Comments on proposed notional principal contract regulations.

On July 8, 1991, the Internal Revenue Service issued proposed regulations under section 446 of the Internal Revenue Code, concerning the income tax accounting treatment of notional principal contracts (NPCs). Related regulations were also proposed under section 988, relating to foreign currency transactions, and section 1092, relating to straddles. The proposed regulations (FI-16-89) were published in the Federal Register on July 10, 1991 (56 Fed. Reg. 31350), and in the August 12, 1991, issue of the Internal Revenue Bulletin (1991-32 I.R.B. 6).(1) A public hearing on the proposed regulations was held on October 7, 1991.

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,600 members represent approximately 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tx system that works -- one that is administrable and with which taxpayers can comply.

TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations on the application of section 446 of the Code to notional principal contracts.

Overview

The proposed regulations prescribe rules for the timing of recognition of income and deductions for NPCs. NPCs are agreements between two parties to exchange payments calculated by reference to a hypothetical or "notional" amount. As defined in the proposed regulations, the term encompases a variety of financial products including interest rate swaps, caps, floors and collars, commodity and basis swaps, currency swaps, and other financial innovations. As acknowledged in the preamble, the principal purpose and use of these instruments by nondealer corporations is to reduce the risk of changes in prices, interest rates, and currency rates.

TEI commends the IRS for undertaking to clarify the tax accounting rules for this abstruse yet practically important subject. TEI believes that the regulations, on balance, represent a logical and well-developed extension of the tax accounting rules. There are, however, several issues on which TEI disagrees with the proposed regulatory approach. With particular respect to the amortization of nonperiodic payments, TEI believes the complexity of the proposed regulations will engender compliance burdens for taxpayers -- with concomitant administrative costs to the government -- that are disproportionate to either tax policy or revenue concerns. In other areas, such as permitting integration of NPCs with the assets or liabilities hedged, we regret that the broad power of the government to prescribe tax accounting rules requiring "the clear reflection of income" has not been prudently exercised. TEI's specific recommendations follow.

Integration

The proposed regulations require separate tax accounting for each NPC. The preamble notes, however, that NPCs are frequently used to hedge assets or liabilities and, consequently, that the IRS is considering whether to permit taxpayers that hedge assets or liabilities with NPCs to account for the contracts on an integrated basis with the underlying asset or liability. Comments are requested on the issue.(2)

TEI believes that the IRS should exercise its regulatory authority to permit the integration of NPCs with the hedged assets or liabilities. In this regard, we recognize that section 988(d) expressly authorizes...