WASHINGTON -- Rules issued by the Internal Revenue Service on Friday should help the municipal derivatives market because they clarify the tax accounting principles used for interest rate swaps and other so-called notional principal contracts, several lawyers said this week.

"The rules should permit investors to enter into more flexible hedging transactions with respect to their municipal bond investments because they are more flexible" than rules proposed in 1991, said George Wolf, a lawyer with Orrick, Herrington & Sutcliffe in San Francisco.

However, the new rules also raise questions in some cases, such as whether one provision on interest rate caps is in sync with the recently issued arbitrage rules on hedging transactions, the lawyers said.

In addition, the rules fail to provide guidance on the tax accounting principles that should be used for interest rate caps and floors.

"Although helpful, the rules leave for another day the more difficult issues relating to floors and caps and other types of contracts," said Steve Conlon, a lawyer with Chapman and Cutler in Chicago.

The notional principal contract rules, which were issued in final form, dictate when income and deductions are recognized for income tax purposes from interest rate swaps and other transactions in which parties make payments to each other based on a principal amount that is never actually exchanged.

The rules generally take effect for transactions entered into on or after Dec. 13, which is 60 days from Thursday, when the rules are expected to be published in the Federal Register, IRS officials said.

The IRS issued the rules to prevent parties to swaps from being able to make after-tax profits by recognizing up-front payments when received instead of amortizing them over the life of the swap, agency officials said.

Although the rules apply primarily to financial institutions and investors, they could have an arbitrage impact for state and local bond issuers involved in municipal derivative transactions, the IRS officials said.

The rules divide payments made with respect to interest rate swaps and other notional principal contracts into two general categories -- periodic and nonperiodic.

Taxpayers involved in swaps and other transactions with periodic payments can take the payments into account on a "rateable daily basis" so that the payment is spread over the period for which it was made. A broker-dealer that received a quarterly periodic payment in January, for example, would recognize two-thirds of the payment in its prior tax year and one-third in its current tax year.

For swaps with nonperiodic payments, the payments must be amortized over the life of the swap. The rules provide several methods of amortization. The general method is based on the pricing model that was used to establish the payments. Alternative methods are based on a constant yield to maturity formula.

Most lawyers said this week that the final rules are more helpful in a number of areas than the rules proposed in 1991.

The final rules, in effect, expand the definition of notional principal contracts to include a broader array of transactions. The proposed rules specifically defined interest rate swaps, caps, floors, and other notional principal contracts, and said that the obligations under them were to be determined by reference to one of several "specified" indexes.

The final rules do not define specific transactions and broaden the definition of "specified index" to include "almost any fixed rate or variable rate, price or amount based on current, objectively determinable financial or economic information."

"The rules liberalize the definition of what a notional principal contract is," Conlon said. "They've expanded the rules to take into account what the market has been doing."

The final rules, unlike the proposed rules, also make it clear that the notional principal amount in such contracts can change over time.

"That's very important for bonds because the notional principal amount will go down when the bonds are paid down," Conlon said.

In addition, the final rules drop a provision from the proposed rules that could have been a problem for municipal transactions, Conlon said.

Under the provision, the difference between the date the bonds were issued and the first periodic payment could not exceed the regular interval between payments plus 90 days in order for the swap to be treated as having periodic payments. So if bonds were issued in January and interest was to be paid in six-month intervals but, because of an initial lack of revenues the first payment was postponed until November, the transaction was not treated as having periodic payments.

The final rules, instead, allow a one-year interval between the date the bonds were issued and the date of the first payment for transactions to be treated as having periodic payments.

One potential problem with the final rules, however, is a provision on nonperiodic payments. The rules say that a fee for a cap or floor agreement is a nonperiodic payment even if it is not an up-front fee and its paid in installments.

Bond industry officials and lawyers, in ongoing discussions with IRS officials about the arbitrage rules on hedging transactions, have been contending that cap agreements with periodic payments do not have any investment element and should therefore be treated as qualified hedging transactions that would have fixed yields for arbitrage purposes.

Robert Sharp, a lawyer with Rogers & Wells in New York City, said this provision in the notional principal contract rules could be at odds with the hedging rules, which suggest that some interest rate caps, floors, and collars with periodic payments would be qualified hedges.

A federal official said, however, that while the hedging provisions of the arbitrage rules say that interest rate transactions with nonperiodic payments can not be treated as fixed yield issues, the provisions do not cover caps or floors. "The definition of a qualified hedge does not prohibit a cap or floor from having nonperiod payments," he said.

Most of the lawyers were not sure how a controversial "embedded loan" concept in the final rules will affect municipal derivatives transactions. The rules apply the concept to interest rate swaps, but reserve its application for interest rate caps and floors.

Under the concept, a swap with significant nonperiodic payments is treated as having an embedded loan which must be treated as a separate debt instrument for tax purposes by both parties in the transaction independently from the swap. The embedded loan would throw off interest that would have to be taken into account, in addition to the swap payments.

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