IRS Audits Conduit Offerings

WASHINGTON — The Internal Revenue Service is auditing the tax-exempt bonds in a number of conduit deals where the borrowers entered into total return swaps and is questioning whether the bonds may be taxable because of arbitrage rule violations, market participants said Monday.

The first IRS audit of this kind to publicly surface involves $16.6 million of revenue bonds issued by the New Jersey Health Care Facilities Financing Authority in 1994. The conduit borrower, which was originally the Jersey Shore Medical Center Obligated Group but is now Meridian Hospitals Corp., entered into a total return swap with a dealer in 2006, sources said.

The authority has received three information document requests from the IRS and the latest one stated that “the bonds are taxable bonds as a result of failing to comply with Internal Revenue Code Section 148” on arbitrage, the issuer said in a recent event notice it filed on the Municipal Securities Rulemaking Board’s EMMA system. The authority cautioned that the IRS has not officially determined the bonds are taxable.

“Importantly, the IRS has not issued an adverse tax opinion, a proposed or final determination of taxability or a Notice of Proposed Issue with respect to the tax status of the bonds,” it said. “Moreover, in the most recent [information document request] the IRS has described a number of facts and made certain assumptions that are contrary to the borrower’s understanding.”

The authority said it and the borrower are providing documents to the IRS and that the borrower is fully cooperating with the agency. “It is unknown at this time what the outcome of the IRS examination will be,” the authority added.

Neither authority officials nor lawyers with McCarter & English LLP in Newark, N.J., which is representing the borrower, would comment beyond the information in the event notice. Sources said Cain Brothers helped structure the total return swap entered into by Meridian and often served as a kind of middleman in total return swaps. The firm’s executives were unavailable for comment.

But market participants said the dozens of total return swaps have been done during the last 10 years, typically in the hospital-health care sector, and that the IRS is currently auditing a number of them.

One source who did not want to be named said most of the Wall Street firms and the big regional firms have done these kinds of swaps.

“These were not controversial structures by some were “very aggressive from a tax standpoint,” said another market participant who did not want to be named. “There have been a lot of big-name law firms that have given opinions on these,” but many of them demanded that the transactions be structured in certain ways to avoid tax law problems, he said.

These transactions typically involve long-term tax-exempt bonds sold by hospitals or health care providers. Typically the bonds were insured. If the borrower wanted to refund the bonds because of lower interest rates, it could not do so because of restrictions on refundings or because the insurer was no longer was willing or able to insure the bonds.

When the bonds became callable, the issuer would announce the call, and would put out a tender notice for the bonds, typically offering a better price for bondholders that would tender the bonds back to it ahead of the call. The goal of the issuer and borrower would be to have all of the bonds tendered back so they could be sold to a dealer. The dealer would put the bonds into a tender-option bond program.

At the same time the borrower would enter into a total return swap with the dealer for a short period, such as three years. The bonds would still have the original interest rate, for example, 5%. Under the swap, the dealer would pay the borrower that 5% interest rate in exchange for the borrower’s paying the dealer a much lower variable interest rate, perhaps 1.5%.

The borrower also agrees that, at the end of the swap transaction, it will pay the dealer the difference between the par amount of the bonds and the value of the bonds when the swap terminates if the value of the bonds is less than par. Often the value of the bonds is less than par.

The borrower gets a lower net cost of borrowing and the dealer gets whatever spread it can earn in the TOB program.

Market participants believe the IRS may be questioning whether the issuer’s bond yield should be lower than reported by the issuer, and the issuer may have earned illegal arbitrage, if one takes into account the fact that’s its borrowing costs were reduced by the total return swap. q

But one lawyer questioned the IRS’ reasoning, saying these transactions did not involve a so-called “qualified hedge” if the total return swap were entered into more than 15 days after the bonds were issued. In a qualified hedge, the issuer must take both the bonds and swap into account in determining its bond yield.

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