In late February, the IRS proposed a new set of rules that affect how companies pay taxes on contingent swaps with nonperiodic payments. Under the rules, companies would project out the expected amount of a contingent payment and report a portion of the projected amount each year. (The alternative would be to elect a mark-to-market method, which would reduce the administrative burden but might increase the tax liability.)

“The issue here is the timing of recognition of gains, losses, income and deductions,” explains Peter Connors, a partner with Orrick, Herrington & Sutcliffe LLP. Currently IRS rules do not address the treatment of a “contingent swap.”

I/R swap example. Assume a swap provides for a payment of libor currently, plus a contingent amount, based on the value of an equity index at maturity. “Under current rules, it is generally possible to deduct the libor payments, and the contingent amount is taxable upon maturity,” Mr. Connors explains. The IRS perceives this to result in a mismatch of income and deductions since the libor would be deductible but the contingent amount not taxable until maturity. The proposed rules require accrual using projected amounts, or allow taxpayers to elect to mark to market.

“The proposed regulations are controversial since if stock were purchased, the financing costs would be fully deductible but the value would not be taxable until maturity.”