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 already open.

Swaps allow 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.

The regulations, 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 deductions.  A 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.

Currently, most 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.

The proposed 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 deemed loan.

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 regulations.  The 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 27^th.   This implies that the proposals could be applied retroactively.  If 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.

The controversy 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.