WASHINGTON - The Internal Revenue Service has settled two key arbitrage issues that affect detachable call option bonds, but still must resolve a crucial reissuance question, federal officials and bond lawyers said last week.
The arbitrage issues were settled in the arbitrage rules published in June and the subsequent technical corrections issued in August. The rules and corrections became effective for bonds issued after Aug. 14 but also could be applied retroactively to outstanding bonds.
The new arbitrage rules say that when an issuer sells its call right, the bonds are treated as reissued for rebate purposes and the bond yield must be refigured after taking into account the money from the sale of the call right.
The technical corrections clarify that the proceeds from the sale of the call right must be treated as bond proceeds and, therefore, can only be invested at a yield below the bond yield.
IRS officials thought the rules issued in June had said the sale of the call right should be treated as bond proceeds, but published the clarification after bond lawyers said they were confused about the matter.
Still unresolved is the question of whether the sale of a call right would cause the bonds to be reissued, a development that could create tax law problems for the issuer and the investor.
These reissuance concerns, which may be dealt with in reissuance regulations that have not yet been issued in final form, only affect transactions in which the call rights are sold after the issuance of the bonds.
The concern for the issuer is that the reissued bonds would be subject the most recent tax laws and regulations, which could be more restrictive than the ones in effect when the bonds were first issued, industry officials said. If the reissued bonds do not comply with the most recent restrictions, the tax-exempt status of the bonds will be thrown into question, they said.
In addition, the officials said, investors probably would have a capital gains tax problem because the reissued bonds would be worth more than the bonds that were first issued.
An issuer would be most likely to sell the call right to its bonds when interest rates have fallen, a federal official said. The issuer would use the money from the sale of the call right to reduce its borrowing costs. But if interest rates have fallen, the value of the bonds will have risen. So if the bonds are reissued, the investor will owe capital gains taxes on the gain, he said.
It is not clear when the Internal Revenue Service or the Treasury will resolve the question of whether a reissuance occurs when an issuer sells its call right.
The IRS proposed a broad set of reissuance regulations last year, but the rules were controversial and did not directly address detachable call option bonds.
The proposed rules did, however, contain provisions that could be applied to detachable call option bonds.
Some bond lawyers believe that, under the rules, bonds would be reissued if the issuer sold the call right and the sale price was not fixed at the time of issuance.
Other bond lawyers and industry officials, however, have argued that the proposed rules would not apply to detachable call option bonds.
There are two arguments to support this view.
One is that the proposed rules were intended to cover actions between the issuer and the lender and, therefore, should not be applied to detachable call option bonds because the sale of the call right is between the issuer and a third party investor.
The other argument is that the rules seem to say that, for a reissuance to occur, the issuer must be required to receive a payment for the sale of the call right. While issuers typically are paid for selling their call right, there may be no requirement that they be paid, proponents of this view contend.