WASHINGTON - An Internal Revenue Service rule designed to prevent yield burning is unworkable and causing problems for some municipal issuers who want to invest bond proceeds in U.S. Treasuries, bond lawyers said this week.
The rule, which was included in allocation and accounting regulations that recently went into effect, aims to ensure that issuers investing in Treasuries take into account the fair market prices of those securities rather than artificially contrived prices that would lower their investment yield for rebate and yield restriction purposes.
The rule requires issuers to use the mean between the bid and the ask price of Treasuries - regardless of the price they actually paid - to determine their investment yield to comply with rebate or yield restriction requirements.
But bond lawyers say the mean price of a Treasury bond is virtually impossible to determine at any given time and almost never equals the price the issuer actually pays for the bond.
"In no event, except by pure luck, will the mean between the bid and the ask price be the same as the actual purchase price," said Richard Chirls, a lawyer with Orrick, Herrington & Sutcliffe in New York.
Typically, dealers sell at the "ask" price, or the price they are asking for the Treasuries, and buy at the "bid" price, or the price they are bidding for the securities, the lawyers said. Issuers thus usually pay more than the mean prices for the Treasuries they purchase, the lawyers explained.
As a result of the IRS rule, the lawyers said, if the mean price is lower than the price actually paid, the issuer may have to rebate arbitrage even though its investment yield is not above its bond yield.
The rule also wreaks havoc with issuers who purchase Treasuries for a refunding escrow that will be used to redeem previously issued bonds. Under yield restriction requirements, the yield on the Treasuries in the escrow cannot exceed the yield of the refunding bonds.
However, the lawyers said it is virtually impossible under the IRS rule to make sure the yield of the escrowed Treasuries will be below the yield of the refunding bonds, because an issuer never knows if it is purchasing a Treasury bond at its mean price.
The mean price of a Treasury may change during the day, they said, and often newspapers and financial services do not agree in their daily reports of the previous day's mean prices for these securities.
"You don't know the mean between the bid and ask at any given moment," said Richard Nicholls, a lawyer with the firm of Mudge Rose Guthrie Alexander & Ferdon in New York.
Mr. Chirls said the rule raises questions like, "Do you use the price information at the beginning of the day or the end of the day?" Another question is, at what point during a transaction should Treasury prices be taken into account - when an issuer informally commits to a price, when the issuer signs the bond purchase agreement, or when the bond transaction closes?
An IRS official said this week that the IRS is aware of these questions and may issue a technical correction to the rule. The correction would clarify that an issuer could use the actual purchase price of a Treasury bond in Determining its investment yield as long as the price was a fair market price and not a price contrived to distort its investment yield.
However, two lawyers from Squire, Sanders & Dempsey, a law firm based in Ohio, told IRS officials in a recent letter that a technical correction is unnecessary because the rule, as written, is of limited application.
Jackson Browning Jr., and William Conner said the rule applies only in situations where an issuer needs an interim valuation of a Treasury bond for rebate calculations because it is based on 1989 rules that were limited to such situations. The IRS rule does not apply in situations where an issuer is actually buying or selling Treasuries, they said.
"We're saying, 'Here's a way to interpret this rule, the mean between the bid and the ask price should be used only in situations where you need a deemed price for Treasuries - not where you have an actual price," said Mr. Conner.