IRS proposes to treat weather, catastrophe and longevity derivatives as notional principal contracts

Newly proposed regulations from the U.S. Internal Revenue Service (IRS) could change the way certain over-the-counter derivative transactions are treated for taxation purposes. The proposal would generally allow for OTC derivatives which are based on objective non-financial information to qualify as notional principal contracts (NPC’s).

Law firm Sidley Austin LLP have published a client note about the proposed regulation changes here. The IRS proposal explicitly mentions weather derivatives and weather related swaps as contracts which would be classified as NPC’s if this rule change is adopted. Sidley Austin suggest that catastrophe derivatives and longevity derivatives would also fall under this rule change as they are based on non-financial information. It’s also safe to assume that industry-loss warranties (ILW’s) could fall under this rule as a type of catastrophe derivative.

The IRS proposal document says:

Weather-Related and Other Non-Financial Index Based Swaps

Since the time that the Sec. 1.446-3 regulations were promulgated, markets have developed for contracts based on non-financial indices. Many of these contracts are structured as swaps, and payments are calculated based on indices such as temperature, precipitation, snowfall, or frost. For example, payments made under a weather derivative may be based on heating degree days and cooling degree days. As a technical matter, a weather-related swap currently is not a notional principal contract because a weather index does not qualify as a “specified index” under Sec. 1.446-3(c)(2) of the current regulations, which generally require that such index be a financial index.

The Treasury Department and the IRS believe that swaps on non-financial indices should be treated as notional principal contracts. Accordingly, Sec. 1.446-3(c)(2)(ii) of the proposed regulations expands a specified index to include non-financial indices that are comprised of any objectively determinable information that is not within the control of any of the parties to the contract and is not unique to one of the parties’ circumstances, and that cannot be reasonably expected to front-load or back-load payments accruing under the contract.

As you can see they are using weather swaps as an example of a non-financial contract but it’s safe to assume that this could affect the catastrophe and longevity contracts as mentioned above.

According to Sidley Austin, the proposed regulation would mean that NPC’s would be excluded from the mark-to-market system of Section 1256 of the U.S. Internal Revenue Code. The proposed regulations would classify credit default swaps (CDS’) as NPC’s and contracts not based on financial information.

The IRS will accept comments on its proposals so if you have any concerns about the federal income tax treatment of these derivatives we suggest you get in touch with an IRS representative.

The full proposal from the IRS can be accessed here.