Proposed Regs Could
Make Swaps Less Attractive
The Treasury has recently published
proposed regulations that may force swap
investors to change the tax accounting method for their swap
contracts. And the
Treasury staff would like the changes to apply to swaps that are
investors to: 1) defer realization of gains until exiting the
position, 2) convert the income that would have been earned on the
“referenced” security to long-term gain (or loss) on the swap,
and 3) the ability to take losses as ordinary deductions rather
than capital losses. If
these new rules were put into effect, then swaps would still
enable investors to defer the realization of gains and also
convert income to long-term, but the ability to take ordinary
losses would be lost unless the investor was willing to
mark-to-market the position.
published February 26, 2004,
attempt to clarify the nature of payments and receipts under a
contingent swap as well as the timing of the income and
contingent payment swap is one in which one or more payments are
contingent upon the value of an asset or the occurrence of certain
events. Equity swaps
are one type of contingent payments swap; during the term of a
typical equity swap, the long investor makes periodic payments to
the counterparty based upon a hypothetical cost to carry the
notional amount of the swap, and at maturity the long participant
receives the amount of appreciation or pays out the amount of
depreciation of the underlying equity.
investors use the “wait and see” approach in accounting for
equity swaps: the investors don’t recognize income or expense
under the swap until an amount is either payable or receivable.
Typically the carrying costs are paid on a current basis
while the payment with respect to the stock’s price movement
does not accrue until the swap’s maturity.
Under this approach, if a swap investor makes money, the
swap structure may produce deferral and capital gain, while if the
investor loses money, the swap structure may create ordinary loss.
Other derivative products may produce deferral, but the
swap structure was unique in its ability to produce ordinary loss
if the bet went against the investor. For this reason, many tax
experts have recommended swaps as a tax-efficient method of
gaining exposure to an asset or asset class.
regulations would do away with the “wait and see” methodology.
They would force investors to recognize income or expense
during a swap’s term depending upon any change in the underlying
stock’s price. The
regulations suggest two methodologies: “mark-to-market” or
“assumed profit”. Under
the mark-to-market method, a swap investor calculates swap profits
and losses each year at year-end.
This approach would only be available to certain investors,
including those who use dealers as their counterparties.
The second methodology, assumed profit, involves the
creation of a deemed loan between the swap parties in addition to
the swap contract. Under
this method, a swap’s parties would be required to recognize
both income (or loss) due to the changes in the stock’s price
and income (or expense) due to interest.
So each year as the underlying stock’s price changes and
as interest rates also change, the swap parties would be required
to perform complex calculations to determine the proper amounts of
income or loss to be recognized under the swap and also the proper
amount of interest income or expense to be recognized on the
In addition to
complicating the methodology for swap accounting, the new rules
make clear that any contractual payments on a swap will be treated
as ordinary. However,
an investor could still terminate a swap prior to its maturity and
treat the gain or loss upon the termination as capital.
Only the amount of appreciation or depreciation since the
last time the swap was revalued would be treated as capital.
There is some
controversy surrounding the effective date of the proposed
effective date clause in the regulations states that the rules
will be effective for swaps entered into more than 30 days after
the proposed regulations are published in the Federal Register.
That date was March 27, 2004.
However, the preamble to the regulations states that the
new rules would apply to swap contracts “that are in effect”
as of March 27th. This implies that the proposals could be applied
swap investors had not adopted a method of accounting for a swap
as of that date, then they would be required to adopt a method
that accounts for contingent payments over the life of the swap
using a reasonable basis.
surrounding the proposals’ effective date is twofold.
First, the preamble is not part of the regulations and
cannot include any operative rules, so the effective dates
provided in the preamble should not be given any weight.
In addition, these regulations are merely proposed, so they
are not effective until they are made temporary or final.
Therefore, the effective date of March 27, 2004 is merely a
proposal until the regulations go into effect.
Until that time, investors are not obligated to follow the
rules in the proposed regulations.
the future of these regulations and of their possible effective
date remains cloudy, conservative investors may still wish to err
on the side of caution.
If these proposals should become law, many swap investors
would be served just as well using other derivative instruments,
such as forward sales or “plain vanilla” derivatives.
When investors make money while employing properly
structured forward sales or derivatives, these tools may create
both deferral and capital gain.
The only drawback associated with these techniques is that
if an investment loses money, these hedges will produce a capital
loss, which is less valuable than an ordinary loss.
But when an investment is successful, these tools are
generally as tax-efficient as swaps have been.
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investors. Before engaging in an options
transaction, investors must review the booklet "Characteristics
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