WASHINGTON -- The Internal Revenue Service may never resolve the main tax law issue facing the municipal swap market: whether an issuer must take into account the payments or receipts from a swap contract in determining the yield of the related tax-exempt bonds, agency officials say.

The issue -- put more broadly, whether a municipal swap contract should be integrated with the bond issue it hedges for tax purposes -- is becoming increasingly important as the firth anniversary of the tax reform act rolls around and more municipal issuers begin rebating arbitrage to the federal government.

"The only real issue for municipal issuers, from Treasury's perspective, is what to do about arbitrage," said Thomas A. McGavin Jr., a lawyer with Rogers & Wells in New York.

But IRS officials say that in trying to come up with rules on integration for arbitrage and other tax purposes they have been stumped by the complexities of municipal swap transactions and concerns that the IRS may not have all of the authority it needs for such a regulatory project.

"It's certaintly something we've considered. But we don't know how we're going to go about resolving it, if we resolve it at all," one agency official said last week. "The two major difficulties we have with a major regulatory project in that area are complexity and authority."

'Notional' Principal Amount

In a municipal interest rate swap, an issuer pays floating rates on fixed-rate debt or fixed rates on floating-rate debt based on a swap contract with a financial institution that is called the swap counterparty. The payments are based on a "notional" principal amount of the bonds, so-called because the principal is never actually exchanged.

Some bond lawyers have theorized that the IRS and Treasury may never settle the integration issue for arbitrage purposes, because they cannot win from a revenue standpoint.

"The reason the IRS is unable or unwilling to decide what to do is they cannot answer the question, 'Which is better for the Treasury? '" said a New York lawyer who did not want to be named. "Some swap transactions would hurt Treasury and others would help it" in terms of revenue, he added.

For example, if an issuer sells floating-rate debt and swaps to get fixed-rate payments, it might be in the Treasury's interest to require the issuer to use the bond yield for arbitrage purposes. Floating-rate yields are typically. Floating-rate yields are typically lower than fixed-rate yields, and the bond proceeds would have to be invested at a lower rate t avoid arbitrage earnings.

But if the issuer sells fixed-rate debt and swaps to get floating rate payments, the Treasury might prefer to integrate the swap payments with the bond yield for the same reason.

IRS officials are offended at the notion that they would craft rules to raise revenue. "We don't sit around here and try to figure out ways to maximize revenues," the agency official said. "Our goal is to write good guidance for the market."

And one problem for the IRS, he said, is that there are many variations of swap transactions and they are all relatively complex. For example, a swap contract may last only five seven years, but the related bond issue might not mature for 20 or 30 years. The swap may be for a notional principal amount that is less than the principal of the related bonds. Or the swap agreement might be entered into months or years after the bonds are issued.

"How are we supposed to take all of these things into account?" asked the IRS official. Doing so would likely take a set of rules even more complex than the much-criticized arbitrage rebate rules, he said. And, he added, ever since the rebate rules were issued, officials at the IRS and Treasury have become "very sensitive about trying to rule the world with a set of regulations."

In particular, the integration issue for swaps does not lend itself to "a nice clean solution," he said.

The question about whether the IRS would have the authority it needs for such rules stems from the concern that integration -- while in some cases a good idea from a tax standpoint -- could cause swap transactions to generate more tax-exempt income than would have come from the related tax-exempt bonds. That would not sit well with the policymakers at the Treasury or Congress, the official said.

Last year, the IRS issued a private letter ruling that allowed a tax-exempt bond issuer to integrate the swap payments with its bond yield for arbitrage purposes. But IRS and industry officials said the transaction on which the ruling was based was so unusual that it would not represent 99% of the municipal market transactions that have occurred or could be expected to occur.

In that transaction, a state housing authority was to sell $100 million of variable-rate mortgage revenue bonds to finance fixed-rate 30-year mortgages and would swap fixed-rate payments for floating-rate payments.

But that transactin was unusual in that the swap contract was entered into at the time the bonds were issued, the term of the contract matched the term of the bonds, and the payments that the issuer and insurance company were to make were based on the same amount of notional principal. And in a rare circumstance, the variable specified index of the swap was equivalent to the remarketing rate for the variable-rate bonds in the transaction.

Further, industry officials say, the swap was integral to the bond issue. "That transaction was fully integrated," said the New York attorney. "The swap had to be there to pay the bonds." And swap transactions, he added, are seldom like that.

Need for Further Guidance

Nevertheless, some bond lawyers are concerned that a few issuers are mistakenly relying on that ruling in their own swap transactions to integrate the swap with the bonds.

Without further guidance, what is an issuer who participated in a swap transaction supposed to do in determining its yield for arbitrage computations?

"Assume you don't integrate" and use the bond yield, said a Treasury Department official. He noted that integration also relates to other tax issues besides arbitrage that are likely to have more of a financial impact on the parties to a swap transaction. And the IRS stated in rules proposed last July on interest rate swaps and other so-called notional principal contracts that agency rules do not now permit integration but that it was considering whether to permit taxpayers to integrate swap agreements with bonds or other any assets and liabilities that the agreements hedge.

Apart from the arbitrage question, the IRS has published rules or plans to publish rules on other tax law issues that generally affect the municipal swap market.

One set of rules that was proposed in 1989 and published in final form earlier this year resolved the issue of whether the U.S. party or the foreign party in a global swap transaction would be considered the source of income for tax purposes. Under these rules, the income from the swap will be "sourced" by residence to the recipient of the swap payments. So if net payments from the swap are made to a swap counter-party in the United Kingdom, the payments are taxable income in the United Kingdom.

The notional principal contract rules proposed last July provide guidance on when income and deductions are recognized for tax purposes for interest rate swaps and other notional principal contracts.

They provide methods for amortizing non-periodic payments and requirements for netting and acrual of periodic payments from a swap. The rules say that upfront swap payments must be amortized or spread out over the life of the swap agreement. They say that the periodic payments by the issuer or swap counter-party must be netted and accrued to the end of each tax year.

Swap market participants generally praised these proposed rules for taking the right approach, but complained about certain policy calls in the rules such as the embedded loan concept.

The Embedded Loan Concept

Under that concept a swap that has significant non-periodic payments is treated as having an embedded loan that must then be treated as a loan for tax purposes independently from the swap. Industry officials urged that the concept be eliminated from the rules, but said if it is kept, the IRS should provide a test for determining when non-periodic payments would be significant enough to result in an embedded loan.

Another regulatory issue that must still be resolved, but has become confused by a recent Supreme Court case, involves the socalled character of interest rate swaps and other hedlges. The issue here is whether an interest rate swap is a capital asset that is subject to capital gains and losses.

IRS and Treasury officials seemed to be comfortable with the notion that these kinds of transactions were not capital assets if used as hedges. But the Supreme Court confused the issue by suggesting in the case of Arkansas Best Corp. v. Commissioner of Internal Revenue that the only exceptions to capital asset treatment were the five exceptions specified in Section 1221 of the Internal Revenue Code -- none of which are swaps or other hedging transactions.

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