Sec. 1.446-3 Notional principal contracts.

(1) Notional principal contract.

(2) Specified index.

(3) Notional principal amount.

(4) Special definitions.

(1) Definition.

(2) Recognition rules.

(1) Definition.

(2) Recognition rules.

(1) Disguised notional principal contracts.

(2) Hedged notional principal contracts.

(3) Options and forwards to enter into notional principal contracts.

(4) [Reserved]. For further guidance, see § 1.446-3T(g)(4).

(5) Caps and floors that are significantly in-the-money. [Reserved]

(6) Examples.

(1) Definition.

(2) Taxable year of inclusion and deduction by original parties.

(3) Taxable year of inclusion and deduction by assignees.

(4) Special rules.

(i) In general.

A notional principal contract is 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. An agreement between a taxpayer and a qualified business unit (as defined in section 989(a)) of the taxpayer, or among qualified business units of the same taxpayer, is not a notional principal contract because a taxpayer cannot enter into a contract with itself. Notional principal contracts governed by this section include interest rate swaps, currency swaps, basis swaps, interest rate caps, interest rate floors, commodity swaps, equity swaps, equity index swaps, and similar agreements. A collar is not itself a notional principal contract, but certain caps and floors that comprise a collar may be treated as a single notional principal contract under paragraph (f)(2)(v)(C) of this section. A contract may be a notional principal contract governed by this section even though the term of the contract is subject to termination or extension. Each confirmation under a master agreement to enter into agreements governed by this section is treated as a separate notional principal contract.

(ii) Excluded contracts.

A contract described in section 1256(b), a futures contract, a forward contract, and an option are not notional principal contracts. An instrument or contract that constitutes indebtedness under general principles of Federal income tax law is not a notional principal contract. An option or forward contract that entitles or obligates a person to enter into a notional principal contract is not a notional principal contract, but payments made under such an option or forward contract may be governed by paragraph (g)(3) of this section.

(iii) Transactions within section 475.

To the extent that the rules provided in paragraphs (e) and (f) of this section are inconsistent with the rules that apply to any notional principal contract that is governed by section 475 and regulations thereunder, the rules of section 475 and the regulations thereunder govern.

(iv) Transactions within section 988.

To the extent that the rules provided in this section are inconsistent with the rules that apply to any notional principal contract that is also a section 988 transaction or that is integrated with other property or debt pursuant to section 988(d), the rules of section 988 and the regulations thereunder govern.

(i) A fixed rate, price, or amount;

(ii) A fixed rate, price, or amount applicable in one or more specified periods followed by one or more different fixed rates, prices, or amounts applicable in other periods;

(iii) An index that is based on objective financial information (as defined in paragraph (c)(4)(ii) of this section); and

(iv) An interest rate index that is regularly used in normal lending transactions between a party to the contract and unrelated persons.

(i) Related person and party to the contract.

A related person is a person related (within the meaning of section 267(b) or 707(b)(1)) to one of the parties to the notional principal contract or a member of the same consolidated group (as defined in section 1.1502-1(h)) as one of the parties to the contract. For purposes of this paragraph (c), a related person is considered to be a party to the contract.

(ii) Objective financial information.

For purposes of this paragraph (c), objective financial information is any current, objectively determinable financial or economic information that is not within the control of any of the parties to the contract and is not unique to one of the parties' circumstances (such as one party's dividends, profits, or the value of its stock). Thus, for example, a notional principal amount may be based on a broadly-based equity index or the outstanding balance of a pool of mortgages, but not on the value of a party's stock.

(iii) Dealer in notional principal contracts.

A dealer in notional principal contracts is a person who regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in notional principal contracts with customers in the ordinary course of a trade or business.

(i) In general.

All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a periodic payment for the taxable year to which that portion relates.

(ii) Rate set in arrears.

If the amount of a periodic payment is not determinable at the end of a taxable year because the value of the specified index is not fixed until a date that occurs after the end of the taxable year, the ratable daily portion of a periodic payment that relates to that taxable year is generally based on the specified index that would have applied if the specified index were fixed as of the last day of the taxable year. If a taxpayer determines that the value of the specified index as of the last day of the taxable year does not provide a reasonable estimate of the specified index that will apply when the payment is fixed, the taxpayer may use a reasonable estimate of the specified index each year, provided that the taxpayer (and any related person that is a party to the contract) uses the same method to make the estimate consistently from year to year and uses the same estimate for purposes of all financial reports to equity holders and creditors. The taxpayer's treatment of notional principal contracts with substantially similar specified indices will be considered in determining whether the taxpayer's estimate of the specified index is reasonable. Any difference between the amount that is recognized under this paragraph (e)(2)(ii) and the corresponding portion of the actual payment that becomes fixed under the contract is taken into account as an adjustment to the net income or net deduction from the notional principal contract for the taxable year during which the payment becomes fixed.

(iii) Notional principal amount set in arrears.

Rules similar to the rules of paragraph (e)(2)(ii) of this section apply if the amount of a periodic payment is not determinable at the end of a taxable year because the notional principal amount is not fixed until a date that occurs after the end of the taxable year.

Example 1. Accrual of periodic swap payments.

(a) On April 1, 1995, A enters into a contract with unrelated counterparty B under which, for a term of five years, A is obligated to make a payment to B each April 1, beginning April 1, 1996, in an amount equal to the London Interbank Offered Rate (LIBOR), as determined on the immediately preceding April 1, multiplied by a notional principal amount of $100 million. Under the contract, B is obligated to make a payment to A each April 1, beginning April 1, 1996, in an amount equal to 8% multiplied by the same notional principal amount. A and B are calendar year taxpayers that use the accrual method of accounting. On April 1, 1995, LIBOR is 7.80%.

(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section, and both LIBOR and a fixed interest rate of 8% are specified indices under paragraph (c)(2) of this section. All of the payments to be made by A and B are periodic payments under paragraph (e)(1) of this section because each party's payments are based on a specified index described in paragraphs (c)(2)(iii) and (c)(2)(i) of this section, respectively, are payable at periodic intervals of one year or less throughout the term of the contract, and are based on a single notional principal amount.

(c) Under the terms of the swap agreement, on April 1, 1996, B is obligated to make a payment to A of $8,000,000 (8% x $100,000,000) and A is obligated to make a payment to B of $7,800,000 (7.80% x $100,000,000). Under paragraph (e)(2)(i) of this section, the ratable daily portions for 1995 are the amounts of these periodic payments that are attributable to A's and B's taxable year ending December 31, 1995. The ratable daily portion of the 8% fixed leg is $6,010,929 (275 days/366 days x $8,000,000), and the ratable daily portion of the floating leg is $5,860,656 (275 days/366 days x $7,800,000). The net amount for the taxable year is the difference between the ratable daily portions of the two periodic payments, or $150,273 ($6,010,929 - $5,860,656). Accordingly, A has net income of $150,273 from this swap for 1995, and B has a corresponding net deduction of $150,273.

(d) The $49,727 unrecognized balance of the $200,000 net periodic payment that is made on April 1, 1996, is included in A's and B's net income or net deduction from the contract for 1996.

(e) If the parties had entered into the contract on February 1, 1995, the result would not change because no portion of either party's obligation to make a payment under the swap relates to the period prior to April 1, 1995. Consequently, under paragraph (e)(2) of this section, neither party would accrue any income or deduction from the swap for the period from February 1, 1995, through March 31, 1995.

Example 2. Accrual of periodic swap payments by cash method taxpayer.

(a) On April 1, 1995, C enters into a contract with unrelated counterparty D under which, for a period of five years, C is obligated to make a fixed payment to D each April 1, beginning April 1, 1996, in an amount equal to 8% multiplied by a notional principal amount of $100 million. D is obligated to make semi-annual payments to C each April 1 and October 1, beginning October 1, 1995, in an amount equal to one-half of the LIBOR amount as of the first day of the preceding 6-month period multiplied by the notional principal amount. The payments are to be calculated using a 30/360 day convention. C is a calendar year taxpayer that uses the accrual method of accounting. D is a calendar year taxpayer that uses the cash receipts and disbursements method of accounting. LIBOR is 7.80% on April 1, 1995, and 7.46% on October 1, 1995.

(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section, and LIBOR and the fixed interest rate of 8% are each specified indices under paragraph (c)(2) of this section. All of the payments to be made by C and D are periodic payments under paragraph (e)(1) of this section because they are each based on appropriate specified indices, are payable at periodic intervals of one year or less throughout the term of the contract, and are based on a single notional principal amount.

(c) Under the terms of the swap agreement, D pays C $3,900,000 (0.5 x 7.8% x $100,000,000) on October 1, 1995. In addition, D is obligated to pay C $3,730,000 (0.5 x 7.46% x $100,000,000) on April 1, 1996. C is obligated to pay D $8,000,000 on April 1, 1996. Under paragraph (e)(2)(i) of this section, C's and D's ratable daily portions for 1995 are the amounts of the periodic payments that are attributable to their taxable year ending December 31, 1995. The ratable daily portion of the 8% fixed leg is $6,000,000 (270 days/360 days x $8,000,000), and the ratable daily portion of the floating leg is $5,765,000 ($3,900,000 + (90 days/180 days x $3,730,000)). Thus, C's net deduction from the contract for 1995 is $235,000 ($6,000,000 - $5,765,000) and D reports $235,000 of net income from the contract for 1995.

(d) The net unrecognized balance of $135,000 ($2,000,000 balance of the fixed leg - $1,865,000 balance of the floating leg) is included in C's and D's net income or net deduction from the contract for 1996.

Example 3. Accrual of swap payments on index set in arrears.

(a) The facts are the same as in Example 1, except that A's obligation to make payments based upon LIBOR is determined by reference to LIBOR on the day each payment is due. LIBOR is 8.25% on December 31, 1995, and 8.16% on April 1, 1996.

(b) On December 31, 1995, the amount that A is obligated to pay B is not known because it will not become fixed until April 1, 1996. Under paragraph (e)(2)(ii) of this section, the ratable daily portion of the periodic payment from A to B for 1995 is based on the value of LIBOR on December 31, 1995 (unless A or B determines that the value of LIBOR on that day does not reasonably estimate the value of the specified index). Thus, the ratable daily portion of the floating leg is $6,198,770 (275 days/366 days x 8.25% x $100,000,000), while the ratable daily portion of the fixed leg is $6,010,929 (275 days/366 days x $8,000,000). The net amount for 1995 on this swap is $187,841 ($6,198,770 - $6,010,929). Accordingly, B has $187,841 of net income from the swap in 1995, and A has a net deduction of $187,841.

(c) On April 1, 1996, A makes a net payment to B of $160,000 ($8,160,000 payment on the floating leg - $8,000,000 payment on the fixed leg). For purposes of determining their net income or net deduction from this contract for the year ended December 31, 1996, B and A must adjust the net income and net deduction they recognized in 1995 by $67,623 (275 days/366 days x ($8,250,000 presumed payment on the floating leg - $8,160,000 actual payment on the floating leg)).

(i) In general.

All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a nonperiodic payment for the taxable year to which that portion relates. Generally, a nonperiodic payment must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract.

(ii) General rule for swaps.

A nonperiodic payment that relates to a swap must be recognized over the term of the contract by allocating it in accordance with the forward rates (or, in the case of a commodity, the forward prices) of a series of cash-settled forward contracts that reflect the specified index and the notional principal amount. For purposes of this allocation, the forward rates or prices used to determine the amount of the nonperiodic payment will be respected, if reasonable. See paragraph (f)(4) Example 7 of this section.

(iii) Alternative methods for swaps.

Solely for purposes of determining the timing of income and deductions, a nonperiodic payment made or received with respect to a swap may be allocated to each period of the swap contract using one of the methods described in this paragraph (f)(2)(iii). The alternative methods may not be used by a dealer in notional principal contracts (as defined in paragraph (c)(4)(iii) of this section) for swaps entered into or acquired in its capacity as a dealer.

(iv) General rule for caps and floors.

A payment to purchase or sell a cap or floor must be recognized over the term of the agreement by allocating it in accordance with the prices of a series of cash- settled option contracts that reflect the specified index and the notional principal amount. For purposes of this allocation, the option pricing used by the parties to determine the total amount paid for the cap or floor will be respected, if reasonable. Only the portion of the purchase price that is allocable to the option contract or contracts that expire during a particular period is recognized for that period. Thus, under this paragraph (f)(2)(iv), straight-line or accelerated amortization of a cap premium is generally not permitted. See paragraph (f)(4) Examples 1 and 2 of this section.

(v) Alternative methods for caps and floors that hedge debt instruments.

Solely for purposes of determining the timing of income and deductions, if a cap or floor is entered into primarily to reduce risk with respect to a specific debt instrument or group of debt instruments held or issued by the taxpayer, the taxpayer may amortize a payment to purchase or sell the cap or floor using the methods described in this paragraph (f)(2)(v), adjusted as appropriate to take account of increases or decreases in the notional principal amount. The alternative methods may not be used by a dealer in notional principal contracts (as defined in paragraph (c)(4)(iii) of this section) for caps or floors entered into or acquired in its capacity as a dealer.

(vi) Additional methods.

The Commissioner may, by a revenue ruling or a revenue procedure published in the Internal Revenue Bulletin, provide alternative methods for allocating nonperiodic payments that relate to a notional principal contract to each year of the contract. See section 601.601(d)(2)(ii)(b) of this chapter.

Example 1. Cap premium amortized using general rule.

(a) On January 1, 1995, when LIBOR is 8%, F pays unrelated party E $600,000 for a contract that obligates E to make a payment to F each quarter equal to one-quarter of the excess, if any, of three-month LIBOR over 9% with respect to a notional principal amount of $25 million. Both E and F are calendar year taxpayers. E provides F with a schedule of allocable premium amounts indicating that the cap was priced according to a reasonable variation of the Black-Scholes option pricing formula and that the total premium is allocable to the following periods:

(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section, and LIBOR is a specified index under paragraph (c)(2)(iii) of this section. Any payments made by E to F are periodic payments under paragraph (e)(1) of this section because they are payable at periodic intervals of one year or less throughout the term of the contract, are based on an appropriate specified index, and are based on a single notional principal amount. The $600,000 cap premium paid by F to E is a nonperiodic payment as defined in paragraph (f)(1) of this section.

(c) The Black-Scholes model is recognized in the financial industry as a standard technique for pricing interest rate cap agreements. Therefore, because E has used a reasonable option pricing model, the schedule generated by E is consistent with the economic substance of the cap, and may be used by both E and F for calculating their ratable daily portions of the cap premium. Under paragraph (f)(2)(iv) of this section, E recognizes the ratable daily portion of the cap premium as income, and F recognizes the ratable daily portion of the cap premium as a deduction based on the pricing schedule. Thus, E and F account for the contract as follows:

(d) Any periodic payments under the cap agreement (that is, payments that E makes to F because LIBOR exceeds 9%) are included in the parties' net income or net deduction from the contract in accordance with paragraph (e)(2) of this section.

Example 2. Cap premium allocated to proper period.

(a) The facts are the same as in Example 1, except that the cap is purchased by F on November 1, 1994. The first determination date under the cap agreement is January 31, 1995 (the last day of the first quarter to which the contract relates). LIBOR is 9.1% on December 31, 1994, and is 9.15% on January 31, 1995.

(b) E and F recognize $9,192 (61 days/365 days x $55,000) as the ratable daily portion of the nonperiodic payment for 1994, and include that amount in their net income or net deduction from the contract for 1994. If E's pricing model allocated the cap premium to each quarter covered by the contract, the ratable daily portion would be 61 days/92 days times the premium allocated to the first quarter.

(c) Under paragraph (e)(2)(ii) of this section, E and F calculate the payments using LIBOR as of December 31, 1994. F recognizes as income the ratable daily portion of the presumed payment, or $4,144 (61 days/92 days x .25 x .001 x $25,000,000). Thus, E reports $5,048 of net income from the contract for 1994 ($9,192 - $4,144), and F reports a net deduction from the contract of $5,048.

(d) On January 31, 1995, E pays F $9,375 (.25 x .0015 x $25,000,000) under the terms of the cap agreement. For purposes of determining their net income or net deduction from this contract for the year ended December 31, 1995, E and F must adjust their respective net income and net deduction from the cap by $2,072 (61 days/92 days x ($9,375 actual payment under the cap on January 31, 1995 - $6,250 presumed payment under the cap on December 31, 1994)).

Example 3. Cap premium amortized using alternative method.

(a) The facts are the same as in Example 1, except that the cap provides for annual payments by E and is entered into by F primarily to reduce risk with respect to a debt instrument issued by F. F elects to amortize the cap premium using the alternative level payment method provided under paragraph (f)(2)(v)(A) of this section. Under that method, F amortizes the cap premium by assuming that the $600,000 is repaid in 3 equal annual payments of $241,269, assuming a discount rate of 10%. Each payment is divided into a time value component and a principal component, which are set out below.

(b) The net of the ratable daily portions of the principal component and the payments, if any, received from E comprise F's annual net income or net deduction from the cap. The time value components are needed only to compute the ratable daily portions of the cap premium, and are otherwise disregarded.

Example 4. Cap premium paid in level installments and amortized using alternative method.

(a) The facts are the same as in Example 3, except that F agrees to pay for the cap in three level installments of $241,269 (a total of $723,807) on December 31, 1995, 1996, and 1997. The present value of three payments of $241,269, discounted at 10%, is $600,000. For purposes of amortizing the cap premium under the alternative method provided in paragraph (f)(2)(v)(B) of this section, F is treated as paying $600,000 for the cap on January 1, 1995, and borrowing $600,000 from E that will be repaid in three annual installments of $241,269. The time value component of the loan is computed as follows:

(b) F is treated as making periodic payments equal to the amortized principal components from a $600,000 cap paid in advance (as described in Example 3), increased by the time value components of the $600,000 loan, which totals $241,269 each year. The time value components of the $600,000 loan are included in the periodic payments made by F, but are not characterized as interest income or expense. The effect of the alternative method in this situation is to allow F to amortize the cap premium in level installments, the same way it is paid. The net of the ratable daily portions of F's deemed periodic payments and the payments, if any, received from E comprise F's annual net income or net deduction from the cap.

Example 5. Upfront interest rate swap payment amortized using alternative method.

(a) On January 1, 1995, G enters into an interest rate swap agreement with unrelated counterparty H under which, for a term of five years, G is obligated to make annual payments at 11% and H is obligated to make annual payments at LIBOR on a notional principal amount of $100 million. At the time G and H enter into this swap agreement, the rate for similar on-market swaps is LIBOR to 10%. To compensate for this difference, on January 1, 1995, H pays G a yield adjustment fee of $3,790,786. G provides H with information that indicates that the amount of the yield adjustment fee was determined as the present value, at 10% compounded annually, of five annual payments of $1,000,000 (1% x $100,000,000). G and H are calendar year taxpayers.

(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section. The yield adjustment fee is a nonperiodic payment as defined in paragraph (f)(1) of this section.

(c) Under the alternative method described in paragraph (f)(2)(iii)(A) of this section, the yield adjustment fee is recognized over the life of the agreement by assuming that the $3,790,786 is repaid in five level payments. Assuming a constant yield to maturity and annual compounding at 10%, the ratable daily portions are computed as follows:

(d) G also makes swap payments to H at 11%, while H makes swap payments to G based on LIBOR. The net of the ratable daily portions of the 11% payments by G, the LIBOR payments by H, and the principal component of the yield adjustment fee paid by H determines the annual net income or net deduction from the contract for both G and H. The time value components are needed only to compute the ratable daily portions of the yield adjustment fee paid by H, and are otherwise disregarded.

Example 6. Backloaded interest rate swap payment amortized using alternative method.

(a) The facts are the same as in Example 5, but H agrees to pay G a yield adjustment fee of $6,105,100 on December 31, 1999. Under the alternative method in paragraph (f)(2)(iii)(B) of this section, H is treated as paying a yield adjustment fee of $3,790,786 (the present value of $6,105,100, discounted at a 10% rate with annual compounding) on January 1, 1995. Solely for timing purposes, H is treated as borrowing $3,790,786 from G. Assuming annual compounding at 10%, the time value component is computed as follows:

(b) The amortization of H's yield adjustment fee is equal to the amortization of a yield adjustment fee of $3,790,786 paid in advance (as described in Example 5), increased by the time value component of the $3,790,786 deemed loan from G to H. Thus, the amount of H's yield adjustment fee that is allocated to 1995 is $1,000,000 ($620,921 + $379,079). The time value components of the $3,790,786 loan are included in the periodic payments paid by H, but are not characterized as interest income or expense. The net of the ratable daily portions of the 11% swap payments by G, and the LIBOR payments by H, added to the principal components from Example 5 and the time value components from this Example 6, determines the annual net income or net deduction from the contract for both G and H.

Example 7. Nonperiodic payment on a commodity swap amortized under general rule.

(a) On January 1, 1995, I enters into a commodity swap agreement with unrelated counterparty J under which, for a term of three years, I is obligated to make annual payments based on a fixed price of $2.35 per bushel times a notional amount of 100,000 bushels of corn and J is obligated to make annual payments equal to the spot price times the same notional amount. Assume that on January 1, 1995, the price of a one year forward for corn is $2.40 per bushel, of a two year forward $2.55 per bushel, and of a 3 year forward $2.75 per bushel. To compensate for the below-market fixed price provided in the swap agreement, I pays J $53,530 for entering into the swap. I and J are calendar year taxpayers.

(b) This contract is a notional principal contract as defined by paragraph (c)(1) of this section, and $2.35 and the spot price of corn are specified indices under paragraphs (c)(2)(i) and (iii) of this section, respectively. The $53,530 payment is a nonperiodic payment as defined by paragraph (f)(1) of this section.

(c) Assuming that I does not use the alternative methods provided under paragraph (f)(2)(iii) of this section, paragraph (f)(2)(ii) of this section requires that I recognize the nonperiodic payment over the term of the agreement by allocating the payment to each forward contract in accordance with the forward price of corn. Solely for timing purposes, I treats the $53,530 nonperiodic payment as a loan that J will repay in three installments of $5,000, $20,000, and $40,000, the expected payouts on the in-the-money forward contracts. With annual compounding at 8%, the ratable daily portions are computed as follows:

(d) The ratable daily portion of the principal component is added to I's periodic payments in computing its net income or net deduction from the notional principal contract for each taxable year. The time value components are needed only to compute the principal components, and are otherwise disregarded.

(i) General rule. Except as provided in paragraph (g)(4)(ii) of this section, a swap with significant nonperiodic payments is treated as two separate transactions consisting of an on-market, level payment swap and a loan. The loan must be accounted for by the parties to the contract independently of the swap. The time value component associated with the loan, determined in accordance with paragraph (f)(2)(iii)(A) of this section, is recognized as interest expense to the payor and interest income to the recipient.

(ii) Exception for cleared swaps and non-cleared swaps subject to margin or collateral requirements. Paragraph (g)(4)(i) of this section does not apply to a swap if the contract is described in paragraph (g)(4)(ii)(A) or (B) of this section.

(iii) Coordination with section 163(j). For the treatment of swaps with significant nonperiodic payments under section 163(j), see §1.163(j)-1(b)(22)(ii).

Example 1. Cap hedged with options.

(a) On January 1, 1995, K sells to unrelated counterparty L three cash settlement European-style put options on Eurodollar time deposits with a strike rate of 9%. The options have exercise dates of January 1, 1996, January 1, 1997, and January 1, 1998, respectively. If LIBOR exceeds 9% on any of the exercise dates, L will be entitled, by exercising the relevant option, to receive from K an amount that corresponds to the excess of LIBOR over 9% times $25 million. L pays K $650,000 for the three options. Furthermore, K is related to F, the cap purchaser in paragraph (f)(4) Example 1 of this section.

(b) K's option agreements with L reduce risk with respect to F's cap agreement with E. Accordingly, under paragraph (g)(2) of this section, F cannot use the alternative methods provided in paragraph (f)(2)(v) of this section to amortize the premium paid under the cap agreement. F must amortize the cap premium it paid in accordance with paragraph (f)(2)(iv) of this section.

(c) The method that E may use to account for its agreement with F is not affected by the application of paragraph (g)(2) of this section to F.

Example 2. [Reserved]. For further guidance, see § 1.446-3T(g)(6), Example 2.

Example 3. [Reserved]. For further guidance, see § 1.446-3T(g)(6), Example 3.

Example 4. [Reserved]. For further guidance, see § 1.446-3T(g)(6), Example 4.

(i) Assignment of one leg of a contract.

A payment is not a termination payment if it is made or received by a party in exchange for assigning all or a portion of one leg of a notional principal contract at a time when a substantially proportionate amount of the other leg remains unperformed and unassigned. The payment is either an amount loaned, an amount borrowed, or a nonperiodic payment, depending on the economic substance of the transaction to each party. This paragraph (h)(4)(i) applies whether or not the original notional principal contract is terminated as a result of the assignment.

(ii) Substance over form.

Any economic benefit that is given or received by a taxpayer in lieu of a termination payment is a termination payment.

Example 1. Termination by extinguishment.

(a) On January 1, 1995, P enters into an interest rate swap agreement with unrelated counterparty Q under which, for a term of seven years, P is obligated to make annual payments based on 10% and Q is obligated to make semi-annual payments based on LIBOR and a notional principal amount of $100 million. P and Q are both calendar year taxpayers. On January 1, 1997, when the fixed rate on a comparable LIBOR swap has fallen to 9.5%, P pays Q $1,895,393 to terminate the swap.

(b) The payment from P to Q extinguishes the swap contract and is a termination payment, as defined in paragraph (h)(1) of this section, for both parties. Accordingly, under paragraph (h)(2) of this section, P recognizes a loss of $1,895,393 in 1997 and Q recognizes $1,895,393 of gain in 1997.

Example 2. Termination by assignment.

(a) The facts are the same as in Example 1, except that on January 1, 1997, P pays unrelated party R $1,895,393 to assume all of P's rights and obligations under the swap with Q. In return for this payment, R agrees to pay 10% of $100 million annually to Q and to receive LIBOR payments from Q for the remaining five years of the swap.

(b) The payment from P to R terminates P's interest in the swap contract with Q and is a termination payment, as defined in paragraph (h)(1) of this section, for P. Under paragraph (h)(2) of this section, P recognizes a loss of $1,895,393 in 1997. Whether Q also has a termination payment with respect to the payment from P to R is determined under section 1001.

(c) Under paragraph (h)(3) of this section, the assignment payment that R receives from P is a nonperiodic payment for an interest rate swap. Because the assignment payment is not a significant nonperiodic payment within the meaning of paragraph (g)(1) of this section, R amortizes the $1,895,393 over the five year term of the swap agreement under paragraph (f)(2) of this section.

Example 3. Assignment of swap with yield adjustment fee.

(a) The facts are the same as in Example 2, except that on January 1, 1995, Q paid P a yield adjustment fee to enter into the seven year interest rate swap. In accordance with paragraph (f)(2) of this section, P and Q included the ratable daily portions of that nonperiodic payment in their net income or net deduction from the contract for 1995 and 1996. On January 1, 1997, $300,000 of the nonperiodic payment has not yet been recognized by P and Q.

(b) Under paragraph (h)(2) of this section, P recognizes a loss of $1,595,393 ($1,895,393 - $300,000) in 1997. R accounts for the termination payment in the same way it did in Example 2; the existence of an unamortized payment with respect to the original swap has no effect on R.

Example 4. Assignment of one leg of a swap.

(a) On January 1, 1995, S enters into an interest rate swap agreement with unrelated counterparty T under which, for a term of five years, S will make annual payments at 10% and T will make annual payments at LIBOR on a notional principal amount of $50 million. On January 1, 1996, unrelated party U pays T $15,849,327 for the right to receive the four remaining $5,000,000 payments from S. Under the terms of the agreement between S and T, S is notified of this assignment, and S is contractually bound thereafter to make its payments to U on the appropriate payment dates. S's obligation to pay U is conditioned on T making its LIBOR payment to S on the appropriate payment dates.

(b) Because T has assigned to U its rights to the fixed rate payments, but not its floating rate obligations under the notional principal contract, U's payment to T is not a termination payment as defined in paragraph (h)(1) of this section, but is covered by paragraph (h)(4)(i) of this section. The economic substance of the transaction between T and U is a loan that does not affect the way that S and T account for the notional principal contract under this section.