Interest rate swaps are a primary type of hedging method used by participants to mitigate their risks. With these swap contracts, participants can exchange their interest payments with another party to receive favourable terms in the future. There are several types of interest rate swaps that participants can use for that purpose.
The most prevalent type of interest rate swaps includes exchanging floating and fixed interest payments. This way, one party gets to pay fixed interests, which is more secure and involves lower risks. If the interest rates in the market increase, the party responsible for fixed interest payments will be at an advantage. In contrast, the party with the floating rate interest payments can also benefit. However, the interest rates in the market must go down for that to happen.
Interest rate swaps are complicated contracts. It is because each participant assumes responsibility for the other party’s interest payments. However, the debtholder is ultimately responsible for their own interest payments. The tax treatment for interest rate swaps can also be an area of confusion for both the involved parties.
What is a Notional Principal Contract?
Under the taxation rules, interest rate swaps fall under notional price contracts. It is a term of art used by the US federal income tax professionals. Notional price contracts describe contracts based on an underlying notional amount. In these contracts, neither party actually holds the property that comprises the underlying amount.
As mentioned, with interest rate swaps, each party is ultimately responsible for its own debt payments. However, one party pays the other an amount after each period depending on the underlying notional amount. They do so by multiplying a floating and a fixed rate with the other party’s principal amount. For this reason, interest rate swaps fall under notional principal contracts.
What is Interest Rate Swap tax treatment?
The tax treatment of interest rate swaps is the same as notional price contracts. Any party involved in these contracts must recognize any amount under a swap contract in accordance with the rules governing the recognition of such payments. It may go against or override the party’s usual method of accounting for federal income tax purposes.
Any party that receives an amount under interest rate swaps must recognize it as ordinary income. These amounts do not constitute capital gains for federal tax purposes. The source for this income is the residence of the recipient. For the party making the periodic payments under an interest rate swap, these payments constitute deductible expenses.
Notional principal contracts may also come with nonperiodic payments, which are different from periodic payments. These payments are recognized over the term of a contract in a manner that reflects the contract’s economic substance. Each party must also treat nonperiodic payments as ordinary income or expense.
Lastly, some notional principal contracts may have terminational payments associated with them. For these payments, each party must recognize a capital gain or loss if the contract is a capital asset for the taxpayer. Each party must recognize any termination payments in the year of the extinguishment, assignment, or exchange.
Interest rate swaps allow participants to exchange their interest payments with another party. For taxation purposes, interest rate swaps meet the definition of notional principal contracts. Therefore, the taxation treatments for interest rate swaps are the same as notional principal contracts.