IRS Revenue Ruling
2002-30

Code Sec. 446

<<FULL TEXT>>

26 CFR 1.446-3: Notional Principal Contracts.

Notional Principal Contract. This ruling provides that where a
nonperiodic payment made pursuant to a notional principal contract is
comprised of noncontingent and contingent components, the parties must
recognize the noncontingent component of the nonperiodic payment over the
term of the notional principal contract.


REV. RUL. 2002-30

ISSUE

What is the appropriate method for the inclusion into income or
deduction of a nonperiodic payment made pursuant to a notional principal
contract where the payment is comprised of noncontingent and contingent
components?


FACTS

T enters into a notional principal contract ("NPC") with CP on October
1, 2002, for a term of 18 months. Pursuant to the terms of the NPC, T
agrees to make quarterly payments to CP based on three-month LIBOR
multiplied by a notional principal amount of $100,000,000. In exchange, CP
agrees that upon expiration of the NPC on March 31, 2004, CP will pay T 6
percent per year multiplied by a notional principal amount of $92,000,000
(the fixed payment amount). In addition, CP or T will make a payment upon
expiration equal to the percentage change in the value of the S&P 500
stock index multiplied by a notional principal amount of $8,000,000. If
the change is positive (an appreciation amount), CP will make a payment to
T; if the change is negative (a depreciation amount), T will make a
payment to CP. Any depreciation amount payable by T will be netted against
the fixed payment amount payable by CP.


LAW

Section 1.446-3 of the Income Tax Regulations provides rules on the
timing of inclusion of income and deductions for amounts paid or received
pursuant to NPCs.

Section 1.446-3(c)(1)(i) defines a NPC as a financial instrument that
provides for the payment of amounts by one party to another at specified
intervals calculated by reference to a specified index upon a notional
principal amount, in exchange for specified consideration or a promise to
pay similar amounts. Payments made pursuant to NPCs are divided into three
categories (periodic, nonperiodic, and termination payments), and the
regulations provide separate timing regimes for each.

Section 1.446-3(e)(1) defines periodic payments as payments made or
received pursuant to a NPC that are payable at intervals of one year or
less during the entire term of the contract, that are based on a specified
index, and that are based on a notional principal amount. Section
1.446-3(e)(2) provides that all taxpayers, regardless of their methods of
accounting, must recognize the ratable daily portion of a periodic payment
for the taxable year to which that portion relates.

Section 1.446-3(h)(1) defines a termination payment as a payment made
or received to extinguish or assign all or a proportionate part of the
remaining rights and obligations of any party under a NPC.

Section 1.446-3(f)(1) provides that a nonperiodic payment is any
payment made or received with respect to a NPC that is not a periodic
payment or a termination payment. The recognition rules for nonperiodic
payments are set forth in section 1.446-3(f)(2). Section 1.446-3(f)(2)(i)
provides that all taxpayers, regardless of their methods of accounting,
must recognize the ratable daily portion of a nonperiodic payment for the
taxable year to which that portion relates. Generally, a nonperiodic
payment must be recognized over the term of a NPC in a manner that
reflects the economic substance of the contract.

Section 1.446-3(f)(2)(ii) provides generally that a nonperiodic payment
must be recognized over the term of the contract by allocating it in
accordance with the forward rates of a series of cash-settled forward
contracts that reflect the specified index and the notional principal
amount.

Section 1.446-3(f)(2)(iii)(A) provides that an upfront payment may be
amortized by assuming that the nonperiodic payment represents the present
value of a series of equal payments made throughout the term of the swap
contract (the level payment method).

Section 1.446-3(f)(2)(iii)(B) provides that nonperiodic payments other
than an upfront payment may be amortized by treating the contract as if it
provided for a single upfront payment (equal to the present value of the
nonperiodic payments) and a loan between the parties. The single upfront
payment is then amortized under the level payment method described in
section 1.446-3(f)(2)(iii)(A). The time value component of the loan is not
treated as interest, but together with the amortized amount of the deemed
upfront payment, is recognized as a periodic payment. See section
1.446-3(f)(4), Example 6, for an illustration of these rules.

Section 1.446-3(g)(4) provides that a swap with significant nonperiodic
payments is treated as two separate transactions consisting of an
on-market, level payment swap and a loan. The loan must be accounted for
by the parties to the contract independently of the swap. The time value
component associated with the loan is not included in the net income or
net deduction from the swap under section 1.446-3(d) of this section, but
is recognized as interest for all purposes of the Internal Revenue Code.

Section 1.446-3(d) provides that for all purposes of the Code, the net
income or net deduction from a NPC for a taxable year is included in, or
deducted from, gross income for that taxable year. The net income or net
deduction from a NPC for a taxable year equals the total of all of the
periodic payments that are recognized from that contract for the taxable
year under section 1.446-3(e), and all of the nonperiodic payments that
are recognized from that contract for the taxable year under section
1.446-3(f). Each party to the NPC determines its payments and receipts
attributable to the taxable year and takes into account, as net income or
net deduction, the result of those payments and receipts. See section
1.446-3(e)(3), Example 1; and section 1.446-3(g)(6), Example 3.


ANALYSIS

The agreement between T and CP is a NPC as defined in section
1.446-3(c)(1)(i). Pursuant to the terms of the contract, T will pay to CP
amounts based on LIBOR quarterly, in exchange for CP's promise to pay
specified consideration at expiration.

The amounts that T pays to CP are periodic payments as defined in
section 1.446-3(e)(1). These LIBOR-based payments are payable at intervals
of less than one year and are calculated by reference to a specified index
upon a notional principal amount of $100,000,000. Pursuant to section
1.446-3(e)(2), T and CP must recognize the ratable daily portion of each
periodic payment for the taxable year to which that portion relates.

The amount payable on March 31, 2004, is a nonperiodic payment, which T
and CP are required to recognize over the term of the NPC in a manner that
reflects the economic substance of the NPC. In substance, the nonperiodic
payment that CP must pay T on expiration equals the sum of two independent
components, one noncontingent and the other contingent. The noncontingent
component (the fixed payment amount) equals $8,280,000, that is the
product of 6 percent per year, or 9 percent for 18 months, and the
notional principal amount of $92,000,000. The contingent component (the
appreciation or depreciation amount) equals the product of the percentage
appreciation or depreciation in the value of the S&P 500 stock index and
the notional principal amount of $8,000,000. In order to reflect the
economic substance of the NPC, each component must be treated separately
for purposes of applying the NPC rules in section 1.446-3. As a result,
pursuant to section 1.446-3(f)(2)(i), the fixed payment amount due on
March 31, 2004, must be recognized over the term of the NPC in a manner
consistent with section 1.446-3(f)(2)(ii) or (iii). This treatment of the
fixed payment amount payable by CP is not affected by the possibility that
T may be required to pay a depreciation amount to CP that, under the terms
of the NPC, will be netted against CP's obligation to pay the fixed
payment amount. Pursuant to section 1.446-3(g)(4), T must accrue interest
income and CP may accrue interest deductions.


HOLDING

T and CP must recognize the noncontingent component of the nonperiodic
payment over the term of the NPC, and must also account for interest, in a
manner consistent with sections 1.446-3(f)(2)(ii) or (iii), and
1.446-3(g)(4).


DRAFTING INFORMATION

The principal author of this revenue ruling is Elizabeth Handler of the
Office of Associate Chief Counsel (Financial Institutions and Products).
For further information regarding this revenue ruling, contact Ms. Handler
at (202) 622-3930 (not a toll-free call).

<<END RULING>>

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