Total Rate of Return Swaps

June 15, 2014

General Background:

A total rate of return swap (TRORS), sometimes called a Total Return Swap or TRS, is a financial contract that transfers both the credit risk and market risk of an underlying asset.  One party makes payments based on a set rate (either fixed or variable) and the other party makes payments based on the return of the underlying asset (which includes income it generates and any capital gains).  The underlying asset is usually a bond or loans or an equity index.  TRORSs allow the party receiving the total return (the TRORS recipient or investor) to gain exposure and benefit from a reference asset without actually having to own it.

The key reason receivers of the total rate of return enter into this transaction is to take advantage of leverage.  […] The payer in a TRS creates a hedge for both price risk and default risk of the reference asset, although the payer in the TRS is a legal owner of the reference asset.  Investors who cannot short securities may be able to hedge a long position by paying the total rate of return in a TRS.

See Janet Tavakoli, Introduction to Total Return Swaps (available at for a good overview of TRORSs.  See this video for a basic overview of Total Rate of Return Swaps.

TRORSs can be combined with tender option bond programs.  For notes concerning tender option bond programs, see this posting.

See PLR 201502008 (May 21, 2014):  Extension of the TRS is not an abusive arbitrage device and the TRS will not be integrated with the bonds under the authority of 1.148-10(e).  The issuer/borrower agree to file a “cautionary” IRS Form 8038 just in case the IRS might mistake the bonds for having been reissued.

See “IRS Issues Favorable But Limited Ruling on Total Return Swaps” article in the January 27, 2015 edition of The Bond Buyer.

Instrumentality (Rev. Rul. 57-128)

June 13, 2014


The status of an entity as an “instrumentality” of a state or local governmental unit is relevant for the following purposes:

  • I.R.C. 141:  Private activity bonds test (see Treas. Reg. 1.141-1(b) definition of “governmental person”);
  • I.R.C. 170:  Deductions for contributions and gifts to or for the use of a state, a possession or any political subdivision of the foregoing (see I.R.C. 170(c)(1)) or an instrumentality of a state or an instrumentality of a political subdivision of a state if the contributions are made for exclusively public purposes (see Rev. Rul. 75-359);
  • I.R.C. 3121(b)(7) and 3306(c)(7):  Federal Insurance Contribution Act (FICA) taxes on the wages paid by an employer to employees with respect to employment.

The term “instrumentality” is not defined in the Code or regulations.

Revenue Ruling 57-128 sets forth the following factors to be taken into account in determining whether an entity is an instrumentality of one or more governments:

  1. Whether the organization is used for a governmental purpose and performs a governmental function;
    •  See GCM 39683 relating to a state bar association.  An entity may still be an instrumentality even if it performed private functions in addition to governmental functions.
  2. Whether the performance of the organization’s functions is on behalf of one or more states or political subdivisions;
    • See GCM 39683.  If the activities serve governmental functions as well as private functions, it is not clear whether the performance of those functions is on behalf of the state.
  3. Whether there are private interests involved, or whether the states or political subdivisions involved have the powers and interests of an owner;
  4. Whether control or supervision of the organization is vested in public authority or authorities;
    • See GCM 39683.  Control of purse strings may be insufficient if the control exists merely to ensure that expenditures are within the purposes of the act creating the entity.  However, appointment by Texas Supreme Court of members of the state bar means power to control is vested in a public authority.
  5. Whether express or implied statutory or other authority is necessary or exists for the creation and/or use of the organization; and
    • Does the entity need statutory authority to conduct its functions?  For example, to reprimand members or bring disbarment proceedings, in the case of GCM 39683 and the state bar.
  6. The organization’s degree of financial autonomy and the source of its operating expenses.

These criteria were developed under I.R.C. 3121(b)(7) and 3306(c)(7) which exclude from the definition of “employment” services performed in the employ of a state, or any political subdivision thereof, or any instrumentality of any one or more of the foregoing which is wholly owned thereby.

The status of an entity as an instrumentality does not automatically mean that the entity is also an on-behalf-of issuer (Click link to view topic) for purposes of I.R.C. 103(c)(1).  On-behalf-of issuer status is tested based on “constituted authority” status under Rev. Rul. 57-187 or on-behalf-of status under Rev. Proc. 63-20.  There are some PLRs in which the entity at issue is both an instrumentality (usually for purposes of proving that the entity is a governmental purpose of the private activity bond test) and an on-behalf-of issuer.

Rulings and Resources:

GCM 36088 (Nov. 18, 1974):  Whether a contribution for exclusively public purposes to a wholly-owned instrumentality of a state or of a political subdivision is a contribution to rather than merely for the use of such state or political subdivision for the purposes of I.R.C. 170(c)(1) and, therefore, is subject to the 50 percent limitation on deductions for contributions by individuals under I.R.C 170(b)(1)(A).  The memorandum distinguishes between wholly owned instrumentalities and integral parts of states or political subdivisions to hold that gifts to the later are gifts “to” the state or political subdivisions.

Rev. Rul. 75-359: Deductions for contributions and gifts.  I think this is the ruling described and revised by GCM 36088.

GCM 36781 (Jul. 6, 1976):  Whether the entity is conducting a governmental function. The entity is an urban league that is organized to aid in the development of a secure and exemplary American democracy by assisting communities to ameliorate conditions and to solve problems arising out of racial inequities within the American community and to work on problems and opportunities in the fields of job development and employment, education and youth incentives, housing, and health and welfare and that is exempt from federal income taxes under the 1954 Code as a 501(c)(3).  GCM concerned the exemption from federal excise taxes on communication services. [Not particularly helpful to common 103-related instrumentality fact patters.]

GCM 39683 (Jun. 14, 1987):  Whether the bar association is performing a governmental function.  Memorandum relates to unemployment tax liability.  Under Section 3306(c)(7), employment does not include services performed in the employ of a state, a political subdivision thereof, or any instrumentality of any one or more of the foregoing which is wholly owned y one or more states or political subdivisions, and any service performed in the employ of any instrumentality of one or more states or political subdivisions to the extent that the instrumentality is, with respect to such services, immune under the Constitution of the Untied States from the tax imposed by Section 3301.  General Counsel concludes that the state bar is not a political subdivision because it does not possess any sovereign powers.   The powers to investigate and prosecute grievance actions and unauthorized practice suits are not traditional governmental powers but rather are customary powers of professional associations.  Then, General Counsel concludes that the bar is not a public corporation in the constitutional sense.  At least part of the purposes, functions and activities of the state bar are private and not governmental in nature, including encouraging cordial intercourse among its members, the protection of the professional interests of the members, etc.

PLR 200026013:  Concerns the status of the Authority as an instrumentality for purposes of I.R.C. 141 private activity bond tests, applying Rev. Rul. 57-128.  Authority is a membership corporation.  Members are all political subdivisions.  Persons serving on the board are required to be officers or employees of the members.  Each member has the power to remove (with or without cause) any of the directors that it appointed.  A removed director’s successor is appointed by the member that removed the director to serve the unexpired term.  The entity’s purpose is to coordinate the operation of electric generation resources.  The entity receives funding from its members.  The entity submits financial reports to its members.  No net earnings of the Authority may be paid or inure to the benefit of any private person.  Upon dissolution, any assets remaining after the entity satisfies its obligations are distributed ratably to its members.

PLR 200225010:  The issue addressed in this ruling is whether an Authority, which is a joint venture between tribes, is an “instrumentality” (within the meaning of Rev. Rul. 57-128) of its governmental/tribal members and therefore a “governmental person” for purposes of the private activity bond tests.

PLR 200510016: Whether (1) the Association’s income is exempt from taxation under I.R.C. 115, (2) the Association is an instrumentality for purposes of I.R.C. 3121(b)(7) and 3306(c)(7), under Rev. Rul. 57-128 and (3) the contributions made to the Association are deductible by the donors as charitable contributions under I.R.C. 170(c)(1).  Association was created by City for the purpose of carrying out the promotion of tourism for the City.  By promoting tourism in the City, the Association will contribute to the economic development of the City through increased tourism and visitation to the City and will increase the expenditure of tourist dollars at local businesses.

PLR 200524015:  That (1) Agency and Agency’s Subsidiary are instrumentalities under Rev. Rul. 57-128 for purposes of the private activity bond tests, (2) income of Agency and Agency’s Subsidiary is excludable from gross income under I.R.C. 115(l) and (3) Agency’s use of bond proceeds will not constitute use meeting either the private business tests of I.R.C. 141(b) or the private loan tests of I.R.C. 141(c).  Agency was formed by governmental entities to perform the functions of, or to carry out the purposes, of its members with a view towards maximizing the efficient acquisition, management and delivery of natural gas supplies and reducing operating costs of its members. (Keyword: Piggybacking Instrumentality.)

PLR 200718002:  A System is an instrumentality of the County under Rev. Rul. 57-128 for purposes of the private activity bond rules of I.R.C. 141 (i.e., the bond-financed facility is therefore used by a governmental person and not a private business user) as well as an on-behalf-of issuer (constituted authority under Rev. Rul. 57-187) of the County for purposes of issuing tax-exempt bonds (i.e., the System could issue tax-exempt bonds on behalf of the County).  County Board created System as a public corporation that will operate as a subsidiary of County to provide health care and related services to the general public and related education and research programs.  System is required to provide services to persons who are indigent.

PLR 200736022: [To come]

PLR 200836005:  Issues include (1) whether the entity’s income is exempt from taxation under I.R.C. 115, (2) whether the entity qualifies as an instrumentality for purposes of making charitable contributions to the entity under I.R.C. 170(c)(1) and (3) whether interest on bonds issued by the entity are excludible from gross income because the entity is a constituted authority under Rev. Rul. 57-187.

PLR 201220005, February 3, 2012:  Public corporation established to support state’s schools for the vision and hearing impaired qualifies as an “instrumentality of the state” contributions to which are deductible under I.R.C. 170(c)(1).

PLR 201308010 (Nov. 20, 2012):  The Internal Revenue Service applies the six factors in Rev. Rul. 57-128 to economic development corporations created by City.  Ruling relates to determining whether services provided to the corporations are “employment” under FICA.

PLR 201411018 (Aug. 9, 2013):  The Internal Revenue Service applies the six factors in Rev. Rul. 57-128 to a state university or community college and concludes that the university/college is an instrumentality of the state for purposes of I.R.C. 141 private activity bond tests and is eligible to receive charitable contributions under I.R.C. 170(c)(1) (“A state, a possession of the United States, or any political subdivision of any of the foregoing, or the United States or the District of Columbia, but only if the contribution or gift is made for exclusively public purposes”).


Tax Opinion Practice

June 12, 2014

This entry describes general matters relating to the tax opinion practice.  For a helpful overview of the “tax opinion practice,” see Robert P. Rothman, “Tax Opinion Practice,” originally published at 64 The Tax Lawyer 301 (Winter 2011) and Joseph M. Erwin, “How Much Tax is in that Opinion,” Dallas Bar Association – Section of Taxation, Sept. 4, 2012.

Confidence Levels for Written Tax Advice:

  •  “Will” opinion:  90-95% probability of position being sustained.
    • Use this opinion in connection with SEC securities registrations.  See SEC Staff Legal Bulletin No. 19.
    • Often used in customary practice as a condition for closing a transaction.
    • This opinion provides the highest level of comfort.  But note that “a legal opinion is not an insurance policy.”  A judge could still decide adversely on the matter, so the opinion should not be considered a guarantee of absolute certainty.
    • The conclusion of the opinion giver may be that there is no material risk of being wrong.
  • “Should” opinion:  70% to 75% probability of position being sustained.
    • Use this in connection with SEC securities registration.  See SEC Staff Legal Bulletin No. 19.
    • May also be used in memorandums, notes, etc. in support of tax items on GAAP financial statements.  See FAS 5.
    • This opinion standard implies a reasonably high level of confidence that the position will be sustained and is significantly higher than the “more likely than not” standard but allows for a not insignificant risk of being wrong.
  • “More likely than not” opinion: More than 50% probability of position being sustained.
    • If considering likelihood of audit, settlement possibilities and approach of tax authority, e.g., for GAAP financial statements, see FIN 48 (interpreting FAS 109)
    • If not considering likelihood of audit, e.g., for covered opinions, see pre-June 2014 version of Circular 230, Sec. 10.35
    • Regulations impose minimum requirements that must be satisfied in order for an opinion to provide a possible mechanism to establish the reasonable cause-good faith defense of I.R.C. § 6664(c) to avoid the imposition of the substantial understatement penalty (I.R.C. § 6662(b)(2)) against a corporate taxpayer in connection with a tax shelter (Treas. Reg. § 1.6664-4(f)).  One of these requirements is that the opinion “unambiguously [state] that the tax advisor concludes that there is a greater than 50-percent likelihood that the tax treatment of the item will be upheld if challenged.”
    • If the IRS asserts a reportable transaction understatement penalty (tax-exempt bonds are not reportable transactions) under I.R.C. § 6662A, a taxpayer may be able to avoid the penalty by meeting the requirements of I.R.C. § 6664(d).  Among the requirements imposed by I.R.C. § 6664(d) is that the taxpayer must have reasonably believed that the claimed treatment was more likely than not correct.
    • A tax return preparer who claims a position with respect to a tax shelter or reportable transaction may be subject to a penalty under I.R.C. § 6694 unless it is reasonable to believe that the position would more likely than not be sustained.
    • “One situation where an issue can arise is where the weight of authority, as between two possible outcomes, is almost evenly balanced.  There are two schools of thought concerning this situation.  One school of thought reasons that, for any proposition of law, either that proposition or its converse must be more likely than not correct, and goes on to conclude that it should therefore always be possible to render a ‘more likely than not’ opinion on one side or the other of a binary issue. Accordingly to this school of thought, if a practitioner has any doubt about whether he can render an opinion that the consequences of a particular transaction will more likely than not be X, he need only ask himself if he could render an opinion that the consequences would more likely than not be something other than X; if the answer to that question is negative, he can always give the X opinion.”   Other practitioners, however allow for the possibility that there can exist issues that are simply too close to call.
  • “Substantial authority” opinion: Less than “more likely than not” but greater than “reasonable basis” (34% to 40% likelihood)
    • Helpful for substantial underpayment penalty for reportable transactions under I.R.C. 6662A.  See I.R.C. 6664(d)(1), (3)
    • Substantial understatement penalty for tax shelter items for non-corporate taxpayers.  See Treas. Reg. 1.6662-4(g)
    • Substantial understatement penalty for tax shelter items for corporate taxpayers.  See Treas. Reg. 1.6664-4(f)
    • Workpaper/opinion for tax return preparer for reportable transaction and tax shelter items.  See Treas. Reg. 1.6694-2(a)(1)(i)
    • There is “substantial authority” for a position if the weight of authorities in support of the position is substantial in relation to the weight of authorities supporting contrary treatment.  The standard is less stringent than “more likely than not,” but requires more than a “reasonable basis.”
    • “Significant” authorities that can be taken into consideration includes PLRs, TAMs, GCMs, which technically cannot be cited as precedent but are still acceptable for evaluating substantial authority.
    • The regulations (Treas. Reg. § 1.6662-4(d)(3)(i)) specifically acknowledge the possibility that there can be substantial authority for more than one position.
    • “The substantial authority standard is a creature of statute and is relevant in specific circumstances for purposes of avoiding penalties.”
    • Can be used to avoid substantial understatement penalty for non-disclosed non-reportable transactions, etc. tax return positions, other than tax shelters.  See I.R.C. 6662(d)(2)(B)(i)
    • Minimum standard for non-disclosed non-reportable transactions, etc. tax return positions for tax return preparers.  See I.R.C. 6694(a)(2)(A); Treas. Reg. 1.6694-2(d)(1), (2)
    • Limited scope opinions.  See Circular 230, Sec. 10.35
    • If the IRS asserts a reportable transaction understatement penalty under I.R.C. § 6662A, the taxpayer may be able to avoid the penalty by meeting the requirements of I.R.C. § 6664(d), including that substantial authority for the position actually exists (and the taxpayer has a reasonable belief that the claimed treatment was more likely than not correct).
    • Tax return preparer may use this standard to avoid a possible penalty under I.R.C. § 6694 (but not in connection with a tax shelter or reportable transaction).
    • The IRS or court reviewing the determination will make its own independent determination of whether there is substantial authority – if it determines that there was not substantial authority, the taxpayer’s belief that there was, no matter how reasonable, is not relevant.
    • “The mere existence of the opinion will not help if the Service disagrees with the opinion’s conclusion.”
  • Realistic possibility of being sustained on its merits:  One-in-three possibility (33%)
    • Disclosed position of disregard of Rev. Rul. or IRS Notice.  See Treas. Reg. 1.6662-3(a), (b)(1)
    • “There seems to be a continuing sense among practitioners that, as between the two standards [reasonable basis and realistic possibility of being sustained on its merits], realistic possibility is probably slightly higher
  • “Reasonable basis” opinion:  Higher than “not frivolous” but lower than “substantial authority” (20-30%)
    • Substantial understatement penalties for disclosed items. I.R.C. 6662(d)(2)(B)(ii)
    • Prevailing interpretation of reasonable basis as requiring something less than a one-in-three chance “may not be totally unassailable.”
    • Minimum standard for disclosed non-reportable transactions, etc. tax return positions for tax return preparers. I.R.C. 6694(a)(2)(A); Treas. Reg. 1.6694-2(d)(1), (2).  A taxpayer facing a substantial underpayment penalty under I.R.C. § 6662(b)(2) (other than in connection with a tax shelter) can avoid the penalty if he specifically discloses the position and there is a reasonable basis for the claimed treatment.
    • A preparer facing a possible preparer penalty under I.R.C. § 6694 (other than in connection with a tax shelter or reportable transaction) can avoid the penalty if the preparer specifically discloses the position and there is a reasonable basis for the claimed treatment.
    • For purposes of the negligence disregard penalty of I.R.C. § 6662(b)(1), a taxpayer is not treated as negligent in claiming a position for which there exists a reasonable basis.  Treas. Reg. § 1.6662-3(b)(1).
    • Disclosed position of disregard of rule or regulation. Treas. Reg. 1.6662-3(c)
    • Limited scope opinion. See Circular 230, Sec. 10.34(a)
    • Client discussion memorandum.  This is consistent with customary practice.
    • The regulations suggest that the analysis of whether reasonable basis is satisfied is based on the same types of authorities as those considered for purposes of substantial authority.
    • As with “substantial authority,” the operative legal provisions that directly depend on reasonable basis all turn on whether a reasonable basis is actually found to exist, not on the taxpayer’s belief, reasonable or otherwise.  Therefore, no opinion at the reasonable basis level can insulate the taxpayer from penalties, although it may assist in establishing “reasonable cause and good faith” (if applicable) and, in any event, can serve to give the taxpayer some comfort that penalties will not apply as long as disclosure is made.
  • Not Frivolous
    • Lowest level at which there is some modicum of comfort as to a position.  “Frivolous” was defined by regulations (no longer in effect) as “patently improper.”
    • This is the position the tax practitioner may apply wearing his “advocate” hat.
    • The tax practitioner’s arguments must satisfy the “laugh test.”

Opinions may often include qualifiers, particularly in the case of higher levels of confidence, such as “although not free from doubt,” “although no assurance can be given,” or “although not entirely free from doubt.”  Rothman suggests that there does not appear to be consistent practice as to the use of such qualifiers or as to what, if anything, they really mean.

Functions of Tax Opinions:

Tax opinions typically serve one or more of the following functions:

  1. Comfort opinion:  Provides the taxpayer with comfort that a transaction the taxpayer is considering entering into will have the expected tax consequences.
  2. Contractual condition opinion:  This opinion is used to effect a particular transaction, with the obligation of one or both parties to close conditioned on the receipt of the opinion that the transaction will have the tax consequences specified in the contract.
  3. Third-party inducement opinion:  This opinion induces the third party to agree to a course of action.
  4. Disclosure opinion: This opinion gives comfort regarding a person’s duty to disclose.
  5. Penalty protection opinion: This opinion is intended to permit clients to rely on to avoid possible civil penalties.
  6. FIN 48 opinion:  This opinion provides advice regarding the tax treatment of items for purposes of financial statements.  The “more likely than not” standard is required in order to recognize, for financial statement purposes, a tax benefit with respect to which there is some legal or factual uncertainty.
  7. Reporting opinion:  This opinion provides advice regarding the proper tax reporting of a completed transaction.

Penalty Protection Opinion:

The penalty protection opinion must comply with I.R.C. §§ 6662 and 6664 and case law that addresses when a legal opinion will provide a defense to an asserted penalty.

Four types of penalties are most likely to be involved in a penalty protection opinion.  The negligence-disregard of rules penalty (I.R.C. § 6662(b)(1)), the substantial understatement penalty (I.R.C. § 6662(b)(2)), the substantial valuation misstatement penalty (I.R.C. § 6662(b)(3)), penalties for understatements of tax from reportable transactions (I.R.C. § 6662A).


Notice 2007-39, providing guidance to practitioners that may be subject to monetary penalties.

Opinion Concerning 501(c)(3) Status:

My opinion counts!

  1. Opinion Regarding Disregarded Entity Status:  The borrower is an LLC with a single member, which is a 501(c)(3) organization. One firm (“Firm A”) is engaged to be counsel to the borrower. Another firm (“Firm B”) is engaged to be counsel to the 501(c)(3) organization.  Firm B expects to give an opinion that the 501(c)(3) organization is an organization described under Section 501(c)(3) of the Code.  Should Firm B also be required to give an opinion that the borrower is a disregarded entity for federal income tax purposes such that the 501(c)(3) status “flows through” to the borrower?  Most bond counsel would probably require Firm B to provide such opinion, in part because the disregarded status matter is naturally connected to the 501(c)(3) status of the member.

Unqualified Opinions:

  1. No Reasonable Possibility:  Bond counsel must determine that it would be unreasonable for the court to hold to the contrary. Bond counsel must determine that there is no reasonable possibility that the IRS would not concur or acquiesce in the opinion, if it considered all material legal issues and relevant facts. See “Statement Concerning Standard Applied in Rendering the Federal Income Tax Portion of Bond Opinions,” adopted by the Board of Directors of NABL on November 29, 1993. NABL, 1997 Model Bond Opinion.
  2. High Degree of Confidence:  Bond counsel may render an “unqualified” opinion regarding the validity and tax exemptions of bonds if it is firmly convinced (also characterized as having a “high degree of confidence”) that, under the law in effect on the date of the opinion, the highest court of the relevant jurisdiction, acting reasonably and properly briefed on the issues, would reach the legal conclusions stated in the opinion. NABL, 2003 Model Bond Opinion, p. 7.
  3. Firmly Convinced:  In light of lack of judicial precedent and unique body of Internal Revenue Service administrative guidance, bond counsel may nonetheless give an unqualified opinion with respect to federal income tax matters if it is firmly convinced that, upon due consideration of the material facts and all of the relevant sources of applicable law on federal income tax matters, the Supreme Court would reach the federal income tax conclusions stated in the opinion or the IRS would concur or acquiesce in the federal income tax conclusions stated in the opinion. NABL, 2003 Model Bond Opinion, p. 8.
  4. Not Unqualified Opinion:  An opinion is not “unqualified” if it includes (1) a non-customary assumption, limitation or qualification, (2) a phrase such as “while the matter is not free from doubt” (generally referred to as a “qualified opinion”), or (3) a legal analysis for the opinion (generally referred to as a “reasoned” or “explained” opinion). NABL, 2003 Model Bond Opinion, p. 7.

Exempt Facility Bonds for Airports (I.R.C. § 142)

June 10, 2014

General Matters

A private activity bond for an airport facility issued as an exempt facility bond is a “qualified bond” that is eligible for tax-exempt treatment.  I.R.C. §§ 141(e)(1), 142(a)(1).

Certain general matters relating to exempt facility bonds, including such bonds for airports, are described in this post.

An airline’s right to net revenues from an airport may be considered an ownership-like interest that must be treated as private business use just as outright ownership would.

Multipurpose Issue

Treas. Reg. 1.141-13(d) provides that, for I.R.C. § 141 purposes, the multipurpose issue allocation rules of Treas. Reg. 1.148-9(h) apply, including allocations involving refunding purposes of the issue. An allocation under that subsection may be made at any time but once made may not be changed.  An allocation, however, is not reasonable if it achieves more favorable results under I.R.C. § 141 than could be achieved with actual separate issues.  The issue to be allocated and each of the separate issues under the allocation must consist of one or more tax-exempt bonds.  Allocations made under this paragraph (d) and Treas. Reg. § 1.148-9(h) (arbitrage rules for refundings) must be consistent for purposes of I.R.C. § 141 and I.R.C. § 148.

In connection with the proposed Accounting and Allocation regulations of September/October 2006 (the 2006 Proposed Regulations), NABL raised the concern that Treas. Reg. 1.141-13(d) suggests that a single issue with governmental and, e.g., exempt facility airport bonds will not be eligible for tax-exemption.  The single issue, if analyzed as a whole against I.R.C. § 141, would not “consist of one or more tax-exempt bonds” even though the two components, analyzed separately, would qualify.

The 2006 Proposed Regulations revised Treas. Reg. 1.141-13(d) and permitted retroactive application.  The relevant revision changes the bold sentence above to “[e]ach of the separate issues under the allocation must consist of one or more tax-exempt bonds,” thereby removing the requirement that the issue as a whole consist of tax-exempt bonds.  The 2006 Proposed Regulations also added an Example 5 to provide further guidance.

NABL stated the following in its comments to the 2006 Proposed Regulations:

NABL greatly appreciates the step taken in the Proposed Regulations to fix the inadvertent error introduced into Treas. Reg. §1.141-13(d). Correction of this error will mean that issuers will not be forced to separate issues by more than 15 days when issuance of them as a single issue will still result in tax-exempt debt if the two parts of the issue are analyzed separately.

Example 5 of the 2006 Proposed Regulations states:

(i) In 2006, State D issues bonds to finance the construction of two office buildings, Building 1 and Building 2. D expends an equal amount of the proceeds on each building. D enters into arrangements that result in private business use of 8 percent of Building 1 and 12 percent of Building 2 during the measurement period under § 1.141-3(g). In addition, D enters into arrangements that result in private payments in percentages equal to that private business use. These arrangements result in a total of 10 percent of the proceeds of the 2006 bonds being used for a private business use and for private payments. In 2007, D purports to make a multipurpose issue allocation under paragraph (d) of this section of the outstanding 2006 bonds, allocating the issue into two separate issues of equal amounts with one issue allocable to Building 1 and the second allocable to Building 2. An allocation is unreasonable under paragraph (d) of this section if it achieves more favorable results under section 141 than could be achieved with actual separate issues. D’s allocation is unreasonable because, if permitted, it would allow more favorable results under section 141 for the 2006 bonds (for example, private business use and private payments which exceeds the aggregate 10 percent permitted de minimis amounts for the 2006 bonds allocable to Building 2) than could be achieved with actual separate issues. In addition, if D’s purported allocation was intended to result in two separate issues of tax-exempt governmental bonds (versus tax-exempt private activity bonds), the allocation would violate paragraph (d) of this section in the first instance because the allocation to the separate issue for Building 2 would fail to qualify separately as an issue of tax-exempt governmental bonds as a result of its 12 percent of private business use and private payments, which exceed the 10 percent permitted de minimis amounts.

(ii) The facts are the same as in paragraph (i) of this Example 5, except that D enters into arrangements that result in 8 percent private business use for Building 1, and it expects no private business use of Building 2. In 2007, D allocates an equal amount of the outstanding 2006 bonds to Building 1 and Building 2. D selects particular bonds for each separate issue such that the allocation does not achieve a more favorable result than could have been achieved by issuing actual separate issues. D uses the same allocation for purposes of both section 141 and 148. D’s allocation is reasonable.

(iii) The facts are the same as in paragraph (ii) of this Example 5, except that as part of the same issue, D issues bonds for a privately used airport. The airport bonds if issued as a separate issue would be qualified private activity bonds. The remaining bonds if issued separately from the airport bonds would be governmental bonds. Treated as one issue, however, the bonds are taxable private activity bonds. Therefore, D makes its allocation of the bonds under §§ 1.141-13(d) and 1.150-1(c)(3) into 3 separate issues on or before the issue date. Assuming all other applicable requirements are met, the bonds of the respective issues will be tax-exempt qualified private activity bonds or governmental bonds.

Note that the rule in Treas. Reg. § 1.141-13(d) applies for I.R.C. § 141 purposes only.  It does not, for example, cause a multipurpose allocation for I.R.C. § 148 purposes.

Assume proceeds are on deposit in a construction fund for the governmental portion of airport bonds (the “Governmental Fund”) and in a construction fund for the exempt facility portion of airport bonds (the “Exempt Facility Fund”).  For I.R.C. § 141 purposes, moneys in the Exempt Facility Fund could be used for the governmental portion of the project, but care would need to be taken to ensure that moneys in the Governmental Fund don’t end up paying for the exempt facility portion of the project.  Interest earnings on the Governmental Fund during the project period should be captured and directed to the governmental project portion as long as the project is underway.



Accrued Market Discount (I.R.C. § 1276)

June 7, 2014

Basic Rules

Remember: There is a “disposition” and recognition event at the time of redemption under sec. 1271(a).

There is Market Discount (MD) in the following situations:

  1. For an original issue discount (OID) debt instrument (DI):  MD if Buyer pays < Adjusted Issue Price
  2. For other debt instrument:  MD if Buyer pays < redemption price

Why would someone buy bonds at a price of less than redemption price?  Because other bonds may be available on the market with higher rates.

There is no immediate effect on the purchaser if the purchaser buys at a MD.  The effect is when the bond matures (remember, there is a “disposition” (sale or exchange) upon maturity) or when the bond is sold.  At that time, there is a determination of the “Accrued Market Discount,” and you have a gain at that time.  The gain is ordinary income to the extent it does not exceed the Accrued Market Discount (I.R.C. § 1276(a)(1)).  In other words:  The gain upon disposition doesn’t reflect capital appreciation of an asset (which would give capital gain) but instead reflects “mere” interest (which gives ordinary income).

Approach to addressing Market Discount issues:

  • First step: Calculate the MD at the time you buy.
  • Second step: Calculate the AMD upon disposition.
  • Third step: If you have gain upon sale, ordinary income up to AMD and thereafter capital gain.
  • Fourth step: If there is capital gain, determine short-term or long-term capital gain.
  • Fifth step: Ordinary income and capital gain is recognized at time of disposition, unless elected out.

Definition of Market Discount:

  • For OID DI: MD = Adj. IP – Buyer Cost
  • For other DI: MD = SRPM – Buyer Cost

Definition of Accrued Market Discount:  AMD = MD x (No. of days T held DI / No. of days to maturity of DI when bought)

Definition of Adjusted Issue Price:

  • Take the original IP and increase by the OID that you have already included.
  • Also sometimes referred to as the “revised issue price.”

Therefore, if you hold the DI all the way to maturity, AMD = MD, and all MD is ordinary income.  If you hold two of four years, AMD = MD x 2/4 = Ordinary Income.  The first dollars of the gain here are Ordinary Income. Rest is capital gain.

When to report Ordinary Income due to MD:  Ordinary income due to MD (or better, due to AMD) occurs at the time of disposition of the DI, which is when the holder sells it before maturity or when the holder receives the SRPM at the time of maturity. BUT:

  1. Holder may elect to recognize AMD each year, but who would?
  2. Holder can also elect to sell early and possibly have only part be OI.

Note: Disposition can also be by gift!

Also note for Tax-Exempt Obligations:  Market Discount is NOT tax-exempt income.  I.R.C. § 1276 says the MD is still ordinary income and fully taxable.  This is because, unlike OID, Market Discount occurs unrelated to any actions of the municipality.  It is simply based on market conditions, so policy should not cast this discount as tax-exempt interest.

Comparison of OID to MD:  For OID, remember that the imputed interest occurs on an effective yield to maturity basis each year the holder owns the DI.


Example 1

T buys a 5-year, $100,000 bond that pays 10% interest.  It is given that the bond is not an OID bond.  Interest rates rise and value of the bond goes down.  At the end of year 3, B buys the bond from T for $90,000, and holds to maturity.  At maturity, B has a gain of $10,000 ($100,000 A/R – $90,000 cost basis).

  • Step 1: MD = $10K.
  • Step 2: AMD = MD * Days Held/Days to Maturity = MD
  • Step 3: There is gain of $10K (given above).  Gain up to the AMD is ordinary income.  Thus, all is ordinary income.
  • Step 4: There is no leftover gain after ordinary income recognition, so there is no capital gain.
  • Step 5: The ordinary income is recognized by B at the time of disposition, not earlier, unless elected.

Therefore, on maturity, B has $10,000 of ordinary income (B really wanted $10,000 more interest on bond).

Example 2

Same facts, but B sells at the end of year 4 after owning it one year.  How much ordinary income and capital gain must B recognize?

  • Step 1: MD = $10K
  • Step 2: AMD = $10K * 1/2 = $5,000 (remember, B only holds for one year)
  • Step 3: Gain up to AMD is OI, so $5,000 is ordinary income.  The rest is capital gain.
  • Step 4: Rest is capital gain.  If B held for more than one year, this would be long-term capital gain.
  • Step 5: Ordinary income and capital gain is recognized at time of disposition, not before.

Example 3

What are the consequences if B’s sales price was $90,000 instead of $100,000?  In this case, B would have no gain (A/R $90K – A/B $90), and therefore there is no ordinary income.  H must only recognize ordinary income if there is gain on the disposition.

Example 4

What if sales price was $94,000?  B has gain of $4,000 and all is ordinary income because there is $5,000 of AMD at time of disposition (assuming he sells at end of fourth year).

Example 5

What if sales price was $98,000?  B has gain of $8,000 and must treat $5,000 (AMD) as ordinary income and balance of $3,000 as capital gain. If he held long enough, he can get long-term capital gain.

Other Matters

I.R.C. 1276(b) states that market discount is accrued using the ratable accrual method.  The bondholder may elect to accrue based on the basis of constant interest rate instead.  For a bond the principal of which may be paid in two or more payments, the amount of accrued market discount is to be determined under regulations.  As of 2015, no such regulations have been promulgated.

Original Issue Discount (I.R.C. §§ 1273 and 163(e))

June 7, 2014

Context and Basic Rules

The holder of a debt instrument that is issued with original issue discount (OID) must include part of the OID in gross income in each taxable year that the debt instrument is held, even though the OID is not paid until maturity (I.R.C. § 1272). The current inclusion applies regardless of the method of accounting used by the holder of the debt instrument.  The current inclusion rule does not, however, apply to “any tax-exempt obligation” (I.R.C. § 1272(a)(2)(A)), which makes sense, because OID is treated as interest and, with respect to a tax-exempt obligation, should be excludable from gross income.

The policy of OID is to prevent taxpayers from trying to convert ordinary income (interest income) into capital gains (appreciation), and also to prevent taxpayers from deferring recognition of interest.  The current inclusion under I.R.C. § 1272 does not apply to a holder who purchases the debt instrument (DI) at a premium or whose basis in the DI is determined by reference to its basis in the hands of a person who purchased at premium (I.R.C. § 1272(c)(1)).

The OID rules under I.R.C. §§ 1272 and 163(e) (deduction of interest with respect to OID) essentially place both taxpayers (the issuer and the buyer) on the accrual method of accounting.  You are required to account for interest as it is earned based on passage of time and effective yield to maturity.

See “Discount and Premium Bonds: Dealing with the Tax Issues” and “Taxation of Municipal Bonds Flash Cards” for additional discussion.

Calculation Rules

OID = Stated redemption price at maturity (SRPM) – Issue Price (§ 1273(a))

SRPM, as defined in I.R.C. § 1273(a)(2) means the amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time (other than any interest based on a fixed rate, and payable unconditionally at fixed periodic intervals of 1 year or less during the entire term of the debt instrument). (The regulations more clearly define SRPM as the sum of all payments provided by the debt instrument other than qualified stated interest payments.)

Issue Price (I.R.C. §§ 1273(b) and 1274) = (1) If DI has Adequate Stated Interest (ASI), IP = Stated Principal Amount (SPA) (2) If DI does not have ASI, Issue Price = Imputed Principal Amount (IPA)

ASI (I.R.C. § 1274(c)(2)) = Yes, if the SPA of the DI (the face amount) <= IPA

IPA (I.R.C. § 1274(b)) = Sum of the PVs of all payments due on the DI (the AFR is used to compute the PV, and compounding is done semi-annually).

OID is treated as zero if the excess is less than 1/4 of one percent of the stated redemption price at maturity, multiplied by the number of complete years to maturity (§ 1273(a)(3)).  But note that I.R.C. § 1288 states that OID for a tax-exempt obligation is calculated without taking into account the de minimis OID rule of I.R.C. § 1273(a).  Therefore, de minimis OID does not exist for tax-exempt bonds.

Discussion of OID Rules

Rules of thumb:  (1) If the bond bears interest at least at the applicable federal rate (AFR), there is adequate stated interest (ASI) and therefore no OID; and (2) If the Issue Price = SRPM, there is no OID.

The definition of IP depends on whether the DI was issued for money or property, and whether the debt instrument is publicly traded. “Property” includes services and the right to use property, but does not include money.  (Note that stock and securities are “property” and therefore cannot be “cash” – as suggested by I.R.C. 1273(b)(3)(B) references to stock and securities.)

  1. IP of publicly offered DI issued for money = initial offering price to public at which substantial amount of DI is sold.
  2. IP of not publicly offered DI issued for money = price paid by the first buyer of instrument.
  3. IP of publicly offered DI issued for property = FMV of the property.
  4. IP of not publicly offered DI issued for non-publicly offered property = look at ASI.

Note the following special rules to distinguish between I.R.C. §§ 1273 and 1274 application:

  1. Special I.R.C. § 1274 definition of “Issue Price” does not apply if none of the payments due on DI are due more than 6 months after the date of the sale or exchange of the debt instrument.
  2. I.R.C. § 1274 does not apply to publicly offered debt instruments.

Determination of AFR: Is set by IRS pursuant to Rev. Proc. DI term is < 3 years, use short-term AFR. DI term is > 3 years and < 9 years, use mid-term AFR. Otherwise, use long-term AFR. Debt Instrument (I.R.C. § 1275(a)(1)) = Bond, debenture, note or certificate or other evidence of indebtedness.

Effect on Issuer = Issuer may deduct the same amount under I.R.C. § 163(e).

Effect on Purchaser = Purchaser is required to include part of the OID in gross income currently.

Amount to be included = Sum of “daily portions” of OID for each day during the taxable year during which the holder held the debt instrument. Daily Portion = Allocate to each day that day’s ratable portion of the increase.

Increase for any accrual period = (Adj. IP at beginning * Yield to Maturity) – Sum(Amts payable as interest on the DI during the accrual period).

Early redemption by the Issuer = Issuer has COD, which is ordinary income.

If DI is a municipal bond (I.R.C. § 1288):

  • Do get basis adjustment, even though interest is not taxable.
  • Can still take loss.
  • Market Discount rules apply (and O.I. will be taxable at disposition!).
  • Acquisition Premium (irrelevant for federal tax purposes, but still reduce basis)

OID need not be included in gross income for the following:

  • Tax-exempt obligations
  • U.S. Savings bonds
  • Short-term obligations
  • Certain other DIs

I.R.C. § 1271(a): Amounts received by the holder on retirement of a debt instrument shall be considered as amounts received in exchange thereof.

Once an OID bond, always an OID bond. In all subsequent transactions involving the bond, you look at the original OID inclusion schedule.


Example 1

Assume S sells property (FMV of $100K and A/B of $20K) to B. B gives S a promissory note where B will pay $150K to S in 5 years, with no interest. S reports no income until the fifth year, when B pays the $150K, and then reports $130K as capital gain ($150K A/R – $20K A/B). AFR is 8.447%. May S report $130K as capital gain, and thereby convert interest income (that would otherwise apply) into capital gain?

  • SRPM = $150K
  • IPA = $100K (PV of $150K payment to be made in 5 years using the AFR of 8.447%)
  • ASI = No, because the stated principal amount of $150K is not less than the IPA.

At maturity: You have picked up all OID, and upon maturity and the deemed S/E treatment, your basis is equal to the A/R.

Thus, because there is not ASI, use IPA for Issue Price. OID is therefore $50K (difference between SRPM – IP).

S is therefore deemed to have received $50K of interest income (not capital appreciation) over the five years.  S therefore only has capital gain of the difference between her “Gain” from the S/E ($130K) and the portion constituting interest ($50K). That capital gain is $80K, not $130K that S had hoped for.

Example 2

Assume same facts but assume B’s note provides B will pay $30K in five equal installments, with the first payment due one year after closing.  The effect of this is that it changes the total amount imputedly paid.  By paying down principal earlier, B will be paying less interest.

  • IPA = Sum of PVs of each payment using the AFR of 8.447%. Thus, IPA here turns out to be $119,789 (simply b/c paid down earlier).
  • OID = $150,000 – 119,789 = $30,211

$30,211 would be considered ordinary income (because it is OID which is interest) and the remaining $119,789 would be capital gain.

Example 3

Seller S sells property to B for $100K cash plus a buyer’s note of $100K, payable over 10 years at $10,000 principal per year. The APR is 10%. Under the note, however, B will pay 5% interest.  This is a below market loan, so we already know this is an OID candidate.

  • IPA = the PV of the ten payments is $79,570. So, no adequate stated interest. Thus, use IPA as Issue Price.
  • OID = $100,000 – 79,570 = $20,430.

Example 4

Assume the same facts, but B’s note provided for interest of 10%.  Would there be OID?  No.  The AFR is also 10% and the sum of PV of the payments to be made under the note would be $100,000.  There is adequate stated interest because the stated principal of $100K is less than or equal to the IPA.

Example 5

What if the interest rate were 12% and the AFR is 10%?  No OID.  The sum of the PV of the payments to be made would be $108,746.  There is adequate stated interest because the stated principal amount of $100K is less than or equal to the IPA which is $108,749.