July 30, 2013

Taxing Issues for Swap Futures

The latest chapter in the story of swap-futures is detailed in a Risk article potential tax issues for Deliverable Swap Futures . To quote Risk:

The US taxman is holding back growth in CME Group’s new swap futures contract, according to some market participants. This is a consequence of the product’s design, in which users can end up taking delivery of an over-the-counter swap at an off-market rate when the contract reaches expiry. The fear is that US tax rules may treat this as a loan, which prompted some users to roll their positions at the product’s first two maturity dates in March and June, rather than allowing them to expire. The CME is now trying to clarify the product’s treatment with the Internal Revenue Service (IRS).

To summarise its key points:

  • Some investors are concerned that the deliverable nature of the underlying swap contracts in CME swap futures (or DSFs) renders them similar to loans in terms of their taxation treatment.
  • Some believe that this may hinder the growth of this market.
  • This issue also has the potential to threaten the growth of the nascent market in standardised OTC IR swaps.

For further clarity around why this is the case, Columbia Journal of Tax Law provides a good explanation on p.14:

"Under a special rule for NPCs [Notional Principal Contracts] that are swaps … if a nonperiodic payment is “significant,” the upfront payment is treated as an amortizing loan providing for level principal and interest payments over the life of the NPC, and the NPC is treated as entered into at market rates."

The prevailing concern among market participants is that swap rates will move significantly enough between the initial listing of the DSF and the expiry date, that the upfront fee will be "significant" enough to warrant the aforementioned taxation treatment. Ben

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