WASHINGTON - The growing derivatives market, until now almost bereft of guidance on tax issues, has suddenly been hit with a number of new tax requirements from Congress and federal regulatory agencies.
These include the tax law's new mark-to-market requirements and several sets of regulations issued by the Treasury Department and Internal Revenue Service on the arbitrage consequences and tax treatment of swaps and other hedging and non-hedging derivatives transactions.
The key questions are how these new requirements relate to one another and how they affect derivatives transactions and their participants.
Perhaps the most important of the requirements for the municipal derivatives market are the hedging provisions of the arbitrage rules, lawyers say.
These rules, which were published in June and generally took effect in July, govern the arbitrage consequences of derivatives transactions for state and local bond issuers.
As currently written, the arbitrage hedging rules guarantee fixed-yield treatment only for interest rate swaps in which the issuer pays fixed rates and receives floating rates.
Industry officials are pushing for the IRS to expand the rules so that they assure fixed-yield treatment for other municipal derivatives - such as interest rate caps and matched floating-rate and inverse floating-rate bonds - that would, practically speaking, result in a fixed yield and not give rise to any arbitrage abuses.
Issuers generally want fixed-yield treatment for derivatives deals so their bond yield is easily determined for arbitrage calculations, remains constant, and, for advance refundings, more accurately reflects the interest costs over the life of the bonds.
The mark-to-market requirements, which were enacted in August, dictate the timing and character of the taxation of derivatives contracts held by dealers.
Dealers are defined under the tax law as securities dealers, banks, and others that regularly purchase or sell securities or loans.
The mark-to-market requirements call for dealers to take into account the market value, rather than the cost, of the derivatives contracts they hold at the end of the tax year in determining whether they have experienced gains or losses for tax purposes.
The requirements are expected to take more of a tax bite from many dealers that have been valuing their derivatives at the lower of either cost or market value.
The rules dictate timing by making it clear that dealers must determine their gains and losses from derivatives contracts at the end of each tax year.
They dictate character by saying that the gains and losses are to be treated as ordinary, rather than capital, gains and losses.
While corporations are subject to a 35% tax rate for both ordinary and capital gains, they can use ordinary losses to offset their taxable income and reduce their tax bill. Capital losses, in contrast, can be used only to offset capital gains.
The notional principal contract rules, which are called the swaps rules, are timing rules that mostly apply to non-dealer taxpayers involved in interest rate swaps and other transactions in which payments are based on a principal amount that is never exchanged.
These rules, which primarily affect non-hedging transactions, dictate when income and deductions can be recognized on the payments made in connection with such contracts.
For swaps with non-periodic payments, the payments, whether treated as income or a deduction, must be amortized over the life of the contract. For swaps with periodic payments, the payments must be taken into account on a "ratable daily basis" so that they are spread over the tax period for which they were made.
These rules were issued, in part, to prevent taxpayers from using swaps to gain unfair tax advantages. Some companies with operating losses that could no longer be carried over into the next tax year were entering into off-market swaps under which they would receive huge upfront payments for agreeing to pay above-market rates in return for market rates. The companies could then recognize the upfront payments in their current tax years and use their net operating losses to shelter that income. They could get tax deductions for their payments for the years the swaps remained in effect.
The hedging rules, which were published by the IRS two weeks ago, are actually three sets of effective and proposed rules that govern the timing and character of the taxation of hedging transactions, including swaps, for non-dealer taxpayers.
The hedging rules include temporary rules on character that allow taxpayers to treat gains or losses from hedging transactions as ordinary, rather than capital, gains or losses. The temporary rules are effective until issued in final form, but expire at the end of three years.
The hedging rules also contain proposed rules on character that specify how hedging transactions and whatever they are hedging should be identified in order for taxpayers to be able to recognize ordinary losses and gains.
In addition, they contain proposed rules on timing that generally require a taxpayer, for both a hedging transaction and whatever is being hedged, to match the timing of income, deductions, gains, and losses.
The proposed hedging rules would not take effect until 60 days after being issued in final form. The IRS has announced that it will accept public comments on the proposed rules until Dec. 20 and that it will hold a hearing on the rules on Jan. 19.
The hedging rules are aimed at resolving the controversy that surrounded an IRS interpretation of the Supreme Court's decision in 1988 in Arkansas Best v. Comissioner.
Under the IRS' interpretation of the decision, virtually any transaction hedging a liability risk would be a capital risk and therefore subject to capital gains and losses.