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.
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