WASHINGTON -- Technical corrections to the arbitrage rules issued by the IRS yesterday would allow bonds with derivatives that provide issuers with fixed costs to be treated as having a fixed yield for arbitrage purposes.

The several dozen technical corrections also would affect tax and revenue anticipation notes, so-called double-barreled bonds, and bond issues that are exempt from arbitrage certificate requirements.

A few of the technical corrections were issued in final form and one in proposed form. Most of them were issued in temporary and proposed form, which means that they will take effect early next month but are subject to public comment and possible revision. Public comments are due 60 days after the corrections are published in the Federal Register.

The IRS said it would give issuers the option of applying the technical corrections to any bonds that are subject to the final arbitrage rules that were issued last June.

Almost half of the technical corrections are revisions to the arbitrage rule's hedging provisions, and most of these are aimed at expanding the kinds of municipal derivative products that will be treated as "qualified hedges" or as fixed-yield bonds. In a transaction that is treated as a qualified hedge, an issuer can integrate the bond and the hedge for arbitrage purposes. The transaction must meet additional criteria to qualify for fixed-yield treatment.

The current arbitrage rules treat as fixed-yield only interest rate swaps in which the issuer makes fixed-rate payments and receives floating-rate payments. Municipal derivatives market participants complained that the rules are too limited and could halt or hinder the use of some of the derivative products that have become commonplace in the municipal market.

Issuers typically want fixed-yield treatment for their bonds so that their yields remain constant and accurately reflect their interest costs. This is especially the case for refundings because variable yields can have disastrous economic consequences for issuers.

The Public Securities Association had argued that tax-exempt bonds with derivatives that provide issuers with fixed costs should be treated as fixed-yield for arbitrage purposes.

The IRS and the Treasury appear to have agreed with them in the technical corrections which would treat as fixed-yield most hedges in which the issuer's net costs over the term of the issue, taking into account the bonds and the hedge, are fixed. This would includes interest rate swaps, swaps on inverse floating-rate bonds, bonds with caps, and other products.

However, the IRS makes clear in the preamble to the proposed and temporary technical corrections that even though the revisions to the hedging provisions provide fixed-yield treatment for embedded derivative products, this is no guarantee that the interest payments will be treated as tax-exempt under the IRS' forthcoming contingent interest rules.

The technical corrections include a new rule outside of the arbitrage rules' hedging provisions specifying that matching floating-rate and inverse floating-rate bonds, like Lehman Brothers' RIBs/SAVRs [residual interest bonds/select auction variable-rate bonds], would be treated as fixed yield for arbitrage purposes. Under the current rules these are treated as variable-rate rather than fixed-rate.

Meanwhile, technical corrections to the hedging provisions clarify that forward or anticipatory transactions would be treated as qualified hedges and, in certain cases, as fixed-yield bonds.

Transactions in which an issuer enters in a forward swap and gets an up-front payment from the counter-party would be treated as qualified hedges, despite the up-front payment.

Hedge transactions would qualify for fixed-yield treatment, if the hedge is terminated within five years and the bondholder converts to a fixed-rate, as long as the issuer's costs do not change.

In the case of a hedge that was terminated because of bankruptcy or insolvency of the hedge provider, an issuer could seek a ruling from the IRS commissioner that this would not cause the bonds to retroactively become variable-rate bonds.

"We wanted to deal with these on a case-by-case basis," one Treasury official said.

In order for bonds to qualify as hedge bonds, issuers must identify the hedge within three days after entering into it. Issuers must also give additional information for forward or anticipatory hedges, such as the expected purpose of the issue, its date, and size.

Under one proposed technical correction that would not take effect unless it is adopted in final form, bonds with caps would have to meet three criteria to avoid being treated as "investment property" that is subject to all of the arbitrage restrictions.

Under these criteria, the caps would have to be paid for by the issuer in level installments; would have to have a rate that is not below the on-market swap rate; and could not hedge a bond that is not a variable-rate debt instrument, as defined within IRS' rules on original issue discount.

If adopted, these provisions probably would mean that issuers would not be able to do leveraged embedded cap bonds, the Treasury official said.

In other technical corrections issued yesterday, issuers would not have no prepare arbitrage certificates for tax-exempt bond issues of up to $1 million in size. This would be a significant change to the current rules, which exempt from the arbitrage certificate requirements only those issues of less than $250,000.

The IRS also would revise its definition of a bond issue to clarify that when issuers sell so-called double-barreled bonds (bonds that have both a primary and a secondary source of repayment) and non-double-barreled bonds at about the same time, both sets of bonds can still qualify to be treated as a single issue.

The technical corrections include a safe harbor that could be applied in financing working capital reserve in tax and revenue anticipation note transactions. The safe harbor allows issuers to use their average monthly balances for prior one-year period to determine if they have maintained a working capital reserve, which would allow them to finance the reserve as well as their cash flow deficit.

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