WASHINGTON - Tax rules affecting the municipal derivatives market should be broadly written and provide safe harbors that describe the kinds of transactions that would comply, the Public Securities Association said in a recent letter to the Internal Revenue Service.

"The market clearly needs and wants guidance, but at the same time, rules established today cannot foresee the path along which the market may develop in the future," the PSA said in the letter to James P. Malloy, the IRS' assistant chief counsel for financial institutions and products.

Rules that provide some flexibility but that also contain anti-abuse provisions will ensure the continued growth of the municipal derivatives market, the PSA said in the letter. It was sent last month after the group's task force on municipal derivatives met with agency officials.

Arbitrage rules proposed by the IRS late last year "generally strike this balance" but could be further improved, the letter says.

The letter also asks the IRS to clarify or revise the arbitrage rules, as well as the proposed rules on reissuance and original issue discount, to ensure consistent tax treatment of municipal derivatives and to reflect current market practices.

"Basically, they've made a tremendous effort" to deal with some of the tax issues posed by derivatives, said Robert K. Sharp, a lawyer with Rogers & Wells in New York and an adviser to the PSA task force.

"What we're really talking about here is fine-tuning," Sharp said in an interview. "We just want the IRS to give us the leeway and flexibility to continue with current products and to experiment with new products that are not abusive."

The PSA letter focuses on inverse floater bonds and embedded cap bonds, both of which result in lower fixed-rate borrowing costs for issuers and offer investors the potential for above-market variable rate returns.

Inverse floaters act contrary to the market and pay investors more when short-term rates fall. Embedded cap bonds provide investors with additional interest whenever a specific short-term tax-exempt interest rate index floats above a specified fixed rate. These products give investors the option, if the market turns against them, of converting to fixed rates in return for a payment or interest rate adjustment.

The PSA letter says the IRS' reissuance rules, which were proposed in December, and the contingent payments rules, which were proposed earlier this year but withdrawn for further review by Clinton officials, could affect the interest rate conversion features of these products "in an adverse way" and could "retard development of the municipal derivatives market."

The reissuance rules could be interpreted to mean that a reissuance would occur any time interest rates are converted by the investor in return for a payment to the issuer that is not fixed at the time of issuance, the PSA said.

The rules should be modified to make clear that bonds will not be reissued just because an investor in a derivative product converts to fixed rates, the group said.

The PSA said it was worried that the IRS might write contingent payment rules so that the payments made in connection with an interest rate conversion would be treated as taxable payments rather than tax-exempt interest.

The group urged the IRS to incorporate some safe harbors in these rules, such as one specifying that payments no higher than 20% of the price of the bonds will be treated as tax-exempt interest.

The PSA also was worried that the proposed original issue discount rules could be interpreted to mean hat mutual funds would have to take into account the net present value of the entire amount of a payment made for interest rate conversion. As a result of such a requirement, a mutual fund might not be able to meet federal rules requiring that at least 90% of its income be distributed among shareholders.

The group asked the IRS to clarify in the proposed rules that mutual funds can take such payments into account when they are received on a cash basis.

The PSA letter lauded the IRS for addressing swaps in the proposed arbitrage rules, but said the rules are confusing because they appear to suggest that issuers have the option of taking the net swap payments into account in determining the bond yield for arbitrage purposes.

The rules should be revised to make clear that issuers involved in so-called qualified hedging transactions - in which the swap agreement closely matches the underlying bonds - are required to take the net swap payments into account in determining bond yield, even if they fail to disclose the existence of the hedge in the bond documents, the PSA said.

The PSA said the arbitrage rules also should include some safe harbors specifying that net payments do not have be to taken into account for yield.

On a related subject, the PSA urged the IRS to relax the proposed arbitrage rules on swaps "to reflect market practice and require that only those bonds in an issue that need to be hedged are hedged and that such hedges be in place only so long as they need be."

Under the current proposed rules, swaps are qualified hedging transactions that can take net payments into account for bond yield only if they meet three of the following four criteria: the hedge must be entered into within 15 days from when the bonds were issued; the notional principal amounts of the hedge and issue price must be the same; the interest rates on the issue and the amounts paid by the provider under the hedge are based on substantially the same method of calculation; and the maturity dates of the hedge and the issue are substantively the same.

But most swap agreements cover only portions of bond issues and are for terms that are less than the terms of the bonds, so they do not meet the notional amount and maturity requirements, industry officials have said.

The PSA urged the IRS to revise the arbitrage rules to address situations in which hedges are terminated early or replaced after they expire.

In another matter, the PSA questioned whether the proposed arbitrage rules should say that hedging transactions with "embedded loans" will not be treated as qualified hedging transactions. While it appears the IRS is concerned that some hedges may be disguised investments, the group said, both the purchase and sale of a cap and the establishment of a substitute hedge would give rise to an "embedded loan," and neither are investments.

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