Investors select assets based on the returns they provide. This return may come in different forms based on the underlying investment. For example, for stocks, it may include dividends and capital gains. For debt instruments, it consists of the interest received. The combined return from underlying investments is known as its total return.
Total returns are relevant in many areas. One of these includes involvement in swap agreements. In these agreements, two parties exchange cash flows based on different metrics. When one of these metrics is the total return on the underlying assets, it is called a total return swap. The tax treatment of these swaps is crucial for various reasons.
What is a Total Return Swap?
A total return swap is a derivative contract between two parties that involves the exchange of the returns on their respective assets. With this swap, one party pays the other based on the total return on a specific investment. On the other hand, the other party makes a payment to the other based on a set rate. The terms of these payments come from the swap agreement between both parties.
Total return swaps include different assets for which the parties calculate the total return. These may consist of stocks, bonds, loans, etc. As mentioned above, it contains all the returns that come from the asset. This swap differs from other forms where only a specific cash flow stream falls under the exchange. The total return swap comes with a periodic payment schedule and a fixed tenure.
What is the Total Return Swap Tax Treatment?
A total return swap is a form of equity swap. Therefore, the tax treatment for total return swap also falls under a notional principal contract. IRS requires taxpayers to differentiate between periodic and non-periodic payment instruments in these contracts. Since total return swaps involve a periodic payment for a specific tenure, they fall within the former category.
The tax treatment rules for notional principal contracts with periodic payments are straightforward. The IRS requires the taxpayer to recognize a ratable daily portion of periodic payment for a taxable year to which that portion relates. However, the accounting method used by the taxpayer does not play a role in determining how the total return swap gets treated under the tax treatment.
However, a total return swap may have tax implications for the taxpayer obtaining the payments. The taxpayer may receive different types of returns, for example, capital gains and dividends. Under regular tax treatment, these would fall into different categories. However, if it comes from a total return swap, all forms of returns qualify as income and fall under income tax rules. Therefore, total return swaps are often considered tax-inefficient.
Conclusion
A total return swap is a derivative contract involving two parties. One party assumes responsibility for paying the total returns on a specific asset to the other. On the other hand, the payer receives a regular interest payment, usually based on LIBOR. The tax treatment of total return swaps falls under notional principal contracts. However, all returns from these swaps fall under income tax.
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