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Bifurcation rules revisited.

Corporate

Several months ago Merrill Lynch created MITTS (market index target term securities), a debt instrument promising to pay at maturity the instrument's issue price plus a contingent payment equal to 115% of any increase in the Standard & Poor's 500 index.

These instruments were subject to "bifurcation" rules so that, for tax purposes, a MITT was treated as two separate instruments--a zero coupon bond (bearing original issue discount) and a cash settlement option on the S&P 500 index.

At issue was whether the option would be viewed as a listed nonequity option. If so, a holder would be constrained to mark the instrument to market each year and pay tax (prematurely) on the unrealized gain. Due to the uncertainty of whether the option created by the bifurcation rules should be regarded as listed, it was reported in the press that Merrill Lynch marketed the produced exclusively to tax-exempt investors.

Merrill Lynch has now created a second generation MITTS product-known as SMART Notes (stock market annual reset term notes)that it believes can be sold to taxable investors. The five-year notes make interest payments (subject to a floor and ceiling) at an annual rate equal to 70% of the increase in the S&P 500 index.

Again, the bifurcation rules apply and, in this case, the rules would treat each note as a debt instrument and a series of six sequential cash settlement options on the index.

Tax attorneys, however, have opined that if the options are renot affect a calendar-year tax-payer. In this situation, such a taxpayer would be taxed only on the gain attributable to the option paid during the year.

There would be no requirement to mark to market the ensuing options (known as the "cold S&P right"--the right to payments based on the following years increase in the S&P index) at the close of a year. This is because as of the last business day of the year, the exact terms of the cold S&P right are not set.

Observation: Without commenting on the efficacy of this position, it is safe to say the IRS needs to clarify the scope of the bifurcation rules, particularly with respect to the nature of the option that invariably results from application of the rules.
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Publication:Journal of Accountancy
Article Type:Brief Article
Date:Dec 1, 1992
Words:379
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