The ABA encourages the IRS to continue this effort in future regulations' projects as it simplifies the cross-reference activities that are inherent in the Internal Revenue Code. In three areas, however, the ABA is disappointed that the rules are more complicated than necessary in that they: (1) severely limit the availability of the dealer election to use the mark-to-market method by requiring them to use mark-to-market for ALL derivative financial instruments and forego the use of the lower-of-cost-or-market ("LCM") method for securities and commodities; (2) create two conceptually different safe harbors for nonperiodic payments made for swaps and caps/floors; and (3) recharacterize certain NPCs with "significant" nonperiodic payments as involving one or more loans.

A detailed discussion for each of these items is included below. However, in an effort to facilitate the pinpointing of all of the ABA's observations, our comments are presented in the same order as the Notice of Proposed Rulemaking.

COMMENTS TO THE PREAMBLE

INTEGRATION

The Proposed Regulations do not permit taxpayers to integrate NPCs with assets or liabilities hedged by those contracts for timing or character purposes. However, these Regulations indicate that the IRS is contemplating integrating NPCs with each other and with offsetting assets or liabilities in certain circumstances. The ABA agrees that the IRS's authority to require a method of accounting which clearly reflects income is broad enough to permit the adoption of specific rules that would minimize the amount of mismatching (due to timing differences) wherever possible.

The ABA believes that integration, for purposes of the Section 446 Regulations, would be welcomed by its members. Such integration should be available as an alternative accounting method as it would more clearly reflect income with respect to NPCs used as hedges and would be consistent with similar treatment under other provisions of the Internal Revenue Code. The ABA recommends that the same rules should be applied to hedges in functional and non-functional currencies in order to add simplicity to the Code. In general, the foreign currency hedging rules of Treasury Regulation Section 1.988- 5T should be the model for integration. However, with respect to the requirement that integration can only occur with a non-related party, the ABA recommends the IRS reconsider this position as most banks hedge positions internally and file as a consolidated group; and therefore, would be precluded from the benefits of this rule.

CHARACTER

The Proposed Regulations, in general, do not address the character of income, loss, or deductions with respect to NPCs. However, the Preamble suggests (as a result of Proposed Section 1.1092(d)-1) that the termination (extinguishment or assignment) of a NPC would generally be treated as a sale or exchange under IRC Section 1234A; and any gain or loss arising from the termination will therefore be treated as a capital gain or loss. It is the ABA's understanding that the determination of character is related to whether the taxpayer is a dealer and whether the use of the instrument as a hedge causes it to fall outside the definition of a capital asset.

It is the ABA's opinion that a notional principal payment creates ordinary treatment for a commercial bank (as well as a dealer) as the bank either uses the NPC as inventory or as hedges in the ordinary course of business to manage risk. However, uncertainty has arisen since the Supreme Court's decision in Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988), which has left the character issue in a state of flux. Consequently, the ABA recommends that the character of NPCs be addressed imminently -- either in these Final Regulations or as a separate regulation or ruling project. At a minimum, it should be clarified that ordinary treatment is appropriate for dealers and traders in NPCs, even with respect to terminations.

EQUITY SWAPS

The Preamble notes that the IRS is currently considering whether equity and equity index swaps should be treated in the same manner as interest rate and commodity swaps for sourcing and withholding tax purposes. Presently, equity swaps (just like commodity swaps) are subject to the residence-based source rules under Treasury Regulation Section 1.863-7(a)(1). As such, no withholding issues currently exist.

The ABA questions whether the IRS is currently considering withdrawing the final regulations under IRC Section 863. If so, the ABA recommends that any changes be prospective since taxpayers have relied on the final regulations and may not have the appropriate documentation for withholding tax purposes. Additionally, the ABA recommends that equity and equity index NPCs be treated in the same manner as interest rate and commodity NPCs for sourcing and withholding tax purposes.

MARK-TO-MARKET ELECTION

The Preamble suggests that an electing dealer may also be required to make an adjustment under IRC Section 481(a) due to the prohibition against the use of the LCM method.

The ABA recommends that where a taxpayer has to make an adjustment due to the switch from LCM to mark-to-market accounting, the taxpayer should be permitted to follow Revenue Procedure 84-74. Under this recommendation, the taxpayer would spread the adjustment over the period of years provided in Rev. Proc. 84-74. Additionally, the ABA recommends that where the taxpayer makes the Section 1.446-4 election, the IRS's consent to the change of accounting method resulting from such election should be automatic. Examples of such automatic consents are contained in Rev. Proc. 84-27 (Rule of 78's Method Change) and Rev. Proc. 91-51 (Excess Mortgage Servicing Fees).

COMMENTS CONCERNING SECTION 1.446-3

This Section provides the definitions to be used in the context of these rules. As mentioned above, the ABA supports the IRS's decision to use the same definition for NPCs in this subsection (- 3(c)) as is currently used in Treas. Reg. Section 1.863-7(a)(1). The ABA recommends conformity wherever possible.

In this vein, the ABA suggests that a notional principal amount be defined so as not to exclude currency swaps (within the meaning of the regulations under IRC Section 988) which involve an actual exchange of a principal amount. A cross-reference to Treas. Reg. Section 1.988-5T(a)(4)(ii) would achieve this recommendation.

"SPECIFIED INDEX"

The Proposed Regulations, unlike current Treasury regulations under Section 863, define what constitutes a "specified index". Under the Proposed Regulations, a specified index may include, for example, commodity prices, fixed and floating interest rates, equity indices, and the price of an individual publicly traded stock or security. The regulations under IRC Section 863 do not contain such a listing.

The ABA questions whether this definition is intended to apply to transactions under Section 863 and whether this overrides the definition of "objective interest index" within the meaning of Prop. Treas. Reg. Section 1.1275-5(b). The ABA recommends that amendments be made concerning the "specified index" under IRC Sections 863 and 1275 to conform these provisions to Proposed Regulation Section 1.446- 3.

Additionally, the ABA recommends that Section 1.446-3(c)(2)(ii) be rewritten to cover additional indices such as those based upon certificate of deposits. For example, NPCs that are indexed to a bank's 6-month CD rate would not currently meet the description under Section 1.446-3(c)(2)(ii). The ABA believes the following language would correct this oversight: "(ii) an interest rate that is made known publicly and offered currently to or from unrelated persons in lending or borrowing transactions entered into by a financial institution;".

NOTIONAL PRINCIPAL AMOUNT

Under the Proposed Regulations, a notional principal amount is defined as any specified amount of money or property which, when multiplied by a specified index, measures the parties' obligations under the contract. As currently drafted, this definition is too limiting as it does not appear to cover currency swaps. For example, one party may make payments based on 15 billion yen LIBOR while the other makes payments based on 100 million U.S. dollars LIBOR. In that case, it could be argued that there are two notional principal amounts and not one.

The ABA believes that a notional principal amount should include more than one specified amount and such amount should be permitted to fluctuate over the life of the contract (i.e., as the principal balance on a loan being hedged declines). The ABA believes an additional sentence should be added to this subsection, -3(c)(3), between the present first and second sentence. The following language should clarify that the first sentence is not as limiting as its literal language provides. The "new" second sentence should read: "Notional principal amounts need not be the same amount for each party and may fluctuate over the life of the contract." For example, consider swaps designed to hedge mortgage portfolios where the value decreases over the life of the contract or in the case of a total return equity swap where the amount of the payment may change because the stock value changes.

Additionally, the ABA believes the resulting third sentence needs to be modified to clarify that currency swaps are to be included as NPCs. The ABA recommends that the third sentence be modified accordingly: "Except in the case of currency swaps as defined in Treas. Reg. Section 1.988-5, the notional principal amount . . ."

TAXABLE YEAR OF INCLUSION

The Proposed Regulations, under Section 1.446-3(e), divide the payments in respect of NPCs into three categories: periodic payments, nonperiodic payments and termination payments. These Regulations require that all taxpayers recognize the ratable daily portion of a periodic payment for the taxable year to which that portion relates. For nonperiodic payments, these Regulations require the taxpayer to recognize this payment over the term of a NPC in a manner that reflects the economic substance of the contract. Termination payments must be recognized, by the assigning and nonassigning party, in the year that the NPC is extinguished or assigned.

MARK-TO-MARKET ELECTION

As currently drafted, it is unclear whether Section 1.446-3(e) applies where a bank has made the mark-to-market election. The ABA believes that it is not the IRS's intention to have this section apply where a Section 1.446-4(a) election has been made. As such, the ABA recommends that the following sentence be added at the beginning of Section 1.446-3(e): "Where a mark-to-market election has been made under Section 1.446-4(a), paragraphs (1)-(6) do not apply to such NPC to the extent that the taxpayer accounts for such NPC under Section 1.446-4."

PERIODIC PAYMENTS

The ABA appreciates the rules under -4(e)(2)(B) for their simplicity and recommends that the IRS conform the rules contained in Treas. Reg. Section 1.1273-1(b)(1)(ii)(A). The definition covering qualified periodic interest payments, under Section 1.446-4(e)(2)(B), is an improvement. The ABA recommends that when the regulations are finalized under IRC Section 1273, this approach be adopted.

The ABA also recommends that the reference to net income under - 4(e)(1) be clarified to state that it is determined on a contract-by- contract basis. Additionally, this section needs to be clarified to provide that the net income from a NPC does not reflect a netting of different NPCs even if a part of a master agreement.

NONPERIODIC PAYMENTS

The ABA understands that many commercial banks use a straight- line amortization method for cap/floor premiums and yield adjustment fees on swaps for financial reporting purposes. In the interests of simplicity and book/tax conformity, the ABA recommends that a straight-line method be permissible for ALL notional principal contracts. In any case, in the optional method for interest rate swaps, the calculation for determining the effective yield, under the constant yield to maturity method, should permit the use of the prevailing market rate of interest, if agreed to by the counterparties, and not necessarily the nominal rate in the swap or the overpayment rate.

As a more general matter, it is the ABA's belief that amortization methods and other analytical models based on option pricing formulae are too complex to be properly administered, and the costs of compliance outweigh any perceived fiscal objectives. The Proposed Regulations place too much emphasis on potentially abusive transactions such as "deep in the money caps" that, as a practical matter, simply do not exist in the marketplace on a scale that warrants such intrusive rules as the proposed loan recharacterization rule. The ABA believes further study is needed before bright line tests such as the 25 basis point rule for caps and floors is adopted.

CAPS AND FLOORS

If a bright line test is to be used, the benchmark for determining whether a cap or floor is "significantly in-the-money", under Section 1.446-3(e)(4)(iv), should not be the initial current value of the specified index. In an economic environment where the yield curve is not flat, the current value of the specified index is not the relevant characteristic for determining whether a cap or floor is considered "significantly in-the-money". Rather, the relevant benchmark should be some measure of the expected values of the indices that are to determine the prices of the series of options making up the cap or floor premium. Typically, this will be the full- term rate rather than the reference rate by which the contract pays or receives income. Appropriate measuring sticks of this full-term rate include the closing Treasury rate with a swap spread figure such as those available from Reuters and Telerate or perhaps the AFR plus 100 basis points.

Alternatively, a bright line test for determining whether a cap or a floor is "significantly in-the-money", could compare the intrinsic value of the cap or floor to the premium actually charged. This can be done by measuring the difference between the strike price and the expected interest rate from the implied forward rate curve. For those strike points at which the implied forward rate exceeds the strike price, the difference between the two, multiplied by the notional principal amount and discounted back so as to be stated as present value, is a fair measure of the intrinsic value of the cap or floor. If the sum of these expected present values over the anticipated life of the contract, taken as a percentage of the premium actually charged, is less than some threshold amount, the contract would not contain a disguised loan. For this purpose, the present value should presumably be determined by using the zero- coupon rate for the applicable period.

SWAPS

There is an inconsistency between Example 5 of Section 1.446- 3(e)(3)(iii) and Example 3 of Section 1.446-3(e)(4)(v) in methodology for calculating the present value of the disguised loan or yield adjustment amount. In Example 5, the discount rate used is the nominal rate and in Example 3, the discount rate used is the market rate. It is the ABA's belief that Example (5) under Section 1.446- 3(e)(3)(iii) needs to be clarified to reflect the same discount rate used to determine whether a loan exists. The rate used in Example (3) (i.e. the market rate and not the nominal rate) under Section 1.446- 3(e)(4)(v) would suffice.

INTERNATIONAL ASPECTS

The ABA believes that "any" nonperiodic payment should not be treated as a constructive loan for IRC Section 956 purposes. It appears contrary to the policy of IRC Section 956 for the Commissioner to make this determination. However, if the Commissioner is to make this review under Section 1.446-3(e)(4)(iii), the Commissioner should only review the payment if it is "significant" and any IRC Section 956 inclusion should be limited to the overall net amount due from a controlled foreign corporation from all NPCs and not the gross amounts from each contract that involves a payment to a related U.S. person.

It is the ABA's view that subjecting the imputed interest on a nonperiodic payment to U.S. withholding tax when the deemed recipient is foreign (as suggested by the Preamble), appears to conflict with the policy evident in other provisions of the Code such as Sections 871(a)(1)(C)(ii) and 881(a)(3)(B) which exempt non-cash items from withholding. If withholding is required, the Final Regulations should clarify that the "portfolio interest" exception of IRC Section 871(h) and reductions in withholding under U.S. tax treaties are applicable.

Finally, for both foreign and domestic recipients, the Final Regulations should state that payors of nonperiodic payments are not subject to any additional reporting or withholding requirements due to the subsequent recharacterization of a portion of the nonperiodic payment as deemed interest.

TERMINATIONS

As currently drafted, the rules under Section 1.446-3(e)(6) will inhibit assignments made for valid business reasons. Typically, most commercial banks permit their customers to assign a NPC for valid credit reasons -- i.e. the customer has reached its credit limit and needs to reorganize its portfolio before another business deal is completed. Also, banks often assign contracts to one another to adjust their flexibility and credit risk. The ABA believes that the assignment of one party's rights and obligations under a NPC should not be considered a termination for the non-assigning party. The ABA recommends that the rules under Section 1.446-3(e)(6) should be deleted from the Final Regulations as they will deter valid assignments and will promote tax abuse as taxpayers may assign a NPC to reduce their Federal tax liability.

EFFECTIVE DATE

The ABA recommends that when the regulations under Section 1.446-3 are finalized, their effective date should provide that the Regulations will be effective for NPCs entered into "during taxable years beginning one year after the date on which the regulations are finalized." The ABA believes that the one-year lag is the most appropriate effective date as numerous computer and programming changes must be incurred to fully comply with the proposed regulations as drafted. At a minimum, the effective date should be modified to cover NPCs entered into during the second quarter after which the regulations have been finalized.

COMMENTS CONCERNING SECTION 1.446-4

The Proposed Regulations provide an election for dealers in derivative financial instruments to use a mark-to-market method of accounting for such instruments. However, in order to make this election, dealers are required to forego the benefits of lower-of- cost-or-market ("LCM") accounting for their securities and commodities inventories.

MARK-TO-MARKET ELECTION

It is the ABA's understanding that the election under Section 1.446-4 can be made on a consolidated basis. However, the Proposed Regulations do not explicitly state this. The ABA recommends that the Final Regulations provide that the election may be made, at the taxpayer's option, on a consolidated basis.

The ABA does not believe that banks should be required to discontinue LCM accounting in order to make the mark-to-market election under Section 1.446-4. Banks typically use LCM for GAAP and Tax accounting purposes in the following areas: (1) troubled country debt trading; (2) distressed loan trading; (3) certain bulk committed asset sales; (4) certain long-term foreign currency contracts; (5) mortgage-backed securities; and (6) U.S. Treasury obligations. Additionally, certain foreign jurisdictions require the use of the LCM method for tax purposes. The ABA recommends that an election to use mark-to-market accounting be permitted without having to forego LCM accounting. Taxpayers should have the option to use both. In addition, the ABA recommends that the taxpayer have the option to make the mark-to-market election for all derivative financial instruments or to make the election for a specified class or activity.

EFFECTIVE DATE

Under the Section 1.446-4(g) of the Proposed Regulations, the Regulations will be effective for taxable years ending after the date on which the Regulations under Section 1.446-4 are finalized. The ABA recommends that the effective date for this provision be modified to provide that this Section, at the election of the taxpayer, be applicable for all open years.

COMMENTS CONCERNING SECTION 1.988-2T(h)

The ABA recommends that where an election is made under Section 1.446-4, the election should override the timing rules of IRC Section 988. An election under Section 1.446-4 should also cover currency swaps as they fit within the definition of NPCs.

COMMENTS CONCERNING SECTION 1.1092(d) AND 1234A

The Proposed Regulations would effectively subject NPCs to the "straddle" rules of Treas. Reg. Section 1.1092 so long as "similar" contracts were traded on an "established financial market". It is the ABA's understanding that there is no active secondary market for the NPCs and as such, they do not meet the requirement of active trading as defined in Treas. Reg. Section 1.1092(d). Therefore, the ABA recommends that this provision be deleted from the Final Regulations under Section 1092.

The Proposed Regulations under Section 1.1092(d)-1(c)(i) state that the rights and obligations of a party to a NPC constitute an interest in personal property. As a consequence, IRC Section 1234A would apply to NPCs. Under Section 1234A, a termination of a NPC could be deemed a sale or exchange. Therefore, the gain or loss arising from the termination will generally be treated as capital in the case of a nondealer and also where the NPC is not used as a hedge. Yet, under a broad interpretation of Arkansas Best, NPCs held by a dealer might, depending on the facts, not qualify as capital assets. It is the ABA's belief that a termination that involves a dealer generally results in ordinary income or loss because a termination is not a "sale or exchange" and a NPC, in the hands of a dealer, is not a capital asset. The ABA recommends that the Final Regulations state that NPCs of dealers or traders in NPCs are not capital assets for purposes of IRC Section 1234A.

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These comments represent the major concerns of ABA members regarding the timing of income and deductions from notional principal contracts. The ABA is available to elaborate upon these comments at your earliest convenience. THE ABA RESPECTFULLY REQUESTS PERMISSION TO TESTIFY AT THE OCTOBER 7TH HEARING. For additional information, please contact us at (202) 663-4986.

Sincerely,