IRS Notice 2008-59: Tax Treatment of Credit Default Swaps

The Internal Revenue Service (IRS) issued guidance to clarify how payments related to credit default swaps (CDS) should be reported for tax purposes. This framework provides a uniform approach for the tax treatment of these financial instruments, reducing confusion among market participants. The guidance addresses the tax consequences for both the regular payments made during the life of the swap and the significant payments that can occur if a default happens.

Defining Credit Default Swaps and Key Terms

A credit default swap (CDS) is a financial derivative contract that allows an investor to offset their credit risk with another investor, similar to an insurance policy. The buyer of the swap makes regular payments to the seller. In return, the seller agrees to provide a payout to the buyer if a specific financial event, such as a loan default or bankruptcy, occurs.

The parties involved are the “protection buyer,” who purchases financial protection, and the “protection seller,” who provides it and collects fees. The underlying asset on which this protection is based is the “reference obligation,” which is a bond or loan issued by a company or government entity. The regular fees paid by the protection buyer are called “periodic payments.”

A “credit event” is the trigger for a payout from the seller to the buyer. This term is defined within the CDS contract and includes events like the failure of the reference entity to make a debt payment. Other examples include a debt restructuring that is disadvantageous to creditors or the bankruptcy of the entity that issued the reference obligation.

Tax Treatment of CDS Payments

Tax guidance clarifies the treatment for payments made under a credit default swap. For the protection buyer, periodic payments made to the seller are treated as ordinary business expenses. These payments are deductible in the year they are made, reducing the buyer’s taxable income.

For the protection seller, the tax treatment is the opposite. The periodic payments received from the protection buyer are considered ordinary income. This income must be recognized over the term of the swap contract as it is earned.

When a credit event happens, the protection seller makes a single, large payment to the protection buyer that is linked to the sale of a capital asset. For the protection buyer, the receipt of this payment, offset by the cost of any defaulted bonds they deliver, results in a capital gain or loss. The protection seller treats the large payout as a capital loss, as it is connected to the deemed sale of the underlying debt instrument.

This characterization as a capital gain or loss is an important aspect of the guidance. Capital gains are often taxed at different rates than ordinary income, and the ability to use capital losses is subject to specific limitations under the tax code. This classification ensures that these major financial events are reported in a consistent fashion.

Nonperiodic Payments and Termination

Credit default swap agreements can also involve nonperiodic payments. A nonperiodic payment is an upfront or one-time payment made at the beginning of the contract that is not part of the regular fee schedule. This payment cannot be fully deducted or recognized as income in the year it is made; instead, it must be amortized over the term of the swap agreement.

The tax treatment for the termination of a CDS contract before a credit event occurs is also addressed. If a party sells its position in the swap or agrees with the counterparty to cancel the contract, any resulting payment is a termination payment. The gain or loss from this early termination is treated as a capital gain or loss, as the termination is viewed as the sale of the contract itself.

This treatment ensures that profits or losses from closing out a CDS position are handled similarly to the sale of other investment assets like stocks or bonds. For example, if a protection buyer sells their contract for a profit because the perceived risk of the reference obligation has increased, that profit would be a capital gain.

Scope and Applicability of Guidance

The tax guidance for credit default swaps applies only to specific situations. It was designed to cover single-name CDSs, which are swaps that reference the debt of a single, specific entity. This focus provides clear tax rules for the most common types of CDS transactions.

The guidance excludes certain more complex or structured products. For instance, credit default swaps that are based on asset-backed securities were not covered. The unique risks of such instruments required a different analysis that fell outside the scope of this particular guidance.

A requirement for applying this tax treatment is consistency. Both the protection buyer and the protection seller must agree to treat the CDS transaction according to established rules for their tax reporting purposes. If the two parties to the swap report their payments and receipts in conflicting ways, they may not be able to rely on the same favorable tax treatment.