Abusive Uses of a Notional Principal Contract to Create
Timing and Character Whipsaws Against the IRS
IRS Notice 2002-35

 

 

In this transaction, promoters make use of a notional principal contract (“NPC”) to create timing and character benefits. A NPC usually involves 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 may be a NPC if certain caps and floors are included in its terms.

The transaction as described in IRS Notice 2002-35 is viewed as abusive because: (1) the fixed component of the nonperiodic payment was relative large (vis-à-vis contingent component) and (2) the parties contemplated an early termination of the arrangements, though this is not apparent in the actual terms of the NPC. According to the IRS, the abusive use of a NPC occurs when the first party attempts to deduct the ratable daily portion of the periodic payments actually made under the NPC, but chooses to defer recognition of income from the payment it will receive until the year in which the termination payment is actually made (with the termination payment treated as capital).

axpayers concerned about whether or not they are faced with an abusive NPC must first determine whether a particular contract meets the particular definition of a NPC under the Federal tax law. Under applicable Treasury Regulations, a NPC is defined as a financial instrument that provides for the payment of amounts by one party to another unrelated party at specified intervals over the life of the contract, with the payments calculated by reference to a “specified index” (usually based on objective financial information or one that is regularly used in normal lending transactions, but not linked to any one party’s dividends, profits, etc.) and a “notional principal amount” (which may be set in advance or vary, based on objective financial information). The instrument is given in exchange for specified consideration. The NPC may be subject to termination or extension. However, contracts described in IRC Section 1256(b), futures contract, forward contracts and options are excluded from the definition of a NPC (even if a cash settlement is contemplated). Options or forward contracts that entitle or obligate a person to enter into an NPC (e.g., a swaption or caption) are also excluded from the definition of a NPC. Regs. Sec. 1.446-3(c).

The proper accounting treatment for a contingent payment in a NPC is governed by IRS Revenue Ruling 2002-30. On February 25, 2004, the IRS released proposed regulations relating to the timing and character of contingent periodic payments made pursuant to a NPC, adopting a variation of the noncontingent swap accounting regime set forth in IRS Notice 2001-44 and further provide for an elective mark-to-market accounting method for NPCs with nonperiodic payments. By proposing a noncontingent swap method accounting method, the government is seeking to provide taxpayers with a timing regime for contingent nonperiodic payments that clearly reflect the economics of the underlying contracts, and achieve substantially similar treatment for all NPCs without regard to whether payments are made on a current, prepaid, or deferred basis, or whether the payment is fixed or contingent. In effect, the noncontingent swap method requires taxpayers to project the expected amount of contingent payments and “reproject” the contingent amounts at various times during the term of the swap, and adjust accordingly. These regulations do contain an anti-abuse rule designed to prevent taxpayers from using the NPC timing rules to materially distort income. Under these regulations, if a taxpayer enters into a transaction with a principal purpose of applying the NPC timing rules to produce a material distortion of income, the IRS is authorized to depart from the rules as necessary to reflect the appropriate timing and deductions from the transaction. Prop.Regs. Sec. 1.446-3(i). The regulations are not entirely clear as to the characterization of items under these rules as either capital or ordinary.

If you believe that you may have engaged in a transaction that is the same or substantially similar to the transaction described above, Federal law may require you to disclose your and other parties’ participation in any such “listed transaction” on IRS Form 8886. For more information about Federal law requirements, please contact us.