Proposed notional principal contract regs. address contingent payments and character.

• Author: Shapiro, David H.

In February 2004, the IRS released long-anticipated proposed regulations (Prop. Kegs. Sec. 1.446-3; REG-16601202), introducing a new regime of tax accounting for contingent nonperiodic payments under notional principal contracts (NPCs)--also known as "swaps." The proposed regulations would also prescribe new rules (Prop. Regs. Sec. 1.1234A-1) for addressing the character of payments made under an NPC, a forward contract and a type of derivative referred to as a "bullet swap."

Timing Rules

Regs. Sec. 1.446-3 provides timing rules for three categories of payments made pursuant to NPCs: periodic, nonperiodic and termination. Nonperiodic payments (i.e., payments made under an NPC's terms, but not at intervals of a year or less) are recognized over the contract's term. However, the current regulations only address how to allocate fixed or noncontingent nonperiodic payments; they do not consider how to recognize contingent nonperiodic payments. The IRS solicited comments on how to treat contingent nonperiodic payments in 1993 (in the preamble to Regs. Sec. 1.446-3) and again in Notice 2001-44.

Absent IRS guidance, taxpayers typically accounted for NPC contingent nonperiodic payments only when a payment became fixed and determinable. In essence, they adopted a "wait-and-see" accounting method, deferring recognition until determining whether they would be making or receiving a payment and could definitively calculate its amount. In Rev. Rul. 2002-30, the IRS observed that the backloaded timing of tax consequences that resulted from this method could be problematic, especially when one party was deducting periodic payments as an ordinary expense, while the other was deterring capital recognition of the contingent payment.

Prop. Regs.

Prop. Regs. Sec. 1.446-3(g)(6)(ii) would disallow the wait--and--see method and require taxpayers to spread contingent nonperiodic payments over an NPC's term under a new "noncontingent swap method." Under this method, taxpayers would estimate the contingent payment's expected amount and take into account annually the projected contingent payment's appropriate portions. They would also revise their payment projections annually and make certain adjustments annually to account for any differences between the projections and the revised amounts. Prop. Regs. Sec. 1.446-3(i) would also provide an elective mark-to-market regime, under certain conditions. The complicated proposed noncontingent swap method has been received...