[Federal Register Volume 69, Number 38 (Thursday, February 26, 2004)]
[Proposed Rules]
[Pages 8886-8898]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-4151]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-166012-02]
RIN 1545-BB82


National Principal Contracts; Contingent Nonperiodic Payments

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
inclusion into income or deduction of a contingent nonperiodic payment 
provided for under a notional principal contract (NPC). This document 
also provides guidance relating to the character of payments made 
pursuant to an NPC. These regulations will affect taxpayers that enter 
into NPCs. This document also provides a notice of a public hearing on 
these proposed regulations.

DATES: Written or electronically transmitted comments and requests to 
speak (with outlines of oral comments to be discussed) at the public 
hearing scheduled for May 25, 2004, at 10 a.m., must be received by May 
4, 2004. Comments on the collection of information should be received 
by April 26, 2004.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-166012-02), room 5203, 
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, 
DC 20044. Submissions may be hand-delivered Monday through Friday 
between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-166012-02), 
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, 
NW., Washington, DC. Alternatively, taxpayers may submit electronic 
comments directly to the IRS Internet site at: http://www.irs.gov/regs. 
The public hearing will be held in the IRS Auditorium, Seventh Floor, 
Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, 
DC.

FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments, 
the hearing, or to be placed on the building access list to attend the 
hearing, Sonya Cruse, (202) 622-7180; concerning the regulations, Kate 
Sleeth, (202) 622-3920 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington, DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, 
Washington, DC 20224. Comments on the collection of information should 
be received by April 26, 2004. Comments are specifically requested 
concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the IRS, including whether the 
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information (see below);
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase of services to provide information.
    The collection of information in these proposed regulations is in 
Sec.  1.446-3(g)(6)(vii). This information is required by the IRS to 
verify compliance with section 446 and the method of accounting 
described in Sec.  1.446-3(g)(6). This information will be used to 
determine whether the amount of tax has been calculated correctly. The 
collection of information is required to properly determine the amount 
of income or deduction to be taken into account. The respondents are 
sophisticated investors that enter into notional principal contracts 
with contingent nonperiodic payments.
    Estimated total annual recordkeeping burden: 25,500 hours.
    Estimated average annual burden per recordkeeper: 6 hours.
    Estimated number of recordkeepers: 4,250.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to 26 CFR Part 1 under 
section 446(b) of the Internal Revenue Code (Code). This document also 
contains proposed amendments under sections 162, 212 and 1234A of the 
Code.
    In 1989, the IRS issued Notice 89-21 (1989-1 C.B. 651), to provide 
guidance with respect to the tax treatment of lump-sum payments 
received in connection with NPCs. The Notice stated that a method of 
accounting that properly recognizes a lump-sum payment over the life of 
the contract

[[Page 8887]]

clearly reflects income and indicated that regulations would be issued 
to provide specific rules regarding the manner in which a taxpayer must 
take into account over the life of an NPC payments made or received 
with respect to the contract. The Notice further stated that ``for 
contracts entered into prior to the effective date of the regulations, 
the Commissioner will generally treat a method of accounting as clearly 
reflecting income if it takes such payments into account over the life 
of the contract under a reasonable amortization method, whether or not 
the method satisfies the specific rules in the forthcoming 
regulations.'' (1989-1 C.B. 652).
    On October 14, 1993, the IRS published in the Federal Register 
final regulations (TD 8491; 1993-2 C.B. 215 [58 FR 53125]) under 
section 446(b) relating to the timing of income and deductions for 
amounts paid or received pursuant to NPCs. Sec.  1.446-3. In this 
preamble, the final regulations published in 1993 are referred to as 
the 1993 Treasury regulations.
    The 1993 Treasury regulations define an NPC as a ``financial 
instrument that provides for the payment of amounts by one party to 
another at specified intervals calculated by reference to a specified 
index upon a notional principal amount in exchange for specified 
consideration or a promise to pay similar amounts.'' Sec.  1.446-
3(c)(1)(i). Payments made pursuant to NPCs are divided into three 
categories (periodic, nonperiodic, and termination payments), and the 
1993 Treasury regulations provide timing regimes for each. The 1993 
Treasury regulations require all taxpayers, regardless of their method 
of accounting, to recognize the ratable daily portion of a nonperiodic 
payment for the taxable year to which that portion relates. Nonperiodic 
payments generally must be recognized over the term of an NPC in a 
manner that reflects the economic substance of the contract. Sec.  
1.446-3(f)(2)(i). Although Sec.  1.446-3 does not distinguish between 
noncontingent and contingent nonperiodic payments, the specific rules 
and examples in the 1993 Treasury regulations address only 
noncontingent nonperiodic payments. The Preamble to the 1993 Treasury 
regulations states that ``the IRS expects to address contingent 
payments in future regulations, and welcomes comment on the treatment 
of those payments.'' (1993-2 C.B. 216). In addition, neither Sec.  
1.446-3 nor any other section provides specific rules governing the 
character of the various types of NPC payments.
    On July 23, 2001, the IRS published Notice 2001-44 (2001-2 C.B. 
77), soliciting comments on the appropriate method for the inclusion or 
deduction of contingent nonperiodic payments made pursuant to NPCs and 
the proper character treatment of payments made pursuant to an NPC. The 
Notice set forth four different methods under consideration by the IRS 
and Treasury and asked the public to comment on the extent to which 
each method reflects certain fundamental tax policy principles, 
including certainty, clarity, administrability, and neutrality. Several 
comments were received from the public, which expressed diverse views 
regarding the relative advantages and disadvantages of the different 
methods. Included in the four methods were the noncontingent swap 
method and a mark-to-market method, versions of which are adopted in 
the proposed regulations.
    The Notice also solicited comments on the proper character of 
payments on NPCs and bullet swaps. The comments received on this issue 
also reflected differing views.

Explanation of Provisions

A. Overview

    The IRS and Treasury understand that some taxpayers take into 
account contingent nonperiodic payments on an NPC only when the payment 
becomes fixed and determinable (the open transaction or wait-and-see 
method of accounting). The wait-and-see method, however, is 
inconsistent with the existing specific timing rules for periodic and 
nonperiodic payments and with the general rule in Sec.  1.446-
3(f)(2)(i) respecting recognition of nonperiodic payments over the term 
of the contract. For example, if the amount of a periodic payment is 
set in arrears at the end of an accrual period that spans taxable 
years, the parties cannot use a wait-and-see method for the portion of 
the accrual period in the first taxable year. Instead, the parties must 
use a reasonable estimate of the payment for determining taxable income 
in the year before the payment is fixed. Sec.  1.446-3(e)(2)(ii). In 
addition, some NPCs are structured to provide for nonperiodic payments 
consisting of a noncontingent component and a contingent component, 
which the parties to the contract treat as a single contingent payment 
that they account for under the wait-and-see method. The attempted 
application of the wait-and-see method to these contracts highlights 
the potential for abuse present in the method. See Rev. Rul. 2002-30 
(2002-1 C.B. 971).
    The back-loaded timing of tax consequences that results from the 
wait-and-see method is also inconsistent with the timing regime that 
Sec.  1.1275-4(b) provides for contingent debt instruments subject to 
the noncontingent bond method. Under the noncontingent bond method, the 
parties to a contingent payment debt instrument must determine the 
yield at which a comparable noncontingent debt instrument would be 
issued and then project a fixed amount for each contingent payment and 
each noncontingent payment. The projected amounts are accounted for 
over the term of the debt instrument. The difference, if any, between 
the projected amount of a contingent payment and the actual amount of 
the payment generally is accounted for when payment is made.
    The proposed regulations adopt a variation on the noncontingent 
swap regime described in Notice 2001-44, as well as an elective mark-
to-market regime. The 1993 Treasury regulations reflect an underlying 
principle that nonperiodic payments should be spread over the term of 
an NPC in a manner that properly reflects the economic substance of the 
contract. The proposed regulations build upon this principle. 
Furthermore, the IRS and Treasury believe that the proposed regulations 
provide a timing regime for contingent nonperiodic payments that 
clearly reflects the economics of the underlying contracts. The 
requirement that nonperiodic payments be spread over the term of an NPC 
results in substantially similar treatment for all NPCs without regard 
to whether payment obligations are settled on a current basis through 
periodic payments or are either pre-paid or deferred through 
nonperiodic payments. Adopting this approach for contingent payment 
NPCs achieves symmetry between fixed payment NPCs and contingent 
payment NPCs.
    The proposed noncontingent swap method requires taxpayers to 
project the expected amount of contingent payments, to take into 
account annually the appropriate portions of the projected contingent 
amounts, to reproject the contingent amounts annually, and to reflect 
the differences between projected amounts and reprojected amounts 
through adjustments. The IRS and Treasury recognize that annual 
reprojections will require additional effort by taxpayers and the IRS. 
The IRS and Treasury believe, however, that the annual reprojection 
requirement is essential to ensure clear reflection of income with 
respect to NPCs with one or more contingent nonperiodic payments. 
Moreover, reprojections, and the resulting adjustments to current 
inclusion and deduction amounts, are

[[Page 8888]]

especially important for the income and deductions generated by these 
types of contracts because otherwise taxpayers might be more likely to 
attempt to manipulate the character of the income or deductions from 
the contract.
    In developing the proposed regulations, the IRS and Treasury have 
taken into account comments received in response to Notice 2001-44, as 
well as the following considerations. First, although many comments 
advocated the wait-and-see method of accounting for contingent 
nonperiodic payments, this method encourages the creation of NPCs that 
provide such payments. As a result of the adoption of guidelines for 
taking contingent nonperiodic payments into account over the term of an 
NPC, the tax treatment of payments with respect to an NPC should no 
longer provide an incentive for structuring payments in a particular 
manner. Second, taxpayers using swaps with contingent nonperiodic 
payments are sophisticated investors. Many of these taxpayers will be 
making similar projections and reprojections for their own purposes in 
evaluating the results of their derivative investments and taking 
actions to manage the risks created by their derivative investments. 
Third, the proposed regulations also provide an elective mark-to-market 
method as an alternative to the noncontingent swap method. Taxpayers 
who use a mark-to-market method for financial reporting purposes may 
adopt the elective mark-to-market method to reduce their tax and 
accounting administrative burden for NPCs.
    The IRS and Treasury understand that similar timing issues exist 
for other types of derivative investments, like bullet swaps and 
prepaid forward contracts. Although the application of the proposed 
regulations to these types of transactions may achieve appropriate 
timing, the application of these rules to investments other than NPCs 
could present a number of issues not directly addressed by the rules 
contained in these proposed regulations. The expansion of the scope of 
these proposed regulations to contracts other than NPCs is not being 
proposed at this time so as not to delay the publication of the 
proposed regulations.
    With respect to character, the proposed regulations under sections 
162 and 212 provide that both periodic and nonperiodic payments with 
respect to NPCs are generally ordinary in character. This is because 
neither periodic nor nonperiodic payments (whenever made) involve a 
sale or exchange within the meaning of section 1222, and no other 
section of the Code provides otherwise. The proposed regulations issued 
under section 1234A provide capital treatment for termination payments. 
Under the proposed regulations, however, even nonperiodic payments made 
at the maturity of an NPC are not termination payments under section 
1234A.
    Because of their recurring nature, periodic payments should be 
treated as ordinary income items, whether or not the payments are made 
at the expiration of an NPC. The same rationale applies to nonperiodic 
payments, which are required to be spread over the term of an NPC. Even 
if a nonperiodic payment is made at the expiration or termination of an 
NPC, only the final portion is taken into account on the termination 
date for the contract, and that portion should be treated in the same 
way as a periodic payment.

B. Specific Provisions

Adjustments
    Paragraph (d)(2) of the proposed regulations provides for 
adjustments to be made in the gain or loss realized on the sale, 
exchange, or termination of an NPC, to account for inclusions into 
income and deductions provided for in the 1993 Treasury regulations and 
the proposed regulations, as well as for any payments made or received 
on the NPC. These adjustments are expected to produce consequences 
similar to the consequences that would result if basis were increased 
or decreased for these items. Using adjustments for this purpose avoids 
the issue of negative basis.
Significant Nonperiodic Payments
    Paragraph (g)(4) of the proposed regulations clarifies the rules 
for the treatment of an NPC with a significant upfront nonperiodic 
payment and provides additional rules for the treatment of a 
significant nonperiodic payment that is not paid upfront. The 1993 
Treasury regulations provide that a significant nonperiodic payment on 
an NPC is treated as two separate transactions--an on-market level 
payment NPC and a loan. Sec.  1.446-3(g)(4). The proposed regulations 
clarify that the parties to an NPC with one or more significant 
nonperiodic payments must treat the contract as two or more separate 
transactions consisting of an on-market NPC and one or more loans. In 
some cases, the on-market NPC payments for a party making a significant 
nonperiodic upfront payment will be level payments that may be 
constructed through a combination of the actual payments on the NPC and 
level payments computed under the level payment method described in 
Sec.  1.446-3(f)(2)(iii)(A).
    The proposed regulations also provide that an NPC with a 
significant nonperiodic payment that is not paid upfront is treated as 
if the party receiving the significant nonperiodic payment paid a 
series of annual level payment loan advances, equal to the present 
value of the nonperiodic payment, to the party owing the significant 
nonperiodic payment. The interest component of the level payments is 
treated as interest for all purposes of the Code and is not taken into 
account in determining the income and deductions on the NPC. The 
principal component of the level payments is calculated solely to 
determine the interest amount. The party owing the significant 
nonperiodic payment is then treated as using the level payment loan 
advances to make annual level payment NPC payments, which are included 
in income and deducted as provided in Sec.  1.446-3(d).
Contingent Nonperiodic Payments
    The 1993 Treasury regulations define both periodic and nonperiodic 
payments but do not distinguish between contingent and noncontingent 
nonperiodic payments. Paragraph (g)(6)(i)(B) of the proposed 
regulations defines a contingent nonperiodic payment as any nonperiodic 
payment other than a noncontingent nonperiodic payment. A noncontingent 
nonperiodic payment is defined in paragraph (g)(6)(i)(A) of the 
proposed regulations as a nonperiodic payment that either is fixed on 
or before the end of the taxable year in which a contract commences or 
is equal to the sum of amounts that would be periodic payments if they 
are paid when they become fixed, including amounts determined as 
interest accruals.
    Paragraph (g)(6)(ii) of the proposed regulations sets forth the 
noncontingent swap method for the inclusion into income and deduction 
of contingent nonperiodic payments. The noncontingent swap method 
requires taxpayers to project the reasonably expected amount of the 
contingent nonperiodic payment and to apply the level payment method 
and, as appropriate, the rules for significant nonperiodic payments, to 
the projected amount as if it were a noncontingent nonperiodic payment. 
The risk-free rate of return, which is defined in the proposed 
regulations, is used in applying the level payment method.
    Paragraphs (g)(6)(iii)(A) through (C) of the proposed regulations 
provide the methods for projecting the reasonably expected amount. If 
the contingent

[[Page 8889]]

payment is determined by reference to the value of a specified index at 
a designated future date, the projected amount may be determined by 
reference to the future value of the specified index in actively traded 
futures or forward contracts providing for delivery or settlement on 
the designated future date. If no actively traded contract exists for 
the designated future date, the value may be derived from actively 
traded futures or forward contracts providing for delivery or 
settlement within three months of the designated future date.
    The projected amount may also be determined based on the projected 
future value of the current market price of the specified index. The 
future value is determined using a constant yield method at the risk-
free interest rate with appropriate compounding and making appropriate 
adjustments for expected cash payments on the property underlying the 
specified index. The proposed regulations use the applicable federal 
rate under section 1274(d)(1) as the risk-free rate for this purpose. 
Comments are requested on whether this rate is appropriate.
    If neither of the two methods described above results in a 
reasonable estimate of the future value of the specified index, the 
taxpayer must use another method that does result in a reasonable 
estimate of the amount of the contingent payment and that is based on 
objective financial information, and must consistently use the method 
from year to year.
    The proposed regulations require annual adjustments to the 
projected amounts of the contingent payment. Paragraphs (g)(6)(iv) 
through (vi) of the proposed regulations provide rules for the 
redetermination of the projected amount of the contingent payment and 
the subsequent adjustments to the recognition of income and deductions 
under a contract based on the reprojected amount.
    Paragraph (g)(6)(iv) of the proposed regulations provides that the 
projected amount must be redetermined on each successive anniversary 
date (redetermination date) and on each special redetermination date as 
described below. On each redetermination date, the taxpayer must 
reproject the amount of the contingent payment using the same method 
used at the commencement of the NPC but applied to the new current 
value of the specified index. Once the contingent payment is 
reprojected, the level payment method (and the rules for significant 
nonperiodic payments, if applicable) are applied again using the new 
projected amount.
    Comments are requested as to how the reprojection process should 
respond to changes in the availability of market data during the life 
of an NPC. Suppose, for example, that the initial projection is made 
when there are no actively traded futures or forward contracts in the 
specified index but that these contracts come into existence before the 
time of one of the reprojections. Should the reprojections be made 
using the newly available futures data rather than the method employed 
for the first projection?
    Paragraph (g)(6)(v) of the proposed regulations provides rules for 
adjustments following the redetermination of the projected amount of 
the contingent payment. The amounts determined for the redetermined 
projected amount under the level payment method and, as applicable, the 
rules for significant nonperiodic payments, are recognized in the 
current and subsequent taxable years. In addition, any difference 
between the newly determined amounts for prior periods and the amounts 
determined and previously taken into account using the previously 
projected contingent payment are recognized ratably over the one-year 
period beginning with the redetermination date. Any difference in 
amounts that would have been treated as interest under the rules for 
significant nonperiodic payments is also treated as interest for all 
purposes of the Code.
    Paragraph (g)(6)(iv)(B) of the proposed regulations provides a 
special rule for a contingent nonperiodic payment that is fixed more 
than six months before it is due. If the date on which the payment 
becomes fixed is in a different taxable year from the date it is due, 
the date on which the payment becomes fixed is a special 
redetermination date. In such a case, the fixed amount is treated as 
the reprojected amount, and the rules described above for 
redeterminations and adjustments apply.
    In general, under paragraph (g)(6)(vi) of the proposed regulations, 
when a contingent payment is made, the parties must make appropriate 
adjustments to the amount of income or deduction attributable to the 
NPC for any differences between the projected amount of the contingent 
payment and the actual amount of the contingent payment.
    Paragraph (g)(6)(vii) of the proposed regulations provides a 
recordkeeping requirement with respect to the noncontingent swap 
method. Taxpayers must maintain in their books and records a 
description of the method used to determine the projected amount of the 
contingent payment, the projected payment schedules, and the 
adjustments taken into account under the proposed regulations.
    The IRS and Treasury are considering whether to provide an 
alternative to the noncontingent swap method that would permit a 
taxpayer to use a current inclusion method for certain NPCs that 
provide for periodic calculations of amounts due under the terms of the 
NPC, but provide for deferred payment of the amounts. The IRS and 
Treasury are considering permitting current inclusion of income and 
deduction for the amounts so calculated, provided the NPC also provides 
for accrual of interest at a qualified rate until the periodically 
determined amounts are paid or offset against other amounts due under 
the NPC. The purpose of providing a current inclusion method for the 
deferred payment NPC described above is to provide tax treatment for 
NPCs with contingent nonperiodic payments that is economically 
equivalent to the tax treatment of NPCs providing only for periodic 
payments while avoiding the necessity of using projected amounts for 
contingent payments. The IRS and Treasury request comments concerning 
whether an NPC like the deferred payment NPC described above would be a 
viable transaction for market participants, whether a current inclusion 
method would be an appropriate substitute for the noncontingent swap 
method for deferred payment NPCs, and whether that method should 
require separate computation of interest accruals.
Elective Mark-to-Market Methodology
    Paragraph (i) of the proposed regulations provides an elective 
mark-to-market methodology for certain NPCs providing for nonperiodic 
payments. If an election is made, the specific accounting rules for 
nonperiodic payments in Sec.  1.446-3(f)(2) (other than (f)(2)(i)) are 
not applicable. Instead, for any contract that is held at the close of 
the taxable year, the taxpayer determines income inclusions and 
deductions by reference to the gain or loss that would be realized if 
the contract were sold for its fair market value on the last business 
day of the taxable year. Because the determination of fair market value 
takes into account the expected value of future nonperiodic payments, 
the mark-to-market methodology constitutes a reasonable basis for 
amortizing the nonperiodic payments over the term of the contract as 
required by Sec.  1.446-3(f)(2)(i).
    Proper adjustments are made in the amount of gain or loss 
subsequently realized (or calculated) for income inclusions and 
deductions taken into

[[Page 8890]]

account in marking the contract to fair market value. Furthermore, 
under paragraph (i)(5) of the proposed regulations, if an election is 
made for a contract providing for a significant non periodic payment, 
paragraph (g)(4) continues to apply and proper adjustments must be made 
to the income inclusions and deductions recognized under the mark-to-
market methodology to take into account amounts recognized as interest 
and the payment or receipt of the significant nonperiodic payment, 
subject to the special rule set forth below.
    The proposed regulations set forth a special rule for contracts 
providing for significant contingent nonperiodic payments that are 
subject to the mark-to-market election. If a contract provides for a 
significant contingent nonperiodic payment, the taxpayer must apply the 
noncontingent swap method to determine the amounts recognized as 
interest under paragraph (g)(4). However, the taxpayer is not required 
to reproject the amount of the contingent payment each year. The 
interest amounts for subsequent years are the interest amounts as 
determined using the initial projection of the contingent payment. 
Furthermore, an alternative deemed equivalent value method may be used 
to determine the projected amount of the contingent payment. The deemed 
equivalent value method may be applied when the contract fixes the 
timing and amount of all of the payments under the contract, except for 
the significant contingent nonperiodic payment. The amount of the 
significant contingent nonperiodic payment is deemed to be the amount 
that causes the present value of all the payments by the taxpayer to 
equal the present value of all of the payments of the counterparty to 
the contract.
    The inclusion of an elective mark-to-market methodology is intended 
to provide taxpayers with an alternative to the provisions of 
paragraphs (f) of the 1993 Treasury regulations and (g)(6) of the 
proposed regulations respecting nonperiodic payments. With respect to 
significant nonperiodic payments, however, the proposed regulations 
preserve certain features of those provisions for purposes of computing 
an interest component of swap payments. Such a calculation is necessary 
to preserve the characterization of an accrual as interest. The IRS and 
Treasury request comments on the appropriateness of requiring taxpayers 
to compute an interest amount for significant nonperiodic payments 
under the elective mark-to-market methodology and, in particular, on 
any effect that requirement may have on the relative usefulness and 
administrability of the mark-to-market methodology.
    Paragraph (i)(2) of the proposed regulations provides the scope of 
the election. The election is available to contracts that are: (1) 
Actively traded within the meaning of Sec.  1.1092(d)-1(c) (determined 
without regard to the limitation in Sec.  1.1092(d)-1(c)(2)); (2) 
marked to market for purposes of the taxpayer's financial statements 
provided the taxpayer satisfies the requirements in paragraph (i)(4) of 
the proposed regulations; (3) subject to an agreement by a party to the 
contract that is a person to whom section 475 applies to supply to the 
taxpayer the value that it uses in applying section 475(a)(2); or (4) 
marked to market by a regulated investment company (RIC) described in 
section 1296(e)(2). Paragraphs (i)(3) (i) through (iv) of the proposed 
regulations provide the acceptable methods for determining fair market 
value. If the contract is actively traded, the fair market value is 
determined based on the mean between the bid and asked prices quoted 
for the contract. If a contract is not actively traded, but is marked 
to market for financial statement purposes, and the valuations used for 
those purposes comply with the requirements of paragraph (i)(4), the 
fair market value is deemed to be the value used for the financial 
statements. For a contract that is subject to an agreement with a 
dealer in securities to provide a value, the value that is provided by 
the dealer is the fair market value. Finally, for a contract marked to 
market by a RIC, the fair market value is equal to the value used for 
purposes of determining the RIC's net asset value.
    Paragraph (i)(6) of the proposed regulations provides that the 
mark-to-market election shall be made in the time and manner prescribed 
by the Commissioner and is effective for the taxable year in which it 
is made and all subsequent years unless revoked with the consent of the 
Commissioner.
    The proposed regulations indicate that a taxpayer will be permitted 
to elect the mark-to-market method for NPCs that are marked to market 
for purposes of the taxpayer's financial statements and that the values 
used on the financial statements may be used as fair market value under 
the mark-to-market election. However, the proposed regulations also 
indicate that an election to use financial statement values will be 
subject to further requirements. On May 5, 2003, the IRS and Treasury 
published in the Federal Register an Advance Notice of Proposed Rule 
Making (REG-100420-03) requesting comments regarding appropriate rules 
for the use of financial statement values under the mark-to-market 
provisions of section 475 applicable to securities dealers and electing 
commodities dealers and securities and commodities traders. The IRS and 
Treasury will take into account the comments received in response to 
that Advance Notice in developing the rules to be established for use 
of financial statement values under the mark-to-market method set forth 
in paragraph (i) of the proposed regulations. In addition, unlike other 
mark-to-market regimes, the mark-to-market method proposed in paragraph 
(i) does not require a mark immediately before disposition in either a 
recognition or nonrecognition context. Cf. section 1256(c) and proposed 
regulations Sec.  1.475(a)-2. The IRS and Treasury request comments 
regarding this aspect of the proposed regulations and whether taxpayers 
who are eligible to elect a mark-to-market method under section 475 but 
do not do so should be eligible to make the paragraph (i) election for 
NPCs.
Anti-abuse Rule
    Paragraph (i) of the 1993 Treasury regulations provides that if a 
taxpayer ``enters into a transaction with a principal purpose of 
applying the rules of [Sec.  1.446-3] to produce a material distortion 
of income,'' the IRS may depart from those rules ``as necessary to 
reflect the appropriate timing of income and deductions from the 
transaction.'' In light of the comprehensive rules in the proposed 
regulations prescribing methods of accounting for NPCs, the IRS and 
Treasury have determined that a general anti-abuse rule is not 
necessary to prevent these methods being used in a manner that fails to 
clearly reflect income. Accordingly, the proposed regulations delete 
this rule.
Proposed Dates of Applicability
    These proposed regulations contain both new substantive rules as 
well as clarifying changes to the 1993 Treasury regulations. The new 
substantive rules, which are contained in paragraph (g)(6) (the 
noncontingent swap method) (except (g)(6)(i)) and paragraph (i) (the 
mark-to-market election), are proposed to apply to NPCs entered into on 
or after 30 days after the date of publication of the final regulations 
in the Federal Register. Paragraphs (c) (definitions), (d) (taxable 
year of inclusion and deduction), (f) (nonperiodic payments), (g)(4) 
(significant nonperiodic payments), and (g)(6)(i) (definition of 
contingent and noncontingent nonperiodic payments) are proposed to be 
integrated into the 1993 Treasury regulations which apply to NPCs 
entered into on or after December 13,

[[Page 8891]]

1993. Because of their purely clarifying nature, these proposed changes 
will apply to the same transactions that are governed by the 1993 
Treasury regulations.
    With respect to NPCs that provide for contingent nonperiodic 
payments and that are in effect or entered into on or after 30 days 
after the date of publication of these proposed regulations in the 
Federal Register, if a taxpayer has not adopted a method of accounting 
for these NPCs, the taxpayer must adopt a method that takes contingent 
nonperiodic payments into account over the life of the contract under a 
reasonable amortization method, which may be, but need not be, a method 
that satisfies the specific rules in these proposed regulations. If a 
taxpayer has adopted a method of accounting for these NPCs, the 
Commissioner generally will not require a change in the accounting 
method earlier than the first year ending on or after 30 days after the 
date of publication of the final regulations in the Federal Register. 
The preceding sentence does not apply to transactions described in Rev. 
Rul. 2002-30 (2002-1 C.B. 971) or other published guidance.
    The proposed regulations do not contain a specific consistency 
requirement. Nevertheless, under the general rules governing accounting 
methods, once a taxpayer adopts a method of accounting for an item, the 
taxpayer must use the same method from year to year unless the taxpayer 
obtains the Commissioner's consent to change to another method of 
accounting.
Character
    The proposed regulations under Sec.  1.162-30 provide that in 
general, the net periodic and nonperiodic payments (including mark-to-
market deductions) are deductible by the payor under section 162 as 
ordinary and necessary business expenses. However, payments 
representing interest under the rules for significant nonperiodic 
payments as well as termination payments are not deductible under 
section 162. A similar rule is provided for individuals in the proposed 
regulations under Sec.  1.212-1(q). These regulations under sections 
162 and 212 are proposed to apply to NPCs entered into on or after 30 
days after the date of publication of the final regulations in the 
Federal Register.
    Any gain or loss arising from a termination payment, however, is 
treated as capital gain or loss pursuant to the proposed regulations 
under section 1234A. These proposed regulations clarify that periodic 
payments, noncontingent nonperiodic payments, and contingent 
nonperiodic payments are not termination payments.
    The proposed regulations under section 1234A also apply to any gain 
or loss arising from the settlement of obligations under a bullet swap 
or forward contract. A payment in settlement of obligations under a 
bullet swap or forward contract, including a payment pursuant to the 
terms of the bullet swap or forward contract, is treated as gain or 
loss from a termination of the bullet swap or forward contract.
    For purposes of these proposed regulations, a bullet swap is 
defined as a financial instrument that is not an excluded contract as 
defined in Sec.  1.446-3(c)(1)(ii), that provides for the computation 
of an amount or amounts due from one party to another by reference to a 
specified index upon a notional principal amount, and that provides for 
settlement of all the parties' obligations at or close to maturity of 
the contract, rather than for the payment of the specified amounts at 
specific intervals. The definition of bullet swap is intended to cover 
a contract that obligates each party to make a payment at the end of 
the contract, although only one net payment will actually be paid. For 
example, party A is obligated to pay at the end of three years a fixed 
rate multiplied by the notional amount. Also at the end of three years, 
party B is obligated to pay a variable rate multiplied by the same 
notional amount. At the end of three years, only one party makes a net 
payment equal to the difference between the fixed rate multiplied by 
the notional amount and the variable rate multiplied by the notional 
amount.
    These regulations under section 1234A are proposed to apply to NPCs 
entered into on or after 30 days after the date of publication of the 
final regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It is hereby 
certified that these regulations will not have a significant economic 
impact on a substantial number of small entities. This certification is 
based on the fact that very few small businesses enter into NPCs with 
contingent nonperiodic payments because these contracts are costly and 
complex and because they require constant monitoring and a 
sophisticated understanding of the capital markets. Therefore, a 
Regulatory Flexibility Analysis is not required. Pursuant to section 
7805(f) of the Code, this notice of proposed rulemaking will be 
submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small businesses.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and Treasury specifically request comments on the 
clarity of the proposed rules and how they may be made easier to 
understand. All comments will be available for public inspection and 
copying.
    A public hearing has been scheduled for May 25, 2004, beginning at 
10 a.m., in the IRS Auditorium, Seventh Floor, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC. Due to 
building security procedures, visitors must enter at the Constitution 
Avenue entrance. In addition, all visitors must present photo 
identification to enter the building. Because of access restrictions, 
visitors will not be admitted beyond the immediate entrance area more 
than 30 minutes before the hearing starts. For information about having 
your name placed on the building access list to attend the hearing, see 
FOR FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written 
comments or electronic comments and an outline of topics to be 
discussed and the time to be devoted to each topic (a signed original 
and eight (8) copies) by May 4, 2004. A period of 10 minutes will be 
allotted to each person making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Kate Sleeth, Office of 
the Associate Chief Counsel (Financial Institutions and Products). 
However, other personnel from the IRS and Treasury participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

[[Page 8892]]

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.162-30 is added to read as follows:


Sec.  1.162-30  Notional principal contract payments.

    (a) In general. Amounts taken into account by a taxpayer pursuant 
to Sec.  1.446-3(d)(1) (including mark-to-market deductions) with 
respect to a notional principal contract as defined in Sec.  1.446-
3(c)(1)(i), are deductible as ordinary and necessary business expenses. 
However, this section will not apply to any amount representing 
interest expense on the deemed loan component of a significant 
nonperiodic payment as described in Sec.  1.446-3(g)(4). For any loss 
arising from a termination payment as defined in Sec.  1.446-3(h)(1), 
see section 1234A and the regulations thereunder. For the timing of 
deductions with respect to notional principal contracts, see Sec.  
1.446-3.
    (b) Effective date. Paragraph (a) of this section is applicable to 
notional principal contracts entered into on or after 30 days after the 
date a Treasury decision based on these proposed regulations is 
published in the Federal Register.
    Par. 3. In Sec.  1.212-1, paragraph (q) is added to read as 
follows:


Sec.  1.212-1  Nontrade or nonbusiness expenses.

* * * * *
    (q) Notional principal contract payments--(1) Amounts taken into 
account by an individual pursuant to Sec.  1.446-3(d)(1) (including 
mark-to-market deductions) with respect to a notional principal 
contract as defined in Sec.  1.446-3(c)(1)(i), are ordinary and 
necessary, and are deductible to the extent these amounts are paid or 
incurred in connection with the production or collection of income. 
However, this section will not apply to any amount representing 
interest expense on the deemed loan component of a significant 
nonperiodic payment as described in Sec.  1.446-3(g)(4). For any loss 
arising from a termination payment as defined in Sec.  1.446-3(h)(1), 
see section 1234A and the regulations thereunder. For the timing of 
deductions with respect to notional principal contracts, see Sec.  
1.446-3.
    (2) Effective date. Paragraph (q) of this section is applicable to 
notional principal contracts entered into on or after 30 days after the 
date a Treasury decision based on these proposed regulations is 
published in the Federal Register.
    Par. 4. Section 1.446-3 is amended by:
    1. Revising the introductory text of paragraph (a) and the table of 
contents in paragraph (a).
    2. Adding paragraph (c)(5).
    3. Revising paragraphs (d), (f)(2)(i), (f)(2)(iii)(A), and (g)(4).
    4. Redesignating the text of paragraph (g)(6) as paragraph (g)(7).
    5. Adding new paragraph (g)(6).
    6. Amending the newly designated text of paragraph (g)(7) by:
    (a) Revising the heading for Example 3.
    (b) Adding Example 5 through Example 9.
    7. Revising paragraphs (i) and (j).
    The revisions and additions read as follows:


Sec.  1.446-3  Notional principal contracts.

    (a) Table of contents. This paragraph (a) lists captioned 
paragraphs contained in this section.


Sec.  1.446-3  Notional principal contracts.

(a) Table of contents.
(b) Purpose.
(c) Definitions and scope.
    (1) Notional principal contract.
    (i) In general.
    (ii) Excluded contracts.
    (iii) Transactions within section 475.
    (iv) Transactions within section 988.
    (2) Specified index.
    (3) Notional principal amount.
    (4) Special definitions.
    (i) Related person and party to the contract.
    (ii) Objective financial information.
    (iii) Dealer in notional principal contracts.
    (5) Risk-free interest rate and determination date.
    (i) Risk-free interest rate.
    (ii) Determination date.
(d) Taxable year of inclusion and deduction; adjustment of gain or 
loss.
    (1) Inclusion and deduction.
    (2) Adjustment of gain or loss.
(e) Periodic payments.
    (1) Definition.
    (2) Recognition rules.
    (i) In general.
    (ii) Rate set in arrears.
    (iii) Notional principal amount set in arrears.
    (3) Examples.
(f) Nonperiodic payments.
    (1) Definition.
    (2) Recognition rules.
    (i) In general.
    (ii) General rule for swaps.
    (iii) Alternative methods for swaps.
    (A) Prepaid swaps.
    (B) Other nonperiodic swap payments.
    (iv) General rule for caps and floors.
    (v) Alternative methods for caps and floors that hedge debt 
instruments.
    (A) Prepaid caps and floors.
    (B) Other caps and floors.
    (C) Special method for collars.
    (vi) Additional methods.
    (3) Term of extendible or terminable contracts.
    (4) Examples.
(g) Special rules.
    (1) Disguised notional principal contracts.
    (2) Hedged notional principal contracts.
    (3) Options and forwards to enter into notional principal 
contracts.
    (4) Swaps with significant nonperiodic payments.
    (5) Caps and floors that are significantly in-the-money. 
[Reserved]
    (6) Notional principal contracts with contingent nonperiodic 
payments.
    (i) Definitions.
    (A) Noncontingent nonperiodic payments.
    (B) Contingent nonperiodic payments.
    (ii) Noncontingent swap method.
    (iii) Determining projected amount of contingent payment.
    (A) Payment based on actively traded futures or forward 
contracts.
    (B) Payment based on extrapolation from current market prices.
    (C) Payment based on reasonable estimate.
    (iv) Redeterminations of projected payments and level payment 
amounts.
    (A) General rule.
    (B) Special rule for fixed but deferred contingent nonperiodic 
payments.
    (v) Adjustments following redeterminations.
    (vi) Adjustments for differences between projected and actual 
payments.
    (vii) Recordkeeping requirements.
    (7) Examples.
(h) Termination payments.
    (1) Definition.
    (2) Taxable year of inclusion and deduction by original parties.
    (3) Taxable year of inclusion and deduction by assignees.
    (4) Special rules.
    (i) Assignment of one leg of a contract.
    (ii) Substance over form.
    (5) Examples.
(i) Election to mark to market.
    (1) General rule.
    (2) Scope of election.
    (3) Determination of fair market value.
    (i) Determination based on readily ascertainable value.
    (ii) Determination based on value used for financial statements.
    (iii) Determination based on counterparty's mark-to-market 
value.
    (iv) Determination based on value used in determining net asset 
value.
    (4) Requirements for use of financial statement values.
    [Reserved]
    (5) Notional principal contracts accruing interest on 
significant nonperiodic payments.
    (i) General rule.
    (ii) Special rules for significant contingent nonperiodic 
payments.
    (iii) Nonapplicability to regulated investment companies.

[[Page 8893]]

    (6) Election.
(j) Effective dates.
    (1) General rule.
    (2) Exception.
* * * * *

    (c) * * *
    (5) Risk-free interest rate and determination date--(i) Risk-free 
interest rate. The risk-free interest rate is the applicable Federal 
rate determined in accordance with section 1274(d)(1) for a 
determination date and the period remaining in the term of the contract 
on the determination date.
    (ii) Determination date. A determination date is the commencement 
date of the swap, each redetermination date as defined in paragraph 
(g)(6)(ii) of this section, and each special redetermination date as 
defined in paragraph (g)(6)(iv)(B) of this section.
    (d) Taxable year of inclusion and deduction; adjustment of gain or 
loss--(1) Inclusion and deduction. For all purposes of the Internal 
Revenue Code, the net income or net deduction from a notional principal 
contract for a taxable year is taken into account for that taxable 
year. The net income or net deduction from a notional principal 
contract for a taxable year equals the total of all of the periodic 
payments that are recognized from that contract for the taxable year 
under paragraph (e) of this section, all of the nonperiodic payments 
that are recognized from that contract for the taxable year under 
paragraph (f) of this section, and the mark-to-market income inclusions 
and deductions recognized from that contract under paragraph (i) of 
this section.
    (2) Adjustment of gain or loss. Proper adjustment shall be made in 
the amount of any gain or loss realized on a sale, exchange, or 
termination of a notional principal contract for inclusions or 
deductions pursuant to paragraphs (d)(1) and (g)(4) of this section and 
for payments or receipts with respect to the notional principal 
contract.
* * * * *
    (f) * * *
    (2) Recognition rules--(i) In general. All taxpayers, regardless of 
their method of accounting, must recognize the ratable daily portion of 
a nonperiodic payment for the taxable year to which that portion 
relates. Generally, 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. See paragraph (g)(6) of this 
section for additional rules for contingent nonperiodic payments.
* * * * *
    (iii) * * *
    (A) Prepaid swaps. An upfront payment on a swap may be amortized by 
assuming that the nonperiodic payment represents the present value of a 
series of equal payments made throughout the term of the swap contract 
(the level payment method), adjusted as appropriate to take account of 
increases or decreases in the notional principal amount. The discount 
rate used in this calculation must be the rate (or rates) used by the 
parties to determine the amount of the nonperiodic payment. If that 
rate is not readily ascertainable, the discount rate used must be a 
rate that is reasonable under the circumstances. Under this method, an 
upfront payment is allocated by dividing each equal payment into its 
principal recovery and time value components. The principal recovery 
components of the equal payments are treated as periodic payments that 
are deemed to be made on each of the dates that the swap contract 
provides for periodic payments by the payor of the nonperiodic payment 
or, if none, on each of the dates that the swap contract provides for 
periodic payments by the recipient of the nonperiodic payment. The sum 
of the principal recovery components equals the amount of the upfront 
payment. The time value component is used to compute the amortization 
of the nonperiodic payment but is otherwise disregarded. See paragraph 
(f)(4) Example 5 of this section.
* * * * *
    (g) * * *
    (4) Swaps with significant nonperiodic payments. The parties to a 
swap with one or more significant nonperiodic payments must treat the 
contract as two or more separate transactions consisting of an on-
market swap and one or more loans. The parties must account for the 
loans separately from the swap. The payments associated with the on-
market swap are included in the net income or net deduction from the 
swap under paragraph (d) of this section. The time value components 
associated with the loans are not included in the net income or net 
deduction from the swap under paragraph (d) of this section but are 
recognized as interest for all purposes of the Internal Revenue Code. 
The on-market swap must result in recognition of the payments 
associated with the swap in a manner that complies with the principles 
set forth in paragraph (f)(2)(i) of this section. See paragraph (g)(7) 
Example 3 of this section for a situation in which the on-market swap 
payments for a party making a significant nonperiodic upfront payment 
will be level payments that may be constructed through a combination of 
the actual payments on the swap and level payments computed under the 
level payment method provided by paragraph (f)(2)(iii)(A) of this 
section. In certain cases, a swap with significant nonperiodic payments 
other than an upfront payment may be treated as if the swap provided 
for a series of level payment loan advances having a present value 
equal to the present value of the nonperiodic payments, with the amount 
of each loan advance being immediately returned as a level payment on 
the swap. See paragraph (g)(7) Example 5 of this section. For purposes 
of section 956, the Commissioner may treat any nonperiodic swap 
payment, whether or not it is significant, as one or more loans.
* * * * *
    (6) Notional principal contracts with contingent nonperiodic 
payments--(i) Definitions--(A) Noncontingent nonperiodic payments. A 
noncontingent nonperiodic payment is a nonperiodic payment that either 
is fixed on or before the end of the taxable year in which a contract 
commences or is equal to the sum of amounts that would be periodic 
payments if they are paid when they become fixed (including amounts 
determined as interest accruals).
    (B) Contingent nonperiodic payments. A contingent nonperiodic 
payment is any nonperiodic payment other than a noncontingent 
nonperiodic payment.
    (ii) Noncontingent swap method. Under the noncontingent swap 
method, a taxpayer, regardless of its method of accounting, recognizes 
each contingent nonperiodic payment with respect to a notional 
principal contract by determining the projected amount of the payment 
and by applying to that projected amount the level payment method 
described in paragraphs (f)(2)(iii)(A) and (B) of this section. The 
projected amount of a contingent nonperiodic payment is the reasonably 
expected amount of the payment, which is determined by using one of the 
methods described in paragraph (g)(6)(iii) of this section and by using 
the risk-free interest rate in applying the level payment method. On 
each successive anniversary date for the notional principal contract (a 
redetermination date) and each special redetermination date (as defined 
in paragraph (g)(6)(iv)(B) of this section), the taxpayer must 
redetermine the projected amount of each contingent nonperiodic 
payment, reapply the level payment method as provided in paragraph 
(g)(6)(iv) of this section, and

[[Page 8894]]

make the adjustments specified in paragraph (g)(6)(v) of this section. 
If paragraph (g)(4) of this section applies to the notional principal 
contract, redeterminations and adjustments must also be made to account 
for the time value components of the transaction as interest in 
accordance with that paragraph. Except for contingent nonperiodic 
payments governed by paragraph (g)(6)(iv)(B) of this section, in the 
taxable year in which a contingent payment is made or received, the 
parties must make appropriate adjustments to the amount of income or 
deductions attributable to the notional principal contract for any 
differences between projected and actual contingent nonperiodic 
payments as provided in paragraph (g)(6)(vi) of this section.
    (iii) Determining projected amount of contingent payment--(A) 
Payment based on actively traded futures or forward contracts. If a 
contingent nonperiodic payment is determined under the contract by 
reference to the value of a specified index on a designated future 
date, the projected amount of the payment may be determined on the 
basis of the future value for the specified index in actively traded 
futures or forward contracts, if any, providing for delivery or 
settlement on the designated future date. If no actively traded 
contract exists for the designated future date, a determination from 
the future values for the specified index in actively traded futures or 
forward contracts, if any, providing for delivery or settlement on 
dates within three months of the designated future date may be used.
    (B) Payment based on extrapolation from current market prices. If a 
contingent nonperiodic payment is determined under the contract by 
reference to the value of a specified index on a designated future 
date, the projected amount of the payment may be determined on the 
basis of the current value of the specified index as established by 
objective financial information adjusted to convert the current value 
to a future value for the specified index on the designated future 
date. The current value is converted to a future value by adding to the 
current value an amount equal to the accrual of interest on the current 
value under a constant yield method at the risk-free interest rate with 
appropriate compounding and by making appropriate adjustments for 
expected cash payments on the property underlying the specified index.
    (C) Payment based on reasonable estimate. If the methods provided 
in paragraphs (g)(6)(iii)(A) and (B) of this section do not result in a 
reasonable estimate of the amount of the contingent payment, the 
taxpayer must use another method that does result in a reasonable 
estimate of the amount of the contingent payment and that is based on 
objective financial information.
    (iv) Redeterminations of projected payments and level payment 
amounts--(A) General rule. On each redetermination date, the taxpayer 
must redetermine the projected amount using current values on the 
redetermination date and the same method that was used on the 
commencement date of the notional principal contract, and must reapply 
the level payment method as of the commencement date of the notional 
principal contract on the basis of the new projected payment amount and 
the risk-free interest rate in effect on the redetermination date.
    (B) Special rule for fixed but deferred contingent nonperiodic 
payments. If a contingent nonperiodic payment is fixed more than six 
months before it is due, and if the date the payment is fixed is in a 
different taxable year from the date the payment is due, the date on 
which the payment is fixed is a special redetermination date. As of 
that date, the taxpayer must treat the fixed amount as the projected 
amount for that contingent nonperiodic payment and apply paragraphs 
(g)(6)(iv) and (v) of this section as if the special redetermination 
date were a redetermination date.
    (v) Adjustments following redeterminations. Following each 
redetermination of projected payments and level payment amounts, the 
taxpayer must apply the new schedule of level payments for purposes of 
determining amounts to be recognized in the current and subsequent 
taxable years with respect to the contingent nonperiodic payments. Any 
difference between the amounts recognized in prior taxable years and 
the amounts that would have been recognized in those years had the new 
level payment schedule been in effect for those years is taken into 
account as additional payments or receipts with respect to the contract 
ratably over the one-year period beginning with the redetermination 
date and, to the extent attributable to a difference in the interest 
amounts calculated under paragraph (g)(4) of this section, is 
recognized as interest for all purposes of the Internal Revenue Code.
    (vi) Adjustments for differences between projected and actual 
payments. Any difference between the amounts taken into account under 
paragraph (f) and this paragraph (g)(6) on the one hand and the amount 
of the actual payment under the contract on the other hand is taken 
into account as an adjustment to the net income or net deduction from 
the notional principal contract for the taxable year during which the 
payment occurs, and not as an adjustment to interest income or expense.
    (vii) Recordkeeping requirements. The books and records maintained 
by a taxpayer must contain a description of the method used to 
determine the projected amount of a contingent payment, projected 
payment schedules, any adjustments following redeterminations, and any 
adjustments for differences between projected and actual contingent 
payments.
    (7) * * *

    Example 3. Upfront significant nonperiodic payment. * * *
* * * * *
    Example 5. Backloaded significant nonperiodic payment. (i) On 
January 1, 2003, unrelated parties P and Q enter into an interest 
rate swap contract. Under the terms of the contract, P agrees to 
make five annual payments to Q equal to LIBOR times a notional 
principal amount of $100,000,000. In return, Q agrees to pay P 6% of 
$100,000,000 annually, plus $24,420,400 on December 31, 2007. At the 
time P and Q enter into this swap agreement the rate for similar on-
market swaps is LIBOR to 10%. Assume that on January 1, 2003, the 
risk-free rate is 10%.
    (ii) The $24,420,400 payment from Q to P is significant when 
compared to the present value of the total payments due from Q under 
the contract. Accordingly, pursuant to paragraph (g)(4) of this 
section, the transaction is recharacterized as two separate 
transactions. First, P is treated as paying to Q a series of 
$4,000,000 level payment loan advances. The present value of the 
level payment loan advances equals the present value of $24,420,400, 
the significant nonperiodic payment. Stated differently, the sum of 
the level payment loan advances and accrued interest on those 
advances equals the significant nonperiodic payment.
    (iii) Next, Q is treated as using each loan advance to fund five 
annual level swap payments of $4,000,000. The level payment loan 
advances and accrued interest on the advances computed with annual 
compounding at 10% are as follows:

[[Page 8895]]



------------------------------------------------------------------------
                                                              Accrued
                                           Level payment     interest
------------------------------------------------------------------------
2003....................................      $4,000,000              $0
2004....................................       4,000,000         400,000
2005....................................       4,000,000         840,000
2006....................................       4,000,000       1,324,000
2007....................................       4,000,000       1,856,400
                                         -----------------
                                             $20,000,000      $4,420,400
------------------------------------------------------------------------

    (iv) P recognizes interest income, and Q accrues interest 
expense, each taxable year equal to the interest accruals on the 
deemed level payment loan advances. These interest amounts are not 
included in the parties' net income or net deduction from the swap 
contract under paragraph (d) of this section.
    (v) The level payment amounts of $4,000,000 are taken into 
account in determining the parties' net income and deductions on the 
swap pursuant to paragraph (d) of this section.
    Example 6. Contingent nonperiodic payment on an equity swap. (i) 
On January 1, 2005, unrelated parties V and W enter into an equity 
swap contract. Under the terms of the contract, V agrees to make 
three annual payments to W equal to 1-year LIBOR times a notional 
principal amount of $50,000,000. In return, W agrees to make a 
single payment on December 31, 2007, equal to the appreciation, if 
any, of a $50,000,000 investment in a basket of equity securities 
over the term of the swap. V is obligated to make a single payment 
on December 31, 2007, equal to the depreciation, if any, in the same 
$50,000,000 investment in the basket of equity securities. Assume 
that on January 1, 2005, 1-year LIBOR is 9.5%, and the risk-free 
rate is 10.0%.
    (ii) This contract is a notional principal contract as defined 
in paragraph (c)(1) of this section. The annual LIBOR-based payments 
from V to W are periodic payments and the single payment on December 
31, 2007, is a contingent nonperiodic payment.
    (iii) Pursuant to the method described in (g)(6)(iii)(B) of this 
section, the parties determine that the projected amount of the 
contingent nonperiodic payment that W will pay V on December 31, 
2007, is $16,550,000. The present value of this projected fixed 
payment is significant when compared to the present value of the 
total payments due from W under the contract. Accordingly, pursuant 
to paragraph (g)(4) of this section, the transaction is 
recharacterized as two separate transactions.
    (iv) As a preliminary step, using the risk-free rate of 10.0% as 
the discount rate, the parties determine the level payment amounts 
that have a present value equal to the present value of $16,550,000, 
the projected significant nonperiodic payment. Stated differently, 
the sum of the level payment amounts and accrued interest at 10.0% 
on those amounts must equal the projected significant nonperiodic 
payment. The level payment amounts thus determined are $5,000,000.
    (v) Next, V is treated as paying to W a series of $5,000,000 
loan advances.
    (vi) Then, W is treated as using each loan advance to fund one 
of the three annual level swap payments of $5,000,000. The level 
payment loan advances and accrued interest on the advances computed 
with annual compounding at 10.0% are as follows:

[[Page 8896]]



------------------------------------------------------------------------
                                                              Accrued
                                           Level payment     interest
------------------------------------------------------------------------
2005....................................      $5,000,000              $0
2006....................................       5,000,000         500,000
2007....................................       5,000,000       1,050,000
                                         -----------------
                                             $15,000,000      $1,550,000
------------------------------------------------------------------------

    (vii) No interest amount is taken into account for the contract 
year 2005.
    (viii) The level payment amount of $5,000,000 is taken into 
account for the contract year 2005 in determining the parties' net 
income and deductions on the swap pursuant to paragraph (d) of this 
section.
    (ix) For the contract year 2005, V makes a swap payment to W 
equal to 1-year LIBOR at 9.5% times $50,000,000, or $4,750,000, and 
W is deemed to make a swap payment to V equal to the annual level 
payment of $5,000,000. The net of the ratable daily portions of 
these payments determines the annual net income or deduction from 
the contract for both V and W.
    Example 7. Initial Adjustment. (i) The terms of the equity swap 
agreement are the same as in Example 6. In addition, assume that on 
January 1, 2006, the first redetermination date, 1-year LIBOR is 
10.0%, and the risk-free rate is 10.5%. On that date, the parties 
redetermine the projected amount of the contingent nonperiodic 
payment using current values in effect on that date. Under the 
method described in (g)(6)(iii)(B) of this section, the parties 
determine that the reprojected amount of the contingent nonperiodic 
payment that W will pay V on December 31, 2007, is $23,261,500. The 
present value as of January 1, 2005, of this projected fixed payment 
is significant when compared to the present value of the total 
payments due from W under the contract. Accordingly, pursuant to 
paragraph (g)(4) of this section, the transaction is recharacterized 
as two separate transactions.
    (ii) The parties use the redetermined projected amount of 
$23,261,500, to reapply the method provided by paragraph (g)(4) of 
this section effective as of the commencement date of the swap. As a 
preliminary step, using the risk-free rate of 10.5% as the discount 
rate, the parties determine the level payment amounts that have a 
present value equal to the present value of $23,261,500, the 
reprojected significant nonperiodic payment. Stated differently, the 
sum of the level payment amounts and accrued interest at 10.5% on 
those amounts must equal the reprojected significant nonperiodic 
payment. The level payment amounts thus determined are $6,993,784.
    (iii) Next, V is treated as paying to W a series of $6,993,784 
loan advances.
    (iv) Then, W is treated as using each loan advance to fund one 
of the three annual level swap payments of $6,993,784. The level 
payment loan advances and accrued interest on the advances computed 
with annual compounding at 10.5%, are as follows:

------------------------------------------------------------------------
                                                              Accrued
                                           Level payment     interest
------------------------------------------------------------------------
2005....................................      $6,993,784              $0
2006....................................       6,993,784         734,347
2007....................................       6,993,784       1,545,801
                                         -----------------
                                             $20,981,352      $2,280,148
------------------------------------------------------------------------

    (v) For the contract year 2006, V recognizes interest income, 
and W accrues interest expense equal to the accrued interest of 
$734,347 on the deemed level payment loan advance. These interest 
amounts are not included in the parties' net income or net deduction 
from the swap contract under paragraph (d) of this section.
    (vi) The level payment amount of $6,993,784 is taken into 
account for the contract year 2006 in determining the parties' net 
income and deductions on the swap pursuant to paragraph (d) of this 
section.
    (vii) The parties also take into account for the contract year 
2006 the difference between the amount recognized for 2005 and the 
amount that would have been recognized in 2005 had the new level 
payment schedule in this Example 7 been in effect in 2005. Thus, for 
purposes of paragraph (d) of this section, W is treated as making a 
swap payment, and V is treated as receiving a swap payment of 
$1,993,784 ($6,993,784-$5,000,000) for purposes of paragraph (d) of 
this section.
    (viii) For the contract year 2006, V makes a swap payment to W 
equal to 1-year LIBOR at 10.0% times $50,000,000, or $5,000,000, and 
W is deemed to make a swap payment to V equal to the annual level 
payment of $6,993,784 and the adjustment amount of $1,993,784. The 
net of the ratable daily portions of these payments determines the 
annual net income or deduction from the contract for both V and W.
    Example 8. Subsequent Adjustment. (i) The terms of the equity 
swap agreement are the same as in Example 7. In addition, assume 
that on January 1, 2007, the second redetermination date, 1-year 
LIBOR is 11.0%, and the risk-free rate is also 11.0%. On that date, 
the parties redetermine the projected amount of the contingent 
nonperiodic payment using current values in effect on that date. The 
parties determine that the reprojected amount of the contingent 
nonperiodic payment that W will pay V on December 31, 2007, is 
$11,050,000. The present value as of January 1, 2005, of this 
projected fixed payment is significant when compared to the present 
value of the total payments due from W under the contract. 
Accordingly, pursuant to paragraph (g)(4) of this section, the 
transaction is recharacterized as two separate transactions.
    (ii) The parties use the redetermined projected amount of 
$11,050,000, to reapply the method provided by paragraph (g)(4) 
effective as of the commencement date of the swap. As a preliminary 
step, using the risk-free rate of 11.0% as the discount rate, the 
parties determine the level payment amounts that have a present 
value equal to the present value of $11,050,000, the reprojected 
significant nonperiodic payment. Stated differently, the sum of the 
level payment amounts and accrued interest at 11.0% on those amounts 
must equal the reprojected significant nonperiodic payment. The 
level payment amounts thus determined are $3,306,304.
    (iii) Next, V is treated as paying to W a series of $3,306,304 
loan advances.
    (iv) Then, W is treated as using each loan advance to fund one 
of the three annual level swap payments of $3,306,304. The level 
payment loan advances and accrued interest on the loan advances 
computed with annual compounding at 11.0% are as follows:

------------------------------------------------------------------------
                                                              Accrued
                                           Level payment     interest
------------------------------------------------------------------------
2005....................................      $3,306,304             $ 0
2006....................................       3,306,304         363,693

[[Page 8897]]

 
2007....................................       3,306,304         767,393
                                         -----------------
                                              $9,918,912      $1,131,086
------------------------------------------------------------------------

    (v) For 2007, V recognizes interest income, and W accrues 
interest expense equal to the $767,393 accrued interest amount for 
2007 on the deemed loan advances. In addition, V has a net interest 
expense item and W has a net interest income item equal to $370,654 
($734,347-363,693), the difference between the interest accrual 
taken into account for 2006 and the amount that would have been 
taken into account for 2006 had the new level payment schedule in 
this Example 8 been in effect for 2006. As a result, V has net 
interest income and W has net interest expense in the amount of 
$396,739 for 2007. These interest amounts are not included in the 
parties' net income or net deduction from the swap contract under 
paragraph (d) of this section.
    (vi) The level payment amount of $3,306,304 is taken into 
account for the contract year 2007 in determining the parties' net 
income and deductions on the swap pursuant to paragraph (d) of this 
section.
    (vii) For 2007, the parties also take into account for 2007 the 
difference between the amounts previously recognized for 2005 and 
2006 and the amounts that would have been recognized for those years 
had the new level payment schedule in this Example 8 been in effect 
in 2005 and 2006. The amounts previously recognized were: a total of 
$6,993,784 for 2005, which is the sum of $5,000,000 (in 2005) and 
$1,993,784 (in 2006), and a total of $6,993,784 for 2006 (in 2006). 
The adjustment amount, therefore, equals two times $3,687,480 
($6,993,784-$3,306,304), or $7,374,960. This amount is taken into 
account as a payment for purposes of paragraph (d) of this section.
    (viii) For the contract year 2007, V makes a swap payment to W 
equal to 1-year LIBOR at 11.0% times $5,000,000, or $5,500,000. W is 
deemed to make a swap payment to V equal to the annual level payment 
for 2007 of $3,306,304, and V is deemed to make a swap payment to W 
equal to the adjustment amount of $7,374,960. The net of the ratable 
daily portions of these payments determines the annual net income or 
deduction from the contract for both V and W.
    Example 9. Adjustment for actual payment. (i) The terms of the 
equity swap agreement are the same as in Example 8. In addition, on 
December 31, 2007, W makes a payment to V of $25,000,000, an amount 
equal to the appreciation of a $50,000,000 investment in the basket 
of equity securities.
    (ii) For 2007, $13,950,000, the difference between $25,000,000 
and $11,050,000, the projected amount of the contingent payment as 
of January 1, 2007, is taken into account as an adjustment to the 
parties' net income or deductions for each party's taxable year that 
contains December 31, 2007, pursuant to paragraph (d) of this 
section.
* * * * *

    (i) Election to mark to market. A taxpayer may elect to mark to 
market notional principal contracts providing for nonperiodic payments. 
The rules of paragraphs (f) (other than (f)(2)(i)), (g)(6)(ii) through 
(vii), and (h) of this section do not apply to contracts to which this 
paragraph (i) applies. See paragraph (i)(5) of this section for rules 
respecting interest accruals under paragraph (g)(4) of this section for 
contracts providing for significant nonperiodic payments to which this 
paragraph (i) applies.
    (1) General rule. In the case of any contract held at the close of 
the taxable year to which this paragraph (i) applies, the taxpayer 
shall determine income inclusions and deductions by reference to the 
gain or loss that would be realized if the contract were sold for its 
fair market value on the last business day of the taxable year. Proper 
adjustment shall be made in the amount of any gain or loss subsequently 
realized (or calculated) for the income inclusions and deductions taken 
into account by reason of this paragraph (i)(1) as provided in 
paragraph (d)(2) of this section.
    (2) Scope of election. The election provided by this paragraph is 
available for notional principal contracts that are--
    (i) Of a type that is actively traded within the meaning of Sec.  
1.1092(d)-1(c) (determined without regard to the limitation in Sec.  
1.1092(d)-1(c)(2));
    (ii) Marked to market by the taxpayer for purposes of determining 
the taxpayer's financial income provided the taxpayer satisfies the 
requirements in paragraph (i)(4) of this section;
    (iii) Subject to an agreement by a party to the contract that is 
subject to section 475 to supply to the taxpayer the value that it uses 
in applying section 475(a)(2); or
    (iv) Marked to market by a regulated investment company described 
in section 1296(e)(2).
    (3) Determination of fair market value. For purposes of paragraph 
(i)(1) of this section, fair market value is determined by applying the 
rules set forth in paragraphs (i)(3)(i) through (iv) of this section.
    (i) Determination based on readily ascertainable value. For a 
contract described in paragraph (i)(2)(i) of this section, fair market 
value is determined based on the mean between the bid and asked prices 
quoted for the contract on an established financial market as defined 
in Sec.  1.1092(d)-1(b)(1), or, if bid and asked prices are not 
available, comparable prices determined on the basis of recent price 
quotations described in Sec.  1.1092(d)-1(b)(2).
    (ii) Determination based on value used for financial statements. 
For a contract described in paragraph (i)(2)(ii) of this section that 
is not described in paragraph (i)(2)(i) of this section, fair market 
value is the value used by the taxpayer for purposes of preparing its 
financial statements under paragraph (i)(4) of this section.
    (iii) Determination based on counterparty's mark-to-market value. 
For a contract described in paragraph (i)(2)(iii) of this section that 
is not described in paragraph (i)(2)(i) of this section, fair market 
value is the mark-to-market value provided by a counterparty as being 
the value the counterparty used for purposes of section 475(a)(2).
    (iv) Determination based on value used in determining net asset 
value. Notwithstanding paragraphs (i)(3)(i) through (iii) of this 
section, for a contract described in paragraph (i)(2)(iv) of this 
section, fair market value is the value used by the taxpayer in 
determining its net asset value.
    (4) Requirements for use of financial statement values. [Reserved].
    (5) Notional principal contracts accruing interest on significant 
nonperiodic payments--(i) General rule. If a notional principal 
contract that is marked to market under this paragraph (i) provides for 
one or more significant nonperiodic payments, paragraph (g)(4) of this 
section applies to the contract (computed with regard to the rule in 
paragraph (i)(5)(ii) of this section). Proper adjustment shall be made 
in the amount of any income inclusions or deductions recognized under 
paragraph (i)(1) of this section to take into account amounts 
recognized as interest under paragraph (g)(4) of this section and the 
payment or receipt of the nonperiodic payment or payments.
    (ii) Special rules for significant contingent nonperiodic payments. 
In the case of a contract providing for a significant contingent 
nonperiodic payment, the projected amount of the payment is determined 
by applying one

[[Page 8898]]

of the methods described in paragraph (g)(6)(iii) of this section or by 
applying the deemed equivalent value method described in this paragraph 
(i)(5)(ii). The amount of the payment is not redetermined except as 
provided in paragraph (g)(6)(iv)(B) of this section. The deemed 
equivalent value method may be applied if the contract fixes the timing 
and amount of all of the payments under the contract, except for a sole 
significant contingent nonperiodic payment. Under the deemed equivalent 
value method, the amount of the significant contingent nonperiodic 
payment is the amount that, as of the date the terms of the contract 
are fixed, causes the present value of all of the payments by the 
taxpayer to equal the present value of all of the payments of the 
counterparty to the contract. The present value of each payment of the 
contract is determined by applying the risk-free interest rate.
    (iii) Nonapplicability to regulated investment companies. 
Paragraphs (i)(5)(i) and (ii) of this section do not apply to a 
regulated investment company described in paragraph (i)(2)(iv) of this 
section that makes an election under paragraph (i) of this section.
    (6) Election. An election to apply this paragraph (i) must be made 
with respect to all notional principal contracts described in paragraph 
(i)(2) of this section to which the taxpayer is a party. The election 
must be made in the time and manner prescribed by the Commissioner and 
is effective for the taxable year for which made and all subsequent 
taxable years, unless revoked with the consent of the Commissioner.
    (j) Effective dates--(1) General rule. Except as provided in 
paragraph (j)(2) of this section, this section is applicable for 
notional principal contracts entered into on or after December 13, 
1993.
    (2) Exception. Paragraphs (g)(6) (other than (g)(6)(i)) and (i) of 
this section are applicable for notional principal contracts entered 
into on or after 30 days after the date a Treasury decision based on 
these proposed regulations is published in the Federal Register.
    Par. 5. Section 1.1234A-1 is added to read as follows:


Sec.  1.1234A-1  Notional principal contracts, bullet swaps, and 
forward contracts.

    (a) General rule. If a taxpayer has a position in a notional 
principal contract governed by the rules of Sec.  1.446-3, any gain or 
loss arising from a termination payment as defined in Sec.  1.446-
3(h)(1) is treated as gain or loss from a termination of the notional 
principal contract.
    (b) Nonapplicability to payments other than termination payments. 
For purposes of section 1234A, none of the following payments terminate 
or cancel a right or obligation: a periodic payment described in Sec.  
1.446-3(e), a nonperiodic payment described in Sec.  1.446-3(f), a 
contingent nonperiodic payment described in Sec.  1.446-3(g)(6) to 
which Sec.  1.446-3(g)(6)(ii) applies, or mark-to-market income 
inclusions and deductions described in Sec.  1.446-3(i)(1). 
Accordingly, section 1234A does not apply to any of these items, 
including any final scheduled payment. If a payment made or received 
pursuant to a notional principal contract is not a termination payment 
as defined in Sec.  1.446-3(h)(1), the payment constitutes ordinary 
income or expense. See sections 162 and 212 and the regulations 
thereunder.
    (c) Bullets swaps and forward contracts--(1) Any gain or loss 
arising from the settlement of obligations under a bullet swap or 
forward contract (including a payment pursuant to the terms of the 
obligations) is treated as gain or loss from a termination of the 
bullet swap or forward contract.
    (2) Definition of bullet swap. A bullet swap is a financial 
instrument that is not an excluded contract as defined in Sec.  1.446-
3(c)(1)(ii), that provides for the computation of an amount or amounts 
due from one party to another by reference to a specified index upon a 
notional principal amount, and that provides for settlement of all the 
parties' obligations at or close to maturity of the contract.
    (d) Effective date. Paragraphs (b)(1) and (c) of this section are 
applicable to notional principal contracts, bullet swaps, and forward 
contracts entered into on or after 30 days after the date a Treasury 
decision based on these proposed regulations is published in the 
Federal Register.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 04-4151 Filed 2-25-04; 8:45 am]
BILLING CODE 4830-01-P