Tax and Accounting Issues
The U.S federal income tax treatment of credit default swaps is uncertain. Commentators generally believe that, depending on how they are drafted, they are either notional principal contracts or options for tax purposes, but this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event).
If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income. If a payment is a termination payment, its tax treatment is even more uncertain. In 2004, the Internal Revenue Service announced that it was studying the characterization of credit default swaps in response to taxpayer confusion, but it has not yet issued any guidance on their characterization. A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States.
The accounting treatment of Credit Default Swaps used for hedging may not parallel the economic effects and instead, increase volatility. For example, GAAP generally require that Credit Default Swaps be reported on a mark to market basis. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce considerable volatility into the income statement and balance sheet as the CDS changes value over its life due to market conditions and due to the tendency for shorter dated CDS to sell at lower prices than longer dated CDS. One can try to account for the CDS as a hedge under FASB 133 but in practice that can prove very difficult unless the risky asset owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular CDS that was bought.
Read more about this topic: Credit Default Swap
Famous quotes containing the words tax, accounting and/or issues:
“Parents are used to being made to feel guilty about...their contribution to the population problem, the school tax burden, and declining test scores. They expect to be blamed by teachers and psychologists, if not by police. And they will be blamed by the children themselves. It is hardy a wonder, then, that they withdraw into what used to be called “permissiveness” but is really neglect.”
—C. John Sommerville (20th century)
“At the crash of economic collapse of which the rumblings can already be heard, the sleeping soldiers of the proletariat will awake as at the fanfare of the Last Judgment and the corpses of the victims of the struggle will arise and demand an accounting from those who are loaded down with curses.”
—Karl Liebknecht (1871–1919)
“Your toddler will be “good” if he feels like doing what you happen to want him to do and does not happen to feel like doing anything you would dislike. With a little cleverness you can organize life as a whole, and issues in particular, so that you both want the same thing most of the time.”
—Penelope Leach (20th century)