Hedging Market Risks: Accounting for Notional Principal Contracts

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 and obligations under the contract, but is not borrowed or loaned between the parties as part of the contract.”³

The list of financial instruments governed by the rules for accounting for income and deductions from notional principal contracts includes “interest rate swaps, currency swaps . . . equity index swaps, and similar agreements.”⁴ A specified index includes an index that is based upon “objective financial information,”⁵ which is separately defined as:

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 party’s circumstances (such as one party’s dividends, profits or value of its stock).⁶

Certain financial instruments that might otherwise appear to be included within the definition of notional principal contracts are not subject to the rules for accounting for notional principal contracts.⁷ These include “Sec. 1256 contracts” described in Sec. 1256(b), futures contracts, forward contracts, options, and contracts that constitute indebtedness under general principles of federal income tax law.⁸ Also, the mark-to-market accounting rules, rather than the accounting rules under Sec. 446, govern the treatment of notional principal contracts held by dealers in such securities.⁹

Example: An LLC, L, enters into a swap transaction that requires it to pay amounts to a counterparty (a capital markets firm) at specific intervals of less than one year each, calculated by reference to the London Interbank Offered Rate (LIBOR), upon a principal amount of $500 million, in exchange for the counterparty’s promise to pay similar amounts. The amount payable by the counterparty to L also is payable at a specific interval (18 months after initiation of the swap or its earlier termination or assignment) and is calculated by reference to two separate specified indices (LIBOR and a published aviation fuel price index) upon combined notional principal amounts equal to $500 million.

LIBOR is a specified index, as is the aviation fuel index, because both can be determined from readily available, objective financial information. Neither LIBOR nor the aviation fuel index constitutes a related party to any party to the swap contracts, nor are they within the control of L or the capital markets firm. The swap contracts negotiated between L and the capital markets firm are private and unregulated, are denominated in U.S. dollars, and are not options or indebtedness that are excluded from the definition of notional principal contracts. Likewise, the fact that L has a limited number of swap contracts as part of the swap transaction indicates that L is not a dealer in notional principal contracts requiring application of the Sec. 475 mark-to-market accounting rules for dealers in securities to the swap transactions rather than Sec. 446.

Accordingly, the swap transaction should meet the definition of a notional principal contract. The Treasury regulations governing notional principal contracts provide rules for the timing of income and deductions associated with the payments made under the contracts.¹⁰ The regulations provide separate timing rules depending upon whether payments are classified as periodic payments, nonperiodic payments, or termination payments.¹¹ For a chart summarizing the tax consequences of each of these types of payments under a notional principal contract, see the exhibit below.

Periodic Payments

Periodic payments are defined as “payments made or received pursuant to a notional principal contract that are payable at intervals of one year or less during the entire term of the contract.”¹² Taxpayers recognize periodic payments ratably on a daily basis for the tax year to which the payment portion relates.¹³ This requirement is applicable regardless of the method of accounting (e.g., cash or accrual) used by the taxpayer.¹⁴

The Sec. 446 regulations applicable to notional principal contracts address only the timing of recognition for payments but do not specifically address the character of those payments. However, deductions related to notional principal contracts are included in the Treasury regulations concerning ordinary business expenses. Regs. Sec. 1.162-1(b)(8) cross-references Regs. Sec. 1.446-3, which addresses the timing of deductions related to notional principal contracts. The IRS added the cross-reference from the regulations under Sec. 162 governing ordinary business deductions to the Sec. 446 regulations when it finalized the Sec. 446 regulations governing the timing of income and deductions with respect to notional principal contracts.¹⁵ Further, Technical Advice Memorandum (TAM) 9730007 from the IRS National Office held that monthly payments under a commodity swap determined to be a notional principal contract were periodic payments properly characterized as ordinary income and expenses.

The IRS also issued a field service advice memorandum concluding that a net periodic payment made under an interest rate swap is deductible under Sec. 162 as a trade or business expense, as opposed to being deductible under Sec. 163 as interest expense.¹⁶

The IRS reasoned in the TAM that periodic payments under a notional principal contract do not give rise to capital gain or loss because there is no sale or exchange as required under Sec. 1222. This reasoning is consistent with the accrual recognition approach taken by the Sec. 446 regulations for periodic payments, versus the event-recognition approach associated with the Sec. 1222 sale-or-exchange requirement for capital assets.¹⁷

Additionally, the rules governing which types of income and deductions are included in determining unrelated business taxable income (UBTI) distinguish between income from capital transactions and income from notional principal contracts. For example, Sec. 512(b)(5) excludes from UBTI gains and losses from property substantially similar to capital assets, and Regs. Sec. 1.512(b)-1(a) defines investment income excluded from UBTI to include income from notional principal contracts.

Nonperiodic Payments

Nonperiodic payments are defined to include any payment made or received with respect to a notional principal contract that is neither a periodic payment nor a termination payment (described below).¹⁸ Under a swap contract, often the counterparty’s payment to the taxpayer will “terminate” the swap transaction because the counterparty’s only obligation to the taxpayer is the single payment at the end of the swap term, and, thus, the payment is not the type contemplated by the normal definition of a termination payment discussed here. Because scheduled swap payments at the end of the swap term are often neither periodic payments nor termination payments, they should be treated as nonperiodic payments.

Taxpayers recognize nonperiodic payments over the term of a notional principal contract in a manner that reflects the economic substance of the contract.¹⁹ While the Sec. 446 regulations provide examples of the application of economic accrual for fixed or determinable nonperiodic payments,²⁰ no example addresses the issue of contingent payments. Further, the preamble to the Sec. 446 regulations issued in 1993 expressly notes the lack of examples of how to treat nonperiodic payments that are not fixed in amount at the inception of the contract, and the IRS requested suggestions on the proper methodology for treating contingent payments.²¹ Although the preamble states that the IRS expected to address contingent payments in future regulations, it has provided no such regulations, nor has it issued any other administrative guidance under Sec. 446 regarding the treatment of contingent nonperiodic payments.

One example of a contingent payment to a taxpayer pursuant to a notional principal contract occurs in a swap transaction that is based upon both an interest and commodity index where the amount of the payment is determined by the value of the commodity index at the maturity of the swap. Based on the historical volatility of the commodity that the taxpayer is hedging and the effect of that volatility on the payment amount due at the maturity of the swap, the economic effect of the swap is contingent and unable to be accurately determined until the conclusion of the swap. Any sudden and significant movements in the commodity index immediately before maturity of the swap could substantially alter the payment amount due to the taxpayer.

Frequently, the contingent nature of the swap payment between the counterparty and the taxpayer is significantly different from any of the nonperiodic payment examples provided in the Sec. 446 regulations. Each example in the Sec. 446 regulations regarding nonperiodic payments concerns a fixed nonperiodic payment that is appropriately amortizable and accounted for over the term of the swap transaction. No accrual over the term of the swap transaction should be required if the economic result of the swap transaction cannot be determined until maturity due to (1) the contingent nature of the counterparty’s payment obligation, and (2), as the IRS has acknowledged, the absence of contingent nonperiodic payment guidance in the Sec. 446 regulations and the continued lack of guidance on the subject to date. Likewise, the contingent nature of the counterparty’s payment obligation to the taxpayer prevents determination of whether the nonperiodic payment is substantial (and the economic substance of the transaction) until maturity of the swap transaction.

Nonperiodic payments include premiums for caps and floors²² and generally require recognition of the payments associated with those agreements over the term of the relevant agreement.²³ A cap and a floor that make up a collar may be treated as a separate notional principal contract,²⁴ and the net nonperiodic payment for the collar may be amortized over the term of the agreement.²⁵

As previously noted, the Sec. 446 regulations do not expressly address the character of payments made under notional principal contracts. The Sec. 446 regulations, however, do use the terms “income” and “deduction” in reference to nonperiodic payments, while using the terms “gain” and “loss” in reference to termination payments.²⁶ Further, the IRS has ruled privately that a nonperiodic payment gives rise to ordinary income or expense.²⁷

Although the Sec. 446 regulations suggest, and the IRS has privately ruled, that nonperiodic payments result in ordinary income or deductions, those positions are in reference to nonperiodic payments made other than upon maturity of the notional principal contract, as in the case of many swap contracts. Based upon this reasoning, a counterparty’s payment to a taxpayer may be a nonperiodic payment upon maturity of the swap transaction that is deemed to constitute ordinary income to the taxpayer.

Termination Payments

A termination payment is defined as a payment made or received to extinguish or assign all or a proportionate part of the remaining rights and obligations of a party to a notional principal contract.²⁸ Termination payments include a payment made between the original parties to the contract (an extinguishment), a payment made between one party to the contract and a third party (an assignment), and gain or loss realized upon the exchange of one notional contract for another.²⁹ The parties receiving termination payments recognize them in the year in which the notional principal contract is extinguished, assigned, or exchanged.³⁰

A literal reading of the regulations suggests that any payment that extinguishes the obligations of the parties under a notional principal contract will constitute a termination payment, even if the payment is nothing more than the last payment in a series of periodic payments that settles the contract at maturity. Because the regulations governing termination payments also indicate that termination payments are recognized only in the year in which they are paid, treating the final payment in a series of periodic payments as a termination payment rather than as a periodic payment would render incorrect the calculations provided in the examples in the regulations concerning the timing of recognition of periodic payments.³¹ Accordingly, the better view is that termination payments include payments other than regularly scheduled payments due upon the maturity of a notional principal contract.³²

Swap transactions may permit either party to designate an early termination of the swap contracts. An election by either party to a swap transaction to terminate the contracts prior to maturity would require payments that would extinguish the rights and obligations between the parties and should constitute termination payments.

The character of any economic gain or loss recognized upon termination of the swap transaction will depend upon whether the swap contracts are capital assets of the taxpayer. The definition of “capital asset” includes all assets owned by a taxpayer other than certain excluded property.³³ In addition, courts have long recognized that securities, including stock and commodities contracts, are capital assets in the hands of investors and traders, as opposed to dealers in securities.³⁴ A taxpayer recognizes capital gain or loss upon the sale or exchange of a capital asset or the termination of the rights and obligations with respect to property that is a capital asset in the taxpayer’s hands.³⁵

Prior to the revision of Sec. 1234A in 1997, there was considerable confusion over the tax consequences of various methods of extinguishing contractual rights or obligations between parties either by sale or exchange, disposition, abandonment, termination, or cancellation, among other methods.³⁶ Concern over confusion and administrative difficulties raised over the potentially different tax treatment applied to these various terms gave Congress reason to require all extinguishment transactions involving capital assets to be treated as a sale or exchange resulting in capital gain or loss.³⁷ The regulations under Sec. 446 requiring the “extinguishment” of a notional principal contract to be characterized as a termination payment preceded the revisions to Sec. 1234A. However, the legislative purpose in the revisions to Sec. 1234A in 1997 led to the conclusion that a so-called termination payment under the Sec. 446 regulations should constitute a termination under Sec. 1234A resulting in sale or exchange treatment.

Bifurcation of Taxpayer Activities

A taxpayer could design trading activities to profit from frequent trades based upon short-term movements in the traded futures markets, while swap transactions represent large positions taken over a longer term, such as 18 months. Because of the disparity between futures trading activity and swap transactions, the IRS may raise an issue of whether the taxpayer’s activities reflect two separate purposes: one as a trader in securities and another as an investor in the swap transactions. Such a conclusion would result in a bifurcation of the taxpayer’s accounting for income, gain, loss, and deduction in a manner that would result in substantial partner-level limitations on an LLC’s deductions and interest expense related to the swap transaction.

The IRS raised the bifurcation issue in analogous circumstances in King.³⁸ In that case, the taxpayer was an individual who had engaged for a number of years in the trade or business of trading commodities futures. His trading activities primarily involved frequent trades over short periods of a wide variety of commodities futures contracts. However, in 1978, he took physical delivery of a large quantity of gold pursuant to 100 long gold futures contracts. Because commodities futures contracts trade on margin, the taxpayer borrowed a substantial sum to finance the purchase and delivery of the gold. The taxpayer held the gold during the tax years 1979 and 1980 and deducted the interest expense incurred in financing the gold purchase. The IRS argued that the interest incurred on the gold financing was subject to the investment interest limitations, on the theory that the taxpayer’s activity of holding the gold for two years was an investment activity, separate from his regular trade or business of short-term commodity futures trading.

In determining that taking physical delivery of the gold and the debt incurred to do so was part of the taxpayer’s regular trade or business, the court first noted the historical anomaly that allows a trader to engage in a trade or business that produces capital gains and losses rather than ordinary income and losses.³⁹ Based upon an analysis of the taxpayer’s trading activities, the court readily concluded that the taxpayer was a trader rather than an investor in commodities and that any debt incurred as part of that business would be deductible without respect to the investment interest limitations.⁴⁰ The court concluded that taking physical delivery of the gold was part of the taxpayer’s trade or business because the gold was acquired as a result of delivery on futures contracts in which the taxpayer regularly dealt, the taxpayer periodically took delivery of commodities and held them for a period, and the taxpayer took no affirmative action to set apart or distinguish the gold transaction from his regular business.⁴¹

In support of its position, the IRS offered the case of Reinach,⁴² in which a self-employed writer of put and call options attempted to claim ordinary, rather than capital, loss treatment on seven option transactions that were held open considerably longer than his usual options. In Reinach, the taxpayer argued that losses incurred on stock held under short positions resulting from option contracts should be ordinary because he held the stock for sale to customers in the ordinary course of business and, thus, it was not a capital asset.⁴³ The court rather summarily dismissed the relevance of Reinach to the facts of King, noting that the parties did not raise the trader-or-investor issue in Reinach and that no basis was presented for determining whether similar commodities transactions should be separated from the trade or business of a commodity trader.⁴⁴

Investment Interest Expense Limitation

Taxpayers other than corporations may deduct investment interest expense only to the extent of their net investment income.⁴⁵ Investment income is income from property held for investment.⁴⁶ Property held for investment includes capital assets that generate portfolio income and interests in trade or business activities that are not passive activities and with respect to which the taxpayer does not materially participate.⁴⁷ The character of partnership items of income, gain, loss, and deduction are determined at the partnership level.⁴⁸ A partner’s distributive share of the partnership investment interest expense is separately reported to the partner.⁴⁹ Although property held for investment includes stocks, bonds, and other securities that generate portfolio income, such property is not always held for investment.⁵⁰ The result has been expressly recognized in the context of the investment interest limitation rules under Sec. 163(d).⁵¹ If the trading activities by a taxpayer, including through an LLC, are determined to be those of an investor rather than those of a trader, the interest expense paid in connection with a loan for swap transactions will constitute investment interest expense subject to the investment interest expense limitations.

Conclusion

Entities hedge market risks for economic reasons. However, at some point, a tax adviser must be available to report to interested parties and the IRS the tax results of these closed transactions. Tax advisers must have a knowledge of the intricate notional principal contract rules to fulfill their responsibility. However, the activities undertaken to hedge market risks may be more efficient if the participants are aware of the tax rules. Tax advisers should be included in the design process to create the most efficient hedging vehicle, using their knowledge of the notional principal contract rules.  

Footnotes

¹Taleb, “Learning to Love Volatility,” The Wall Street Journal (Nov. 16, 2012), available at www.wsj.com.

²Regs. Sec. 1.446-3(c)(1)(i).

³Regs. Sec. 1.446-3(c)(3).

⁴Regs. Sec. 1.446-3(c)(1)(i).

⁵Regs. Sec. 1.446-3(c)(2)(iii).

⁶Regs. Sec. 1.446-3(c)(4)(ii).

⁷Regs. Sec. 1.446-3(c)(1)(ii).

⁸Id.

⁹Regs. Sec. 1.446-3(c)(1)(iii).

¹⁰Regs. Sec. 1.446-3.

¹¹Regs. Secs. 1.446-3(e), (f), and (h).

¹²Regs. Sec. 1.446-3(e)(1).

¹³Regs. Sec. 1.446-3(e)(2)(i).

¹⁴Id.

¹⁵T.D. 8491.

¹⁶FSA 1998-124.

¹⁷Regs. Sec. 1.446-3(e)(2)(i).

¹⁸Regs. Sec. 1.446-3(f)(1).

¹⁹Regs. Sec. 1.446-3(f)(2).

²⁰Regs. Sec. 1.446-3(f)(4).

²¹T.D. 8491.

²²Regs. Sec. 1.446-3(f)(1).

²³Regs. Sec. 1.446-3(f)(2)(iv).

²⁴Regs. Sec. 1.446-3(c)(1)(i).

²⁵Regs. Sec. 1.446-3(f)(2)(v)(C).

²⁶Regs. Secs. 1.446-3(f)(2)(iii) and (v).

²⁷IRS Letter Ruling 9824026.

²⁸Regs. Sec. 1.446-3(h)(1).

²⁹Id.

³⁰Regs. Sec. 1.446-3(h)(2).

³¹Regs. Sec. 1.446-3(e)(3).

³²See FSA 1998-124 and FSA 200145010.

³³Sec. 1221.

³⁴Burnett, 118 F.2d 659 (5th Cir. 1941).

³⁵Secs. 1221 and 1234A.

³⁶See H.R. Rep’t No. 148, 105th Cong., 1st Sess. 451 (1997).

³⁷Id. at 453, 454.

³⁸King, 89 T.C. 445 (1987), acq. in result, 1988-2 C.B. 1.

³⁹Id. at 457, citing Wood, 16 T.C. 213 (1951), acq. in result, 1951-2 C.B. 4.

⁴⁰Id. at 463.

⁴¹Id. at 464—465.

⁴²Reinach, 373 F.2d 900 (2d Cir. 1967).

⁴³Id. at 902.

⁴⁴King, 89 T.C. at 466.

⁴⁵Sec. 163(d)(1).

⁴⁶Sec. 163(d)(4)(B).

⁴⁷Sec. 163(d)(5)(A).

⁴⁸Sec. 702(b).

⁴⁹Sec. 702(a)(7).

⁵⁰King, 89 T.C. 445 (1987), acq. in result, 1988-2 C.B. 1.

⁵¹Rev. Rul. 2008-38.