Cash Management

IRS Plugging Another Loophole

Tax man tightening rules for treatment of NPCs.
Alix StuartSeptember 21, 2001

Timing is everything, especially when it comes to taxes. So the Internal Revenue Service wants to tighten the leeway corporate treasurers enjoy when they “pick and choose” the tax treatment of contingent, nonperiodic notional principal contracts (NPCs).

Typically swaps that tie payments to movements of a specific index, NPCs fall outside IRS rules for derivatives taxation. This makes them the perfect vehicle for turning capital losses, which are amortized over a certain number of years, into ordinary losses, which are deducted in their entirety — or vice versa, depending on which saves the most taxes in any given period.

Without IRS guidance, treasurers can choose among several treatments of NPCs to produce a desired tax result. At least that’s the case for now.

The IRS, well aware that treasurers can easily “whipsaw” the government with this flexibility, plans to codify and regulate the timing and characterization of nonperiodic payments, as well as those for other financial instruments, just as soon as it figures out how. According to the July Internal Revenue Bulletin, “The existing rules for various financial instruments are so inconsistent with each other…that it is difficult to decide which set of existing rules should be followed.”

So the IRS is soliciting comments on four suggested taxation methodologies, and inviting original ideas, until late November. “The focus may be on specific products, but it really seems as though the IRS is interested in revamping the tax rules for financial products in general,” says William Pomierski, a tax attorney with McDermott, Will & Emery and co-editor of the Journal of Taxation of Financial Products.

In fact, the IRS has talked about releasing new rules on a wider range of tax-planning instruments before it issues new guidelines on the nonperiodic contracts. So you won’t see new regulations on NPCs anytime soon.

“The IRS wants rules that don’t game the government, but anything more than legislative tweaks would probably require congressional approval,” notes Andrea Kramer, a tax attorney and the author of Financial Products: Taxation, Regulation and Design. Still, experts say change is inevitable within a few years.