Subtitle: Should You Let Your Swap Marry Your Bond Issue Without A Pre-Nup?
Subsubtitle: If You Are Going To Let Your Swap Marry Your Bond Issue Without A Pre-Nup, Please Tell Bond Counsel Early in the Process
As discussed in prior posts on this Blog (here and here), since the beginning of the last recession, an increasing number of tax-exempt bonds are purchased directly by banks. As the transaction process begins, the bank will send a term sheet to the borrower with the terms of the bonds for a set period of time. While the bonds often have a nominal maturity of 30 years, most often the bank has only agreed to hold the bonds on the original terms for a much shorter period of time, rarely longer than 10 years. At the end of that initial term, there is typically a mandatory redemption and the borrower must reconvene with the bank to set the terms of the bonds for a subsequent time period or refinance the bonds with another lender. In many cases, those bonds bear interest at a variable rate. In that case, the same bank that buys the bonds may offer to the borrower an opportunity to enter into an interest rate hedge (“Swap”) that hedges the interest rate on the bonds and results in an exchange of cash flows such that, on a net basis, the borrower pays the bank a fixed rate (notwithstanding the nominal variable rate on the bonds) for that initial term.
The Swap has two elements, a floating rate that the bank pays to the borrower (which has the effect of “cancelling out” the nominal variable rate that the borrower pays to the bank under the term sheet) and a fixed rate that the borrower pays to the bank. Typically, the variable rate on the bonds and the variable rate on the swap are identical. In almost all cases, these variable rates are expressed as a percentage of the London Interbank Offered Rate (“LIBOR”) plus a spread. For instance, the variable rate on the bonds might be 72% of LIBOR plus 1.5%. Because the variable rate on the bonds and the variable rate on the Swap are the same, they cancel each other out and the borrower is left to make a net payment of the fixed interest rate on the Swap. For our example, let’s assume the fixed rate on the Swap is 3.75% for the first 10 years and, at that point in time, the swap will terminate.
A Swap is typically documented by an ISDA (which stands for International Swap Dealers Association, in case you were wondering) Master Agreement, which has the boilerplate that every Swap needs, a confirmation that has the particulars of the Swap, and, in some cases, a schedule and a credit support annex. Sometimes, but not always, the Swap documents will have a provision that, if for any reason the bank does not own the bonds at some point in the future but before the 10 year initial term ends, the Swap will terminate on that same date. That provision may be described as an Additional Termination Event and could be found in a schedule to the Swap or the confirmation.
That is all quite nice to know, but you may be wondering: Why should I care about this? The answer is that, because you love the minutiae of tax law (why else would you be reading this Blog), within that minutiae lies a potential trap for the unwary for a bond issue and accompanying Swap where the Swap has a particular type of Additional Termination Event.
The path toward the hidden trap involves the question of when two financial instruments should be treated as one instrument for federal income tax purposes. Should the Swap and the bonds described above be treated as a single financial instrument? In other words, should we consider the Swap and bonds as married and if so, are they married till death do us part?
In the original issue discount portion of the Code, Section 1275 (link) defines a “debt instrument”. Treas. Reg. § 1.1275-2(c) (link) states that debt instruments should be effectively treated as one instrument (or “aggregated”)  , under certain circumstances. But Section 1275 of the Code and Treas. Reg. § 1.1275-2 do not apply to tax-exempt obligations because of the exception found in Section 1272(a)(2)(A) (link) of the Code. Besides, a swap isn’t even a debt instrument. But wait…Treas. Reg. § 1275-6 (link) deals with integration (although the regulations really mean aggregation) of qualifying debt instruments with a hedge which is defined as “any financial instrument if the combined cash flows of the financial instrument and the qualifying debt instrument permit the calculation of a yield to maturity, or the right to the combined cash would qualify as a variable rate debt instrument.” Seemingly, this provision is directly on point with our facts; however, once again, tax-exempt obligations are explicitly excluded from the definition of “qualifying debt instrument.” Phew! We can stop.
Wrong. Code Section 1275(d) authorizes the Secretary of the Treasury to prescribe regulations to govern situations where “other circumstances” cause the purposes of Code Section 1275 and Section 163(e) (link) not to be met. Code Section 163(e) deals with a taxpayer’s ability to deduct original issue discount. Thus, there is a relationship between 163 and 1275.
Rev. Rul. 2003-97 (link) deals with whether two instruments issued by a corporation should be treated as single instrument for purposes of Code Section 163. In this Revenue Ruling, the IRS lays out a two-part test for whether the instruments are separate. First, the instruments have to be separately transferable. Second, the mere existence of a legal right to separate is not sufficient if the holder of the two instruments suffers an economic compulsion to keep the instruments together. It is this latter point where the pre-nup can be useful. While we don’t know whether economic compulsion is contagious or perhaps in the directory of disorders used in the psychology profession, we do know that we need to analyze the phrase.
This being tax law, it will not surprise you to learn that the Revenue Ruling, citing some case law, tells us that economic compulsion is determined based on all the facts and circumstances. But the Revenue Ruling contains some helpful guidance, saying that “[t]he need to take certain steps to effect a separation does not contradict the separateness that can ultimately be achieved.” Therefore, overcoming a few minor inconveniences is not tantamount to being economically compelled to keep two instruments together.
So, let’s return to our bonds, purchased by the bank, and our swap, to which the bank is a party, and the same borrower on the other side of both transactions. If it were not for the Additional Termination Event, the bank could sell the bonds separately from the swap, and the swap could remain outstanding; i.e., the instruments are separable. Even if the instruments are married in some sense, they effectively have a pre-nup that establishes what happens if they divorce. While the borrower would probably want to terminate the swap if the bonds went away, there does not seem to be any economic compulsion to do so. But, if you add back in the Additional Termination Event, there does seem to be a lack of separate transferability because the swap must go away if the bonds are transferred or paid off so there is no pre-nup that allows for a peaceful separation.
That is all well and good, but what does that mean as a practical matter? If the bonds and the swap are treated as a single instrument for tax purposes, then the bond counsel opinion for the bonds may no longer be correct. If the bonds and the swap are treated as a single instrument, the variable rate payments between the borrower and the bank will actually cancel each other out, and the parties will be left with a single instrument that has a “synthetic” fixed rate. In this case, there may not be tax-exempt interest if the variable rate on the bonds rises above the synthetic fixed rate. In our example, if 72% of LIBOR plus 1.5% exceeds the fixed rate on the swap of 3.75%, any portion of the variable rate of interest on the bonds above the fixed rate on the swap of 3.75% may not be tax-exempt. If bond counsel has to limit its opinion as to interest above the synthetic fixed rate, the bank has to decide to either accept the opinion or revise the Additional Termination Event in a way that does not lead to economic compulsion and allows for separate transferability.
There are several ways to accomplish that. The practical problem is that the swap documentation often arrives late in a transaction. So, if you are considering letting your swap be married to your bonds until death do they part in a bank direct purchase, it would be best to tell the bond counsel very early in the planning process and generate the swap documents at that early stage so that the appropriate language can be included in the pre-nup to allow for actual separate transferability and reduce the danger of economic compulsion.
IMPORTANT DISCLAIMER: Notwithstanding that some of the same considerations (e.g., term of both agreements, timing of interest payments, etc.) are implicated by both, treating an issue of tax-exempt bonds and a swap as a single debt instrument for federal tax purposes is a completely separate tax concern from “integrating” a debt instrument and a swap under Treas. Reg. § 1.148-4(h). Integrating a swap and a debt instrument under Treas. Reg. § 1.148-4(h) is a way to include the payments on the hedge in the yield determination for the issue of hedged bonds. Integration pursuant to Treas. Reg. § 1.148-4(h) does not raise any federal tax law concerns that the two instruments will be “aggregated” and treated as a single synthetic instrument.
 Confusingly, the various authorities (Code, Treasury Regulations, IRS publications and case law (applying the “substance over form” doctrine that keeps tax lawyers up at night) that addresses treating two separate financial instruments as a single instrument commonly refer to such a practice as both “integrating” the two instruments as well as “aggregating” the two.
 An interesting practice point is whether, for purposes of applying the integration rules in 1.1275-6, the IRS would treat the bonds as maturing on the bonds’ final maturity date or the date of the mandatory redemption at the end of the bank rate period (usually 10 years). The integration rules in 1.1275-6 provide that a financial instrument will not qualify as a hedge (and therefore will not be aggregated with the debt instrument) if the resulting synthetic debt instrument does not have the same term as the qualifying debt instrument.