DENVER — Discussions with swap advisers and a look at thousands of swaps have given the Internal Revenue Service a good idea of the basis-point spread into which roughly 90% of the municipal bond market falls when paying for swap-related services, according to an agency official.
Michael J. Muratore, senior tax law specialist in the IRS’ office of tax-exempt bonds, declined to specify numbers for that range but said the agency plans to use them when conducting audits to determine whether payments seem appropriate. He summarized some of the agency’s preliminary findings from correspondence examinations of about 50 swap transactions at a meeting of the American Bar Association’s tax-exempt financing committee here late Friday afternoon.
Attorneys at the session had strong reactions to Muratore’s report, arguing that municipal market forces will do the work of enforcement efforts by pushing out any firms that overcharge issuers for swap-related services. They also contended that bond counsel are not in the position or business of valuing swap transactions because the quantitative analysis is out of their range of expertise.
Muratore stressed that the IRS has not reached any formal conclusions about its findings yet and has not determined that bond counsel have any “new” responsibilities. He said the IRS wanted to look at derivatives on the bond side because it had previously examined structured finance only in terms of investments made with bond proceeds.
Exponential growth has characterized the municipal derivatives market in recent years, and Muratore said the IRS had heard from other regulatory bodies that underwriters were placing greater emphasis on the financial products, which are used to hedge interest rate risk on municipal bonds. In a typical swap, an issuer of variable-rate bonds and a counterparty agree to swap fixed- and variable-rate payments on the bonds.
Muratore said the agency decided a few months ago to look at a sample of issues in three broad categories: the qualification of hedges; whether the accounting of hedges was done properly, via yield computations and spot-checks of payments; and the valuation of hedges. Such elements are part of the calculation of bond yield, which partly determines the amount of legal arbitrage issuers can earn on invested bond proceeds.
In opening the correspondence exams, the IRS sent letters to issuers who had done interest rate swaps and other derivatives transactions at least six years ago. The letters requested:
— Original bond documents, including the official statement, Form 8038, and the tax certificate.
— Rebate calculations.
— Documents related to the hedge transaction.
— Records showing actual payments made or received on the hedge that were taken into account when computing the yield on the bonds.
— Records showing any other payments related to the hedge that did not go into bond yield calculations.
— Records related to the hedge identified on information returns.
— Documents related to any hedge subsequently entered into by the issuer.
The IRS also asked issuers to represent that amounts included in their computations of bond yield fell into one of three categories permitted by tax code regulations — that they were related modification of interest rate changes, a hedge provider’s overheard, or a termination payment — and whether any of the five events deemed to be terminations of a hedge had taken place, Muratore said.
In the cases worked up since then, which he said number “less than 50,” the IRS has come across two super-integrated London Interbank Offered Rate swaps — an ambiguous section of the tax laws on which attorneys and issuers have requested clarification for several years — but which were not related to advance refundings, and so were “a little less exciting,” Muratore joked.
It also found at least one anticipatory hedge, at least one “cap,” which unlike a swap is a type of “one-sided” hedge, and a couple of issuers that had not paid arbitrage rebate prior to receiving the correspondence exam letter.
While the agency’s approach to swap valuations is still “preliminary,” its general direction has come together as a process that starts with the mid-market rate for swap provider services and adds various amounts for the cost of the hedge, the credit risk, and dealer profit, Muratore said.
In discussions with swap advisers and examinations of thousands of derivatives transactions, the IRS has observed a basis-point spread into which “roughly 90% of the market falls,” and will go forward using that range in determining whether payments appear appropriate, he said. When asked, Muratore declined to provide specific numbers and cautioned that the IRS is still collecting research and data. “If people have suggestions about how we should look at this, we’re happy to hear that,” he said.
Michael G. Bailey of Foley & Lardner LLP in Chicago indicated to Muratore that applying a standard basis-point range to a universe of different transactions was inconsistent with what bond counsel hear from swap advisers — that each deal needs to be assessed on its own facts and circumstances.
“Are you suggesting it would be a good idea for bond counsel to ask what the spread is above mid-market?” he asked. “It might not mean anything to us. Lawyers aren’t going to have the ability to evaluate [the numbers].”
Bailey said the IRS could adopt a rule that the pricing of the swap will be presumed to be on-market and fair if the issuer or borrower obtains a certificate from an independent financial adviser with respect to the pricing.
David A. Caprera of Kutak Rock LLP here advised the IRS to take credit enhancement fees into account in its calculations.
“If I’ve got an issuer that’s a lousy credit, I’ve got two choices: I can enter into a swap, have a big spread, and get audited,” he said. “Or [I can] pay a credit enhancement fee. Now I’m a triple-A rated swap and my spread’s within your statistical range, and I don’t get audited. It seems to me that if you don’t take credit enhancement fees into account … you’re going to force all these guys into the mode of getting credit enhancement if they want to avoid being audited.”
Attorneys also urged the IRS to recognize that the municipal market will force out “bad” underwriters, swap advisers, and other parties that overcharge issuers for services related to derivatives transactions.
“Every underwriter who wants an issuer as a client will examine the client’s previous issues and swaps, and loves nothing more than saying, ‘Boy did you get taken,’ ” one audience member said.
“If someone’s going to overcharge, people are going to go to someone who charges less,” another pointed out. “The whole market can’t conspire, and since the goal of the issuer is to pay as little as possible, why isn’t this eventually going to work itself out?”
Appearing on the enforcement panel with Muratore and Bailey was ABA committee chair Clifford M. Gerber of Sidley Austin LLP in San Francisco. Before and after Muratore’s report on swaps, Gerber and Johanna Som de Cerff, senior technician reviewer in the IRS office of chief counsel’s tax-exempt bond branch, discussed regulatory developments, namely the recently released allocation and accounting regulations and proposed rules for payments in lieu of taxes, or PILOTs.
Those rules, which could be finalized as soon as Feb. 16, attempt to clarify phrasing in the tax code that requires PILOTs to be “commensurate with” generally applicable taxes and delete a line from the end of the current regulations relating to the special charge limitation that was deemed somewhat confusing, Som de Cerff said.
PILOT deals are typically done for economic development projects and involve payments from a private entity used instead of tax revenues to pay debt service on tax-exempt bonds. An issuer normally takes title to a parcel of land, thereby removing it from the tax rolls, and allows a private business to use the property while charging the user PILOTs based on the amount of real property taxes that would otherwise be payable on the land. The amount of the PILOTs could be a percentage of the actual taxes on the property, or the lesser of a fixed payment schedule and actual taxes on the property, for instance.
To comply with private-activity restrictions for municipal bonds, those PILOTs must be less than and “commensurate with” the taxes that would have been collected on the property otherwise, and may not be special charges as defined in tax code regulations.
The proposed regulations specify that PILOTs cannot be tied “in any way” to debt service on related bonds, but instead must be a fixed percentage of, or a fixed adjustment to, the generally applicable taxes that would otherwise be due.
Bruce Serchuk, a partner with Nixon Peabody LLP, was bond counsel for two PILOT deals done recently by the New York City Industrial Development Authority- that favorable IRS private-letter rulings for transactions which would not appear to be permissible if the proposed regulations applied to them. He asked Som de Cerff about what drove the agency to add the requirement that PILOTs be linked more closely with generally applicable taxes.
“What we’re aiming to do here is to be in a better position to look at a payment and see that it is derived from” or resembles the generally applicable taxes that would be due on a property if it was not tax-exempt, she responded. “You could start with that and negotiate various other things to come up with a number that’s needed to support the debt service [but] the key is, what is it based on.,” She said there should be a the nexus between generally applicable taxes and the payment being made.
Attorneys at the session suggested that it would be simpler and more workable for the regulations to require that PILOTs are less than generally applicable taxes.
And Serchuk argued that the regulations accommodate a narrower class of PILOT structures than the current regulations — to the exclusion of commonplace techniques such as contracts calling for PILOTs based on incremental upward adjustments of the percentage of the assessed value of the underlying property that is included in the PILOT computation during the early years of a project — to allow the enterprise to get on its feet.
Issuers want flexibility with the forms of subsidies they provide, according to Serchuk: “The decision should be left to the local government whether it wants to charge 0% [of generally applicable taxes], 100%, or just what it needs to finance a project. Issuers should be given the opportunity to do what they please with tax revenues.”
Larry Carlile of Kutak Rock LLP here pointed out that PILOTs are part of a transactional concept that inherently includes debt service, so the proposed regulations’ language stipulating that PILOTs that are “in any way connected” with debt service is troubling.
“The ‘in any way’ language makes you a little nervous, because in most bond transactions paid from PILOTs, those payments are in some way, shape, or form related to the debt service,” Serchuk said.
Som de Cerff remarked that the IRS is in the “observing” stage on the proposed PILOT rules and will consider those and other concerns expressed before the Jan. 16 comment deadline. A public hearing on the regulations is scheduled for Feb. 13.
Som de Cerff also outlined the Treasury Department-IRS “cleanup” project for the arbitrage regulations, which is still in the planning stages.
As other officials have indicated, potential items that could be the subject of new guidance under the project include Libor and other swaps, yield reduction payments, the qualification of interest rate hedges, electronic bidding for guaranteed investment contacts, and concerns related to the “issue price” of municipal bonds.
Gerber and Scott R. Lilienthal of Hogan & Hartson LLP in Washington suggested federal regulators consider pursuing the arbitrage regulations project in two segments. One would be for the more esoteric issues that require a lot of deliberation, such as super-integration of swaps and bonds. The other would be for the more immediate and current issues that have “easy fixes,” such as yield-reduction payments — when an issuer can just “open up [its] checkbook” to rebate excess escrow earnings to the IRS — and Libor swaps in the context of advance refundings.
The tax-exempt bond branch of chief counsel is trying to figure out “what can we do, what can we handle,” Som de Cerff said. “This is one of those things [where it might be better] not to get to the little esoteric points and nail everything down,” but rather create a “middle zone” of rules regulators can easily administer.
She also said attorneys, issuers, and other market participants can aid federal regulators by submitting comments that explain why a proposal is “a good thing,” who it will help, how much of the tax-exempt bond universe it takes care of, what kinds of transactions or types of bonds it applies to, and so forth. “You need to bring that to get support for [suggested changes]; whether it’s an economic thing … and provide real-world examples,” she said.
When asked about what precise concerns IRS enforcement and regulatory staff have regarding issue price, Som de Cerff did not answer specifically but said the issue is “definitely on the wish list” for the arbitrage regulations cleanup project, and said recent comments from the National Association of Bond Lawyers on the topic were very helpful.
