Basis of tax-exempt bonds.

While many high-yielding exempt bonds have been redeemed in recent years, some such bonds do remain outstanding. Those redemptions can present, in the case of original issue discount (OID) bonds, an opportunity for some tax planning.

OID bonds are those issued at a discount equal to at least the bond's redemption value times of 1% times the number of full years from the date of issuance to the date of maturity. Some of these OID bonds were issued with an intent, on the part of the issuer, to redeem the bonds before maturity. If that is the case, any gain realized on the sale, exchange or redemption of the bonds is ordinary income up to the amount of the OID (less any OID already included in income). If there was no intent to redeem the bonds early, the gain realized on the bonds' sale, exchange or redemption is ordinary income up to the amount of OID "earned" during the period the bond was held, not up to the full amount of the OID.

The IRS has applied the rule for bonds issued with an intent to redeem early to tax-exempt bonds issued after June 8, 1980, in Rev. Rul. 80-143. In that ruling, the taxpayer owned an OID tax-exempt bond that was not issued with an intent to redeem early. The bond was in fact redeemed early, at a price greater than the original issue price. Under prior rulings, all of the gain realized would have been interest income and therefore exempt from tax. However, the Service decided that it was more correct to apply the rule for most taxable OID bonds issued with an intent to redeem early to the redemption of tax-exempt OID bonds issued with an intent to redeem early. Those "amounts that are not treated as interest under section 1232(a)(2)(B)(ii) [requiring that some gain on the sale, exchange or redemption of OID bonds be treated as ordinary income] should [not] be treated as interest for purposes of section 103(c) [exempting interest on certain municipal bonds]."

The question of whether the rule for taxable OID bonds issued with an intent to redeem early should also apply to exempt OID bonds issued with an intent to redeem early is still open. It is arguable that the same rule should apply. The IRS explicitly relied on Sec. 1231 reasoning when there was no intention to redeem. Sec. 1231 reasoning could also apply then to exempt bonds when there was an intention, at the time of issuance, to redeem the bonds early. If this reasoning is correct, no gain or loss would be recognized by the holder of a tax-exempt OID bond issued with an intent to redeem early when such a bond is redeemed early (unless the redemption price exceeded the bond's maturity value). All of the gain realized (up to an amount equal to the OID) would be ordinary income. But such ordinary income, in the case of tax-exempt bonds, would itself be tax-exempt (Sec. 1271(a)(2)).

Equally uncertain, however, is what an intention to redeem is. In trying to explain an intention to redeem early under Sec. 1231, the IRS more fully explained what evidences the lack of an intention to redeem a bond early (Regs. Sec. 1.1232-3(b)(4)).

An intention to redeem is determined from all of the facts and circumstances of a particular case. Communication of that intention by the issuer to the ultimate purchaser is not necessary. Neither reservation of a right to redeem early nor a lack of a reservation of a right to redeem early is by itself dispositive of the issue; however, either fact would add to all the facts and circumstances used to determine whether an intention to redeem early did in fact exist. Similarly, the mere fact that bonds were or were not redeemed early is not by itself sufficient to show that an intent to redeem did or did not exist. Further, an intent to redeem early may be valid even if the redemption is to take place only if certain conditions are met.

Based on what indicates a lack of an intention to redeem a bond early, the strongest indication of an intent to redeem early would be a yield lower than that which comparable issuers would offer for a similar bond. Of course, other factors, such as the reservation of a right to redeem early or a history of early redemptions, would strengthen an argument that the issuer did intend to redeem the bonds early.

It should be emphasized that the mere fact that bonds were redeemed early because of lower interest rates, as has happened in the past, is not indicative of an intention to redeem early. If that were so, most bonds would be issued with an intention to redeem early, because most bond issuers will redeem high-interest bonds early if the issuer can save dollars. These regulations would be superfluous. Since the regulations were written, the intent to redeem early must require something more than a desire to redeem bonds if interest can be saved.

Therefore, it may be advisable for practitioners to examine the intent of issuers when a large dollar amount of a client's exempt OID bonds have been redeemed early. A considerable savings could be effected if the bonds were issued with an intention to redeem them early.