PAYMENTS UNDER EXEMPT BOND DEFAULT AGREEMENT WON'T BE EXLCUDABLE.

Rev. Rul. 94-42

ISSUE

If an owner of bonds issued by a political subdivision of a state contracts with a third party for the third party to pay amounts equal to any shortfalls in the debt service on the bonds in the event that the issuer defaults, under what circumstances are amounts paid or accrued under the agreement for defaulted interest excludable from gross income under section 103 of the Internal Revenue Code?

FACTS

County C issued zero-coupon bonds having a 30-year term and a stated redemption price at maturity of $204x. The bonds are payable solely from revenues of a facility acquired with the bond proceeds.

One year later, in an unrelated transaction, M, the holder of the bonds, entered into an agreement with G, under which, in exchange for a payment of $14x from M, G "insured" the payment of all scheduled debt service on the bonds to M or any subsequent holder. At that time there was significant risk that revenues from the bond- financed facility would be insufficient to pay debt service. In connection with its agreement with M, G purchased $14x of United States Treasury securities yielding approximately 9.6 percent, which G transferred to a trust to secure its obligations under the agreement. The principal and interest on these securities will be sufficient to provide for timely payment of substantially all of the debt service on the bonds. G is unrelated to either M or C.

The G agreement enabled M to obtain the highest rating for the bonds from a national rating agency. M then sold the bonds to the general public for a price of $20x, giving the purchasers an annual yield of approximately 8.3 percent.

LAW AND ANALYSIS

Section 103(a) generally provides that gross income does not include interest on any State or local bond. Section 1.103-1 of the Income Tax Regulations provides that interest on obligations of a state, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof is not includable in gross income except as otherwise provided.

The exclusion from gross income of interest on obligations of states and political subdivisions thereof is not all-embracing and applies only where consistent with the purposes of section 103. See, e.g., United States Trust Co. of New York v. Anderson, 65 F.2d 575, 579 (2d Cir. 1933). An overriding purpose of section 103 is to enable state and local governments to borrow at subsidized interest rates to carry out governmental purposes.

In the present situation, the purchasers of the "insured" bonds acquired two obligations from M: the obligation of C on the bonds and the obligation of G under the agreement. The question presented is whether amounts paid or accrued on the G agreement are excludable from the gross income of the bondholders as a substitute for tax- exempt interest.

The economic substance of a transaction, rather than its form, governs for tax purposes. Gregory v. Helvering, 293 U.S. 465 (1935), XIV-1 C.B. 193. The characterization of a transaction by the parties is not determinative for federal tax purposes. Paulsen v. Commissioner, 469 U.S. 131 (1985).

Treating amounts paid or accrued under the G agreement as excludable from gross income would, in substance, permit either G, the issuer of the purported insurance, or M, the purchaser of the purported insurance, to obtain the benefit of borrowing at a tax- exempt rate and investing the proceeds at a taxable rate. The transaction closely resembles a taxable arbitrage bond under section 148, in which the issuer borrows an amount far greater than needed for its governmental purposes solely so that it can pay the costs of its governmental purposes from the arbitrage profit obtained from investing bond proceeds at taxable interest rates. Obtaining the benefit of borrowing at tax-exempt rates provides the arbitrage benefit and assures the economic viability of the purported bond insurance arrangement. This result is inconsistent with the purposes of section 103. Accordingly, in the present situation, amounts paid or accrued under the G agreement are not treated as payments on an obligation of a political subdivision.

The present situation is distinguishable from Rev. Rul. 72-134, 1972-1 C.B. 29, Rev. Rul. 72-575, 1972-2 C.B. 74, and Rev. Rul. 76- 78, 1976-1 C.B. 25. Rev. Rul. 72-134 provides that bond insurance purchased by a political subdivision against default in the payment of principal and interest on bonds of the political subdivision does not affect the exclusion from gross income of interest on those bonds under section 103(a) and that payments of defaulted interest by the insurance company to the bondholders are excludable from gross income under section 103(a). Rev. Rul. 72-575 and Rev. Rul. 76-78 extend the holding of Rev. Rul. 72-134 to bond insurance acquired by an underwriter for the bonds or by a bondholder.

Each of these revenue rulings involved a customary bond insurance contract. Such insurance, whether purchased by the issuer or separately by the bondholders, enhances the marketability of the bonds, without artificially overburdening the market with tax-exempt bonds. Accordingly, integrating the insurance contract with the obligation of a political subdivision, and treating payments of defaulted interest by the insurance company as excludable from gross income, is generally not inconsistent with the purposes of section 103. However, such treatment would be inconsistent with the purposes of section and other related Code provisions if the bond insurance either were not incidental to the bonds or were a separate debt instrument or similar investment.

For this purpose, an insurance contract or similar agreement is treated as both incidental to bonds and not a separate debt instrument or similar investment only if, at the time it is purchased, the amount paid is reasonable, customary, and consistent with the reasonable expectation that the issuer of the bonds, rather than the insurer, will pay debt service on the bonds. Compare section 1.148-4(f)(3), which provides that, for an arrangement to be a qualified guarantee for section 148 purposes, the guarantor must not expect to make any payments other than payments for which it will be reimbursed immediately.

On the facts presented, at the time M entered into the agreement with G, the premium was not reasonable and customary, and M looked primarily to G for payment of the debt service on the bonds. The reasonable expectation that G rather than C would make the payments is evidenced by M's payment to G of an amount sufficient to fund substantially all of the payments of debt service.

Accordingly, any amount paid or accrued on the G agreement is not appropriately treated as a payment by C for purposes of section 103 of the Code. Rather, those amounts are subject to the general tax rules for taxable investments. On the facts presented, the G agreement is a debt instrument subject to the rules of sections 1271 through 1275 of the Code.

HOLDING

Amounts paid or accrued under an agreement for defaulted interest are not excludable from gross income under section 103 if the agreement is not incidental or is in substance a separate debt instrument or similar investment when purchased. An agreement is treated as both incidental and not a separate debt instrument or similar investment if, at the time it is purchased, the amount paid to obtain the agreement is reasonable, customary, and consistent with the reasonable expectation that the issuer of the bonds, rather than the insurer, will pay debt service on the bonds. The result is the same regardless of whether the holder that purchases the agreement acquired the bonds at original issuance or on the secondary market.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 72-134, Rev. Rul. 72-575, and Rev. Rul. 76-78 are clarified and distinguished.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Michael G. Bailey and Nancy M. Lashnits of the Office of Assistant Chief Counsel (Financial Institutions and Products). For further information regarding this revenue ruling contact Nancy M. Lashnits on (202) 622- 3980 (not a toll-free call).