Hedging market risks: accounting for notional principal contracts.

AuthorKnight, Ray A.
PositionCover story

EXECUTIVE SUMMARY

* Notional principal contracts typically employ swaps or other reciprocal arrangements that provide for payments at specified intervals by a party to a counterparty calculated by reference to a specified index applied to a notional principal amount, for which the counterparty promises to pay similar amounts.

* Periodic payments under a notional principal contract are payable at intervals of one year or less and are recognized ratably on a daily basis. IRS guidance indicates that periodic payments can be deductible as ordinary business expenses and that such amounts received are likely to be ordinary income.

* Nonperiodic payments--those that are neither periodic nor termination payments--include swap payments at the end of a swap term. They are recognized over the term of a notional principal contract in a manner reflecting the economic substance of the contract.

* Termination payments, which extinguish or assign rights and obligations of a party to a notional principal contract, are recognized by the party receiving them in the year in which the contract is extinguished, assigned, or exchanged. Their character depends on whether the contract is a capital asset in the hands of the taxpayer.

* Swap transactions may have a longer term than other futures trading activities of a taxpayer, which may lead the IRS to claim a taxpayer should bifurcate his or her activities between those of a trader and an investor. This treatment may lead to limitations on the taxpayer's interest expense and other deductions.

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Wealthy individuals and businesses often use specialized investment strategies to shield themselves from significant market or industry risks while achieving profits. Many of these activities are housed in a separate entity such as a limited liability company (LLC). A risk manager advises clients about ways to manage the price, interest rate, and currency exchange risks associated with their assets and liabilities, with a view toward prescribing a strategy involving a derivative financial product or commodity.

The business activities of the entity can include the use of a substantial portion of the entity's assets to collateralize one or more swaps or notional principal contracts for payments and receipts based upon the value or performance of designated indexes. Other activities use funds to profit from active trading strategies involving various types of securities and derivative instruments.

The entity may use substantial leverage to increase its profit potential and may attempt to limit the interest rate and currency index risk in a swap transaction through the use of a cap and floor collar. Active trading in a variety of financial products may yield profits from short-term market movements. Trading specialists with different histories, trading styles, and product focuses are normally involved. The total notional amount of trades executed over a short period may exceed the notional amount of the swap transaction.

Economic risk-sharing considerations tend to override tax considerations in the hedging process. Thus, when principals, corporate treasurers, CFOs, or their representatives look to counterparties such as capital markets firms to structure beneficial strategies, they often overlook the tax consequences. Tax advisers often become involved later, when their assistance is needed to explain the tax consequences of the transactions to interested parties or report them to the IRS on tax returns. Therefore, tax advisers should be familiar with the tax consequences of these strategies so they are able to explain and report the tax consequences of these closed transactions.

Volatility

In the economic life of a business, forecasting and risk management are used to predict events (e.g., shortages of raw materials caused by world economic and political events) that could damage the financial viability of the business (potential blowups). As Nassim Nicholas Taleb has observed, "Fragility is the quality of things that are vulnerable to volatility." (1) To counteract and neutralize this volatility, businesses enter into financial investment packages (strategies) that benefit from market volatility. Thus, volatility may be a risk that, if harnessed with a strategy, can produce a profit, and a business is able to thrive and improve in the face of volatility.

Investment techniques for hedging and/or managing risk may involve a sophisticated risk management process to oversee and manage exposures using derivatives and other instruments.

Derivatives

Derivatives are financial instruments based on agreements or contracts that derive their value from an underlying asset, instrument, or index. Derivatives are one of the most popular instruments for hedging interest rate risk, among other purposes. Investors in derivatives can use them to make speculative investments on the movement of the value of an underlying asset, to obtain exposure to an area that it is not possible to invest in directly, or create options where the value of the derivative is linked to a specific condition or event.

Derivatives generally create leverage. As a result, a small movement in the underlying asset's value can cause a large difference in the value of the derivative and result in large profits or losses, depending on the direction of the change. Examples of derivatives include futures; options; forward currency contracts; options on future contracts; and swaps, such as interest rate swaps (exchanging a floating rate for a fixed rate), total return swaps (exchanging a floating rate for the total return of a security or index), and credit default swaps (buying or selling credit default protection). Tax law must describe the tax consequences of using each of these instruments.

Notional Principal Contracts

A hedging strategy, notional principal contracts often involve derivatives, frequently in the form of swap transactions or other reciprocal arrangements. The size and nature of swap transactions in relation to the activities of an entity can have a significant effect upon the federal income tax consequences of an investment in the entity.

A notional principal contract is defined 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." (2) A notional principal amount is defined as "any specified amount of money or property that, when multiplied by a specified index, measures a party's rights...

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