The term notional principal contract (NPC) is a term of art used by U.S. federal income tax professionals for

contract A contract is a legally enforceable agreement between two or more parties that creates, defines, and governs mutual rights and obligations between them. A contract typically involves the transfer of goods, services, money, or a promise to tran ...

s based on an underlying

notional amount The notional amount (or notional principal amount or notional value) on a financial instrument is the nominal or face amount that is used to calculate payments made on that instrument. This amount generally does not change and is thus referred to a ...

(other financial services professionals refer to such NPCs under the more general heading " swaps," although not all swaps are NPCs). The reason the underlying amount is "notional" is that neither party to the NPC is required to actually hold the property comprising the underlying amount. NPCs involve two parties who agree contractually to pay each other amounts at specified times, based on the underlying notional amount. The simplest example of an NPC is a so-called interest rate swap, in which one party (Party A) pays the other party (Party B) an amount each quarter determined by multiplying a floating, market-determined interest rate (e.g.,

LIBOR The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...

) by the notional amount; and Party B pays Party A on the same date an amount determined by multiplying a fixed interest rate by the notional amount.

Definition Provided in Treasury Regulations

For U.S. federal income tax purposes, currently applicable

Treasury Regulation Treasury Regulations are the tax regulations issued by the United States Internal Revenue Service (IRS), a bureau of the United States Department of the Treasury. These regulations are the Treasury Department's official interpretations of the Inter ...

s define a Notional Principal Contract as "a

financial instrument Financial instruments are monetary contracts between parties. They can be created, traded, modified and settled. They can be cash (currency), evidence of an ownership interest in an entity or a contractual right to receive or deliver in the form ...

that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts." (Treas. Reg. § 1.446-3(c)(1)(i)). It is not defined in the

Internal Revenue Code The Internal Revenue Code (IRC), formally the Internal Revenue Code of 1986, is the domestic portion of federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 ...

itself. Treasury Regulations § 1.446-3 provides extensive and detailed rules governing the taxation of NPCs in the United States. While the Treasury Regulations provide examples of contracts that are treated as NPCs, including " interest rate swaps,

currency swap In finance, a currency swap (more typically termed a cross-currency swap, XCS) is an interest rate derivative (IRD). In particular it is a linear IRD, and one of the most liquid benchmark products spanning multiple currencies simultaneously. I ...

s, basis swaps,

interest rate cap An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for ...

s, interest rate floors,

commodity swap A commodity swap is a type of swap agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period. The vast majority of commodity swaps involve oil. Many airline and rail c ...

equity swap An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. The two cash flows are usually referred to as "legs" of the swap; one of ...

s, and similar agreements." (Treas. Reg. § 1.446-3(c)(1)(i)), there are significant limitations on the types of contracts that may be treated as NPCs, particularly contracts that provide for an actual delivery of the underlying amount.

Tax Consequences

Any amounts received under an NPC must be recognized by the taxpayer in accordance with the rules governing the recognition of such payments in the Treasury Regulations, which may override the taxpayer's normal method of accounting for U.S. federal income tax purposes. (Treas. Reg. § 1.446-3(e)(2)(i)). In general, amounts paid or received under an NPC are treated as ordinary income (and not capital gain) for U.S. federal income tax purposes, and are sourced by the residence of the recipient (e.g., if a non-U.S. resident receives a payment under an NPC, that payment is, in general, treated as non-U.S. source income for U.S. federal income tax purposes). The usual result of this treatment is that non-U.S. persons can receive payments on an NPC without outbound U.S. federal income tax withholding tax being applied. However, the U.S. federal income tax rules governing NPCs, withholding tax and the taxation of financial products, in general, is an intricately complicated subject, and taxpayers as a general matter almost always seek the assistance of a competent adviser to assist them in these matters. A 2016 article in the AICPA Publication ''The Tax Adviser'' provides additional information about notional contracts.

References

< {{DEFAULTSORT:Notional Principal Contract Contract law Taxation in the United States