IRS contingent-payment rules hit muni debt hard, lawyers say.

WASHINGTON - Proposed IRS rules governing contingent payments on debt instruments will probably discourage the sale of floating-rate tax-exempt bonds containing highly leveraged embedded derivatives, bond lawyers said yesterday.

While bond interest would continue to be tax-exempt under the rules, any additional income derived from the embedded derivative would be deemed taxable, and any loss incurred as a result of the derivative could not be deducted for tax purposes.

"These are very harsh rules for tax-exempt bonds," said one bond lawyer after examining the rules.

"I think the result will be that there won't be tax-exempt bonds sold subject to these rules" once the rules become effective, said the lawyer, who asked to remain anonymous. "People will stop doing leveraged inverse floaters because the consequences are too harsh."

Another lawyer agreed that the rules are likely to dry up the market for such debt instruments, but added that it "is a relatively small group of debt instruments. Very little of that has been done this year."

The proposed rules are scheduled for publication in today's Federal Register, and the Internal Revenue Service will accept comment on them through March 16, 1995. The rules are fully prospective: They will not become effective until 60 days after their final version is published in the Federal Register.

The rules on tax-exempt bonds are only a small part of the 107-page regulation, which is mainly designed to tell taxpayers how the agency treats taxable debt instruments with contingent payments. The rules govern debt instruments not covered by regulations issued in January telling taxpayers who originally purchased or sold bonds at a discount how to compute and take the discount into account for tax purposes.

For tax-exempt bonds, the January original-issue discount rules cover most types of variable-rate bonds and treat the interest on those bonds as tax-exempt.

To be covered by the less-stringent January rules, a tax-exempt bond's interest rate would have to be pegged to a relatively traditional interest rate formula, and could use only an unleveraged, stand-alone inverse floater.

The tougher contingent-payment rules, by contrast, apply to bonds in which the inverse floating rate is based on a multiple of an interest rate index.

Bonds governed by the contingent-payment rules might, for example, bear an inverse floating rate of 10% minus five times the J.J. Kenny high-grade index. To qualify under the January original-issue discount rules, the inverse floating rate would have to be 10% minus the Kenny index, without the multiplier.

Unlike the January rules, the contingent payment rules treat a portion of bond income as taxable. "The IRS and Treasury beheve that, given the limited exclusion provided in Section 103 [governing municipal bond interest! it is generally inappropriate to treat payments on a property right embedded in a tax-exempt obligation as interest on an obligation of a state or political subdivision," the regulations state.

Thus, "all positive adjustments are treated as taxable gain from the sale or exchange of the obligation rather than as interest," according to the rules. "Negative adjustments are treated as reducing tax-exempt income, and, therefore, are generally not taken into account as deductible losses."

In addition, the proposed rules provide that the projected yield determined for a tax-exempt obligation may not exceed "the greater of the yield on the obligation determined without regard to contingent payments and the tax-exempt Adjusted Federal Rate that applies to the obligation," the regulations state.

Bond lawyers noted that this is the fourth time the IRS has attempted to write regulations on contingent payments. On the corporate side, in particular, the issues involved are extremely complex and have made it difficult for service officials to come up with rules. The lawyers said it is possible the regulations may never be made final.

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