WASHINGTON -- The Internal Revenue Service on Friday issued final rules that dictate when income and deductions are recognized for income tax purposes for interest rate swaps and other so-called notional principal contracts.

The rules generally take effect for such swaps and other notional principal contacts that are entered into on or after Dec. 13, which is 60 days after Oct. 14, when the rules are expected to be published in the Federal Register, an IRS official said.

Notional principal contracts are transactions in which parties make payments to each other based on a principal amount that is never actually exchanged.

The final rules apply a controversial "embedded loan" concept to interest rate swaps, but reserve its application for interest rate caps and floors, the IRS official said.

Tax lawyers have been concerned that the rules could complicate the tax treatment of municipal derivatives or affect the way some interest rate swaps are treated under the hedging provisions of the arbitrage rules, which the IRS issued in June.

Steve Conlon, a lawyer with Chapman and Cutler in Chicago who represents municipal market participants, said Friday that based on a brief discussion with an IRS official, the rules "sound positive, over all."

"It sounds like they're trying to make the rules better. But there may still be some questions," he said.

But Conlon and other lawyers said they are reluctant to comment on the new rules without having read and studied them.

Under the final rules, a swap with significant nonperiodic payments is treated as having an embedded loan that must be treated as a loan for tax purposes by both parties in the transaction independently from the swap.

The IRS said it would continue to consider proposed rules first issued in July 1991, under which interest rate caps and floors would have embedded loans if, on the date the cap or floor was entered into, the current value of the specified index differed from the cap or floor rate by more than 25 basis points.

The final rules do not elaborate on what constitutes a "significant" nonperiodic swap payment and, instead, retain the test that was included in the proposed rules issued in 1991.

The rules do, however, expand the definition of a "specified index" to include "almost any fixed rate or variable rate, price or amount based on current, objectively determinable financial or economic information."

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