# Prop. Treas. Reg. § 1.446-3: Notional principal contracts. Proposed regulation, not in force. REG-100420-03, 69 FR 8886, published 2004-02-26 . Interprets 26 U.S.C. § 446. Par. 4. Section 1.446-3 is amended by: 1. Revising the introductory text of paragraph (a) and the table of contents in paragraph (a). 2. Adding paragraph (c)(5). 3. Revising paragraphs (d), (f)(2)(i), (f)(2)(iii)(A), and (g)(4). 4. Redesignating the text of paragraph (g)(6) as paragraph (g)(7). 5. Adding new paragraph (g)(6). 6. Amending the newly designated text of paragraph (g)(7) by: (a) Revising the heading for Example 3. (b) Adding Example 5 through Example 9. 7. Revising paragraphs (i) and (j). The revisions and additions read as follows: (a) Table of contents. This paragraph (a) lists captioned paragraphs contained in this section. (a) Table of contents. (b) Purpose. (c) Definitions and scope. (1) Notional principal contract. (i) In general. (ii) Excluded contracts. (iii) Transactions within section 475. (iv) Transactions within section 988. (2) Specified index. (3) Notional principal amount. (4) Special definitions. (i) Related person and party to the contract. (ii) Objective financial information. (iii) Dealer in notional principal contracts. (5) Risk-free interest rate and determination date. (i) Risk-free interest rate. (ii) Determination date. (d) Taxable year of inclusion and deduction; adjustment of gain or loss. (1) Inclusion and deduction. (2) Adjustment of gain or loss. (e) Periodic payments. (1) Definition. (2) Recognition rules. (i) In general. (ii) Rate set in arrears. (iii) Notional principal amount set in arrears. (3) Examples. (f) Nonperiodic payments. (1) Definition. (2) Recognition rules. (i) In general. (ii) General rule for swaps. (iii) Alternative methods for swaps. (A) Prepaid swaps. (B) Other nonperiodic swap payments. (iv) General rule for caps and floors. (v) Alternative methods for caps and floors that hedge debt instruments. (A) Prepaid caps and floors. (B) Other caps and floors. (C) Special method for collars. (vi) Additional methods. (3) Term of extendible or terminable contracts. (4) Examples. (g) Special rules. (1) Disguised notional principal contracts. (2) Hedged notional principal contracts. (3) Options and forwards to enter into notional principal contracts. (4) Swaps with significant nonperiodic payments. (5) Caps and floors that are significantly in-the-money. [Reserved] (6) Notional principal contracts with contingent nonperiodic payments. (i) Definitions. (A) Noncontingent nonperiodic payments. (B) Contingent nonperiodic payments. (ii) Noncontingent swap method. (iii) Determining projected amount of contingent payment. (A) Payment based on actively traded futures or forward contracts. (B) Payment based on extrapolation from current market prices. (C) Payment based on reasonable estimate. (iv) Redeterminations of projected payments and level payment amounts. (A) General rule. (B) Special rule for fixed but deferred contingent nonperiodic payments. (v) Adjustments following redeterminations. (vi) Adjustments for differences between projected and actual payments. (vii) Recordkeeping requirements. (7) Examples. (h) Termination payments. (1) Definition. (2) Taxable year of inclusion and deduction by original parties. (3) Taxable year of inclusion and deduction by assignees. (4) Special rules. (i) Assignment of one leg of a contract. (ii) Substance over form. (5) Examples. (i) Election to mark to market. (1) General rule. (2) Scope of election. (3) Determination of fair market value. (i) Determination based on readily ascertainable value. (ii) Determination based on value used for financial statements. (iii) Determination based on counterparty's mark-to-market value. (iv) Determination based on value used in determining net asset value. (4) Requirements for use of financial statement values. [Reserved] (5) Notional principal contracts accruing interest on significant nonperiodic payments. (i) General rule. (ii) Special rules for significant contingent nonperiodic payments. (iii) Nonapplicability to regulated investment companies. (6) Election. (j) Effective dates. (1) General rule. (2) Exception. * * * * * (c) * * * (5) Risk-free interest rate and determination date— (i) Risk-free interest rate. The risk-free interest rate is the applicable Federal rate determined in accordance with section 1274(d)(1) for a determination date and the period remaining in the term of the contract on the determination date. (ii) Determination date. A determination date is the commencement date of the swap, each redetermination date as defined in paragraph (g)(6)(ii) of this section, and each special redetermination date as defined in paragraph (g)(6)(iv)(B) of this section. (d) Taxable year of inclusion and deduction; adjustment of gain or loss— (1) Inclusion and deduction. For all purposes of the Internal Revenue Code, the net income or net deduction from a notional principal contract for a taxable year is taken into account for that taxable year. The net income or net deduction from a notional principal contract for a taxable year equals the total of all of the periodic payments that are recognized from that contract for the taxable year under paragraph (e) of this section, all of the nonperiodic payments that are recognized from that contract for the taxable year under paragraph (f) of this section, and the mark-to-market income inclusions and deductions recognized from that contract under paragraph (i) of this section. (2) Adjustment of gain or loss. Proper adjustment shall be made in the amount of any gain or loss realized on a sale, exchange, or termination of a notional principal contract for inclusions or deductions pursuant to paragraphs (d)(1) and (g)(4) of this section and for payments or receipts with respect to the notional principal contract. * * * * * (f) * * * (2) Recognition rules— (i) In general. All taxpayers, regardless of their method of accounting, must recognize the ratable daily portion of a nonperiodic payment for the taxable year to which that portion relates. Generally, a nonperiodic payment must be recognized over the term of a notional principal contract in a manner that reflects the economic substance of the contract. See paragraph (g)(6) of this section for additional rules for contingent nonperiodic payments. * * * * * (iii) * * * (A) Prepaid swaps. An upfront payment on a swap may be amortized by assuming that the nonperiodic payment represents the present value of a series of equal payments made throughout the term of the swap contract (the level payment method), adjusted as appropriate to take account of increases or decreases in the notional principal amount. The discount rate used in this calculation must be the rate (or rates) used by the parties to determine the amount of the nonperiodic payment. If that rate is not readily ascertainable, the discount rate used must be a rate that is reasonable under the circumstances. Under this method, an upfront payment is allocated by dividing each equal payment into its principal recovery and time value components. The principal recovery components of the equal payments are treated as periodic payments that are deemed to be made on each of the dates that the swap contract provides for periodic payments by the payor of the nonperiodic payment or, if none, on each of the dates that the swap contract provides for periodic payments by the recipient of the nonperiodic payment. The sum of the principal recovery components equals the amount of the upfront payment. The time value component is used to compute the amortization of the nonperiodic payment but is otherwise disregarded. See paragraph (f)(4) Example 5 of this section. * * * * * (g) * * * (4) Swaps with significant nonperiodic payments. The parties to a swap with one or more significant nonperiodic payments must treat the contract as two or more separate transactions consisting of an on-market swap and one or more loans. The parties must account for the loans separately from the swap. The payments associated with the on-market swap are included in the net income or net deduction from the swap under paragraph (d) of this section. The time value components associated with the loans are not included in the net income or net deduction from the swap under paragraph (d) of this section but are recognized as interest for all purposes of the Internal Revenue Code. The on-market swap must result in recognition of the payments associated with the swap in a manner that complies with the principles set forth in paragraph (f)(2)(i) of this section. See paragraph (g)(7) Example 3 of this section for a situation in which the on-market swap payments for a party making a significant nonperiodic upfront payment will be level payments that may be constructed through a combination of the actual payments on the swap and level payments computed under the level payment method provided by paragraph (f)(2)(iii)(A) of this section. In certain cases, a swap with significant nonperiodic payments other than an upfront payment may be treated as if the swap provided for a series of level payment loan advances having a present value equal to the present value of the nonperiodic payments, with the amount of each loan advance being immediately returned as a level payment on the swap. See paragraph (g)(7) Example 5 of this section. For purposes of section 956, the Commissioner may treat any nonperiodic swap payment, whether or not it is significant, as one or more loans. * * * * * (6) Notional principal contracts with contingent nonperiodic payments— (i) Definitions— (A) Noncontingent nonperiodic payments. A noncontingent nonperiodic payment is a nonperiodic payment that either is fixed on or before the end of the taxable year in which a contract commences or is equal to the sum of amounts that would be periodic payments if they are paid when they become fixed (including amounts determined as interest accruals). (B) Contingent nonperiodic payments. A contingent nonperiodic payment is any nonperiodic payment other than a noncontingent nonperiodic payment. (ii) Noncontingent swap method. Under the noncontingent swap method, a taxpayer, regardless of its method of accounting, recognizes each contingent nonperiodic payment with respect to a notional principal contract by determining the projected amount of the payment and by applying to that projected amount the level payment method described in paragraphs (f)(2)(iii)(A) and (B) of this section. The projected amount of a contingent nonperiodic payment is the reasonably expected amount of the payment, which is determined by using one of the methods described in paragraph (g)(6)(iii) of this section and by using the risk-free interest rate in applying the level payment method. On each successive anniversary date for the notional principal contract (a redetermination date) and each special redetermination date (as defined in paragraph (g)(6)(iv)(B) of this section), the taxpayer must redetermine the projected amount of each contingent nonperiodic payment, reapply the level payment method as provided in paragraph (g)(6)(iv) of this section, and make the adjustments specified in paragraph (g)(6)(v) of this section. If paragraph (g)(4) of this section applies to the notional principal contract, redeterminations and adjustments must also be made to account for the time value components of the transaction as interest in accordance with that paragraph. Except for contingent nonperiodic payments governed by paragraph (g)(6)(iv)(B) of this section, in the taxable year in which a contingent payment is made or received, the parties must make appropriate adjustments to the amount of income or deductions attributable to the notional principal contract for any differences between projected and actual contingent nonperiodic payments as provided in paragraph (g)(6)(vi) of this section. (iii) Determining projected amount of contingent payment— (A) Payment based on actively traded futures or forward contracts. If a contingent nonperiodic payment is determined under the contract by reference to the value of a specified index on a designated future date, the projected amount of the payment may be determined on the basis of the future value for the specified index in actively traded futures or forward contracts, if any, providing for delivery or settlement on the designated future date. If no actively traded contract exists for the designated future date, a determination from the future values for the specified index in actively traded futures or forward contracts, if any, providing for delivery or settlement on dates within three months of the designated future date may be used. (B) Payment based on extrapolation from current market prices. If a contingent nonperiodic payment is determined under the contract by reference to the value of a specified index on a designated future date, the projected amount of the payment may be determined on the basis of the current value of the specified index as established by objective financial information adjusted to convert the current value to a future value for the specified index on the designated future date. The current value is converted to a future value by adding to the current value an amount equal to the accrual of interest on the current value under a constant yield method at the risk-free interest rate with appropriate compounding and by making appropriate adjustments for expected cash payments on the property underlying the specified index. (C) Payment based on reasonable estimate. If the methods provided in paragraphs (g)(6)(iii)(A) and (B) of this section do not result in a reasonable estimate of the amount of the contingent payment, the taxpayer must use another method that does result in a reasonable estimate of the amount of the contingent payment and that is based on objective financial information. (iv) Redeterminations of projected payments and level payment amounts— (A) General rule. On each redetermination date, the taxpayer must redetermine the projected amount using current values on the redetermination date and the same method that was used on the commencement date of the notional principal contract, and must reapply the level payment method as of the commencement date of the notional principal contract on the basis of the new projected payment amount and the risk-free interest rate in effect on the redetermination date. (B) Special rule for fixed but deferred contingent nonperiodic payments. If a contingent nonperiodic payment is fixed more than six months before it is due, and if the date the payment is fixed is in a different taxable year from the date the payment is due, the date on which the payment is fixed is a special redetermination date. As of that date, the taxpayer must treat the fixed amount as the projected amount for that contingent nonperiodic payment and apply paragraphs (g)(6)(iv) and (v) of this section as if the special redetermination date were a redetermination date. (v) Adjustments following redeterminations. Following each redetermination of projected payments and level payment amounts, the taxpayer must apply the new schedule of level payments for purposes of determining amounts to be recognized in the current and subsequent taxable years with respect to the contingent nonperiodic payments. Any difference between the amounts recognized in prior taxable years and the amounts that would have been recognized in those years had the new level payment schedule been in effect for those years is taken into account as additional payments or receipts with respect to the contract ratably over the one-year period beginning with the redetermination date and, to the extent attributable to a difference in the interest amounts calculated under paragraph (g)(4) of this section, is recognized as interest for all purposes of the Internal Revenue Code. (vi) Adjustments for differences between projected and actual payments. Any difference between the amounts taken into account under paragraph (f) and this paragraph (g)(6) on the one hand and the amount of the actual payment under the contract on the other hand is taken into account as an adjustment to the net income or net deduction from the notional principal contract for the taxable year during which the payment occurs, and not as an adjustment to interest income or expense. (vii) Recordkeeping requirements. The books and records maintained by a taxpayer must contain a description of the method used to determine the projected amount of a contingent payment, projected payment schedules, any adjustments following redeterminations, and any adjustments for differences between projected and actual contingent payments. (7) * * * Example 3. Upfront significant nonperiodic payment. * * * * * * * * Example 5. Backloaded significant nonperiodic payment. (i) On January 1, 2003, unrelated parties P and Q enter into an interest rate swap contract. Under the terms of the contract, P agrees to make five annual payments to Q equal to LIBOR times a notional principal amount of $100,000,000. In return, Q agrees to pay P 6% of $100,000,000 annually, plus $24,420,400 on December 31, 2007. At the time P and Q enter into this swap agreement the rate for similar on-market swaps is LIBOR to 10%. Assume that on January 1, 2003, the risk-free rate is 10%. (ii) The $24,420,400 payment from Q to P is significant when compared to the present value of the total payments due from Q under the contract. Accordingly, pursuant to paragraph (g)(4) of this section, the transaction is recharacterized as two separate transactions. First, P is treated as paying to Q a series of $4,000,000 level payment loan advances. The present value of the level payment loan advances equals the present value of $24,420,400, the significant nonperiodic payment. Stated differently, the sum of the level payment loan advances and accrued interest on those advances equals the significant nonperiodic payment. (iii) Next, Q is treated as using each loan advance to fund five annual level swap payments of $4,000,000. The level payment loan advances and accrued interest on the advances computed with annual compounding at 10% are as follows: | | Level payment | Accrued interest | | --- | --- | --- | | 2003 | $4,000,000 | $0 | | 2004 | 4,000,000 | 400,000 | | 2005 | 4,000,000 | 840,000 | | 2006 | 4,000,000 | 1,324,000 | | 2007 | 4,000,000 | 1,856,400 | | | $20,000,000 | $4,420,400 | (iv) P recognizes interest income, and Q accrues interest expense, each taxable year equal to the interest accruals on the deemed level payment loan advances. These interest amounts are not included in the parties' net income or net deduction from the swap contract under paragraph (d) of this section. (v) The level payment amounts of $4,000,000 are taken into account in determining the parties' net income and deductions on the swap pursuant to paragraph (d) of this section. Example 6. Contingent nonperiodic payment on an equity swap. (i) On January 1, 2005, unrelated parties V and W enter into an equity swap contract. Under the terms of the contract, V agrees to make three annual payments to W equal to 1-year LIBOR times a notional principal amount of $50,000,000. In return, W agrees to make a single payment on December 31, 2007, equal to the appreciation, if any, of a $50,000,000 investment in a basket of equity securities over the term of the swap. V is obligated to make a single payment on December 31, 2007, equal to the depreciation, if any, in the same $50,000,000 investment in the basket of equity securities. Assume that on January 1, 2005, 1-year LIBOR is 9.5%, and the risk-free rate is 10.0%. (ii) This contract is a notional principal contract as defined in paragraph (c)(1) of this section. The annual LIBOR-based payments from V to W are periodic payments and the single payment on December 31, 2007, is a contingent nonperiodic payment. (iii) Pursuant to the method described in (g)(6)(iii)(B) of this section, the parties determine that the projected amount of the contingent nonperiodic payment that W will pay V on December 31, 2007, is $16,550,000. The present value of this projected fixed payment is significant when compared to the present value of the total payments due from W under the contract. Accordingly, pursuant to paragraph (g)(4) of this section, the transaction is recharacterized as two separate transactions. (iv) As a preliminary step, using the risk-free rate of 10.0% as the discount rate, the parties determine the level payment amounts that have a present value equal to the present value of $16,550,000, the projected significant nonperiodic payment. Stated differently, the sum of the level payment amounts and accrued interest at 10.0% on those amounts must equal the projected significant nonperiodic payment. The level payment amounts thus determined are $5,000,000. (v) Next, V is treated as paying to W a series of $5,000,000 loan advances. (vi) Then, W is treated as using each loan advance to fund one of the three annual level swap payments of $5,000,000. The level payment loan advances and accrued interest on the advances computed with annual compounding at 10.0% are as follows: | | Level payment | Accrued interest | | --- | --- | --- | | 2005 | $5,000,000 | $0 | | 2006 | 5,000,000 | 500,000 | | 2007 | 5,000,000 | 1,050,000 | | | $15,000,000 | $1,550,000 | (vii) No interest amount is taken into account for the contract year 2005. (viii) The level payment amount of $5,000,000 is taken into account for the contract year 2005 in determining the parties' net income and deductions on the swap pursuant to paragraph (d) of this section. (ix) For the contract year 2005, V makes a swap payment to W equal to 1-year LIBOR at 9.5% times $50,000,000, or $4,750,000, and W is deemed to make a swap payment to V equal to the annual level payment of $5,000,000. The net of the ratable daily portions of these payments determines the annual net income or deduction from the contract for both V and W . Example 7. Initial Adjustment. (i) The terms of the equity swap agreement are the same as in Example 6. In addition, assume that on January 1, 2006, the first redetermination date, 1-year LIBOR is 10.0%, and the risk-free rate is 10.5%. On that date, the parties redetermine the projected amount of the contingent nonperiodic payment using current values in effect on that date. Under the method described in (g)(6)(iii)(B) of this section, the parties determine that the reprojected amount of the contingent nonperiodic payment that W will pay V on December 31, 2007, is $23,261,500. The present value as of January 1, 2005, of this projected fixed payment is significant when compared to the present value of the total payments due from W under the contract. Accordingly, pursuant to paragraph (g)(4) of this section, the transaction is recharacterized as two separate transactions. (ii) The parties use the redetermined projected amount of $23,261,500, to reapply the method provided by paragraph (g)(4) of this section effective as of the commencement date of the swap. As a preliminary step, using the risk-free rate of 10.5% as the discount rate, the parties determine the level payment amounts that have a present value equal to the present value of $23,261,500, the reprojected significant nonperiodic payment. Stated differently, the sum of the level payment amounts and accrued interest at 10.5% on those amounts must equal the reprojected significant nonperiodic payment. The level payment amounts thus determined are $6,993,784. (iii) Next, V is treated as paying to W a series of $6,993,784 loan advances. (iv) Then, W is treated as using each loan advance to fund one of the three annual level swap payments of $6,993,784. The level payment loan advances and accrued interest on the advances computed with annual compounding at 10.5%, are as follows: | | Level payment | Accrued interest | | --- | --- | --- | | 2005 | $6,993,784 | $0 | | 2006 | 6,993,784 | 734,347 | | 2007 | 6,993,784 | 1,545,801 | | | $20,981,352 | $2,280,148 | (v) For the contract year 2006, V recognizes interest income, and W accrues interest expense equal to the accrued interest of $734,347 on the deemed level payment loan advance. These interest amounts are not included in the parties' net income or net deduction from the swap contract under paragraph (d) of this section. (vi) The level payment amount of $6,993,784 is taken into account for the contract year 2006 in determining the parties' net income and deductions on the swap pursuant to paragraph (d) of this section. (vii) The parties also take into account for the contract year 2006 the difference between the amount recognized for 2005 and the amount that would have been recognized in 2005 had the new level payment schedule in this Example 7 been in effect in 2005. Thus, for purposes of paragraph (d) of this section, W is treated as making a swap payment, and V is treated as receiving a swap payment of $1,993,784 ($6,993,784−$5,000,000) for purposes of paragraph (d) of this section. (viii) For the contract year 2006, V makes a swap payment to W equal to 1-year LIBOR at 10.0% times $50,000,000, or $5,000,000, and W is deemed to make a swap payment to V equal to the annual level payment of $6,993,784 and the adjustment amount of $1,993,784. The net of the ratable daily portions of these payments determines the annual net income or deduction from the contract for both V and W . Example 8. Subsequent Adjustment. (i) The terms of the equity swap agreement are the same as in Example 7. In addition, assume that on January 1, 2007, the second redetermination date, 1-year LIBOR is 11.0%, and the risk-free rate is also 11.0%. On that date, the parties redetermine the projected amount of the contingent nonperiodic payment using current values in effect on that date. The parties determine that the reprojected amount of the contingent nonperiodic payment that W will pay V on December 31, 2007, is $11,050,000. The present value as of January 1, 2005, of this projected fixed payment is significant when compared to the present value of the total payments due from W under the contract. Accordingly, pursuant to paragraph (g)(4) of this section, the transaction is recharacterized as two separate transactions. (ii) The parties use the redetermined projected amount of $11,050,000, to reapply the method provided by paragraph (g)(4) effective as of the commencement date of the swap. As a preliminary step, using the risk-free rate of 11.0% as the discount rate, the parties determine the level payment amounts that have a present value equal to the present value of $11,050,000, the reprojected significant nonperiodic payment. Stated differently, the sum of the level payment amounts and accrued interest at 11.0% on those amounts must equal the reprojected significant nonperiodic payment. The level payment amounts thus determined are $3,306,304. (iii) Next, V is treated as paying to W a series of $3,306,304 loan advances. (iv) Then, W is treated as using each loan advance to fund one of the three annual level swap payments of $3,306,304. The level payment loan advances and accrued interest on the loan advances computed with annual compounding at 11.0% are as follows: | | Level payment | Accrued interest | | --- | --- | --- | | 2005 | $3,306,304 | $ 0 | | 2006 | 3,306,304 | 363,693 | | 2007 | 3,306,304 | 767,393 | | | $9,918,912 | $1,131,086 | (v) For 2007, V recognizes interest income, and W accrues interest expense equal to the $767,393 accrued interest amount for 2007 on the deemed loan advances. In addition, V has a net interest expense item and W has a net interest income item equal to $370,654 ($734,347−363,693), the difference between the interest accrual taken into account for 2006 and the amount that would have been taken into account for 2006 had the new level payment schedule in this Example 8 been in effect for 2006. As a result, V has net interest income and W has net interest expense in the amount of $396,739 for 2007. These interest amounts are not included in the parties' net income or net deduction from the swap contract under paragraph (d) of this section. (vi) The level payment amount of $3,306,304 is taken into account for the contract year 2007 in determining the parties' net income and deductions on the swap pursuant to paragraph (d) of this section. (vii) For 2007, the parties also take into account for 2007 the difference between the amounts previously recognized for 2005 and 2006 and the amounts that would have been recognized for those years had the new level payment schedule in this Example 8 been in effect in 2005 and 2006. The amounts previously recognized were: a total of $6,993,784 for 2005, which is the sum of $5,000,000 (in 2005) and $1,993,784 (in 2006), and a total of $6,993,784 for 2006 (in 2006). The adjustment amount, therefore, equals two times $3,687,480 ($6,993,784−$3,306,304), or $7,374,960. This amount is taken into account as a payment for purposes of paragraph (d) of this section. (viii) For the contract year 2007, V makes a swap payment to W equal to 1-year LIBOR at 11.0% times $5,000,000, or $5,500,000. W is deemed to make a swap payment to V equal to the annual level payment for 2007 of $3,306,304, and V is deemed to make a swap payment to W equal to the adjustment amount of $7,374,960. The net of the ratable daily portions of these payments determines the annual net income or deduction from the contract for both V and W . Example 9. Adjustment for actual payment. (i) The terms of the equity swap agreement are the same as in Example 8. In addition, on December 31, 2007, W makes a payment to V of $25,000,000, an amount equal to the appreciation of a $50,000,000 investment in the basket of equity securities. (ii) For 2007, $13,950,000, the difference between $25,000,000 and $11,050,000, the projected amount of the contingent payment as of January 1, 2007, is taken into account as an adjustment to the parties' net income or deductions for each party's taxable year that contains December 31, 2007, pursuant to paragraph (d) of this section. * * * * * (i) Election to mark to market. A taxpayer may elect to mark to market notional principal contracts providing for nonperiodic payments. The rules of paragraphs (f) (other than (f)(2)(i)), (g)(6)(ii) through (vii), and (h) of this section do not apply to contracts to which this paragraph (i) applies. See paragraph (i)(5) of this section for rules respecting interest accruals under paragraph (g)(4) of this section for contracts providing for significant nonperiodic payments to which this paragraph (i) applies. (1) General rule. In the case of any contract held at the close of the taxable year to which this paragraph (i) applies, the taxpayer shall determine income inclusions and deductions by reference to the gain or loss that would be realized if the contract were sold for its fair market value on the last business day of the taxable year. Proper adjustment shall be made in the amount of any gain or loss subsequently realized (or calculated) for the income inclusions and deductions taken into account by reason of this paragraph (i)(1) as provided in paragraph (d)(2) of this section. (2) Scope of election. The election provided by this paragraph is available for notional principal contracts that are— (i) Of a type that is actively traded within the meaning of § 1.1092(d)-1(c) (determined without regard to the limitation in § 1.1092(d)-1(c)(2)); (ii) Marked to market by the taxpayer for purposes of determining the taxpayer's financial income provided the taxpayer satisfies the requirements in paragraph (i)(4) of this section; (iii) Subject to an agreement by a party to the contract that is subject to section 475 to supply to the taxpayer the value that it uses in applying section 475(a)(2); or (iv) Marked to market by a regulated investment company described in section 1296(e)(2). (3) Determination of fair market value. For purposes of paragraph (i)(1) of this section, fair market value is determined by applying the rules set forth in paragraphs (i)(3)(i) through (iv) of this section. (i) Determination based on readily ascertainable value. For a contract described in paragraph (i)(2)(i) of this section, fair market value is determined based on the mean between the bid and asked prices quoted for the contract on an established financial market as defined in § 1.1092(d)-1(b)(1), or, if bid and asked prices are not available, comparable prices determined on the basis of recent price quotations described in § 1.1092(d)-1(b)(2). (ii) Determination based on value used for financial statements. For a contract described in paragraph (i)(2)(ii) of this section that is not described in paragraph (i)(2)(i) of this section, fair market value is the value used by the taxpayer for purposes of preparing its financial statements under paragraph (i)(4) of this section. (iii) Determination based on counterparty's mark-to-market value. For a contract described in paragraph (i)(2)(iii) of this section that is not described in paragraph (i)(2)(i) of this section, fair market value is the mark-to-market value provided by a counterparty as being the value the counterparty used for purposes of section 475(a)(2). (iv) Determination based on value used in determining net asset value. Notwithstanding paragraphs (i)(3)(i) through (iii) of this section, for a contract described in paragraph (i)(2)(iv) of this section, fair market value is the value used by the taxpayer in determining its net asset value. (4) Requirements for use of financial statement values. [Reserved]. (5) Notional principal contracts accruing interest on significant nonperiodic payments —(i) General rule. If a notional principal contract that is marked to market under this paragraph (i) provides for one or more significant nonperiodic payments, paragraph (g)(4) of this section applies to the contract (computed with regard to the rule in paragraph (i)(5)(ii) of this section). Proper adjustment shall be made in the amount of any income inclusions or deductions recognized under paragraph (i)(1) of this section to take into account amounts recognized as interest under paragraph (g)(4) of this section and the payment or receipt of the nonperiodic payment or payments. (ii) Special rules for significant contingent nonperiodic payments. In the case of a contract providing for a significant contingent nonperiodic payment, the projected amount of the payment is determined by applying one of the methods described in paragraph (g)(6)(iii) of this section or by applying the deemed equivalent value method described in this paragraph (i)(5)(ii). The amount of the payment is not redetermined except as provided in paragraph (g)(6)(iv)(B) of this section. The deemed equivalent value method may be applied if the contract fixes the timing and amount of all of the payments under the contract, except for a sole significant contingent nonperiodic payment. Under the deemed equivalent value method, the amount of the significant contingent nonperiodic payment is the amount that, as of the date the terms of the contract are fixed, causes the present value of all of the payments by the taxpayer to equal the present value of all of the payments of the counterparty to the contract. The present value of each payment of the contract is determined by applying the risk-free interest rate. (iii) Nonapplicability to regulated investment companies. Paragraphs (i)(5)(i) and (ii) of this section do not apply to a regulated investment company described in paragraph (i)(2)(iv) of this section that makes an election under paragraph (i) of this section. (6) Election. An election to apply this paragraph (i) must be made with respect to all notional principal contracts described in paragraph (i)(2) of this section to which the taxpayer is a party. The election must be made in the time and manner prescribed by the Commissioner and is effective for the taxable year for which made and all subsequent taxable years, unless revoked with the consent of the Commissioner. (j) Effective dates —(1) General rule. Except as provided in paragraph (j)(2) of this section, this section is applicable for notional principal contracts entered into on or after December 13, 1993. (2) Exception. Paragraphs (g)(6) (other than (g)(6)(i)) and (i) of this section are applicable for notional principal contracts entered into on or after 30 days after the date a Treasury decision based on these proposed regulations is published in the Federal Register .