TAXATION OF FINANCIAL PRODUCTS

NEW RULING ON THE CHARACTER OF PAYMENTS UNDER SWAPS

By Viva Hammer, Esq., Price
Waterhouse

There has been controversy over the tax character of swap payments ever since swaps became a popular financing tool. In July last year, the IRS released a technical advice memorandum outlining its position regarding the character of payments under a commodity swap entered into by a taxpayer.

Facts

The taxpayer was a U.S. corporation that owned oil and gas interests, but did not operate oil wells, own oil product, or maintain an inventory of oil for sale to customers. The taxpayer entered into a swap agreement with a bank where the parties agreed to make payments on a monthly basis for a 12-month period. The terms of the swap provided that the taxpayer would be required to pay the bank if the floating price of the oil (the monthly average of settlement prices for light sweet crude oil futures on the New York Mercantile Exchange) was greater than the fixed price (set when the contract was entered into). The taxpayer would pay the difference between the fixed and floating amounts multiplied by X barrels of oil. On the other hand, if the floating price was greater than the fixed price of the oil, the bank would have to pay the taxpayer the difference between the two prices multiplied by X barrels of oil.

Over the 12-month period, the taxpayer made two payments to the bank, and the bank made 10 payments to the taxpayer. The swap ended on the date anticipated under its original terms. The taxpayer treated the amounts it paid to the bank under the swap as capital loss and the amounts received from the bank as capital gain.

Analysis

The taxpayer made a number of arguments in support of its treatment of the swap periodic payments as capital:

Series of Forwards. The taxpayer argued that the swap is, in substance, a series of 12 cash-settled forward contracts, and since the underlying property (oil) is a capital asset in the taxpayer's hands, the closing of each "notional" forward should result in capital gain or loss treatment.

The IRS disagreed with this conclusion for a number of reasons. It said that although a swap is economically equivalent to a series of forward contracts, it is considered a single, indivisible contract for tax and other legal purposes (such as bankruptcy law). The IRS states that payments made under a swap no more take their character from the sale of the underlying instrument than do dividends take their character from the sale of the underlying stock, or interest payments take their character from the debt instrument from which they flow.

Observation: It is strange that the IRS uses the analogy of dividends on stock to illustrate the character of payments under a swap, since a share of stock is not an executory contract giving rise to reciprocal payment obligations. A swap agreement has no substance or existence other than the payment obligations it creates, and therefore, when parties make payments under the swap they "extinguish" or destroy, so to speak, part of the essence of the property itself. This is entirely different from a debt or equity instrument, both of which have an existence separate and distinct from the interest or dividend income flowing from those instruments. This will be discussed further below.

The TAM explains that a taxpayer will only get capital gain or loss treatment if there has been the sale or exchange of a capital asset. It is clear, the memorandum states, that a periodic payment under a swap does not constitute a sale or exchange of an asset. Whether or not the swap itself is a capital asset in the hands of the taxpayer, the payments under the swap do not meet the conditions required to obtain capital treatment.

The taxpayer argued that, under IRC section 1234A, the periodic payments should be characterized as capital because each payment was the equivalent of a termination of each of a series of forward contracts. The IRS simply states, again, that a swap is a single financial instrument, and that neither interim periodic payments, nor the final payment under the swap (if contemplated under the original contract) constitute gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to personal property.

It is disappointing that the authors of the TAM do not explain their conclusion, since it seems at least arguable that because a swap is constituted entirely by the payments provided for by its terms, a right or obligation is terminated when a payment is made. Clearly taxpayers will continue making this argument based on the newly expanded wording of section 1234A (which no longer requires actively traded property to bring transactions within its purview), and without clear indication of what the IRS' conclusion was based on.

The transaction is not part of a hedging transaction. The taxpayer asserted that the swap payments should not give rise to ordinary treatment under the hedging rules. Although it is clear that the taxpayer did not make any hedging identifications, this does not prevent the commissioner from identifying a transaction as a hedging transaction. It is not clear what the district director thought the taxpayer was hedging since the TAM dismisses this argument, stating that its conclusion stands irrespective of whether the swap was a hedge or not. It would be interesting to discover what the district director found as the hedged item, since the taxpayer owned neither oil nor oil wells, only net profit interests and royalty interests, which arguably would be capital assets in its hands.

Payments result from oil price fluctuations. The taxpayer claimed that periodic payments on the swap should be capital items because the payments were the result of the operation of market forces on the price of oil and any return based on the appreciation in value of an asset should be considered capital in nature. The IRS states that the cases cited by the taxpayer address whether the disposition or termination of a contract right give rise to capital gain or loss and therefore are not relevant to payments under the swap in question.

Finally, in support of its position, the IRS cites the treatment of swaps under the unrelated business taxable income of an exempt organization under IRC section 512, which appears to be consistent with the conclusion of the IRS. *

Editor:
Viva Hammer, Esq.
Price Waterhouse LLP