New rules, issued as temporary and proposed regulations, will change the way taxpayers account for swaps with nonperiodic payments. A taxpayer who enters into a swap often is required to make a one-time nonperiodic payment. The one-time payment is intended to compensate the other party for below-market periodic payments or for above-market periodic payments under the terms of the contract.
Under the previous rules, the accounting for nonperiodic payments differed based on whether the nonperiodic payment was considered to be significant. If the nonperiodic payment was not significant, the amount simply was amortized over the term of the swap. If the nonperiodic payment was significant, the swap was treated as two separate transactions – an on-market swap and an embedded loan between the two parties. The previous regulations did not provide a test for determining when the nonperiodic payment was significant.
The new rules require all swaps with upfront payments to be accounted for under the embedded loan rules with two exceptions. First, other than for certain transactions entered into by tax-exempt organizations or controlled foreign corporations, the temporary regulations are not required to be followed for a nonperiodic payment made on a swap with a term of one year or less. Second, the temporary regulations provide an exception for swaps with nonperiodic payments that are subject to prescribed margin or collateral requirements.
The application of the embedded loan regulations is illustrated with the following example:
Taxpayer A enters into a three-year interest rate swap with Taxpayer B on a $50 million notional amount. The market rate requires Taxpayer A to pay the London Interbank Offered Rate (Libor) plus 4 percent in exchange for Taxpayer B paying a fixed rate of 3 percent. However, Taxpayer A agrees to pay Libor plus 2 percent and to make an upfront payment of $2.829 million. Taxpayer B provides Taxpayer A with information indicating that the amount of the initial payment was determined as the present value of three annual payments of $1 million (2 percent of $50 million) from Taxpayer A to Taxpayer B, compounded annually at a 3 percent rate.
The upfront payment from Taxpayer A to Taxpayer B is treated as a loan. Taxpayer B is then deemed to make level payments on the loan, on an annual basis, which are treated as periodic payments on the swap. Taxpayer A will recognize interest income, and Taxpayer B will recognize interest expense. The amortization schedule for the embedded loan is as follows:
|Amounts in Thousands ($)|
|Deemed Loan Principal||2,829||1,914||971|
In the example above, Taxpayers A and B would recognize the following items in addition to the periodic payments specified under the swap contract:
|Amounts in Thousands ($) |
|Year||Taxpayer A||Taxpayer B|
|Deemed Swap Payment ($)||Interest Income ($)||Deemed Swap Payment ($)||Interest Expense ($)|
If the $2.829 million upfront payment was not considered to be significant, Taxpayers A and B would have amortized the upfront payment on a straight-line basis, with Taxpayer A deducting and Taxpayer B recognizing income on the swap of $943,000 annually.
The new rules generally are effective for swaps entered into on or after May 8, 2015.