WASHINGTON -- An overlooked tax law problem is creating heartburn for the market for tax-exempt notes with maturities over one year, the money market funds holding the notes and the bond firms and lawyers that put together the note offering statements.
The problem arose when a lot of market participants only recently discovered that the Internal Revenue Service's original issue discount and market discount rules cover tax-exempt notes with maturities of more than a year that do not pay interest at least annually -- even if the notes are sold at a premium.
Under the rules and a recent tax law change, if these notes are sold in the secondary market at a discount from their initial price, the investor ends up with market discount that must be treated as taxable ordinary income.
But taxable income is a dirty word in the tax-exempt market where investors and fund shareholders count on getting tax-exempt returns.
The short term note market has been rocked by the discovery of the tax law problem. The value of the notes has declined and investors are having trouble selling them, market sources say.
"Nobody will buy them. Your bids are not great bids because you've got market discount on them," said one market source who did not want to be identified.
"I hear people are quoting prices," said a lawyer in New York. "It's just that what they think are appropriate prices are not what the sellers want to hear."
In addition, tax-exempt money market funds, which may be holding billions of dollars of these notes, are having trouble maintaining stable daily average net asset values as required by securities laws because of the notes' declining value.
"This is a real concern for the funds," the market source said.
Moreover, some of the issuers and bond firms that sold these notes are worried that they may have violated securities laws by failing to disclose that the notes had original issue discount and could potentially saddle secondary market investors with taxable income.
There is a debate among bond lawyers about whether such disclosures were necessary. Some say they were not because the potential for market discount is only a concern for secondary market investors.
Other lawyers, however, say that it is common practice to disclose when bonds are subject to original issue discount and that, in the corporate note market, the potential for market discount is usually disclosed.
The tax law problem is particularly acute for the 13-month note market, which has grown significantly since last year when the Securities and Exchange Commission's proposed changes to its 2a-7 rules to allow tax-exempt money market funds to hold securities of up to 13 months in maturity.
"A lot of underwriters began issuing 13-month notes just like they had issued 12 month-notes," said one tax law specialist who did not want to be identified. "They didn't realize that changing the maturities from 12 to 13 months would have major tax consequences."
Tax-exempt notes under one year in maturity are not subject to the IRS' market discount rules.
The 13-month note market is especially big in California where cash-strapped localities with long-term economic problems have been more than willing to stretch their notes to 13 months, market sources say.
Bond lawyers and investment banking firms are scrambling to find a quick fix to the tax law problem. They want Treasury and the IRS to take some regulatory action to resolve it.
But so far, the tax regulators do not appear to be sympathetic. They say the market should have known that notes with maturities of more than a year could be subject to market discount, particularly since last April when there was a lot of teeth-gnashing in the market about new tax law provisions that changed the treatment of market discount from capital gains to ordinary income.
Bond firms are considering another possible option for eliminating the market discount problem -- having issuers refund the notes.
In the meantime, a lot of market participants are asking how the tax-exempt money market funds, their investment bankers and bond lawyers could have missed this tax law issue?
"The real story here is who screwed up and how much?" said one East Coast lawyer.
Market sources say that some money market funds and bond lawyers have been aware of the problem ever since the IRS' market discount rules took effect in 1984. But they did not care about the potential for market discount because, until last year's tax law change, it could be treated as capital gains and offset with capital losses.
Other market participants, who were also aware of the potential for market discount, were unconcerned because most short-term notes are sold at a premium. They thought the premium would serve as a cushion to avoid the problem.
The majority of market participants, however, seemed to have missed the potential problem and were treating these notes like premium bonds.
"The ones that knew didn't care because they could trade off capital gains for losses. But the vast majority didn't even know. They thought these were like premium bonds," the market source said. "So you had two classes of buyers, neither of whom cared," he said, "Now everybody cares because nobody can escape it. They realize it's a real problem."
The market caught onto the problem after investment bankers discovered it just before California was to go to market with $4 billion of 22-month revenue anticipation warrants. Orrick was bond counsel for the note issue.
A quick fix was devised by structuring the warrants so that they had two interest payments 11 months apart and would therefore avoid the original issue discount rules. The notes were sold at a premium to provide a cushion against the market discount rules.
Orrick's lawyers, fresh from a near-disaster with the warrant issue, then became concerned they faced a similar but slightly different problem with $3 billion of revenue anticipation notes that California planned to price last Wednesday. These notes had maturities of one year.
The Orrick lawyers believed that these notes, if sold in the secondary market at a discount from their initial price, could saddle investors with taxable capital gains.
The problem, according to Orrick's lawyers, stemmed from the fact that the IRS' final original issue discount rules. which were issued in January and took effect in April, dropped a cross reference that had been in earlier proposed rules. The cross reference, they claimed, had exempted tax-exempt notes with maturities of less than a year from certain provisions of the original issue discount rules.
Without the cross reference, they said, the interest on these notes would be treated as part of the redemption price. In other words, the notes would be treated like zero coupon bonds so that the discount, if purchased in the secondary market at a discount from the initial price, would be treated as capital gains.
The Orrick lawyers -- George Wolf in San Francisco and Richard Chirls in New York -- contended this problem threatened not only the pending California deal but also the other $10 billion of under one year tax-exempt notes that had been issued since April when the original issue discount rules took effect.
On Monday they began lobbying the Treasury and the IRS to take regulatory action to fix the problem so that California could proceed with its note issue, which is to close in two days.
On Tuesday, the IRS issued a notice announcing that market participants did not have to apply certain provisions of the final original issue discount rules to notes with maturities of one year or less.
A lot of market participants are now blaming Orrick for the controversy in the short-term note markets, some of which they say was unnecessary.
Several lawyers and tax experts say there should not have been any problem or controversy in the under one year note market, that the prevailing view among bond lawyers has been that the original issue discount rules do not apply to notes with maturities of less than a year.
"I think they created confusion in the one-year and under note market as a smoke screen to cover up the fact that they've screwed up on the longer-term notes," said the tax law specialist.
"They spooked the market and Treasury. They spooked everybody," he said, "But that cross-reference was not meant to be used in the context that Orrick is using it. It wasn't meant to apply to under one year tax-exempt notes. It was meant to be used when you were applying the rules for taxable bonds."
The East Coast lawyer agreed. "If it's a problem, it was a problem since last April when the final original issue discount rules took effect, it isn't a new problem," he said.
Other lawyers said they already knew about the tax law issue with regard to notes with maturities over one year.
The Orrick lawyers "wanted to make themselves look like heros. They act like they discovered something nobody else knew about. But it's not fair to blame the whole market. A lot of us were already aware of this problem," another East Coast lawyer said.
Orrick's lawyers could not be reached for comment.
