Treasury, IRS Looking for Swaps "Notions"

The agencies are trying to decide whether new regulations or legislation is necessary, before more rules for individual products are put in place.

Tax reform is on everyone’s agenda, from the White House, where the president is mulling over tax reform measures, to the Treasury, where officials are working on a set of proposals aimed at simplifying the administration of the current tax code, according to a Dow Jones report.

And a recent study on tax code complexity, undertaken by the Congressional Joint Committee on Taxation (JCT), found the rules governing taxation of financial instruments to be inconsistent, patchy and full of loopholes and open to abuse.

In addition, the Treasury and the IRS have found “almost limitless flexibility in the design of derivatives, and tax rules that provide for differences in tax treatment that do not reflect economic differences may produce inappropriate tax consequences,” according to a notice scheduled for publication in the Internal Revenue Bulletin.

Notional Principal Contracts

In particular, the agencies are targeting notional principal contracts (NPCs) with contingent non-periodic payments, which are equity swaps where the size of a final payment depends on the movement in a company’s stock price. This type of NPC can also be used to insure against bond defaults and other risks.

Other types of NPCs include interest rate and commodity swaps. Equity swaps are often used as an economically efficient means of obtaining a highly leveraged position in a company’s stock.

At present, the tax rules that apply to NPCs provide for periodic, non-periodic and termination payments, but all of a fixed nature. The lack of guidance for payments that are contingent on some event occurring has resulted in a lack of confidence in the tax system and inefficiencies in the capital, according to the agencies.