Editor: Mary Van Leuven, J.D., LL.M.
After temporary regulations (T.D. 9719) expired in 2018, practitioners hoping for guidance on the proper treatment of swaps with nonperiodic payments received some insight with the release of proposed regulations under Sec. 163(j) (REG-106089-18). Under the proposed regulations, which may be relied upon by taxpayers for tax years beginning in 2018 and thereafter, the IRS would return to a modified version of the rules that predated the temporary regulations. If finalized as currently proposed, an exemption for "cleared swaps" will remove many contracts from the embedded-loan regime imposed under the temporary regulations and carried on in these rules for uncleared swaps with "significant" nonperiodic payments. For those nonexempt swaps, a return to earlier rules reinvites unique problems for taxpayers and practitioners.
In the beginning
A swap is a type of notional principal contract, or NPC — in general, an executory contract under the terms of which two parties exchange differing cash flows, the amounts of which are determined by reference to some fixed rate or index as applied to a notional amount. Each party can then use the cash flows from the NPC to offset, or hedge, risks on other financial instruments. Payments under a swap that must be made in intervals of one year or less and are based on a specified index or rate applied to a fixed (or "notional") amount are called "periodic payments."
Regs. Sec. 1.446-3 allows taxpayers to net periodic payments each year, each party recognizing annually net income or net deduction, based on allocating ratable daily portions of each payment over the year. Calculating the proper tax answer for periodic payments under NPCs may sometimes pose significant arithmetic challenges, but the rules are conceptually sound and have seemingly worked well since promulgation in 1993.
It has proved much more difficult for the government to come up with workable rules for the treatment of nonperiodic payments — any payment under an NPC that is neither a periodic payment nor a termination payment — which was the source of uncertainty that led to action in the first place, as described in Notice 89-21. A nonperiodic payment occurs when, for example, there is an upfront payment or premium made upon entering into the NPC, such as for a cap or floor agreement or for an off-market swap. A prepayment of one leg of a swap is also generally a nonperiodic payment. The ultimate question is one of timing: When, or under what method, are the parties to account for the payment?
The original regulations included general rules for the treatment of nonperiodic payments and uneasily begin with a vague general statement that "a nonperiodic payment must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract" (Regs. Sec. 1.446-3(f)(2)(i)). The general rules that follow attempt to echo the approach to periodic payments, requiring taxpayers to recognize the ratable daily portion of the nonperiodic payment for the tax year, but they quickly devolve into enormous complexity. A proper allocation is made in accordance with forward rates of a series of cash-settled forward contracts that reflect the specified index and the notional amount. The rule's complexity is mitigated somewhat by the availability of two alternate methods: a level-payment method for upfront payments and a similar method for payments that are not upfront payments.
The 1993 regulations, however, provide special treatment for significant nonperiodic payments on an NPC, and this subset of rules has captured most of the government's and public's attention. Under these rules, if the payment was significant, the NPC transaction was bifurcated into two separate transactions: an on-market, level-payment swap and a loan. Payments on the swap were subject to the timing rules for periodic payments, while amortized payments on the hypothetical loan were treated (to the extent allocable to the time value of money) as interest for all federal income tax purposes. These rules require challenging yet manageable computations and may create unexpected tax consequences (e.g., withholding obligations). Importantly, the rules leave unanswered the most basic question of all: What, exactly, makes a payment significant?
The only guidance provided initially about "significant" in this context is in two examples in Regs. Sec. 1.446-3. In the first example, one party agreed to make five annual payments of 11% times $100 million in exchange for the other party's agreement to make five annual payments equal to LIBOR (at a time when that rate was 10%) times $100 million and an upfront payment of $3,790,786 (Regs. Sec. 1.446-3(f)(4), Example (5)). The amount of the upfront payment was determined as the present value, at 10% compounding, of five annual payments of $1 million (the difference between 11% and 10% (or 1%) of $100 million). In the second example, one party agrees to make annual payments of LIBOR (at a time when the rate was 10%) times $100 million annually, in exchange for the other party's agreement to make five annual payments of 6% of $100 million, plus an upfront payment of $15,163,147 (Temp. Regs. Sec. 1.446-3T(g)(6), Example (3)). The upfront payment equaled the present value of five annual payments of $4 million (or 4% of $100 million), using 10% compounding.
The first example concludes that the payment is not significant, while in the second example the payment is significant. Both examples state that the significance of the nonperiodic payment is determined by analyzing the amount of the upfront payment in proportion to the present value of the total amount of fixed payments due under the contract. The regulations do not provide these figures, but they can be readily determined: The present value of five annual payments of $11,000,000 (11% of $100 million) with a discount rate of 10% is $41,698,654, and the present value of five annual payments of $10,000,000 is $37,907,868.
Now, with the help of simple arithmetic, some guidelines on the meaning of "significant" in this context can finally be uncovered. A nonperiodic payment equal to 9.09% of the present value of the fixed payments due under the contract is considered to be insignificant (9.09% = 3,790,786 ÷ 41,698,654). Meanwhile, a nonperiodic payment equal to 40% of that value is significant (40% = 15,163,147 ÷ 37,907,868).
These rules survived for some time until, in 2015, the temporary regulations that have now expired were issued and substantially altered the treatment of nonperiodic swap payments. The purpose was to reduce taxpayer burden and add clarity to the area. To that end, the temporary regulations eliminated the need to determine whether a nonperiodic payment was significant. Instead, all nonperiodic payments were treated as creating an embedded loan unless one of two new, very broad exceptions applied. First, a short-term exception applied to any NPC with a term of one year or less. In addition, certain NPCs that are subject to prescribed margin or collateral requirements — cleared swaps — were not within the rule.
The temporary regulations expired on May 7, 2018, and taxpayers have been operating in a transition period since. Under somewhat confusing applicable transition rules, taxpayers were told to rely on the rules existing before the temporary regulations — that is, to apply the original regulations with their embedded-loan rule that applies only to NPCs with significant nonperiodic payments — and could also use the exceptions provided in the temporary regulations for short-term NPCs and NPCs with margin or collateral requirements.
The Sec. 163(j) proposed regulations provide the first official pronouncement by the government on the treatment of nonperiodic payments on NPCs after the expiry of the temporary regulations. The proposed regulations provide that a swap other than a cleared swap with significant nonperiodic payments is treated as two separate transactions consisting of an on-market, level-payment swap and a loan. The preamble states that the proposed rule would apply in the same manner as the rules in the Sec. 446 regulations that preceded the temporary regulations, only adding the exception for swaps cleared by a qualified derivatives clearing organization. Specifically, the embedded-loan rule would not apply to a collateralized swap that is cleared by a derivatives clearing organization or by a clearing agency. Moreover, the IRS specifically reserved on the treatment of collateralized cleared swaps and stated that the proposed regulations (which include a definition of cleared swap) do not include requirements for testing the assets used for collateralization or condition the exception for cleared swaps on the extent of collateralization. The proposed regulations may be relied upon for tax years beginning after Dec. 31, 2017.
Back to the beginning
It appears, therefore, that Treasury and the IRS are going back to old methods when it comes to the proper accounting for nonperiodic payments on many swaps. The exceptions are broad but could be expanded further. As it is, under the proposed regulations, if a swap is not a cleared swap, even if the swap is fully collateralized, taxpayers will have to determine whether nonperiodic payments on the swap are significant. If they are, the embedded-loan rules apply to the payment. Unless more guidance is provided, taxpayers and practitioners will again have to rely on the benchmarks in the examples to determine whether a nonperiodic payment on an NPC is significant.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.