WASHINGTON -- The Internal Revenue Service issued a revenue ruling Friday designed to crack down on abusive bond deals in which bogus insurance is used to shield an arbitrage scheme that nets the participants huge profits for questionable projects.
Revenue Ruling 94-42 represents the first step taken by the IRS to go after abusive deals that have been targeted under its new beefed-up bond enforcement program, agency officials said. The IRS announced in January that it planned to go after a handful of alleged bond abuses, including arbitrage-driven transactions with tax-exempt bonds whose debt service is backloaded.
The ruling is the first so-called anti-abuse revenue ruling issued by the IRS in almost a decade, officials conceded. The last such ruling was issued in November 1985 to stop the collapsible escrow bond deals under-written by the former Matthews & Wright Inc. and other investment bankers in which issuers had no reasonable expectations that bond proceeds would be used for projects.
Like all revenue rulings, the ruling issued Friday is retroactive and could spell trouble for investors in a number of such deals done in recent years involving bogus insurance, bond lawyers and IRS officials said.
"There were several similar transactions that will be affected by this ruling," said Richard Chirls, a lawyer with Orrick, Herrington & Sutcliffe in New York City. "It is troublesome for investors because many of these deals were done in the secondary market outside the normal, careful scrutiny of bond counsel and the issuer."
In the ruling, the IRS concludes that debt service payments made with such bogus insurance are taxable rather than tax-exempt. That means investors in these deals may have received taxable rather than tax-exempt interest from their bonds.
Although IRS officials refused to discuss specific deals covered by the ruling, several bond lawyers believe it is aimed at deals like the one done by the Marengo County [Ala.] Port Authority in 1989.
"It certainly sounds like a variation of the Marengo County Port Authority deal," said William Loafman, a lawyer with Whitman, Breed, Abbott & Morgan in New York City.
The Marengo County Port Authority issued $3.9 million of junk bonds, which were then "insured," given a credit-rating of AAA, and resold a day later at premium prices for more than $20 million. The proceeds from the reoffering were used to make a huge payment to the "insurer," who then purchased enough taxable securities to fully pay debt service on the bonds.
Bond lawyers and federal regulators who looked at the bond documents for that deal when it came to light in 1992 complained that the insurance was not true credit enhancement, but was instead used to set up a long-term sinking fund of taxable securities that would pay all of the debt service on the bonds and, at the same time, guarantee participants huge profits from the spread between the tax-exempt bond and taxable investment rates.
In its ruling issued Friday, the IRS appears to echo those complaints.
The IRS ruling, however, focuses on a transaction that, while similar to Marengo County's, is different in that the insurance is acquired in an "unrelated transaction" that takes place a year after the bonds are issued.
In the transaction in the ruling, a county issues zero-coupon bonds with a 30-year maturity and a stated redemption price of $204 million. One year later, in an unrelated transaction, the investor who bought the bonds pays a $14 million premium for insurance on the bonds. At the time it appears, there will not be enough revenue from the bond-financed facility to pay debt service on the bonds.
The "insurer" buys $14 million of Treasuries to guarantee payment of "substantially all" of the debt service on the bonds, the ruling says. The bonds are given a higher credit rating and are resold at premium prices. Participants reap huge profits from the spread between the 8.3% yield of the reoffered bonds and the 9.6% yield of the Treasuries backing the bonds.
The IRS ruling concludes that treating the insurance payments as tax-exempt would be inconsistent with the purpose of tax exemption. The ruling finds that because the investor is really looking to the insurance rather than project revenues to pay debt service on the bonds, the investor has purchased two separate investments: the tax-exempt bonds and insurance payments that are more like taxable debt than traditional bond insurance, which is considered in effect to be embedded in the bonds and therefore tax-exempt.
In the ruling, the IRS tries to distinguish between legitimate bond insurance and bogus insurance. Bond insurance is legitimate and part of the tax-exempt debt, the ruling says, when "the amount paid is reasonable, customary and consistent with the reasonable expectation that the issuer of the bonds, rather than the insurer, will pay debt service on the bonds."
The ruling makes clear that three past revenue rulings that treat traditional, legitimate bond insurance as tax-exempt continue to remain valid for nonabusive transactions.
"We havee no intent whatsoever to disturb the municipal bond industry," said Michael Bailey, the IRS' senior technician reviewer for tax-exempt bonds and one of the authors of the ruling. "We affirm the old rulings, but say that in very extreme abusive cases, they don't apply."
Loafman said that while he is pleased that the IRS has issued a ruling to go after abusive deals, he is concerned that it may not be broad enough.
"I worry that it only covers insurance and not other forms of guarantees like letters of credit that can be used to shield sinking funds," he said.
But a Treasury official said that the ruling is broad and covers other similar structures, whether or not the holder of the bonds or another party engages in an arbitrage scheme directly or uses some of form of guarantee, such as a letter of credit, to disguise an arbitrage-driven transaction.
"The main principle underlying the ruling is that a guarantor, bond-holder, or any similar party cannot obtain the benefit from borrowing at tax-exempt rates and investing at taxable rates," he said.
Robert Godfrey, an executive vice president of the Municipal Bond Investors Corp., said Friday that the IRS ruling "is no surprise" and is "reasonably well written."