WASHINGTON -- The National Association of Bond Lawyers told Treasury and Internal Revenue Service officials on Friday that the Supreme Court's recent Cottage Savings decision "should have little, if any, impact" on existing standards for municipal bond reissuance.
The association's general tax matters committee delivered that conclusion in a memo that is intended to serve as guidance for an upcoming discussion of pending rulings by high-level Treasury and IRS officials.
The lawyers are concerned that the IRS will conclude the Cottage Savings decision creates a "hair-trigger" standard for reissuance, under which any change in a bond issue would trigger a reissuance and make the bonds subject to the current, most restrictive tax laws.
In its April 17 decision in Cottage Savings Association v. Commissioner of Internal Revenue, the high court ruled that thrifts could deduct losses claimed from the exchange of substantially similar pools of mortgages. The decision did not directly address municipal bonds, but focused on a section of the Internal Revenue Code that affects municipal bond reissuance.
Under Section 1001 of the tax code -- which generally deals with whether a taxpayer has realized losses or gains for tax purposes from an exchange or sale of property -- a bond issue is deemed to be reissued and subject to current, more restrictive tax laws if changes made to it cause the terms of the bonds to be materially different.
In the Cottage Savings case, the Supreme Court found that the loans exchanged by the thrifts were "materially different" because they embodied "legally distinct entitlements" -- the exchange pools of mortgage loans had different obligors and different sources of collateral.
Some IRS officials have interpreted the decision to mean almost any change in a bond issue would create "legally distinct entitlements" and a material difference in the bond terms.
But in its memo, the lawyers group told Treasury and IRS officials that the high court's ruling "did not make new law" and "merely reaffirmed the materiality standard under Section 1001.
"It has been the long-standing position of the Service and the courts that both an exchange of securities of different obligors and a change in the obligor on a debt instrument result in" a recognition of loss or gain for tax purposes under Section 1001, the memo says.
The Supreme Court was merely reaffirming that the pools of mortgages were exchanged, contrary to what the IRS had argued in the case, it states.
The IRS had argued that no exchange occurred because the pools of mortgages were economically equivalent -- an argument that most tax lawyers believe the IRS should never have made.
The Cottage Savings case stemmed from a dispute over the IRS's denial of the thrift's claim for a deduction for tax losses. In December 1980, Cottage Savings sold a 90% participation in 252 mortgages it held to four other savings and loan associations while, at the same time, it purchased 90% participations in 305 mortgages held by the four thrifts. The exchange was designed to conform to Federal Home Loan Bank Board requirements that allowed thrifts to realize losses for tax deductions without having to report them under rules dealing with capital requirements.
The IRS denied the loss claimed by Cottage Savings after ruling that thrifts should not be allowed to claim losses for tax purposes from such deals. Cottage Savings appealed that decision, and the dispute continued before the Tax Court, the Court of Appeals for the Sixth Circuit, and then the Supreme Court.
The lawyers group, in arguing that the Cottage Savings decision is nothing new, said that the Supreme Court came up with the phrase "legal entitlements" from three other court cases that have provided much of the case law for Section 1001.
"The court's extensive discussion of these cases, together with its use of these cases as the basis for its opinion, strongly supports the notion that the court was merely applying existing law to a new set of facts," the memo says.
The Supreme Court, the memo says, was not trying to upset "the extensive body" of guidance and rules on municipal bond reissuance. And the Cottage Savings decision, in particular, should not be applied when changes in the terms of bonds are made pursuant to provisions in bond documents, such as is the case with variable-rate bonds, it says.
The memo warns that interpreting the ruling on Cottage Savings as creating a "hair-trigger" approach to the material difference standard "will enable taxpayers and issuers of tax-exempt bonds to easily manipulate the tax laws." Issuers and taxpayers could make minor changes in obligations solely to cause an exchange to occur in order to claim losses that can be deducted from their income taxes. This could result in a substantial loss of revenues to the government, the memo says.
If a hair-trigger approach to the material difference standard is adopted, Section 1001 of the code should no longer be applied to bond reissuance, the memo concludes.
