WASHINGTON -- Municipal industry officials have unveiled draft legislation calling for the creation of Temics, tax structures that would allow tax-exempt bonds to be restructured into new securities that are tailor-made for different classes of investors.
The draft legislation was sent to Treasury officials and congressional tax committee aides late last week by Goldman, Sachs & Co. and other firms about four months after industry officials began working on the proposal.
The firms are seeking support for the proposal, which they hope will be included in the next tax bill taken up by Congress. Capitol Hill observers do not expect there will be another tax bill until sometime next year.
"We have some interested sponsors," said Arthur M. Miller, a vice president at Goldman Sachs who, with Aaron Gurwitz, another vice president at Goldman, created the Temic concept. "Ideally, if there were another tax bill we would like this to be a part of that," he said, declining to name the potential sponsors.
Neither Treasury officials nor congressional tax committee aides could be reached for comment on the proposal.
Industry officials say Temics, or tax-exempt municipal investment conduits, could dramatically increase the market for municipal derivatives, improve liquidity of the tax-exempt bond market, and lead to lower borrowing costs for state and local issuers.
"The basic idea is that you create a set of tax rules that would allow for tax-exempt interest on bonds to be sliced and diced in a way that appeals to the classes of investors who may not have any interest in a plain-vanilla bond," said Miller.
For example, fixed-rate municipal bonds could be put into a Temic and restructured into floating-rate and inverse floating rate bonds. The floating rates could be passed through to one class of investors and the inverse floating rates to another class of investors.
Securities firms will be willing to pay issuers more for their bonds if they can take those bonds, put them into a trust, and create municipal derivatives that are tailored to fit investor needs, Miller and others contend.
Temics would allow state and local issuers that are either unable or unwilling to do derivative transactions to reap the benefits from them indirectly, Miller and others say. Temics could be used in the secondary market to create derivatives from outstanding tax-exempt bonds. They could also be used in the primary market by the underwriting firms that buy bonds from issuers.
The Temic structure would ensure that the tax-exempt interest from the bonds would flow through to the investors.
"It's a way to allow investors to get different cash flows from municipal bonds and to have the tax exemption flow through to them," said James M. Peaslee, a lawyer with Cleary, Gottlieb, Steen & Hamilton in New York, who drafted the legislative proposal.
The draft legislation, like the concept, is modeled after Remics, or real estate mortgage investment conduits, which have contributed significantly to the growth of the mortgage-backed securities markets.
But the Temic legislative proposal contains several provisions aimed at preventing abuse and addressing concerns raised by federal officials and congressional aides in recent informal discussions, Miller and Peaslee said.
The legislative proposal was carefully written, for example, to ensure that a Temic would not pass through to investors any more tax-exempt interest than is earned on the bonds held in the Temic.
"The sum of the parts cannot be greater than the whole," said Miller.
The proposal also would ensure that, for Temics that pass through taxable as well as tax-exempt interest, the taxable interest could not be allocated to investors that could escape being taxed, such as pension plans or foreigners.
Market discount bonds, or tax-exempt bonds purchased at a discount from their stated yield, would throw off taxable as well as tax-exempt interest. The bonds' coupon would be tax exempt, but the market discount would be taxed as ordinary income.
The proposal would also prevent securities firms from using Temics to skirt a current tax law that prohibits taxpayers from borrowing to finance the purchase of municipal bonds.
The Temic proposal is aimed at developing a new set of tax laws that would govern the "securitization," or restructuring, of municipal-bonds.
Until now, securities firms have had to restructure municipal bonds through grantor trusts or partnerships, but these arrangements can be cumbersome under current tax laws and regulations that were not written with such structures in mind.
Grantor trusts are like unit investment trusts in that the trust is, in effect, ignored and the investors own portions of the trust's assets. A grantor trust that contains tax-exempt bonds would pass the tax-exempt interest through to investors.
But Peaslee said a major problem with such structures is that, under the so-called Sears regulations, the trust must be taxed like a corporation or a partnership unless the restructuring of securities falls within a few very limited categories. These include bonds that are stripped of interest or principal and debt that is divided among senior and subordinated investors, he said.
Taxing the trust as a corporation would be disastrous because the trust would be subject to alternative minimum tax and the investors would be subject to income taxes, he said.
Investors could receive tax-exempt interest in a partnership. But the problem with partnerships is that they must be structured with some costly restrictive and costly features in order to qualify as a partnership, Peaslee said. In addition, ownership interests in partnerships are subject to some tax rules that could be troublesome for investors of municipal bonds, he said.
Temics would create a simpler tax regime for restructuring municipal bonds and at the same time create a bridge between investors and issuers, Peaslee said.
"The cash flows could be carved up in a way that makes investors happy but also keeps bonds fixed rate for issuers," he said.
