IRS asked to clarify status of municipals: reissuance rules worry investors.

WASHINGTON -- A New York Bar Association committee is urging the Internal Revenue Service to assure the municipal securities market that a 1991 Supreme Court decision does not expose investors to unexpected tax consequences.

In a letter to IRS Commissioner Shirley Peterson, the New York bar's committee on taxation of corporations said the market needs to know that certain minor changes to a bond issue will not be considered a reissuance that makes the bonds subject to more-restrictive tax laws.

The case, Cottage Savings Association v. Commissioner of Internal Revenue, dealt with how thrifts report losses on mortgage securities transactions. But it touched on an area of the tax code that governs municipal bond reissuance.

The modifications worrying the committee include:

* Minimal changes in bond yield.

* Elimination or modification of covenants in bond documents.

* Minor extensions in bond maturities.

* Transactions in which an issuer buys U.S. government securities and puts them in an escrow to pay off the bonds over time.

The New York lawyers committee urged Ms. Peterson not to view the Cottage Savings decision as establishing a new "hair-trigger" standard for reissuance, under which even the slightest modification to a bond issue would cause the bonds to be considered as reissued.

"Adopting a hair-trigger rule not only would disrupt legitimate business transactions," the committee told Ms. Peterson, "but also would invite inappropriate taxpayer manipulation." Taxpayers would be able to make minor changes in their debt and to claim losses while deferring gains, it said.

Instead, Cottage Savings should be viewed as "simply reaffirming the well-established principle that a change of both obligor and collateral will generally result in a reissuance.

Material Differences

In that case the court decided thrifts could deduct losses claimed from the exchange of substantially similar pools of mortgages. It found the loans exchanged "materially different" because they embodied "legally distinct entitlements." The loans had different obligors and sources of collateral.

The decision raised questions among some IRS officials and bond lawyers about whether the court was establishing a new standard for "materially different" in determining whether a taxpayer has realized losses or gains for tax purposes from an exchange or sale of property as well as with bond reissuance.

However, the committee said the Cottage Savings decision "did not eleminate the materiality requirement of section 1001; instead it expressly affirmed it." The decision simply established "administrable rules" to determine when certain changes are material.

The panel said the bond market would be disrupted if the IRS interpreted Cottage Savings as establishing a "hair-trigger" standard for reissuance. That would run counter to a series of rulings published over the years by the IRS as well as some common industry practices, it said.

Earlier Decisions

For example, two private-letter rulings in 1988 and 1989 had concluded that changes in yields of three basis points or less than 12.5 basis points would not cause bonds to be considered reissued.

Revenue ruling 73-160, which the IRS issued in 1973, concluded that if the maturity of a debt obligation is extended without affecting its yield, there is no reissuance. IRS officials have said they are rethinking that ruling.

But the committee said that even if the IRS revokes that ruling, "we urge that minor maturity extensions, and extensions resulting from the financial difficulties of the debtor in meeting its obligation at maturity, not cause a reissuance."

In revenue ruling 85-42, the IRS concluded that a defeasance - in which the issuer puts U.S. government securities in escrow to make debt service payments until the debt can be retired - does not retire the debt for tax purposes.

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