WASHINGTON -- The IRS announced yesterday that certain provisions of its final original issue discount rules will not apply to short-term tax-exempt notes until it has a chance to study a potentially adverse effect of the provisions on these notes.
The IRS announcement, which was made in Notice 94-84, will affect about $10 billion of tax-exempt notes with maturities of one year or less that have been issued since April 4, the date the final original issue discount rules took effect, IRS officials said. Those estimates are based on statistics reported by The Bond Buyer, they said.
The notice paves the way for the state of California to sell $3 billion of revenue anticipation notes today.
IRS officials issued the notice just one day after George Wolf, a partner with Orrick, Herrington & Sutcliffe in San Francisco, discovered that the rules could cause investors who purchase short-term tax-exempt notes in the secondary market to wind up with taxable capital gains as well as tax-exempt interest.
This would be disastrous for tax-exempt money market and other bond funds, which. promise investors tax-exempt income and do not want to receive taxable gains or income in any form.
"The discovery of this threatened to catch the market and most tax lawyers with their pants down," said an East Coast lawyer who did not want to be identified.
Under the final original issue discount rules, capital gains would result if an investor purchased tax-exempt notes in the secondary market at a price that was par or greater but less than the initial issue price.
This is a common occurrence for most tax-exempt notes, which typically are sold at a premium and at maturities of less than a year.
Take for example, $10 million of one-year tax-exempt notes issued with an interest rate of 5% and a price of 102. The notes are resold in the secondary market at a price of 101 to an investor who holds them to maturity.
The note market has been operating under the assumption that the secondary market purchaser would have as much as $500,000 of tax-exempt interest and no taxable income.
But under the original issue discount rules, the secondary market investor would have as much as $100,000 in taxable capital gains as well as tax-exempt interest.
"It's as if these notes were zero-coupon bonds," the lawyer said. "The amount that's treated as tax-exempt interest under the tax law is based on the note's original yield rather than on what the issuer calls interest."
The problem stems from the fact that the original issue discount rules treat all payments, including interest, from obligations with a term of less than a year as part of the stated redemption price rather than as "qualified stated interest."
But while the IRS notice fixes the problem for tax-exempt notes with maturities of one year or less, a similar problem may still exist for notes sold at a premium with longer maturities, the lawyer said.
An investor that purchased these notes in the secondary market at a price that was par or greater but less than the initial issue price would end up with market discount as well as tax-exempt interest, under rules governing original issue and market discount. Market discount must be treated as ordinary income under the current tax law.
There has been a significant amount of these notes issued since the summer of 1993 when the tax laws changed market discount to ordinary income for these types of transactions, but most lawyers and investors have not discovered this problem until recently, the lawyer said.
In its notice yesterday, the IRS said that taxpayers could continue applying the original issue discount rule provisions that are in question to their short-term notes with maturities of less than a year if they choose to do so.
