Qualified Hedging Transactions (Treas. Reg. 1.148-4(h))

February 22, 2010

Termination Payments 

Hedge is not a qualified hedge:  May proceeds from tax-exempt obligations be used to finance termination payments for a hedge that is not a “qualified hedge”?

Hedge is a qualified hedge:  There is general agreement that a termination payment may be financed with proceeds of tax-exempt refunding bonds if the hedge is a “qualified hedge” with respect to the refunded bonds.  This view is suggested in the 2011 Tax and Securities Law Institute handbook for the T-4 session: “Does everyone agree that a payment to terminate a qualified hedge is a good capital expenditure?”  The discussion in that handbook was as follows:

1. A capital expenditure for bond purposes is “any cost of a type that is properly chargeable to capital account (or would be so chargeable with a proper election or with the application of the definition of placed in service under section 1.150-2(c)) under general Federal income tax principles.”  Treas. Reg. 1.150-1.  An item is chargeable to capital account for federal income tax purposes if it creates an asset that benefits future periods.  Indopco, etc.

2. As a general proposition, a termination payment on an interest rate swap is not a capital expenditure even if the payment gives rise to capital gain or loss under IRC 1234A.  IRC 1234A says that gain or loss attributable to a termination is treated as a capital gain or loss.  But is the payment for the termination a capital expenditure?  See generally Treas. Reg. 1.263(a)-4 (dealing with capitalization of intangibles, including notional principal contracts).  Treas. Reg. 1.263(a)-4 states that capitalization is required, generally, to acquire or create an intangible or a separate and distinct intangible asset.  Payment of a termination fee must be capitalized in some instances (to terminate a lease, certain options, noncompetition agreements). In (e)(1)(ii), that section states that amounts paid to terminate an existing agreement are not treated as “facilitating the acquisition or creation” of another agreement – and is therefore not treated as a facilitating transaction cost that is capitalized.

3. A swap that hedges a debt instrument and is properly identified under Treas. Reg. 1.1221-2, however, must be accounted for under Treas. Reg. 1.446-4.  While not spelled out in detail, Treas. Reg. 1.446-4(e)(4) generally requires accounting for termination of a swap properly identified as a hedge over the remaining term of the hedge, i.e., capitalization.

4. That is especially clear for qualified hedges under Treas. Reg. 1.148-4(h)(3)(iv)(B) – “A payment made or received by an issuer to terminate a qualified hedge, including loss or gain realized or deemed realized, is treated as a payment made or received on the hedged bonds, as appropriate.  The payment is reasonably allocated to the remaining periods originally covered by the terminated hedge in a manner that reflects the economic substance of the hedge.”  There is a fair amount of daylight between 1.1221-2 hedges and 1.148-4(h) hedges – timing, rate correlation, etc.  Qualification under 1.1221-2 should be enough for this analysis.

What about financing the termination of swaps that are not qualified under Treas. Reg. 1.1221-2 or Treas Reg. 1.148-4(h)? Many practitioners approach this as an extraordinary working capital question under Treas. Reg. 1.148-6(d)(3)(ii)(B).  Unless a[n] issuer regularly budgets for swap terminations, should they be treated any differently from paying to terminate any other burdensome contract, e.g., an off market energy contract? What term can the bonds have to avoid risk of creating replacement proceeds?

Governmental Accounting for Hedges

Statement No. 53 of the Government Accounting Standards Board (GASB) sets forth certain accounting rules for hedges entered into by governmental entities. Under the GASB 53, if a derivative effectively hedges an identified risk of increasing or decreasing cash flows or fair values, then the periodic changes in the fair value of the derivative can be deferred until the derivative ceases to be effective or the hedged transaction terminates.

If the derivative fails to effectively hedge the identified risk, then the change in fair value is reported immediately as investment income or loss.

Footnotes to the financial statements must disclose additional information about the derivative including identification of risks being hedged and identification of other risks that the governmental entity is exposed to as a result of the derivative instrument.

What it means to “effectively hedge” an identified risk is described in GASB 53, and there are various methods for determining the effectiveness.  For an interpretation of GASB 53, see the recent DerivActive publication available here.  More information about DerivActive is available here.

Qualified Hedge Transactions

The basic rule under Section 1.148-4(h) of the Regulations is that “payments made or received by an issuer under a qualified hedge […] relating to bonds of an issue are taken into account […] to determine the yield on the issue.”  Payments made or received by the issuer include payments deemed made or received when the contract is terminated or deemed terminated under paragraph (h)(3).  The bonds to which the qualified hedge relates are treated as variable yield bonds from the issue date of the bonds, unless paragraphs (h)(4) or (h)(5)(ii)(E) apply.

(Note: The rules under subsection (h) on taking into account payments on the hedge apply only for purposes of Section 143(g), 148 and 149(d) of the Code – and not to other sections.)

A hedge is a “qualified hedge” if the contract satisfies each of the following requirements (unless otherwise specified in paragraph (h)(5)):

  1. Hedge:  Entered into primarily to modify the issuer’s risk of interest rate changes;
  2. No significant investment element:  The contract does not contain a significant investment element (there is a significant investment element if a significant portion of any payment by one party relates to a conditional or unconditional obligation by the other party to make a payment on a different date);
  3. Parties:  The contract is entered into between the issuer or the political subdivision on behalf of which the issuer issues the bonds and a provider that is not a related party (the hedge provider);
  4. Hedged Bonds:  The contract covers, in whole or in part, all of one or more groups of substantially identical bonds in the issue (i.e., all of the bonds having the same interest rate, maturity and terms);
  5. Interest Based:  The contract is primarily interest based (see the Regulations for more details on this one);
  6. Payments Closely Correspond:  The payments received by the issuer from the hedge provider under the hedge correspond closely in time to either the specific payments being hedged on the hedged bonds or specific payments required to be made pursuant to the bond documents, regardless of the hedge, to a sinking fund, debt service fund or similar fund maintained for the issue of which the hedged bond is a part;
  7. Source of Payments:  Payments to the hedge provider are reasonably expected to be made from the same source of funds that, absent the hedge, would be reasonably expected to be used to pay principal and interest on the hedged bonds;
  8. Identification:  The contract must be identified by the actual issuer on its books and records maintained for the hedged bonds not later than three days after the date on which the issuer and the hedge provider enter into the contract (the identification must include certain specific references).

If, in addition to the requirements described above (i.e., the hedge is a qualified hedge), the following apply, the hedged bonds are treated as fixed yield bonds payment a fixed interest rate (and not merely as variable yield bonds), all as further described in Section 1.148-4(h)(4) of the Regulations:

  1. Maturity:  The term of the hedge is equal to the entire period during which the hedged bonds bear interest at variable interest rates, and the issuer does not reasonably expect that the hedge will be terminated before the end of that period;
  2. Payments Closely Correspond:  Payments to be received under the hedge closely correspond in time to the hedged portion of payments on the hedged bonds.  Hedge payments received within 15 days of the related payments on the hedged bonds generally so correspond.
  3. Aggregate Payments Fixed:  Taking into account all payments made and received under the hedge and all payments on the hedged bonds (i.e., after netting all payments), the issuer’s aggregate payments are fixed and determinable as of a date not later than 15 days after the issue date of the hedged bonds.

What is the 80/20 Rule?

This discussion of this rule and concept is contained in a separate post.

Hedge Advisor Certifications:

A hedge advisor may be requested to certify as to the on-market rates of a swap, excluding certain off-market payments being made by one of the hedge parties.  The hedge advisor may also be requested to certify as to other matters relating to the qualification of a hedge as a “qualified hedge” for purposes of the yield calculation rules.  Certifications may include the following:

A.  [The Hedge Advisor is familiar with interest rate swap transactions similar to the Hedge, has obtained shadow mid-market bids from market participants and also determined a mid-market level based upon information from its internal modeling system.  To the best of the Hedge Advisor’s knowledge, after taking into consideration the Borrower’s credit profile and the hereinafter defined Payment, the Fixed Rate payable by Borrower pursuant to the Hedge represents an on-market rate.] -or if mid-market quotes are not received and industry standard swap modeling systems are used with current market feeds- [The Hedge Advisor is familiar with interest rate swap transactions similar to the Hedge and has determined a mid-market level based upon information from its internal modeling system.  To the best of the Hedge Advisor’s knowledge, after taking into consideration the Borrower’s credit profile, the size and duration of the Hedge and the hereinafter defined Payment, the Fixed Rate payable by Borrower pursuant to the Hedge represents an on-market rate.]

B.  [Based upon the historical performance of the Floating Hedge Rate against the actual interest rate on bonds similar to the Bond, we believe that the Floating Hedge Rate will be substantially the same as (but not necessarily identical to) the interest rate on the Bond during the term of the Hedge.] -or- [Based on the Floating Bond Rate formula for the Bond and the Floating Hedge Rate formula for the Hedge, we believe that the Floating Hedge Rate will be substantially the same as (but not necessarily identical to) the interest rate on the Bond during the term of the Hedge.]

Termination or Deemed Termination Payment

A termination of a qualified hedge includes any sale or other disposition of the hedge by the issuer or the acquisition by the issuer of an offsetting hedge.  A deemed termination occurs when the hedged bonds are redeemed or when a hedge ceases to be a qualified hedge of the hedged bonds.  Treas. Reg. 1.148-4(h)(3)(iv)(A).

A termination payment is a payment made or received by an issuer to terminate the qualified hedge, including loss or gain realized or deemed realized.  Treas. Reg. 1.148-4(h)(3)(iv)(B).

When a qualified hedge is deemed terminated, the termination payment is the fair market value of the qualified hedge on the deemed termination date.  See Treas. Reg. 1.148-4(h)(3)(iv)(C).

The following steps are used to calculate the termination payment:

  1. Determine the on-market rate of the hedge on the date of the (deemed) termination (the “On-Market Rate”).  The on-market rate is the rate on the hedge on such date that produces a zero mark-to-market value.
  2. Determine the mark-to-market value of the hedge if, instead of the On-Market Rate, the fixed rate set forth in the hedge is used.  If the fixed rate being paid by the borrower is higher than the fixed rate being paid under an On-Market Rate, the hedge provider will not want to give up the hedge – which means the termination payment must be in the hedge provider’s favor.

In a refunding of a hedged bond using moneys from a refunding bond and other available moneys, how should the termination payment be allocated? Some bond counsel would conclude that the termination payment is allocated proportionately to the refunded bond (to the extent of other available moneys used to accomplish the refunding) and to the refunding bond (to the extent refunding bond proceeds are used to accomplish the refunding).  See Treas. Reg. 1.148-4(h)(3)(iv).

See the 2013 proposed regulations (a summary is available here) regarding certification requirements relating to termination payments and the refunding or redemption of hedged bonds.

Questions and Answers

  1. Deemed Termination Payments:  Assume a city issues bonds in 2005 and enters into a qualified hedge for the bonds.  In 2009, the city refunds the 2005 bonds, which results in a deemed termination of the hedge and a reintegration of the hedge.  The city has a deemed termination payment of the hedge of $x million.  The regulations provide that the deemed payment is allocated to the 2009 bonds over the remaining life of the swap.  In 2012, the 2009 bonds are reissued.  There is another deemed hedge termination, with that payment based on the on-market rate for the new hedge that went into effect in 2009.  Thus, this termination payment is on top of the prior 2009 payment.  The new termination payment is allocated to the 2012 bonds over the remaining term of the swap.  What about the remaining, unamortized portion of the 2009 deemed termination payment? Is it also allocated to the new 2012 bonds over the remaining term of the swap, or does it get taken into account for the 2009 bonds that have been deemed retired?  The regulations appear to require the latter.  Since taking the remaining termination payment into account for the 2009 bonds potentially results in a higher yield on the 2009 bonds (assuming the issuer is making a payment), would it be appropriate to continue to allocate the swap payments over the remaining term?

References

See TAM 200051001 regarding characteristics of a qualified hedge and method of identifying the hedge on the books and records of the issuer.

See 2013 proposed regulations regarding arbitrage matters relating to qualified hedges.

See Rev. Rul. 2002-71 regarding allocation and accounting matters, generally, of gain and loss on a termination payment for a notional principal contract (identified under 1.1221-2) that hedges a portion of the term of a debt instrument issued by the taxpayer.

Advertisements

Qualified Administrative Costs (Treas. Reg. § 1.148-5)

February 18, 2010

General Overview:

The basic rule is that an allocation of gross proceeds of an issue to a payment or a receipt on an investment is not adjusted to take into account any costs or expenses paid, directly or indirectly, to purchase, carry, sell or retire the investment (“administrative costs”).  Therefore, administrative costs do not increase the payments for, or reduce the receipts from, investments, and thus do not affect the computation of yield on such investments.  There are separate rules, however, for nonpurpose investments (Treas. Reg. 1.148-5(e)(2)) and purpose investments (Treas. Reg. 1.148-5(e)(3)) under which certain administrative costs (“qualified administrative costs”) may nonetheless be included in computing yield on the investment.

Rules for Nonpurpose Investments.  Qualified administrative costs can be taken into account.  Qualified administrative costs for this purpose are reasonable, direct administrative costs, other than carrying costs, such as separately stated brokerage or selling commissions, but not indirect costs such as legal and accounting fees and record keeping or custodial costs.  General overhead costs and similar indirect costs of the issuer such as employee salaries and office expenses and costs associated with computing the rebate amount are not qualified administrative costs.  Administrative costs are not reasonable unless they are comparable to administative costs that would be charged for the same investment or a reasonably comparable investment if acquired with a source of funds other than gross proceeds of tax-exempt bonds.  There are special rules for administrative costs of (1) nonpurpose investments in certain RICs and commingled funds, (2) guaranteed investment contracts and (3) investments purchased for a yield restricted defeasance escrow.  For a description of the special rules for guaranteed investment contracts and investments purchased for a yield restricted defeasance escrow, see the heading “Special Rules for GIC and Defeasance Escrow” below.

Rules for Purpose Investments.  Qualified administrative costs paid by the conduit borrower may be taken into account.  These costs increase the payments for, or decrease the receipts from, the purpose investments.  This rule applies even if the payments simply reimburse the issuer.  A pro rata portion of each payment made by the conduit borrower is treated as a reimbursement of reasonable administrative costs, if the present value of those payments does not exceed the present value of the reasonable administrative costs paid by the issuer, using the yield on the issue as the discount rate.  For purpose investments, qualified administrative costs means:

  1. costs or expenses paid, directly or indirectly, to purchase, carry, sell or retire the investment; and
  2. costs of issuing, carrying or repaying the issue, and any underwriters’ discount.

While the first sentence in the regulation and shown above refers to payment by the conduit borrower, the payment can be by the issuer, as passed through to the conduit borrowers.

Special Rules for GIC and Defeasance Escrow:

The maximum amount of qualified administrative costs for GICs or investments purchased for a yield restricted defeasance escrow that may be taken into account in 2010 is set forth by the IRS in Section 3 of Rev. Proc. 2009-50:

.18 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2010, under § 1.148-5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $35,000, and (B) 0.2 percent of the computational base (as defined in § 1.148-5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $100,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2011, that amount is set forth by the IRS in Section 3 of Rev. Proc. 2010-40:

.12 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow.  For calendar year 2011, under § 1.148-5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $36,000, and (B) 0.2 percent of the computational base (as defined in § 1.148-5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $101,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2012, that amount is set forth by the IRS in Section 3 of Rev. Proc. 2011-52:

.18 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2012, under § 1.148-5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $37,000, and (B) 0.2 percent of the computational base (as defined in § 1.148-5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $103,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2013, that amount is set forth by the IRS in Section 3 of Rev. Proc. 2012-41:

.10 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2013, under § 1.148-5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $37,000, and (B) 0.2 percent of the computational base (as defined in § 1.148-5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $106,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2014, that amount is set forth by the IRS in Section 3 of Rev. Proc. 2013-35:

.22 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2014, under § 1.148-5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $38,000, and (B) 0.2 percent of the computational base (as defined in § 1.148-5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $108,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2015, that amount is set forth by the IRS in Section 3 of Rev. Proc. 2014-61:

.23 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2015, under § 1.148–5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $39,000, and (B) 0.2 percent of the computational base (as defined in § 1.148–5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $110,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2016, that amount is set forth by the IRS in Section3 of Rev. Proc. 2015-53:

.23 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2016, under § 1.148–5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $39,000, and (B) 0.2 percent of the computational base (as defined in § 1.148–5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $110,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2017, that amount is set forth by the IRS in Section 3 of Rev. Proc. 2016-55:

.23 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2017, under § 1.148–5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $39,000, and (B) 0.2 percent of the computational base (as defined in § 1.148–5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $111,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.

For 2018, that amount is set forth by the IRS in Section 3 of Rev. Proc. 2017-58:

.23 Safe Harbor Rules for Broker Commissions on Guaranteed Investment Contracts or Investments Purchased for a Yield Restricted Defeasance Escrow. For calendar year 2018, under § 1.148–5(e)(2)(iii)(B)(1), a broker’s commission or similar fee for the acquisition of a guaranteed investment contract or investments purchased for a yield restricted defeasance escrow is reasonable if (1) the amount of the fee that the issuer treats as a qualified administrative cost does not exceed the lesser of (A) $40,000, and (B) 0.2 percent of the computational base (as defined in § 1.148–5(e)(2)(iii)(B)(2)) or, if more, $4,000; and (2) the issuer does not treat more than $113,000 in brokers’ commissions or similar fees as qualified administrative costs for all guaranteed investment contracts and investments for yield restricted defeasance escrows purchased with gross proceeds of the issue.