Although The Bond Buyer has previously reported that the IRS has audited a number of tax-exempt bond issues that involved total return swaps ($) and that the IRS has declared to be taxable an ostensibly tax-exempt bond issue that involved a total return swap ($), the IRS had until a public release on January 9, 2015, never issued publicly available guidance on the tax-exempt bond consequences of a total return swap. The IRS held in recently released Private Letter Ruling 201502008 (Jan. 9, 2015) (pdf) that a total return swap would not be an abusive arbitrage device under Treasury Regulation § 1.148-10(a) and that the total return swap would not be integrated with the issue of tax-exempt bonds as a qualified hedge for federal income tax purposes pursuant to the power of the IRS to compel integration under the anti-abuse rules of Treasury Regulation § 1.148-10(e). Thus, the total return swap at issue in PLR 201502008 did not adversely affect the tax-exempt status of the subject bonds.
PLR 201502008 deals with a conduit issue of fixed-rate current refunding bonds. All of the sale and investment proceeds were spent within 30 days after the bonds were issued, and all of the proceeds of the current refunded bonds had been spent at the time they were refunded with proceeds of the current refunding bonds. Moreover, there is no reserve fund for the current refunding bonds, and amounts are deposited in the debt service fund for these bonds only as debt service payments come due. Consequently, within 30 days after the current refunding bonds were issued, there were no “gross proceeds” of the bonds for federal income tax purposes.
The current refunding bonds were purchased on their issuance date in an arm’s-length private placement transaction by a party whose intent was to hold the bonds for that party’s own account and not for purposes of resale to others. On the issuance date of the bonds, the bondholder and the conduit borrower of the bonds also entered into a total return swap. The notional principal amount of the total return swap equals the principal amount of the bonds, and the notional amount of the total return swap and the principal amount of the bonds amortize according to identical schedules. Under the total return swap, the conduit borrower of the bonds makes variable-rate payments to the bondholder/swap counterparty based on the SIFMA Index, and the bondholder/swap counterparty makes fixed-rate payments to the conduit borrower that are 95 basis points less than the fixed interest rate on the bonds. The conduit borrower’s net financing cost under this arrangement is therefore the SIFMA variable rate plus 95 basis points.
The total return swap also provides that upon a termination of the swap, a payment must be made from one party to the other in an amount equal to the difference between the fair market value of the bonds on the termination date of the total return swap and the base price of the bonds as set forth in the total return swap agreement. If the base price of the bonds exceeds their fair market value upon the termination of the total return swap, the conduit borrower must pay the difference to the bondholder/swap counterparty; conversely, if the fair market value of the bonds exceeds their base price when the total return swap terminates, the bondholder/swap counterparty must pay this difference to the conduit borrower.
The total return swap was not identified on the IRS Form 8038 filed for the bonds, or on any other document, as a qualified hedge to be integrated with the bonds under Treasury Regulation § 1.148-4(h). The private letter ruling was sought here because the conduit borrower and bondholder contemplated amending the terms of the total return swap to extend its term by five years and to increase by 15 basis points the fixed rate payable by the bondholder to the conduit borrower under the total return swap (thus reducing the conduit borrower’s financing cost under the arrangement from the SIFMA variable rate plus 95 basis points to the SIFMA variable rate plus 80 basis points). The parties represented to the IRS that this change to the fixed rate payable under the total return swap was negotiated at arm’s length and reflects improvement in both market conditions and the conduit borrower’s credit quality. It was further represented to the IRS that the issuer of the bonds would, as a precautionary measure, file an IRS Form 8038 upon the amendment of the total return swap for the potentially resulting federal tax reissuance of the bonds, but that the amended total return swap would not be identified on this Form 8038 as a qualified hedge of the potentially reissued bonds.
On these facts, the IRS held in PLR 201502008 that neither the original nor amended total return swap results in an abusive arbitrage device, within the meaning of Treasury Regulation § 1.148-10(a), in respect of the bonds, because neither iteration of the total return swap allows the conduit borrower to exploit the difference between tax-exempt and taxable interest rates for a material financial advantage. No such exploitation was available in PLR 201502008 because all of the gross proceeds of the bonds had been spent and are therefore not available to be invested in non-purpose investments. Accordingly, neither the amended nor the original total return swap affords the conduit borrower the opportunity to exploit differences in tax-exempt and taxable interest rates in making non-purpose investments of the gross proceeds of the bonds.
The IRS also held in PLR 201502008 that neither the original nor amended total return swap resulted in an overburdening of the tax-exempt bond market. The IRS found that the amendments to the total return swap were based on an arm’s-length negotiation that reflected improvements in market conditions generally and in the conduit borrower’s credit quality and that these amendments were not based on the amount of arbitrage that could be earned or on factors other than fair market value pricing. Consequently, the IRS held that the total return swap would not be integrated with the bonds as a qualified hedge pursuant to the IRS’s anti-abuse authority under Treasury Regulation § 1.148-10(e).
Interestingly, the IRS did not address whether the total return swap and the bonds constitute a single instrument for federal tax purposes. It is strongly implicit from PLR 201502008 that the IRS would not treat the total return swap and the bonds in this instance as a single instrument for federal tax purposes. At a minimum, PLR 201502008 provides evidence that a properly structured total return swap or similar arrangement will not automatically cause the otherwise tax-exempt bonds that are part of the arrangement to be taxable bonds. The audit activity involving total return swaps and the beneficial facts of PLR 201502008 highlight that careful planning is necessary with any type of total return swap or similar arrangement, but PLR 201502008 provides some comfort that these arrangements can be undertaken without adversely affecting the tax-exempt status of the associated bonds.