Last week we reported on recently released PLR 201502008 (Jan. 9, 2015), which involved a total return swap (TRS) relating to an issue of tax-exempt bonds (Bonds) where the holder of the Bonds was also the TRS counterparty. The TRS originally had a term of about two years and was being extended an additional five years, resulting in a TRS termination date after the first call date of the Bonds. The pricing terms of the TRS were also being modified to reduce the borrower’s net financing costs under the Bonds and the TRS. The ruling includes some additional details of the TRS, which may be significant to the IRS ruling. (Neither our previous post nor this post describes all the terms of the TRS but please note that in considering a TRS the potential impact of all its terms must be carefully considered.) The IRS ruled in PLR 201502008 that extension of the TRS was not an abusive arbitrage device under Treasury Regulation § 1.148-10(a) and that the TRS would not be integrated with the Bonds under the authority of the IRS to compel integration under the anti-abuse rules of Treasury Regulation § 1.148-10(e).

PLR 201502008 is a helpful ruling that implicitly confirms long-standing authority and IRS private guidance that support the notion that a properly structured arrangement involving a TRS and tax-exempt bonds will not adversely affect the tax-exempt status of the bonds.

As stated in our prior post, the IRS did not address – and presumably was not asked to address — whether the Bonds and the TRS constitute a single instrument for federal tax purposes. The potential consequences of treating the Bonds and the TRS as a single instrument would include changing the amount of tax-exempt interest paid on the instrument to the amount of the net interest payment by the issuer under the combined Bonds/TRS. This would frequently deprive the Bond holder of a significant amount of tax-exempt interest. For example, assume Bonds issued at a fixed rate of 5% subject to a TRS under which the issuer receives a fixed rate of 5% and pays a variable weekly rate. The issuer would likely have a significant net receipt throughout much of the term of the TRS. Treatment of the Bonds and the TRS as a single instrument would presumably reduce the amount treated as tax-exempt interest to the amount of the Bond interest minus the issuer’s TRS net receipt. Of course, for any periods in which the issuer made a net payment under the TRS, the net payment should be treated as additional tax-exempt interest, but net payments by the issuer under the TRS would likely be the exception rather than the rule.

Because the IRS was silent on the question of whether the Bonds and the TRS must be treated as a single instrument, practitioners still must consider it when analyzing a TRS and similar products. Despite the boiler-plate language of the ruling that “[e]xcept as expressly provided herein, no opinion is expressed or implied,” we can probably conclude that the IRS would not challenge the status of the Bonds and the TRS as separate instruments for tax purposes (again noting that each of the detailed terms of the Bonds and TRS may be important to this conclusion). This is because it would seem unlikely that the IRS would give the green light on the specific arbitrage anti-abuse rules explicitly addressed in the ruling if it had serious reservations about the more fundamental question of the separate status of the Bonds and TRS.

The mere fact that we can probably draw this favorable inference from the silence of the ruling is of course not sufficient, by itself, to take any position on a proposed TRS. However, well before this ruling, sufficient authority and informal, non-authoritative pronouncements of the IRS supported the conclusion that a properly structured TRS would be respected as a financial instrument separate from the tax-exempt bonds to which it related. Those authorities and pronouncements established two primary factors that demonstrate that two instruments should be treated as separate: separate transferability and lack of compulsion – economic and otherwise – to keep the multiple instruments together in the hands of a single bondholder/counterparty.

Thus to achieve separate status for bonds and a TRS, it is first important that the two instruments be separately transferable or tradable. This requirement is routinely satisfied. Analysis of the second factor – absence of economic or other compulsion to keep the instruments together – is more subtle and can require both fine-tuning the terms of the TRS relative to the corresponding bonds as well as factual certifications of the parties and a financial expert. This second factor can be further stated as whether economic considerations compel the bondholder to remain as the TRS counterparty, and vice versa. This factor does not require an expectation that the instruments will in fact be separated during their terms but merely that separation is a realistic possibility. Support for such a conclusion should generally be available for a properly structured TRS.

Additional important factors can be found in the authorities and pronouncements relevant to respecting the separate status of bonds and a TRS. One such additional factor is that the instruments represent separate legal obligations. In other words, satisfaction of one of the instruments does not eliminate the obligation to satisfy the other instrument. The classic illustration of this factor is debt convertible into stock as contrasted with an investment unit consisting of a bond and a stock warrant. In the latter case, unlike the former, satisfaction of the bond does not eliminate the issuer’s obligation to satisfy the warrant. Other factors include whether the instruments have identical maturity dates and the degree to which the payment streams under the respective instruments are offsetting.

In summary, long-standing authority and non-authoritative IRS pronouncements, implicitly confirmed by PLR 201502008, provide sufficient comfort for combining tax-exempt bonds with a TRS. However, as is often the case, the challenge comes in setting the detailed terms of the two instruments. This continues to require a careful study of both the legal authorities as well as a thorough understanding of the marketplace in which these instruments exist.