FSA forgoes conventional wisdom in characterizing a remarketing payment under a callable/puttable bond.
The conclusion of the FSA, however, is inconsistent with the current general treatment of these payments by issuers of these types of bonds. Many issuers treat the remarketing payment as an option premium received in connection with a hedging transaction (the call right) that relates to the yield on the remarketed bond. The issuers then generally defer recognition of the premium under the hedge-timing rules of Regs. Sec. 1.446-4. Although the FSA does not constitute authority binding on either the Service or taxpayers, it reflects a potential IRS litigation position.
Corporations issue bonds that allow the holders to "put" the bonds back to the issuer after a stated period. Because of the put right, holders accept lower interest rates than on other bonds. In the past several years, investment banks developed the callable/puttable bond structure, which further lowered interest costs. These callable/puttable bonds effectively bundle an interest rate option with a puttable debt instrument. The investment bank effectively exercises the option when it exercises its right to remarket the bond.
While the corporate issuer benefits from lower interest costs, the dealer benefits by the purchase of the embedded-interest-rate option at a lower premium (cost) than if it purchased a separate option in the derivatives market. These bonds have been issued under several names, such as Remarketable or Redeemable Securities, Puttable Reset Securities and Mandatory Puttable/ Redeemable Securities. Callable/puttable bonds are issued with a stated maturity of 10 to 15 years. The bonds, however, provide for a "reset" or "remarketing" date two to five years out. At this date, an investment bank (i.e., the dealer) has a call right to purchase the bonds from the holders at the face amount (i.e., call right) and remarket them.
If interest rates have decreased since issuance, the bonds' value would exceed the face amount and the dealer can realize a profit by exercising the call right and remarketing the bond. This effectively results in resetting the interest rate from the remarketing date to the stated maturity date based on a predetermined formula. This formula effectively resets the interest rate at an above-market rate (based on the longer term and the issuer's current credit ratings). If the dealer does not exercise the call right (because of an increase in interest rates), the issuer typically must redeem the bonds from the holders. The holders benefit from the redemption because they terminate at below-market interest rates.
FSA 200142005. FSA 200142005 addressed whether the timing of the recognition of the remarketing payment was income taxable to the corporate issuer. On its return, the taxpayer had amortized the remarketing payment on a straight-line basis from the bond's original issue date until its stated maturity date. On audit, the taxpayer argued that the payment was an option premium not recognized as income on receipt. It claimed that the premium should be recognized when the call right lapsed, or if the right were exercised, amortized over the period between the remarketing and the stated maturity dates. The agent's adjustment, if accepted, would have required the payment to be recognized immediately on receipt.
The FSA characterized the remarketing payment as an integral part of the bond's terms. The taxpayer's prospectus stated that the bond proceeds included the remarketing payment. Based on these facts, the FSA included the remarketing payment as part of the proceeds from the bond issuance. As a result, the debt's issue price exceeded the SRPM, creating bond-issuance premium. This analysis is consistent with the IRS's general approach not to bifurcate a debt instrument with option elements into separate components for tax purposes.
The FSA also concluded that the bond's maturity date was the remarketing date; thus, the taxpayer should amortize the bond-issuance premium under Regs. Sec. 1.163-13, based on a constant yield to the remarketing date (which period was only one third of the stated maturity).
In essence, the FSA recognized the existence of two separate debt instruments: (1) a debt with a term from the original issue date to the remarketing date and (2) a debt that may be issued with a term from the remarketing date to the stated maturity date.
Remarketing date treated as maturity date. According to the FSA, the bond's maturity is the remarketing date. Footnote 13 suggests that the conclusion was based on Regs. Sec. 1.1272-1(c), which provides rules for determining the maturity date of a bond that provides the issuer or holder with an unconditional option that, if exercised, would require an alternate payment schedule.
Under Regs. Sec. 1.1275-1(c)(5), in determining the payment schedule and the maturity date on a debt instrument, a holder is presumed to exercise that option in a way that maximizes yield. In determining the yield to maturity, the taxpayer in the FSA appears to have used an interest rate for the remarketing period that, according to the FSA (without explanation), would result in treating the remarketing date as the maturity date under the regulations. However, the uncertainty over the level of future interest rates makes it difficult to determine on the issue date whether the callable/puttable bonds would be redeemed or remarketed on the remarketing date. Thus, on the issue date, it would not be known whether the exercise of either the put option or the call right would increase or decrease the bonds' yield.
If, on the other hand, the puttable/callable bond's maturity date was the stated maturity date, the lack of a known payment schedule past the remarketing date makes the tax treatment unclear. Some issuers had noted in prospectuses that the contingent payment rules under Regs. Sec. 1.1275-4 might apply. Under these rules, the noncontingent-bond method would require an issuer to construct a hypothetical payment schedule and adjust accruals as the payments became known. For versions of the instruments, depending on the manner in which the interest rate is reset on the remarketed bonds, the rules for variable interest rates under Regs. Sec. 1.1275-5 may apply.
Treatment of remarketing payment. As noted, the conclusion in the FSA is inconsistent with the current treatment of remarketing payments received by issuers of these bonds. Many issuers characterize the amount received for the dealer's right to purchase and remarket the bonds as an option payment. The option relates to the dealer's right to purchase the bonds at par and have the issuer reset the interest at an above-market rate. The option premium compensates the issuer for the risk that the bond's interest rate might increase at the remarketing date, reducing that risk. Thus, many issuers treat the remarketing payment as an option premium received in connection with a hedging transaction (i.e., the call right) that relates to the remarketed bond's yield.
Regs. Sec. 1.446-4 provides timing rules for income and deductions from hedging transactions. Under Regs. Sec. 1.446-4(e)(4), gain or loss from a hedging transaction for an anticipated debt issuance must be accounted for by reference to the debt instrument and the period to which the hedge relates. If the dealer does not exercise the call option, the issuer would recognize the remarketing payment at the remarketing date (Regs. Sec. 1.446-4(e)(8)(i)). If the dealer exercises the option, the issuer would amortize the premium over the term of the remarketed security.
In treating the remarketing payment as part of the original bond proceeds, the FSA arguably fails to recognize the underlying economics of the entire transaction. In viewing the option premium as related to a debt that matures on the remarketing date, the FSA ignores the corporation's obligation, on exercise of the call, to reset the interest rate under a formula that would set the rate in excess of current market rates. As such, the FSA ignores the fact that the remarketing premium is compensation for the issuer's obligation to "suffer" these higher interest rates for the period subsequent to the reset date. The FSA also ignores that the issuer had separately hedged its interest-rate risk from the original issue date to the remarketing date through the Treasury-lock transaction described below.
The FSA recognizes the distinction between the original debt issued and the potential for a separate instrument issued as part of the remarketing mechanism, but, oddly, fails to recognize the direct relationship between the remarked debt's option premium and the interest cost.
Other Hedging Issues
Before the issuance of the bonds, the taxpayer had entered into a one-month forward Treasury rate-lock agreement. Pursuant to this agreement, the taxpayer received a payment because of an increase in a benchmarked Treasury yield. (The taxpayer would have made a payment if that yield had decreased.) The benchmarked yield was based on a Treasury security with a term of about one-third the stated term of bonds then issued by the taxpayer.
The taxpayer amortized the payment on a straight-line basis over the term of the bond through the stated maturity, citing the timing rule for hedges under Regs. Sec. 1.446-4. The Service took the position that the payment was includible in income when received under the rules for notional principal contracts (Regs. Sec. 1.446-3).
The FSA concluded that the forward Treasury rate-lock agreement was a forward-rate agreement, not a notional principal contract. Under the facts available, the IRS could not determine if the hedging rules under Regs. Sec. 1.446-4 applied. Without the taxpayer showing that the hedging rules applied, the FSA concluded that the payment received under the rate-lock agreement was includible in income when received. If the hedging rules did apply, the payment should have been amortized under the terms of the bond and the period to which the hedge related. The FSA also concluded that the hedge period was from the bonds' issue date through the remarketing date, not through its stated maturity date.
It is unclear which facts the taxpayer presented to support the characterization as a hedging transaction. It is important for any taxpayer that wants to apply the timing rules under Regs. Sec. 1.446-4, which match the gain or loss from a hedging transaction with the hedged instrument, to identify the hedge properly when entering into it.
FSA 200142005 is the only guidance that specifically addresses these types of debt instruments. Many issuers have taken a position contrary to the FSA. It is uncertain, however, whether the FSA position will prevail if litigated or whether the Service will ever litigate this position.
FROM JO LYNN RICKS, J.D., LL.M., AND THOMAS J. KELLY, J.D., LL.M., WASHINGTON, DC
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|Title Annotation:||Field Service Advice|
|Author:||Sair, Edward A.|
|Publication:||The Tax Adviser|
|Date:||Mar 1, 2002|
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