WASHINGTON -- The Internal Revenue Service took the right approach with its proposals for rules governing municipal swaps and other derivative products, but some of the requirements could hurt the products' growing market, lawyers and accountants said yesterday.

Their comments were made at an IRS public hearing on the July proposals, which would dictate when income and deductions re recognized for income tax purposes for so-called notional principal contracts.

Notional principal contracts are interest rate swaps and other transactions in which parties make payments to each other based on a principal amount that is called "notional" because it is never actually exchanged.

Most of the lawyers and accountants testifying at the hearing said they were concerned about the rules' "embedded loan" concept, the definition of specified indices used in swaps, the definition of periodic payments, and limits on the use of mark-to-market tax accounting for such contracts.

The chief concern over the embedded loan concept is that it would raise a whole host of reporting, deduction, and other tax issues for both parties of an interest rate swap.

Under the proposed rules, a swap that involves significant nonperiodic payments is treated as having an embedded loan which must be treated as a loan for tax purposes by both parties in the transaction independently from the swap. Interest rate caps and floors also 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.

Mikol S. Neilson, a lawyer representing the American Bar Association, questioned whether the complexity of the embedded loan concept was worth the revenue gain and urged the IRS to drop it from the proposed rules. If the IRS insists on keeping the concept, he said, there should be a test for swaps, like the one for caps and floors, to determine whether a loan is embedded in the transaction. But the test should be greater than 25 basis points, he said. Mr. Neilson is a lawyer with the law firm of Venable, Baetjer and Howard.

Steven D. Conlon, a lawyer with Chapman and Cutler, a Chicago-based law firm that represents banks, municipal market participants, and investors regarding interest rate swaps, said that the "embedded loan" concept "has potential draconian consequences" to both parties in swap transactions. He said the IRS should not keep it without providing a test for swaps as well as guidance on the tax issues raised when transactions are deemed to have such loans.

Mr. Conlon also said he was concerned that the proposed rules' definition of a "specified index" that is used in a swap transaction is too narrow and would exclude some of the variable indices that are relied on in the swap market.

The proposed rules define a swap as a notional principal contract that involves parties making periodic payments based on a variable specified index. The rules include a lengthy definition of a specified index. Mr. Conlon, however, said such a definition is "inappropriate" because "it is subject to easy manipulation" and because it would exclude swaps that presently exist in the market from the rules' tax treatment.

Mr. Conlon said another concern to the municipal swap market is that the proposed rules define "periodic payments" in a way that could penalize some municipal issuers in their tax treatment of these payments. The rules define "periodic payments" as payments made or received pursuant to a notional principal contract that are payable at fixed periodic intervals of one year or less during the contract's term.

But for many tax-exempt obligations, he said, the period between the date of issue and the date of the first interest payment can be longer than a year because of the issuer's tax assessment and collection cycle. These longer payments would be characterized as "nonperiodic payments" under the proposed rules and would be subject to complex amortization requirements, he said.

Another complaint about the proposed rules is they allow dealers and traders in derivatives to use mark-to-market tax accounting -- a method whereby gains and losses are recognized at the end of each year -- only if none of the dealers and traders and related parties do not use lower-of-cost-or-market tax accounting for their securities or commodities inventories. The lower-of-cost-or-market accounting method recognizes only losses at the end of each year.

Both the International Swap Dealers Association and the American Bar Association urged IRS officials not to link the two methods of accounting in these rules. If the agency wants to discourage lower-of-cost-or-market accounting, it should do so in a separate rulemaking project, said Stephen Gordon, a lawyer with Cravath, Swaine & Moore representing the swap dealers association, and Peter J. Connors, Ernst & Young's global capital markets tax coordinator, who spoke for the American Bar Association.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.