Timing rules determine when the parties making and receiving payments are required to report their income or deduction to determine their federal tax liability. There are three types of payment that the Internal Revenue Service (hereinafter: IRS) considers when determining the income or loss of a counterparty to a notional principal contract for a particular taxable year. The three types are “periodic”, “non periodic”, and “termination” payments.
Periodic Payments are payable at intervals of one year or less during the entire term of the contract. Periodic payments are based on a specified index and on either a single principal amount or a notional principal amount that varies in the same proportion as the notional principal amount that measures the other party’s payments. Every taxpayer, whether on a cash or accrual basis accounting method, must recognize income equal to the ratable daily portion of a periodic payment for the taxable year to which that portion relates. The ratable daily portion of a periodic payment is determined by netting such payment due by each party and then dividing by the number of days in the payment period. The daily portion is then multiplied by the number of days of the periodic payment period that is within the taxable year. It should be noted that this method does not necessarily generate an income or loss amount for a swap party as the change in the mark-to-market value of the swap is calculated for accounting or performance evaluation purposes. The following example illustrates periodic payments. On 1 April 1998, a payer (hereinafter: P) entered into a total return swap with a receiver (hereinafter: R) where the reference obligation is a five year, 10 per cent annual coupon, USD 1,000,000 XYZ Inc note. Under the swap agreement, P is required to make annual payments in the amount of USD 100,000 (the annual coupon of XYZ Inc note) to R starting on 1 April 1999 and every year thereafter until 1 April 2003. In exchange, R is obligated to make payment to P every 1 amount equal to LIBOR, as determined on the immediately preceding 1 April, plus 4 per cent multiplied by USD 1,000,000 face value of XYZ Inc note (i.e the notional principal amount). P and R are calendar year taxpayers which use the accrual method of accounting. On 1 April 1998, LIBOR is 5.7 per cent.
All of the payments to be made by P and R are periodic payments since each party’s payments are based on a specified index and are payable at periodic intervals of one year or less throughout the term of the contract, and are based on a single notional principal amount. Though no payment was exchanged in 1998, P and R must recognize the ratable daily portion of the 1 April 1999 payments that are attributable to their taxable years ending 31 December 1998. On 1 April 1999, P is obligated to make a payment to R of USD 100,000 (10 per cent coupon times USD 1,000,000) and R is obligated to make a payment to P of USD 97,000 (9.7 per cent times USD 1,000,000). The ratable daily portion of the 10 per cent fixed leg is USD 75, 342 (275 days divided by 365 days times USD 100,000), and the rateable daily portion of the floating legs is USD 73,082 (275 days divided by 365 days times USD 97,99). The net amount for the taxable year is the difference between the ratable daily portion of the two periodic payments, or USD 2,260 (USD 75, 342 minus USD 73,082). For 1998, R has a net income of USD 2,260, and P has a corresponding net deduction of USD 2,260.
A termination payment is one made or received to extinguish or assign all or proportionate part of the remaining rights and obligations of any party. Such payments include payments made between the original parties to the contract (an extinguishment), payments made between once contracting party and a third party (an assignment), and any gain or loss realized on the exchange of one contract for another. In an assignment, the original non-assigning party realized gain or loss if the assignment results in a deemed exchange of contracts and a realization event. A termination payment is generally recognized in the year the contract is extinguished, assigned, or exchanged.
Non-periodic payments are payments that are no periodic payments or termination payments. As with periodic payments, all taxpayers must recognize the ratable daily portions of non-periodic payments for the taxable year to which that portion relates. Examples of non-periodic payments include premiums paid for a cap or floor, the prepayment of part or all of one leg of a swap, and premiums paid for an option to enter into a swap if and when the option is exercised. Such payments must be included in income over the term of the contract and in a manner that reflects the economic substance of the contract. Generally, the payments must be allocated over the term of the contract in accordance with forward rates of a series of cash-settled forward contracts that reflect the specified index and the notional principal amount.