Donald T. Regan promised Congress yesterday that if he becomes Treasury Secretary, he will not interfere in a dispute between the Internal Revenue Service and his old employer, Merrill Lynch, Pierce, Fenner & Smith, over a tax-avoidance scheme known as the butterfly straddle.

At a confirmation hearing on his appointment to the Treasury post, Regan told the Senate Finance Committee he has never personally used or recommended that his clients use the technique to avoid paying taxes.

The Treasury estimates the government loses at least $1 billion a year in income taxes because taxpayers use butterfly straddles to claim artificial tax deductions, said committee member Daniel P. Moynihan (D-N.Y.), one of four senators who questioned Regan about the scheme.

Sen. Spark M. Matsunaga (D-Hawaii) told Regan that Merrill Lynch's promotion of butterfly straddles as a way for wealthy individuals to avoid paying taxes is "a cloud floating over your head."

The Internal Revenue Service in 1977 oulawed the butterfly and refused to recognize deductions for losses produced by the technique. That ruling has been challenged in court by two taxpayers whose butterfly straddles were arranged by Merrill Lynch.

The butterfly straddle involves simultaneously buying and selling commodity contracts for future delivery of some commodity, most often silver. The customer loses money on one of the transactions, but makes a corresponding profit on the other. The loss can be claimed as an income tax deduction, while the profit can be delayed until the following year and taxed at a much lower rate. IRS officials say the technique can cut the income tax rate paid by wealthy investors from 70 percent to as little as 28 percent.

Regan said he already has taken steps to avoid any conflicts of interest between his old job as chairman of Merrill Lynch and his new post as Treasury Secretary.

"While I am secretary of Treasury, I will not involve myself in anything Merrill Lynch is involved in," Regan told the committee. Finance committee Chairman Robert Dole (D-Kan.), who also asked Regan about the commodity tax-avoidance scheme, said Senate ethics officials have looked at possible conflicts. "There isn't any problem as far as he and I know," said Dole.

As Treasury Secretary, Regan both will oversee the Internal Revenue Service and set tax policy for the Reagan administration. Matsunaga and Moynihan questioned the nominee closely about both roles.

Regan assured Matsunaga that he will not try to head off a court confrontation between Merrill Lynch and the IRS over the butterfly tax deductions. "This is a matter that should be allowed to wind its way through the court," he said. "I think they should proceed with the case."

Matsunaga asked Regan why Merrill Lynch had offered to pay off its two clients if they would drop the case against the IRS. The offer apparently was motivated by fear the clients would lose the case, giving the IRS an important legal precident.

"Merrill Lynch did not try to buy off the taxpayers, as the press has reported," Regan insisted. "Merrill Lynch did consider, as most companies that are involved in a lawsuit will, a settlement if the taxpayers lost." He said Merrill Lynch was willing to pay the clients' taxes only if they lost the case.

Internal Revenue Service attorneys and the lawyer for the two Merrill Lynch clients involved in the case have given a different version of that settlement. At a court hearing a few weeks ago, IRS officials said Merrill Lynch offered to pay the clients twice as much as they owed the government if the clients would drop their case against the IRS.

Moynihan said he is preparing legislation to clarify the tax law and close the butterfly loophole and he asked Regan if he would support such a change.

"That's a very complicated question," responded Regan. "If you start fooling around with the commodity markets, you could cause a lot of problems."

Regan said tax straddles were "one of many financial services Merrill Lynch has offerred" its customers.

Regan said the technique is "nothing new . . . tax straddles have been around for 35 or 40 years." Merrill Lynch reportedly has earned as much as $1 million a year arranging tax straddles for its customers; that would amount to less than one-half percent of the annual revenues of the firm, the nation's biggest stock broker.

Merrill's tax straddle business has fallen off since the IRS ruling three years ago. "Merrill Lynch stopped using silver for straddles in 1977 and has done none since," Regan said.

After the hearing, however, Merrill Lynch officials confirmed that the company has continued to arrange tax straddles for its customers in other commodities.