In an action that could affect numerous transactions across the country, the Internal Revenue Service has determined that revenue bonds issued by a New Jersey authority for the Deborah Heart and Lung Center are taxable because the borrower entered into a total return swap.
The IRS' "proposed adverse determination," disclosed by the center (the borrower) in a material event notice filed with EMMA, is likely to spell trouble for a number of conduit deals in which the borrowers, including many hospitals and health care providers, entered into total return swaps after bonds were issued.
In its event notice, the center said the New Jersey Health Care Facilities Financing Authority (the issuer) received the IRS adverse determination on July 24 with regard to $37.4 million of revenue bonds it issued in 1993, about $17.6 million of which remain outstanding.
The authority issued the bonds and lent the proceeds to the center to finance renovations, additions, and the acquisition of equipment for hospital facilities in Browns Mills, N.J., according to the official statement.
"The IRS contends that certain post-isssuance transactions, including total return swaps that occurred in 2004, effected an amendment to the bonds, which cause a 'reissuance' of taxable bonds, and that the transactions utilized an abusive arbitrage device 'creating additional arbitrage investment opportunities for the borrower,'" the center said.
"The proposed adverse determination, if not reversed or settled, may result in the taxability of interest on the bonds to the beneficial owners," it said.
The IRS told the authority it has 30 days to request a review of the finding by the IRS Office of Appeals.
"In the proposed adverse determination, the IRS described a number of facts, made certain assumptions and reached certain conclusions, which the borrower disputes," the notice said.
"The borrower is in the process of assessing its response to the proposed adverse determination, and intends to coordinate and cooperate with the issuer with respect to any such response," the center said, adding, "It is unknown at this time what the outcome of the proposed adverse determination will be."
The IRS has been auditing the bonds since at least 2011 and had warned the issuer in November of that year that the bonds might be taxable because of the total return swap.
The IRS also suggested in November 2011 that bonds issued by the authority in 1994 for Jersey Shore Medical Center Obligated Group, now Meridian Hospitals Corp. were taxable because of a total return swap. But the authority has not reported on EMMA that the IRS has issued a proposed adverse determination letter in that case.
In these transactions, the bonds are typically insured. If the borrower wants to refund the bonds because of lower interest rates, it cannot do so because of restrictions on refundings or because the insurer is no longer willing or able to insure the bonds.
When the bonds become callable, the issuer will announce the call, and will put out a tender notice for the bonds offering a better price for bondholders then they would get if the bonds are called at the call date. The goal of the issuer and borrower is to have all of the bonds tendered back so they can be sold to a dealer. The dealer then puts the bonds into a tender-option bond program.
At the same time the borrower enters into a total return swap with the dealer for a short period, such as three years. The bonds still have their original interest rate, say 5% for example. Under the swap, the dealer pays the borrower that 5% interest rate in exchange for the borrower's paying the dealer a much lower variable interest rate, say 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. The intent is for the borrower to get a lower net cost of borrowing and the dealer to get whatever spread it can earn in the Tender Option Bond program.
The IRS appears to be basing its adverse determination on two theories.
One is that the total return swap effectively causes the bonds to be reissued as taxable bonds because the issuer was not involved in the secondary market swap transaction the nonprofit borrower cannot issue tax-exempt bonds. It can only borrow the tax-exempt bond proceeds from the issuer.
Some bond lawyers contend the total return swap cannot cause a reissuance because there was not a material change to the bonds that would cause a reissuance. The center is still making the same payments to the issuer and the issuer is still making the same payments to the bondholders, they say.
The IRS' other claim is that, even if the total return swap did not cause a reissuance, it was an "abusive arbitrage device" and that the swap was a qualified hedge that should be integrated with the bond issue. Integration would have the effect of lowering the bond yield so the issuer's investment yield was higher than the bond yield and it earned illegal arbitrage.
Bond lawyers argue that the transaction participants never intended for the total return swap to be a qualified hedge.
However, under section 1.148-10(e) of Treasury rules, if the IRS Commissioner finds that an issuer entered into a transaction for the purpose of obtaining a material financial advantage based on the difference between tax-exempt and taxable interest rates in a manner that is inconsistent with section 148, [he or she has the] "discretion to depart from the rules of section 1.148 ... as necessary to clearly reflect the economic substance of the transaction." In this case, the IRS argues, the commissioner can treat the total return swap as a qualified hedge, so that its yield must be integrated with the bond yield.