ABA MEMBERS OFFER RECOMMENDATIONS ON TREATMENT OF RICs' SYNTHETIC DEBT.

The report points out that for a number of years, synthetic tax- exempt securities have been sold to investors in the municipal market. Those securities typically consist of long-term fixed-rate tax-exempt bonds, a liquidity feature such as a put option permitting investors to tender their investment on a daily, weekly, monthly, or longer basis, and a mechanism that converts the fixed rate on the bonds into a short-term variable tax-exempt interest rate.

For a mutual fund to pay dividends that can be characterized as tax-exempt income, the report notes, it must qualify as a regulated investment company (RIC) under the special rules of subchapter M. For a mutual fund to qualify as a RIC, it must meet a number of tests relating to the nature of the income that it earns, the diversification of its investments, and the timing of distributions to its shareholders. The report states that the investment in synthetic tax-exempt securities raises issues relating to the fund's determination that it has satisfied those tests.

In their report, the ABA members address the relevant issues and make a number of recommendations on the treatment of synthetic debt under sections 851, 852, 1223, and 4982. Included with the report is a proposed revenue ruling covering the issues addressed in the report.

I am enclosing comments on the above noted report as prepared by members of the Regulated Investment Companies Committee. This report was reviewed by members of our Committee on Government Submissions.

This report represents the individual views of the members who prepared it and do not represent the position of the American Bar Association or of the Section of Taxation.

Sincerely,

AMERICAN BAR ASSOCIATION

REPORT ON FEDERAL INCOME TAX ISSUES UNDER SUBCHAPTER M OF THE INTERNAL REVENUE CODE RELATING TO THE QUALIFICATION OF TAX-EXEMPT SYNTHETIC DEBT HELD BY MONEY MARKET MUTUAL FUNDS

This report contains the individual views of the members of the Section of Taxation who prepared it and does not represent the position of the American Bar Association or of the Section of Taxation.

This report was prepared by the Qualification of Tax-Exempt Synthetic Debt Task Force (the "Task Force") of the Regulated Investment Companies Committee of the Section of Taxation. Principal responsibility was exercised by Steven D. Conlon, Task Force Chair, Cameron N. Cosby, Steven J. Gee, David J. Mangefrida, Jr., Jeffrey S. Sion and Suzanne M. Russell. Substantial comments were provided by Joseph P. Dunne, Gary A. Herrmann, Richard M. Hervey and Deborah A. Pege. Helpful comments were provided by David M. Mahle. This report was reviewed by Peter J. Connors of the Committee on Government Submissions.

The interests of clients represented by members of the Tax Section may benefit from the adoption of the recommendations which are made in these comments.

Contact Person: Steven D. Conlon (312) 845-3918

                          TABLE OF CONTENTS

As a result of federal tax law changes enacted in 1986, the declining credit quality of a number of issuers and obligors of tax- exempt bonds and the continued growth of the tax-exempt money market fund as an investment vehicle for many individual investors, the demand for high quality short-term tax-exempt investments has outstripped the supply. Accordingly, tax-exempt money market mutual funds have recently turned to "synthetic tax-exempt securities" as a means of satisfying their need for eligible tax-exempt investments.

For a number of years, synthetic tax-exempt securities have been sold to investors in the municipal market. These securities typically consist of long-term fixed-rate tax-exempt bonds, a liquidity feature such as a put option permitting investors to tender their investment for purchase under certain circumstances on a daily, weekly, monthly or longer basis and a mechanism that effectively converts the fixed rate on the bonds into a short-term variable tax-exempt interest rate. Synthetic tax-exempt securities raise several fundamental federal income tax issues, such as (1) the impact of the put on the status of the investor as the owner of the underlying tax-exempt bond (and therefore the recipient of tax-exempt interest); (2) the impact of the investment arrangement on the tax-exempt status of the underlying bond; and (3) the "flow through" treatment of distributions on the underlying bonds to investors as retaining their tax-exempt character (i.e., the determination that the investment arrangement does not constitute an association taxable as a corporation). ¹ In addition, depending upon the specifics of a synthetic tax-exempt security, a number of additional federal income tax issues may be present.

The three highlighted issues and the other federal income tax issues raised by these securities are complex and may possibly require careful analysis by the Internal Revenue Service (the "Service") in light of the inherently factual nature of these issues (which could possibly inhibit the formulation of an easily administrable set of rules relating to these issues that could be applied in a generic fashion to all of the different permutations of these securities). The Service must also give consideration to the collateral impact of issuing guidance in this area on the federal income tax analysis of securities and taxpayers outside of the municipal market. Moreover, many of these fundamental tax issues are not new; synthetic tax-exempt securities have been in the market for some time. Accordingly, although we fully acknowledge the significance of these issues, this report is limited in scope to the application of the specialized rules of Subchapter M of the Code with respect to the ownership by a regulated investment company of these types of securities. The report does not request guidance on the three fundamental federal income tax issues set forth above relating to synthetic tax-exempt securities and is not intended to generally address the taxation of issuers of or investors (other than regulated investment companies) holding financial products.

In order for a mutual fund to pay dividends that can be characterized as tax-exempt income, it must as a prerequisite elect to be treated as and qualify on an ongoing basis as a regulated investment company ("RIC") under the special rules of Subchapter M of the Code.

For a mutual fund to qualify as a RIC under Subchapter M of the Code, it must meet a number of tests relating to the nature of the income that it earns, the diversification of its investments and the timing of distributions of its income to its shareholders. The investment by a mutual fund in synthetic tax-exempt securities raises issues relating to the fund's determination that it has satisfied these tests. Failure to satisfy these tests could have dire consequences for a mutual fund, including the potential reclassification of distributions to its investors as fully taxable that were intended to qualify as tax-exempt. Thus, this report addresses the federal income tax aspects of investments by mutual funds in synthetic tax-exempt securities under the special rules of Subchapter M of the Code and recommends that guidance be provided by the Service on the matters set forth herein in the form of a published revenue ruling.

A. SUMMARY OF RECOMMENDATIONS

1. For purposes of applying Section 851(b)(2)(unless otherwise specified, all "Section" references shall refer to the Code), net payments received under an interest rate swap agreement should constitute qualifying income.

2. For purposes of applying Section 851(b)(3), a put structure should generally be treated as consisting of a single put with multiple payments.

3. For purposes of Section 851(b)(4), a majority of the task force members believe that the synthetic tax-exempt security should be treated as a single security issued by the issuer of the underlying bonds (or in the case of industrial development bonds and private activity bonds, the private business obligated to make payments to the issuer corresponding to the issuer's payments on the bonds). Alternatively, if a "look-through" approach is adopted, the issuer of the related bond should be treated as the issuer of the put and the swap counterparty should be treated as the issuer of any related swap agreement.

4. For purposes of Section 851(b)(4), if a single security approach is adopted, the synthetic tax-exempt security should generally be valued at par. Alternatively, if a "look-through" approach is adopted, the value of the underlying municipal bonds should equal their current market value. A majority of the task force believe that the fund's interest in the par put or the swap agreement should generally be determined under a residual value approach based upon the amount, if any, by which the value of the synthetic tax-exempt security exceeds the value of the underlying bond.

5. A majority of the task force members believe that for purposes of Section 852(a)(1), put fees, like insurance premiums, should be deductible.

6. For purposes of Section 852(a)(1), net swap obligations should be deductible.

7. For purposes of computing its excise tax liability under Section 4982, a RIC should be permitted to estimate its periodic swap payment at the end of the calendar year.

II. BACKGROUND -- RULE 2a-7 AND THE DEMAND FOR ELIGIBLE SECURITIES

A "money market fund," for purposes of this report, is a mutual fund that (1) has registered under the Investment Company Act of 1940 (the "1940 Act"), (2) has elected to be treated as and qualifies as a RIC, and (3) satisfies the special requirements of Section 270.2a-7 of the Rules and Regulations of the 1940 Act ("Rule 2a-7"). Rule 2a-7 permits money market funds to use the amortized cost method of valuing portfolio securities and the penny-rounding method of computing price per share. Rule 2a-7 includes provisions intended to reduce the likelihood that a money market fund will not be able to maintain a stable net asset value. These provisions include requirements relating to portfolio maturity, quality and diversification.

With respect to portfolio maturity, money market funds that use the amortized cost method permitted under the Rule 2a-7 may not purchase any instrument with a remaining maturity of greater than 397 days. ² Subsection (d)(3) of the rule provides that for purposes of calculating the maturity of a "variable rate instrument," such instrument shall be deemed to have a maturity equal to the period remaining until the longer of the period remaining until the next readjustment date of the interest rate or the next date payment of principal can be recovered through demand. Subsection (d)(4) of the rule provides that for purposes of calculating the maturity of a "floating rate instrument," such instrument shall be deemed to have a maturity equal to the period remaining until the next date payment of principal can be demanded. Thus, a qualifying demand feature (a "Demand Feature" or "Put") may be used to effectively shorten the maturity of a tax-exempt security that qualifies as either a "variable rate instrument" or a "floating rate instrument" under Rule 2a-7. ³

Because of the portfolio maturity, quality and diversification requirements that are imposed by Rule 2a-7, tax-exempt money market funds generally seek to invest their assets in short-term tax-exempt obligations that have floating interest rates. ⁴ Over the past several years, the supply of more traditional types of high credit quality, short-term floating rate tax-exempt obligations has dec- lined. ⁵ During the same period, however, the assets of tax-exempt, money market funds have grown dramatically. ⁶ The rapid growth of tax-exempt money market funds, accompanied by the short supply of eligible investments for those funds, has created a strong demand for short-term floating rate tax-exempt obligations. In response to that demand, synthetic tax-exempt securities have gained acceptance in the marketplace, and surveys have suggested that at least forty percent of all tax-exempt money market funds have invested in such securities. ⁷ Synthetic tax-exempt securities are in many cases intended to satisfy the portfolio maturity and quality requirements of Rule 2a-7 and to provide tax-exempt money market funds with income that is exempt from federal income tax. More importantly, because the growth of tax-exempt money market funds as an investment vehicle for many individuals is expected to continue at a rate in excess of the growth of the available supply of more traditional forms of short- term tax-exempt floating rate instruments, it is likely that synthetic tax-exempt securities will become an increasingly important form of eligible investment for tax-exempt money market funds.

Because of the portfolio maturity requirements of Rule 2a-7, synthetic tax-exempt securities generally provide their holders (the "Holders") with a put option exercisable at a price of par plus accrued interest (the "Par Put"). In addition, in order to qualify as floating rate instruments or variable rate instruments under Rule 2a- 7 such synthetic tax-exempt securities are structured so that they convert fixed rate tax-exempt bonds (or in certain cases, floating interest rate bonds)(the "Bonds") into variable rate tax-exempt certificates ("Certificates"). Many variations of these products currently exist in the market. Several basic types of these securities must be more fully described in order to identify the features thereof that raise potential federal income tax issues under Subchapter M of the Code. It is important to note that descriptions set forth below are necessarily general in character, are not intended to describe particular products and do not reflect the detailed analysis of the parties involved.

One type of synthetic tax-exempt security, the "Put Fee Structure," involves the payment of a fee, generally to the provider of the Par Put, that is essentially equivalent to the amount by which the fixed rate on the Bonds, net of ongoing expenses (the "Net Fixed Rate"), exceeds the variable rate on the related Certificates (the "Variable Rate"). The Variable Rate is often determined by a remarketing agent and generally corresponds to a market index for comparable short-term tax-exempt obligations.

A second type of synthetic tax-exempt security, the "Swap Structure," involves the use of an interest rate swap agreement to effectively convert the Net Fixed Rate to the Variable Rate. A separate Par Put is provided to the Holder to satisfy the liquidity requirements of Rule 2a-7. Under the Swap Structure, the fee paid for the put is a nominal fixed amount.

Under either type of structure the Certificates typically represent an interest in a custodial account or trust (the "Issuing Entity"). The Issuing Entity is generally structured to qualify either as a grantor trust or a partnership for federal income tax purposes. ⁸

A. PUT FEE STRUCTURE

The Holders in the Put Fee Structure are entitled to all principal payments received on the Bonds and interest distributions at the Variable Rate. The Net Fixed Rate is converted to the Variable Rate by the Issuing Entity's entering into a fee agreement the "Put Fee Agreement" with one of the sponsors of the transaction the "Put Providee". Under the Put Fee Agreement, the Holders pay the Put Provider an amount equal to any positive difference between the Net Fixed Rate and the Variable Rate multiplied by the outstanding principal balance of the Bonds (the "Floating Rate Spread"). The amount of the Floating Rate Spread received by the Put Provider varies inversely with the Variable Rate and is zero whenever the Variable Rate equals or exceeds the Net Fixed Rate. If the Variable Rate exceeds the Net Fixed Rate, the Put Provider is required to pay the Issuing Entity an amount equal to the difference between the two rates multiplied by the outstanding principal amount of the Bonds. However, because the Variable Rate is typically not permitted to exceed the fixed rate on the Bonds (the "Gross Fixed Rate") under this type of structure, the Put Provider is generally not obligated to fund interest distributions on the Certificates. The Put Provider's only potential liability is its obligation to pay fees owed to other service providers (e.g., custodial, trustee, liquidity, remarketing, and credit enhancement fees) to the extent that the Issuing Entity has insufficient funds to pay such fees because the Variable Rate exceeds the Net Fixed Rate. The Floating Rate Spread paid to the Put Provider is often denominated as a "put fee" paid as compensation for the Put Provider's ultimate obligation to fund any exercise by a Holder of his Par Put. The Put Provider normally obtains a bank letter of credit to secure its obligation to fund any exercise of the Par Put.

The Par Put received by a Holder in the Put Fee Structure is generally designed to insure that the Holder retain certain risks of loss relating to the Bond. This is often accomplished by providing that the Par Put automatically terminates and cannot be exercised if (1) there is a default on the Bonds, (2) the Bonds' ratings fall below investment grade, or (3) an event of taxability occurs with respect to the Bonds. In certain structures, the term of the Par Put expires significantly before the date the Bonds mature and ordinarily cannot be renewed. Holders often have the right to cancel both the Par Put and their obligation to make the fee payment to the Put Provider. Upon exercise of such a right, a Holder would receive direct ownership of the Bond or interest distributions on the Certificate at the Net Fixed Rate. ⁹ In many cases, a Holder who elects to cancel the Par Put must make a termination payment to the Put Provider that is designed to compensate the Put Provider for unwinding any hedging transactions entered into in connection with providing the Par Put.

B. SWAP STRUCTURE

Under the Swap Structure, the Issuing Entity enters into an interest rate swap agreement (the "Swap Agreement") with a third party (the "Swap Counterparty"). The Swap Agreement incorporates a notional principal amount equal to the outstanding principal balance on the Bonds (or the fair market value of the Bonds as of the date the structure is formed) and obligates the Issuing Entity to pay the Swap Counterparty the Net Fixed Rate accruing on the Bonds in exchange for the Variable Rate determined with respect to the Certificates. ¹⁰ On each interest payment date, the payment obligations of the two parties are netted against each other, resulting in a net payment to the Swap Counterparty as long as the Net Fixed Rate exceeds the Variable Rate (the "Net Payment"). If, however, the Variable Rate rises so that it exceeds the Net Fixed Rate, the Swap Counterparty is required to make a net payment to the Issuing Entity.

In many cases, the value of the Bonds at the time the synthetic tax-exempt security is created (which is when the Swap Agreement is executed) and the terms of the swap require one of the parties to make an up-front payment (a "Swap Premium") to the other at closing. A Swap Premium may be paid to compensate the Issuing Entity for the fact that it is more likely to make than to receive payments under the Swap Agreement. The amount of the Swap Premium (and who receives it) may also bear a relationship to the amount of market premium or discount (and accrued interest), if any, with respect to the Bonds as of the time the synthetic tax-exempt security is created.

As is the case with the Put Fee Structure, the Par Put typically expires if there is a default, decline in rating, or event of taxability with respect to the Bonds. Like the Put Fee Structure, a bank usually issues a letter of credit to the liquidity provider to secure the Put Provider's obligation to fund any exercise of the Par Put. If a Holder exercises the Par Put, the Certificate is transferred to the Put Provider and is then remarketed. A Holder is often permitted to elect to terminate the interest in the Swap Agreement that relates to a Certificate, thereby permitting the Holder to either receive directly its share of the Bonds represented by a Certificate or receive interest on the Certificate at the Net Fixed Rate. If the Holder makes this election, it is typically required to either make or receive a terminating payment with respect to the termination of the related portion of the Swap Agreement. The terminating payment is typically determined in the same manner that terminating payments for other types of interest rate swaps are determined (i.e., by reference to the present value of the cost or benefit of replacing the terminated side of the swap at the then- applicable market rate). The Holder may also recognize an offsetting gain or loss on its interest in the Bonds. The Swap Counterparty also has the right to terminate the Swap Agreement, but, if that right exercised, the Holders typically have the option to retain ownership of the Bonds free of the Swap Agreement and the Par Put.

III. IDENTIFICATION OF THE RELEVANT TAX ISSUES

Money market funds investing in synthetic tax-exempt securities expect to receive interest which is tax-exempt for federal income tax purposes. As stated above, the principal federal income tax issues relate to (1) the impact of the Par Put on the Holder's status as the "owner" of the Bonds; (2) the continued tax-exempt status of the Bonds; and (3) the status of the Issuing Entity as a grantor trust or a partnership. All of these issues must be resolved favorably if the Holder is to be ensured of receiving tax-exempt interest. For the reasons indicated at the outset of this report, guidance is not being requested herein on these fundamental issues.

A. TAX OWNERSHIP

It is important to determine that either (1) in a structure where the Issuing Entity is classified as a grantor trust, that the Holder is deemed to be the owner of the underlying Bonds or (2)(A) in a structure where the Issuing Entity is classified as a partnership, that the Issuing Entity is deemed to be the owner of the underlying Bonds, and (B) The RIC owns a partnership interest in the Issuing Entity. Otherwise, the RIC will not receive tax-exempt income. For example, if the Holder of a synthetic tax-exempt security is not deemed to be the owner of the Bond, the transaction may be characterized in a fashion similar to a repurchase agreement or "repo;" i.e., treated as a loan by the Holder to the Put Provider. ¹¹

There is a significant body of law addressing the ownership issue. ¹² The determination or ownership, a factual issue, is based upon an analysis of whether the putative "owner" retains sufficient benefits and burdens ownership. ¹³

In Rev. Proc. 83-55. ¹⁴ the Service announced that it would no longer ordinarily issue rulings regarding the "determination as to who is the true owner of property in cases involving the sale of securities, or participation interests therein, where the purchaser has the contractual right to cause the security, or participation interests therein, to be purchased by either the seller or a third party." This "no ruling" position is currently set forth in Rev. Proc. 92-3. ¹⁵ Consistent with this position, no guidance is requested on this issue with respect to the types of securities described herein.

B. TAX-EXEMPT STATUS OF THE BONDS

Although obvious, it is important to note that the interest on a synthetic tax-exempt security is only tax-exempt if the interest on the underlying Bond qualifies as tax-exempt. ¹⁶ If interest on the Bond is a preference item for alternative minimum tax purposes, distributions of income on the Certificates will similarly constitute a preference item for alternative minimum tax purposes.

C. ENTITY CLASSIFICATION ISSUES

It must be determined whether (1) the Issuing Entity constitutes a separate taxable entity for federal income tax purposes and (2) whether interest received on the Bonds by the Issuing Entity retains its tax-exempt character when such amounts are distributed to the investor (i.e., whether the character of such income "passes through" the Issuing Entity to the Holders for federal income tax purposes).

The Issuing Entity may be structured to qualify as a trust under the "investment trust" rules of Treas. Reg. Section 301.7701-4(c). These rules restrict the trustee's or custodian's power to vary the investments of the trust and generally require that only one class of beneficial interests be present. ¹⁷

Assuming that an Issuing Entity is properly classified as a trust, it must be considered whether the trust will qualify as a "pass-through" entity for federal income tax purposes. Based on a long line of published revenue rulings involving mortgage pass- through trusts and published revenue rulings involving unit investment trusts, an Issuing Entity that is properly classified as a trust under the investment trust rules of Treas. Reg. Section 301.7701-4 should qualify as a "grantor trust" for federal income tax purposes. As a grantor trust, Holders of Certificates issued by an Issuing Entity that is classified as a trust are treated as owning a pro rata portion of the Issuing Entity's assets (i.e., the assets held in the trust or custodial account) and, therefore, are treated as receiving a pro rata portion of the tax-exempt interest on the Bond. ¹⁸ Moreover, under the grantor trust rules, each Holder is deemed to receive a pro rata portion of the fixed rate of interest payable on the Bonds. Similarly, the Holders are deemed to have used a portion of the tax-exempt interest to pay the Put Provider its fee.

As an alternative to the grantor trust arrangement, synthetic tax-exempt securities may be structured as interests in partnerships. A money market fund investing in this type of structure would therefore be a "partner." Typically, the Issuing Entity will be structured as a trust that will be treated as a partnership for federal income tax purposes, with the sponsor or Put Provider as a "general partner" and the investors as "limited partners."

Partnership qualification requires compliance with the four- factor test of Treas. Reg. Section 301.7701-2 and the publicly traded partnership rules of Section 7704. Under the four-factor test of Treas. Reg. Section 301.7701-2, for an entity to be treated as a partnership for federal income tax purposes, not more than two of the four enumerated factors may apply to the entity. These factors are (i) centralization of management; (ii) limited liability; (iii) continuity of life; and (iv) free transferability of interests. These tests are sufficiently straightforward to permit Issuing Entities to qualify as partnerships under this four-factor test.

It must also be determined that an Issuing Entity is not classified as a "publicly traded partnership" under Section 7704, which would be taxed as a corporation. Under Section 7704(b), any partnership whose interests are traded on an established securities market or are readily tradable on a secondary market or the "substantial equivalent" of a secondary market is a "publicly traded partnership." In Notice 88-75, ¹⁹ the Internal Revenue Service provides certain safe harbors from the definition of a "publicly traded partnership." One such safe harbor specifies that interests in a partnership will not be treated as readily tradable on a secondary market or the substantial equivalent thereof if (i) the partnership interests are issued in a transaction that is not registered under the Securities Act of 1933, and (ii) either (A) the partnership does not have more than 500 partners or (B) the initial offering price of each unit is at least $20,000, and the partnership agreement does not permit the subdivision of units into denominations of less than $20,000. ²⁰

D. COLLATERAL TAX ISSUES

1. TAXATION OF OPTIONS

When a RIC invests in puts (options to sell), various tax issues may be raised, particularly related to the treatment of the option premium. The tax consequences depend upon whether the put is exercised, sold, or allowed to lapse without being exercised. In addition, tax consequences can vary depending upon whether there is, in actuality, one long-term put with periodic payment dates or a series of short-term puts (with their own exercise dates) all relating to the same property. Related to this issue are special "married put" rules which apply when an option and the property to which it relates are acquired on the same day. In order to determine whether the married put rules apply, it must be ascertained whether the structure contains only one option or multiple options.

In Dunlap v. Commissioner, ²¹ the Tax Court found a series of options to purchase a building to consist of multiple options and, accordingly, allowed the taxpayer to deduct the cost of an option as that particular option lapsed. ²² However, the Eighth Circuit disagreed with this analysis and concluded that the "option did not lapse because [the taxpayer's] right to purchase the building continued for ten years unless and until it exercised an option." ²³ Accordingly, the Eighth Circuit held that the taxpayer could not realize a loss until the option finally terminated at the end of the ten-year period.

In addition, in Koch v. Commissioner, ²⁴ an agreement was held to constitute a single 5-year option with quarterly payments to keep the option effective rather than a series of 3-month options to buy property. The court referred to the following passage from Rev. Rul. 58-234:

Usually, the premium paid for either a "put" or "call" is not, under its terms or otherwise, applicable, if it is exercised, against its option price, but it is sometimes so provided in "call" options. However, it is considered unrealistic to distinguish, for the purpose of determining proper Federal income tax treatment, between an option whereunder the amount of the premium is applicable, in such event, against the option price and one whereunder the amount of the premium is not so applicable since there is no real difference between them. The substance is the same, and their formal difference involves merely a different way of stating the (real) option price

* * * *

* * * [T]here is no closed transaction nor ascertainable . . . income or gain realized by an optionor upon mere receipt of a premium for granting such an option. . . . It is manifest, from the nature and consequences of "put" or "call" option premiums and obligations, that there is no Federal income tax incidence on account of either the receipt or the payment of such option premiums, i.e., from the standpoint of either the optionor or the optionee, unless and until the options have been terminated, by failure to exercise otherwise, with resultant gain or loss. ²⁵

Accordingly, it seems reasonable to view most structures as embodying a single renewable put with multiple payment dates rather than multiple puts. ²⁶

Various Revenue Rulings have addressed the tax consequences under Section 1234 of premium payments to the optionor and the optionee in terms of character and timing. With respect to the holders of puts, they provide the following rules. Since the purchase of a put is a transaction entered into without respect to any particular acquisition of shares of the stock named, the cost of a put upon its acquisition should not be entered as a part of the purchase price of any particular block of stock. Rather, it should be carried in a deferred account as a capital expenditure made in an incompleted transaction entered into for profit. ²⁷

When a put is sold prior to being exercised, gain or loss recognized to the holder (assuming that the holder is not a dealer and the put relates to a capital asset) is generally a capital gain or loss and is short-term or long-term depending on the holding period of the put. ²⁸ When a put lapses without being exercised, the expiration is treated as a sale or exchange of the put on the expiration date. The resulting loss is a capital loss and is short- term or long-term depending on the holding period of the put. ²⁹

When a put is exercised, the cost of the put reduces the amount realized upon the sale of the underlying stock in determining gain or loss. Such gain or loss is capital gain or loss, depending on the holding period of the stock. ³⁰

A special rule applies to "married puts." Under Section 1234(a)(3)(C), the provisions of Section 1234(a) do not apply in the case of "a loss attributable to failure to exercise an option described in section 1233(c)." Section 1233(c) addresses "an option to sell property at a fixed price acquired on the same day on which the property identified as intended to be used in exercising such option is acquired and which, if exercised, is exercised through the sale of the property so identified." Section 1233(c) provides that the short sale rules of Section 1233(b) do not apply to such options, and that if the option is not exercised, the cost of the option is added to the basis of the property with which it is identified. ³¹ Under Rev. Rul. 78-182, ³² if the put is exercised and the identified property is delivered, the premium paid for the put reduces the amount realized on the sale.

Section 1233(c) is clear in its requirement that the put and the underlying property be acquired on the same day for the put to constitute a "married put." Moreover, Treasury Regulation Section 1.1233-1(c)(3) states that "[i]f the option itself does not specifically identify the property to be used in exercising the option, then the identification of such property shall be made by appropriate entries in the taxpayer's records within 15 days after the date such property is acquired. . . ."

In conclusion, an option with several periodic payments should be treated as a single long-term option, not a series of short-term options. The option premium payments will not be taken into account for tax purposes until the option is sold, lapses, or is exercised. If the put and the underlying property are acquired on the same date, then the special "married put" rules discussed above will govern the tax treatment of the premium.

2. PURCHASE OF BONDS AT DISCOUNT OR PREMIUM.

The price paid by the Holder for the Bond contained in a grantor trust structure and the price paid by the Issuing Entity for the Bond in a partnership structure must be considered in analyzing various tax consequences.

For example, if a Holder is deemed to have paid a price for the Bond that is greater than the face amount of the Bond, the amount of such excess will be treated as "bond premium," which is required to be amortized pursuant to Section 171 of the Code. ³³ As bond premium is amortized, the Holder's basis in the Bond is reduced. It is important to note, however, that the amortization of bond premium with respect to a tax-exempt bond does not result in any deduction from gross income under Section 171(a)(2) of the Code.

If the structure holds Bonds that were originally issued at a discount from their face amount, the difference between the Bond's issue price and its stated redemption price at maturity would constitute tax-exempt "original issue discount." ³⁴ Tax-exempt original issue discount essentially accrues as tax-exempt interest over the life of a tax-exempt bond because it increases the Holder's basis in such Bond as the original issue discount accrues but is not included by the Holder in taxable income. Original issue discount generally accrues on the basis of the constant yield method of accrual. ³⁵ Because original issue discount is added to the investor's cost basis in the bond as it accrues, it is taken into account in determining the amount of any net gain from any subsequent disposition or sale of such bond.

If a Holder of a synthetic tax-exempt security is deemed to have purchased a tax-exempt bond at a "market discount" (i.e., at a price below the outstanding principal amount thereof or, in the case of a bond having original issue discount, the adjusted issue price thereof), taxable gain is recognized upon the receipt of principal payments (both at or prior to its stated maturity). The amount of gain recognized is based upon the difference between the principal amount received and the Holder's basis with respect thereto. Market discount with respect to a tax-exempt bond is not subject to reclassification as ordinary income under the market discount rules of Sections 1276 through 1278, pursuant to Section 1278(a)(l)(B)(ii).

3. INTEREST RATE SWAPS

Swaps raise a number of potential taxable income-generating collateral issues. These are discussed below: ³⁶

(i) INCOME GENERATED BY THE AMORTIZATION OF SWAP PREMIUM

The amortization of any Swap Premium received by the Issuing Entity on behalf of the Holders may generate taxable income to such Holders if the amount of Swap Premium amortized for any particular tax year of a Holder exceeds the amount of Net Payments accrued on the Swap Agreement by the Issuing Entity for such tax year.

It is important to note that regardless of the economic amortization of bond premium, if any, relating to the Bonds held by the Issuing Entity and regardless of whether such bond premium amortization essentially matches the amortization of Swap Premium, the income generated by the ongoing amortization of the Swap Premium is taxable income while the potentially offsetting amount of amortized bond premium is non-deductible. This is the case even though any bond premium must be amortized and will reduce the owner's tax basis in the Bond.

(ii) RECEIPT OF SWAP PAYMENTS DURING TAX YEAR

If on a net basis for any tax year of a Holder, payments are accrued on the Swap Agreement by the Issuing Entity for the benefit of the Holders, these amounts constitute taxable income. They do not constitute tax-exempt interest income. Setting aside the additional amounts of amortized Swap Premium that may need to be taken into account in determining whether net amounts were accrued by a Holder during his tax year, this atypical situation would only occur if the Variable Rate with respect to the Certificates exceeded the Net Fixed Rate, because, under recently issued Proposed Regulations on notional principal contracts (the "Swap Regulations"), ³⁷ the computation of income or expense with respect to a swap agreement is determined on a "net" basis. ³⁸ The Swap Regulations also include a method of estimating ongoing swap payment receipts and liabilities for purposes of computing taxable income when the variable rate on the swap for a particular period is not determined until after the end of the taxpayer's current tax year. During the succeeding tax year of the taxpayer, an adjustment is made to account for any difference between the estimated amount of the ongoing swap payment and the actual amount of the payment. ³⁹

Even in Put Fee Structures, the Floating Rate Spread and any applicable put termination payments may be determined based on notional principal contract elements. In that case, the Swap Regulations appear particularly relevant only if the notional principal contract elements of the put fee are terminated or transferred to a third party. ⁴⁰ If the notional principal elements of the Par Put are considered a straddle (assuming that the floating rate payment obligation constitutes a specified index under the Swap Regulations, which is unclear), ⁴¹ termination will result in capital gain or loss under Section 1234A.

(iii) AMORTIZATION OF SWAP PREMIUM

Similar to the rules previously set forth in Notice 89-21, ⁴² the Swap Regulations provide that Swap Premium is not included in income upon receipt, but rather must be amortized into income over the term of the swap based on a "reasonable method." ⁴³ Under the Swap Regulations, Swap Premium on an interest rate swap can be amortized under only two methods: (1) the level payment constant yield to maturity method or (2) in accordance with the value of a series of cash-settled forward contracts that reflect the specified index and notional principal amount of the swap. ⁴⁴ The straight line method is not permitted. ⁴⁵

Each year, the amount of the Swap Premium to be amortized into the recipient's taxable income must be computed, based upon the permitted method of amortization used by such recipient. ⁴⁶ If the amount of Swap Premium amortized for a particular year by the recipient exceeds the net amount of the periodic payment obligations of the recipient that have accrued to such recipient, it appears clear that the recipient has taxable income.

The Swap Regulations adopt a "netting approach" for purposes of determining the amount of taxable income or expense accrued with respect to the swap for the current tax year by permitting a recipient to first offset the amount of Swap Premium amortizable for the tax year against the year's "net" payment obligation of the recipient that has accrued under the Swap Agreement. ⁴⁷

(iv) EMBEDDED LOAN ISSUES

The Swap Regulations provide that a swap with "significant nonperiodic payments" is to be treated as one or more loans (the "Embedded Loan"). ⁴⁸ The Swap Regulations do not provide clear guidance on what is "significant," even though they do provide two relevant examples. In one example, a Swap Premium equal to 3.7 percent of the notional principal amount of the swap contract (representing 9.1 percent of the present value of the fixed payments on the swap) was not significant, ⁴⁹ while in another example, a swap premium equal to 15.16 percent of the notional principal amount of the swap contract (representing 66.7 percent of the present value of the fixed payments on the swap was significant. ⁵⁰

Where "significant" Swap Premiums are present and a portion of the swap (including the Swap Premium) is recharacterized as an Embedded Loan pursuant to the Swap Regulations, the regulations provide that a portion of the ongoing swap payments made under the Swap Agreement will be treated as interest for all purposes of the Code. The determination that an Embedded Loan exists (which would be treated as a loan to the person receiving the significant nonperiodic payment) is important because the person deemed to have made the loan will receive interest income which it is assumed will generally constitute taxable income. Thus, a key issue with respect to a Swap Structure is whether an Embedded Loan is deemed to exist. In many cases, a Swap Structure involving a Swap Premium, if recharacterized as including an Embedded Loan, would result in a loan TO the Holder rather than FROM the Holder (which would require the computation of the imputed interest expense deductions, rather than imputed taxable interest income).

(v) DISPOSITION & DEEMED TERMINATION OF THE SWAP

There are two principal ways in which the termination of an investment and the termination of a party's interest in and obligations with respect to a Swap Agreement can ordinarily result in taxable income. First, any unamortized Swap Premium must be included in taxable income by the recipient for the recipient's tax year in which the swap terminates. ⁵¹ Second, any swap termination payment received results in taxable income. The Swap Regulations adopt a net item approach with respect to both the recognition of previously unamortized Swap Premium and the receipt of any swap termination payment. ⁵² These amounts must be netted against any ongoing payments recognized with respect to the swap for the year. ⁵³

The Swap Regulations are also clear that the assignment of the swap by either party is treated as if the swap were terminated, requiring the recognition of any unamortized Swap Premium. ⁵⁴ Thus, the assignment of the parties' rights and obligations with respect to the Swap Agreement component of a Swap Structure could potentially result in the recognition of taxable income by the Holders. This income would be capital gain, which should in most instances largely be offset by a corresponding capital loss on the Bonds. ⁵⁵

IV. SECTION 851(b)(2) -- 90% QUALIFYING INCOME ANALYSIS

Section 851(b)(2) imposes a requirement respecting the gross income of RICs to ensure that corporations qualifying as RICs are essentially engaging in passive investment activities rather than acting as normal business corporations. ⁵⁶ In particular, Section 851 (b)(2) sets forth as follows the following income test (the "90% Income Test") that a corporation must satisfy each tax year in order to qualify as a RIC:

at least 90 percent of its gross income is derived from dividends, interest, payments with respect to securities loans (as defined in section 512(a)(5)), and gains from the sale or other disposition of stock or securities (as defined in section 2(a)(36) of the Investment Company Act of 1940, as amended) or foreign currencies, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities, or currencies.

Under Section 2(a)(36) of the 1940 Act, as referenced in the 90% Income Test, a "security" is broadly defined (the "Qualifying Security Definition") as:

any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

A. PUTS

ISSUE: How will the Par Put component of a synthetic tax-exempt security impact the gross income of a RIC for purposes of Section 851(b)(2)?

DISCUSSION: Transactions involving puts purchased by the RIC may affect its gross income for purposes of the 90% Income Test. If a RIC exercises a put option, the cost of the premium paid is offset against the price received on the sale of the underlying stock in determining the amount of gain or loss on the sale of the underlying stock. ⁵⁷ If the RIC sells a put option, the gain realized, if any, qualifies for the 90% Income Test because the Qualifying Security Definition specifically includes a put option. If a put option is allowed to lapse without being exercised, a loss will arise on the day the option lapses. ⁵⁸

CONCLUSION: In each situation involving the purchase, exercise or termination of puts, gains (but not losses) will be included in the computation of qualifying income for purposes of the 90% Income Test. ⁵⁹ Therefore, such treatment does not pose a problem for purposes of determining whether a RIC has satisfied the 90% Income Test.

B. SWAPS

ISSUE: How will the participation in a Swap Agreement by a RIC impact its determination of qualifying income for purposes of the 90% Income Test?

DISCUSSION: With respect to swaps, the reference to "other income" in the statutory definition of the 90% Income Test is relevant. In determining whether the income from swap payments constitutes income for purposes of the 90% Income Test, it seems necessary to consider whether net payments qualify as "other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business in investing in such stock, securities, or currencies." Because the Swap Agreement is an integral component of the synthetic tax-exempt security and the purpose of the Swap Agreement is to hedge interest rate fluctuations with respect to the underlying Bond and create a Rule 2a-7 eligible security, this question should be answered affirmatively.

RECOMMENDATION: Net payments received under a Swap Agreement should constitute qualifying income for purposes of the 90% Income Test.

V. SECTION 851(b)(3) -- THE 30% TEST

Section 851(b)(3) provides, in relevant part, that in order for a corporation to qualify as a RIC, it must derive less than 30 percent of its gross income from the sale or disposition of stock, securities, options, futures, or forward contracts which have been held for less than three months (the "30% Test"). ⁶⁰

Since the 30% Test is based on the amount or time a particular instrument has been "held," the key determinant for purposes of the test is which holding period rules apply. The holding period of an instrument for purposes or the 30% Test is generally determined under the rules of Section 1223. ⁶¹ However, consideration must also be given to whether the holding period tolling rules of Sections 1092 and 1233 apply. Absent application of Section 1092 or Section 1233, a problem under the 30% Test could arise only if the Bond, put or swap component of a synthetic tax-exempt security were disposed of by the RIC within three months of acquisition. ⁶²

A. PUT ANALYSIS

The threshold issue is whether the straddle rules of Section 1092 apply to the Certificates. A "straddle" subject to such rules is defined as offsetting positions with respect to actively traded personal property. ⁶³ The term "position" means an interest (including, among other things, an option) in personal property. ⁶⁴ The Bonds will constitute intangible personal property and will be treated as actively traded if they are the subject of an interdealer market that involves a system of general circulation which regularly disseminates price quotations or price information by identified brokers, dealers, or traders. ⁶⁵

It is likely that both the Bonds and the Par Put will constitute "positions" under Section 1092(d)(2) of the Code, and because the Bonds are personal property, both the Bonds and the Par Put will constitute positions in personal property. Since the Par Put and the Bond are designed to maintain the overall value of the Certificates at par, the two will constitute offsetting positions pursuant to Section 1092(c)(2). Thus, the straddle rules of Section 1092 should apply to determine the holding period pertaining to the positions underlying the Certificates absent some exception.

1. THE PUT AS A SINGLE INSTRUMENT

ISSUE: Which holding period rules will apply when the Par Put is viewed as a single instrument (rather than as multiple puts)?

DISCUSSION: The combination of a Bond and a Par Put would constitute a straddle entered into upon the purchase of a Certificate if the put were treated as a single instrument. ⁶⁶ Temp. Treas. Reg. Section 1.1092(b)-2T(a)(1) provides the general rule that the holding period of any position that is part of a straddle begins on the date the taxpayer no longer holds an offsetting position with respect to the subject position; that is, once the Par Put is exercised or terminated, the holding period on the positions would begin. If this rule applied to a Certificate, any gain on either the Par Put or the Bond when both positions are disposed of upon termination of the straddle would be disqualifying income under the 30% Test since their holding periods would begin and end on the day of disposition.

However, the general tolling rule of Temp. Treas. Reg. Section 1.1092 (b)-2T(a)(1) is overridden by subsection (d) of the same regulation, which contains a special rule for purposes of the 30% Test for positions held by RICs (the "Anti-Tolling Rule"). The Anti-Tolling Rule negates the general tolling rule of subsection (a)(1) of the regulation. Note that if the positions would otherwise constitute a short sale subject to the rules of Section 1233(b) , the rules of Section 1233(b) would be applicable and the straddle rules would not apply. Thus, assuming that the positions do not constitute a short sale, the Anti-Tolling Rule will apply; therefore, the normal holding period rules of Section 1223 will apply and the holding periods of both positions will not be tolled under the straddle rules.

The purchase of a Certificate will not be treated as a short sale due to the operation of the "married put" exception of Section 1233(c). This exception preempts the application of the principles of Section 1233(b) when an option to sell property at a fixed price (the Par Put) and the property to which the option relates (the Bond) are acquired on the same day, provided that if the option is exercised it is exercised through the sale of the related property. Due to the requirements of Rule 2a-7, it is generally not feasible for a money market fund to dispose of the Bond and the Par Put other than simultaneously. Thus, the positions are probably subject to the married put rules and thus the holding period for both positions should not be tolled for purposes of the 30% Test and the holding period rules of Section 1223 should apply.

CONCLUSION: If the Par Put is analyzed as a single put, it appears under existing rules that the holding period of the Bond and the Par Put should not be suspended for purposes of the 30% Test, and the general holding period rules of Section 1223 should apply. Therefore, any problems under the 30% Test would arise only if either the Par Put or the Bond, or both, were disposed of at a gain within three months of acquiring the Certificate.

2. THE PUT AS MULTIPLE INSTRUMENTS

ISSUE: Which holding period rules will apply when the Par Put is viewed as multiple put instruments?

DISCUSSION: The Par Put may be seen as a series of successive puts, with each date on which the interest rate is reset signaling the beginning of a new put. ⁶⁷

In analyzing the holding period impact of viewing the Par Put as a series of successive puts, just as is the case under the single put analysis, the Anti-Tolling Rule would prevent application of the general straddle holding period tolling provision with respect to the first put. ⁶⁸ The analysis set forth under the prior section would only provide relief as to the first put because it is the only put of the succession of puts which is acquired simultaneously with the Bond. Therefore, only the first put would be subject to the holding period rules of Section 1223 due to the application of Temp. Treas. Reg. Section 1.1092(b)-2T(d). The question then involves which holding period rules to apply to all other puts in the series (the "Successive Puts").

Section 1233(a) provides that gain or loss from the short sale of property shall be considered as derived from the sale or exchange of a capital asset to the extent that the property used to close the short sale constitutes a capital asset in the hands of the taxpayer. In general, the acquisition of an option to sell property at a fixed price is considered a short sale, and the exercise or failure to exercise such an option is treated as a closing of the short sale. ⁶⁹ Section 1233(b) provides that of gain or loss from a short sale is treated as a capital gain or loss pursuant to Section 1233(a), and if on the date of such a short sale "substantially identical" property has been held by the taxpayer for not more than one year, or if substantially identical property is acquired by the taxpayer after such short sale and on or before the date of the closing thereof --

(1) any gain on the closing of the short sale is treated as short-term (regardless of the actual holding period of the property used to close the short sale); and

(2) the holding period of the substantially identical property is treated as beginning on the earlier of the date the short sale is closed, or the date of a sale or other disposition of the substantially identical property.

Section 1233(b) will not apply and the general holding period rules of Section 1223 will be applicable to the Successive Puts. Section 1233(b) only affects the characterization of gain on the closing of a short sale and the holding period of the substantially identical property. The Successive Puts do not constitute substantially identical property; therefore, Section 1233(b) does not apply in determining the holding period of the Successive Puts. Section 1233(b)(1) acts only to shorten a holding period for the purpose of characterizing gain as short-term on the substantially identical property (the Bonds) and does not change the actual holding period of the Successive Puts for 30% Test purposes. Furthermore, section 1233(b)(2) only operates as to the property (the Bonds) which is substantially identical to the property sold short (the Bonds) and which is not used to close the short sale, not as to the holding period of the Successive Puts. ⁷⁰

CONCLUSION: The same result will be reached for purposes of determining holding periods under the 30% Test whether the Par Put is viewed as a single put or as a series of puts. In either case, the general holding period rules of Section 1223 will apply. Therefore, a potential problem under the 30% Test will arise only if within three months of purchase of the Certificate gain results from the: (1) exercise of the Par Put; (2) sale of the Certificate; or (3) termination of the Par Put and the sale of the Bond.

A difference between the two analyses will exist, however, after three months from the date of purchase of the Certificates. Under the single put analysis, the only consideration is whether the Certificate is sold within three months of acquisition. In contrast, under the multiple put analysis, unless a particular Successive Put is held by the money market fund for more than three months (which would likely be the case unless the next date that the put right relating to such Successive Put expires is greater than three months away and the Successive Put is in fact not exercised within three months of the date such Successive Put was deemed issued), any gain on the sale of the Successive Put will not likely constitute qualifying income for the purposes of the 30% Test.

B. SWAP ANALYSIS

The analysis which applies in the swap context generally parallels the analysis applying to puts for purposes of the 30% Test. The combination of a Bond and the Swap Agreement most likely constitutes a straddle if either property is actively traded. ⁷¹ A notional principal contract, which includes swaps, is treated as an interest in personal property. ⁷² The Swap Regulations provide that notional principal contracts (which is likely to include interest rate swaps such as the Swap Agreement) will be treated as actively traded if similar types of swaps are traded on an interbank or interdealer market. ⁷³

The analysis of the holding period rules which apply to the Bond and the Par Put component of a Swap Structure is essentially identical to the analysis of the Par Put component of Put Fee Structures that was addressed above in Part A of this Part V. The Swap Agreement represents another offsetting position with respect to the Bond (the Par Put may also constitute a separate offsetting position with respect to the Bond). ⁷⁴ As discussed above, the Anti-Tolling Rule of Temp. Treas. Reg. Section 1.1092-2T(d) overrides the general holding period tolling rule applicable to straddles, provided that the straddle does not constitute a short sale. A Swap Agreement does not appear to constitute a short sale with respect to the Bonds. Therefore, the special Anti-Tolling Rule applicable to RICs should apply and the holding period of the Swap Agreement will be determined under the general holding period rules of Section 1223. As a result, gain on the Swap Agreement component in a Swap Structure would not constitute qualifying income for purposes of the 30% Test only if within three months of acquiring the Certificate such component is sold (either directly or through the sale of the Certificate) or the Swap Agreement is deemed terminated. ⁷⁵

C. THE DESIGNATED HEDGE RULE

Section 851(g)(1) provides that, for purposes of the 30% Test, in the case of any "designated hedge" any changes in the value of the hedge positions shall be netted. One of the circumstances under which a designated hedge exists is where the taxpayer's risk of loss with respect to any position is reduced by reason of the taxpayer having an option to sell substantially identical property and the positions which are part of the hedge are clearly identified in the manner prescribed by the regulations. ⁷⁶ Such regulations have not yet been issued.

The effect of the designated hedge rule is to exclude any gain generated by the positions from both the numerator and denominator of the 30% Test fraction. The downside to such a designation is that it may prevent qualifying income from being taken into account in determining whether the 30% Test has been satisfied. As set forth above relating to the analysis of puts, gain will only be treated as non-qualifying income when one of the positions is sold or terminated at a gain less than three months after acquisition or the deemed issue date of a Successive Put, if a Par Put is characterized as comprised of multiple puts. Therefore, in general, the designated hedge rule is of limited relevance in the context of synthetic tax- exempt securities.

VI. SECTION 851(b)(4) -- ASSET DIVERSIFICATION

A RIC must satisfy a two-pronged asset diversification test (the "Asset Diversification Test") at the close of each quarter of its taxable year. ⁷⁷ The first prong of the Asset Diversification Test is that at least 50% of the value of the RIC's total assets must be represented by (i) cash and cash items (including receivables), (ii) Government securities, ⁷⁸ (iii) securities of other RICs, and (iv) other securities limited in respect of any one issuer to an amount not greater in value than 5% of the value of the total assets of the RIC and to not more than 10% of the outstanding voting securities of such issuer. ⁷⁹ The second prong of the Asset Diversification Test is that not more than 25% of the value of the RIC's total assets can be invested in the securities (other than Government securities or the securities of other RICs) of (i) any one issuer or (ii) two or more issuers that the RIC controls and are determined to be engaged in the same or similar trades or businesses or related trades or businesses. ⁸⁰ The term "value" generally means, with respect to securities for which market quotations are readily available, market value and with respect to other securities and assets, fair value as determined in good faith by the RIC's board of directors. ⁸¹ All other terms used in the context of the Asset Diversification Test have the same meaning as when used in the 1940 Act. ⁸²

A RIC that invests primarily in state or local tax-exempt obligations generally must ensure that at least 50% of the value of its assets are invested in securities that, with respect to each issuer, do not exceed 5% of the value of the RIC's total assets and that no more than 25% of the value of its total assets is invested in securities of any one issuer. ⁸³ In order for a RIC that invests in a synthetic tax-exempt security to determine that it has satisfied the Asset Diversification Test, the RIC first must define the relevant "security" (or securities) represented by the investment for purposes of the test. The RIC must next determine the issuer (or issuers) of such security (or securities) and such security's value (or such securities' values).

A. SECURITIES

ISSUE: Is a Certificate a "security" or is the synthetic tax- exempt instrument treated as comprised of two or more separate "securities" for purposes of the Asset Diversification Test?

DISCUSSION: Because Section 851(c) of the Code does not define the term security, that term has the same meaning as such term has for purposes of the 1940 Act. ⁸⁴ The determination of whether a Certificate is a security for purposes of the 1940 Act is beyond the scope of this report and will in all cases depend upon the facts and circumstances relating to each particular synthetic tax-exempt security structure. Thus, this report will assume that a Certificate may or may not constitute a security for purposes of the 1940 Act.

Despite the statutory cross-reference to the 1940 Act, the Service, in certain instances, has applied a look-through approach to identify the assets that a RIC owns for purposes of applying the Asset Diversification Test. If a RIC owns an interest in a partnership, the Service has not treated the RIC's partnership interest as a security without regard to whether the partnership interest constitutes a security for purposes of the 1940 Act. Instead, the Service has treated the RIC as owning a proportionate interest in each of the assets of the partnership. ⁸⁵ Similarly, if a RIC is the beneficiary of a grantor trust or owns a beneficial interest in a custodial arrangement, the RIC may be treated as owning a proportionate interest in each of the assets of the trust or custodial arrangement. ⁸⁶

Thus, if a RIC owns a Certificate, there are at least two approaches to analyzing such an investment for purposes of the Asset Diversification Test. The preferable approach in the view of a majority of the Task Force members (the "Single Security Approach") is to treat the Certificate as a single security, without regard to whether the Certificate constitutes a security under the 1940 Act. An alternative approach (the "Component Approach") is to look-through the Issuing Entity and treat the RIC as if it owned a proportionate interest in each of the assets (i.e., components) held by the Issuing Entity. Under the Component Approach, the Issuing Entities' assets that could potentially be treated as securities include the Bonds, the Par Put, and the Put Fee Agreement or Swap Agreement. ⁸⁷

RECOMMENDATION: A majority of the Task Force members recommend that the Service adopt the Single Security Approach and treat the Certificate as a single security for purposes of the Asset Diversification Test. We acknowledge that this approach may not be as technically correct as the Component Approach (assuming that the particular Certificate under consideration does not constitute a security for 1940 Act purposes). In addition, in the case of synthetic tax-exempt securities that are classified as partnership interests, we acknowledge that the Single Security Approach is inconsistent with the Service's current look-through approach applicable to investments by RICs in partnerships. ⁸⁸ However, we believe that the Component Approach presents some very complex valuation issues that may substantially impair its practicality, as described more fully below, and may not produce substantially different results under the Asset Diversification Test than the Single Security Approach.

B. ISSUER

ISSUE: Who is the issuer of the security represented by a Certificate?

DISCUSSION: Section 851 does not define the term "issuer." Accordingly, that term should have the same meaning as when used in the 1940 Act. ⁸⁹ Section 2(a)(22) of the 1940 Act defines an issuer as a "person who issues or proposes to issue any security, or has outstanding any security which it has issued." ⁹⁰ In some instances, the Service has followed the Securities and Exchange Commission, the "SEC's") interpretation of who is the issuer of a security. ⁹¹ For example, both the Service and the SEC have ruled that, although a municipal bond normally is issued by a state agency or municipality, an industrial development bond that is issued by a state agency or municipality for the benefit of a private user should be treated as issued by the private user if the interest and principal on the bond is payable solely out of revenues from the project financed and the assets of the private user. ⁹² In other instances, however, the Service has rejected the SEC's treatment of a particular person as the issuer of a security. For example, in the case of an exchange-traded or over-the-counter option, the Service has ruled that the issuer is the corporation whose stock or securities underlie the option, even though the SEC specifically has ruled that the exchange or clearing corporation is the issuer for 1940 Act purposes. ⁹³

SINGLE SECURITY APPROACH. If the Single Security Approach were applied literally, the Issuing Entity would be the issuer of the Certificate. Such a mechanical application, however, ignores the economic reality that the Issuing Entity simply acts as a conduit, forwarding interest and principal payments of the Bonds (net of certain expenses) to the Holders. A more appropriate application of the Single Security Approach, although theoretically impure, would be to treat the issuer of a Certificate as the same person that is treated as the issuer of the Bond (or issuers of the Bonds if the Issuing Entity held multiple Bonds), if the Bond (or Bonds) were held directly by the RIC. ⁹⁴ In this way, our recommended application of the Single Security Approach, although inconsistent with the look- through approach generally adopted by the Service in applying the Asset Diversification Test to a RIC's ownership of a partnership interest, would produce essentially the same result.

COMPONENT APPROACH. Under the Component Approach, the Issuing Entity potentially holds at least two or three securities -- the Bond, the Par Put and, if applicable, the Swap Agreement. The issuer of the Bonds under a component Approach should be the same person that is treated as the issuer of the Bond (or issuers of the Bonds if the Issuing Entity held multiple Bonds), if the Bond (or Bonds) were held directly by the RIC, as discussed above.

Identifying the issuer of the Par Put is more difficult because the value of an option depends partially upon the value of the security to which it relates and partially upon the expectation that the option writer will be able to perform its obligations thereunder. In weighing these factors with respect to over-the-counter options, however, which involves the same essential inquiry, the Service has ruled that the options should be treated as issued by the issuer of the securities that underlie the options, rather than treated as issued by the writer of the options. ⁹⁵

It would appear appropriate to treat the counterparty under the Swap Agreement as the issuer of the Swap Agreement for purposes of the Asset Diversification Test, assuming that the Swap Agreement is considered a security.

RECOMMENDATION: Under the Single Security Approach, we believe that the issuer of the Certificate should be the entity that is treated as the issue of the related Bond. Under the Component Approach, the issuer of the related Bond should be determined in the same manner. A majority of the Task Force members believe that the issuer of the Par Put under the Component Approach should be the same entity that is treated as the issuer of the related Bond. The issuer of the Swap Agreement under the Component Approach should be the counterparty under the agreement.

C. VALUATION

ISSUE: How are each of the securities valued?

DISCUSSION: For purposes of the diversification requirements, value means, with respect to securities (other than those of majority-owned subsidiaries) for which market quotations are readily available, market value of such securities and with respect to other securities and assets, fair value as determined in good faith by the RIC's board of directors. ⁹⁶ Under the Single Security Approach, although market quotations may not be readily available for a Certificate, it would generally appear appropriate to value such Certificate at par because of the Par Put and the fact that the Variable Rate is periodically reset to approximate or equal a market rate.

The Component Approach requires a vague to be assigned to the RIC's pro rata interest in each of the three possible types of securities comprising the synthetic tax-exempt security. Consequently, the value of the Bonds should generally be fair value as determined in good faith by the RIC's board of directors (or trustees). By comparing the interest rates stated on the Bonds with the current market rates for comparable tax-exempt securities, the RIC's board of directors (or trustees) should be able to determine with reasonable accuracy the market value of the Bonds.

The valuation of the Par Put is more difficult. For accounting purposes, a put option generally is not assigned a separate value. ⁹⁷ Notwithstanding the general accounting practice, the Service generally equates the value of a purchased option with the purchaser's investment in the option because the purchaser's potential loss is limited to the premium paid for the option. ⁹⁸ As a third valuation alternative, Rule 2a-7 effectively equates the value of the Par Put with the value of the Bonds that are subject to the Par Put for purposes of the Rule 2a-7 diversification requirements. ⁹⁹ Because the Bonds are valued at their current fair market value under the Component Approach, if any value is assigned to the Par Put, the combined value of the RIC's assets relating to the synthetic tax-exempt security could exceed the Certificate's fair market value.

Moreover, as is the case with over-the-counter options, it would appear impractical and unduly burdensome for a RIC to be required to independently determine the Par Put's fair market value. Accordingly, except where a RIC has actual knowledge of the Par Put's fair market value, we recommend the adoption of a "residual value approach" under which the Par Put would be assigned a value equal to the positive amount, if any, by which the current value of the Certificate (presumably the Certificate will typically have a value equal to par) exceeds the current value of the Bond, determined without respect to the Par Put.

From the RIC's perspective, the Put Fee Agreement should be treated as a liability because the RIC is required to pay, but never stands to receive, payments under the Put Fee Agreement. ¹⁰⁰ Consequently, the Put Fee Agreement should have a negative value. Because of the difficulties of accounting for negative value assets under federal income tax law general and more specifically under the Asset Diversification Test, the Put Fee Agreement probably should be assigned a zero value. With respect to the Swap Agreement, although the Holder would receive payments from the Swap Counterparty if the Variable Rate exceeded the Net Fixed Rate, it is more likely that the Holder would make payments to the Swap Counterparty. Thus, like the Put Fee Agreement, the Swap Agreement could possibly be treated as a liability from the Holder's perspective. Accordingly, except where a RIC has actual knowledge of the Swap's fair market value, we recommend the adoption of a "residual value approach" under which the Holder's interest in the Swap would be assigned a value equal to the positive amount, if any, by which the current value of the Certificate (presumably the Certificate will typically have a value equal to par) exceeds the current value of the Bond, determined without respect to the Swap. It appears appropriate to ignore any Swap Premium received for valuation purposes because it will in all likelihood be reflected in the valuation of the related Bond. Moreover, it appears appropriate to assume that the Par Put component of a Swap Structure has negligible value because the Swap effectively absorbs the risks relating to changes in interest rates and the put is typically not exercisable upon the occurrence of certain other events.

RECOMMENDATION: Under the Single Security Approach, it would appear appropriate to generally value the Certificate at par, unless the RIC has reason to believe that such a valuation is inappropriate because the Par Put has been extinguished or is otherwise unlikely to be available, or the Variable Rate does not approximate a market rate. Under the Component Approach, the value of the Bond should equal its current market value, as estimated by the RIC's board of directors (or trustees), and the value of the Holder's interest in the Par Put or alternatively, if applicable, the Swap Agreement, should be based upon the residual value approach described above.

D. SUMMARY

We have proposed two approaches in analyzing synthetic tax- exempt securities for purposes of the Asset Diversification Test. A majority of the Task Force members strongly recommend the adoption of the Single Security Approach due to its administrability and our belief that it is unlikely that the results obtained under a component approach would be substantially different, although as noted above we acknowledge its technical shortcomings and inconsistency with the Service's position applying a look-through approach to the ownership of partnership interests by RICs. We believe that the Single Security Approach should be applied without regard to whether the particular Certificate constitutes a security under the 1940 Act. As an alternative approach, we recommend a Component Approach that would treat the RIC as owning a pro rata interest in those components of the synthetic tax-exempt security that are treated as securities under the 1940 Act, relying on the Service's existing positions relating to the determination of the issuer of the various components. We are concerned about the administrability of a Component Approach or potential determinations of component fair market value in excess of aggregate value (assuming that negative values cannot be used) if the various components are separately valued. Accordingly, we have recommended that the values of the Par Put or the Swap Agreement generally be determined under a residual value approach.

If the Service adopts the Single Security Approach, we make the following recommendations for purposes of applying the Asset Diversification Test:

1. The Certificate should be treated as the security that the RIC owns.

2. The Certificate should be treated as issued by the entity that would be treated as the issuer of the Bond if held directly by the RIC.

3. The Certificate should generally be valued at par.

If, however, the Service adopts the Component Approach, we make the following recommendations:

1. The issuer of the Bond should be the entity that would be treated as the issuer of the Bond if held directly by the RIC.

2. The issuer of the related Par Put should be the same entity that is treated as the issuer of the Bond.

3. The issuer of the Swap Agreement should be the Swap Counterparty.

4. The Bonds should generally be valued at their fair market value, in the manner set forth above.

5. The value of the Holder's interest in the Par Put or the Swap Agreement, if applicable, should be determined under a residual value approach.

VII. SECTION 852(a)(1) -- THE INCOME DISTRIBUTION TEST

A. IN GENERAL

In order for a corporation to qualify as a RIC, it must annually satisfy an income distribution test imposed by Section 852(a)(1) (the "90% Income Distribution Test") that requires that its dividends-paid deduction ("DPD") must at least equal the sum of (i) 90% of its investment company taxable income (determined without regard to the DPD), and (ii) 90% of its net tax-exempt income. Section 852(a)(1)(B) provides for purposes of determining whether the 90% Income Distribution Test is satisfied that the measure of a RIC's net tax- exempt income is the excess of (i) its Section 103(a) tax-exempt interest over (ii) its deductions which are disallowed under Sections 265 and 171(a)(2).

The concerns relating to the ownership of synthetic tax-exempt securities by RICs in determining compliance with the 90% Income Distribution Test arise from (i) deductions which are disallowed under Code provisions other than Sections 265 and 171(a)(2) and (ii) expenditures which must be capitalized rather than expensed for tax purposes. In either case, concerns may arise because the distributions of cash to the money market fund on a synthetic tax- exempt security will be reduced by ail expenditures made at the synthetic tax-exempt security structural level without regard to whether such expenditures constitute disallowed deductions or capital expenditures for federal income tax purposes. Accordingly, it must be considered whether the net tax-exempt income generated by a synthetic tax-exempt security exceeds the amount of cash distributed to the Holder. If the amount of net tax-exempt income is higher than the amount of cash received, this could force a RIC to distribute invested capital rather than earnings in order to satisfy the 90% Income Distribution Test. The provisions of the Code which are the most likely cause of concern in terms of determining the amount that a RIC must distribute in order to satisfy the 90% Income Distribution Test are: (1) the straddle rules of Sections 1092 and 263(g); (2) the ordinary capitalization of put fees; and (3) the excess capital loss rules of Section 1211(a).

Because a RIC need only distribute 90% of its net investment income in order to satisfy the 90% Income Distribution Test, a fund would have to invest in a fairly substantial amount of Certificates or other types of investments which produce "bad" disallowed deductions or capital expenses before its RIC status would be jeopardized. Nonetheless, as in most tax-oriented analysis, yesterday's remote adverse possibility must be constantly monitored so that it does not become today's painful reality, particularly in light of the draconian consequences that would be triggered if the 90% Income Distribution Test were not met. The analytical starting point for purposes of this section is to classify expenses attributable to the holding of the Certificates according to the applicable provisions of the Code and the relevant regulations.

B. FEES OTHER THAN PUT FEES AND SWAP PAYMENTS

1. RECURRING EXPENSES

ISSUE: Whether the recurring fees a RIC incurs in connection with owning the Certificates will reduce the amount required to be distributed under the 90% Income Distribution Test (the "Distribution Requirement").

DISCUSSION: Certain types of recurring fees which RICs will incur throughout the period Certificates are held might be incurred in either the Put Fee Structure or the Swap Structure. Such fees may include service costs, such as custodial, trustee, liquidity, remarketing or credit enhancement fees, and fees which are payable to the Put Provider.

Section 265 disallows certain expenses and interest relating to tax-exempt income. Section 265 includes a special "pro rata" rule applicable to RICs. ¹⁰¹ Unlike the general rule of Section 265(a)(1) as it applies to corporations other than RICs, this special rule applies to ANY AND ALL DEDUCTIONS OF THE RIC and disallows a portion of a RIC's tax-exempt income for its tax year relative to its total income. ¹⁰² Section 162 allows as a deduction all ordinary and necessary expenses which are paid or incurred during the taxable year in carrying on any trade or business. Given the constraints imposed by the 1940 Act, it appears without question that a RIC's activities fall within this ambit. Items are only deductible under Section 162 to the extent that they constitute ordinary and necessary expenses and do not constitute capital expenditures. ¹⁰³

Treas. Reg. Section 1.162-1(a) provides that among the items included in business expenses are management expenses, commissions and insurance premiums against fire, storm, theft, accident, or other similar losses in the case of a business.

CONCLUSION: Servicing fees paid or incurred in connection with the Certificates, including custodial, trustee, liquidity, remarketing, and credit enhancement fees, are all paid or incurred for the management or insurance of the RIC's interest in the Bonds and other assets held by the Issuing Entity (as represented by the Certificates). The fees are ordinary and necessary in carrying on the RIC's business and do not constitute capital expenditures. Therefore, the fees would otherwise be allowable as Section 162 deductions and thus would be disallowed, if at all, under the special pro-rata rule of Section 265(a)(3) applicable to RICs. Accordingly, to the extent disallowed pursuant to the pro rata rule (or to the extent allowable in computing the RIC's distributable taxable income), the fees will reduce the amount of income that must be taken into account in computing the 90% Income Distribution Test and as a result will not require the distribution of invested capital in order to satisfy the test. As a practical matter, most tax-exempt funds earn only tax- exempt income, and thus all of the Section 162 expenses are disallowed and reduce the required distribution amount.

2. NONRECURRING EXPENSES

ISSUE: Whether nonrecurring fees (such as termination fees) a fund incurs in connection with owning the Certificates will reduce the Distribution Requirement.

DISCUSSION: Funds may incur certain nonrecurring fees in owning the Certificates, such as a termination fee paid to terminate a Put Structure or Swap Structure. However, it is not likely that a money market fund will ordinarily incur a termination fee because doing so would result in direct ownership of the underlying Bonds. ¹⁰⁴ This occurrence is not desired since under the requirements of Rule 2a-7 (1) the maturity of the Bonds may not directly satisfy the maximum maturity requirements of the rule and (2) the underlying Bond may not provide for a floating or variable interest rate which would be necessary to utilize a demand feature to shorten the Bond's maturity for purposes of the rule. It is significantly more likely that a RIC could sell its interest in a Certificate at a gain, thereby realizing the built-in gain associated with terminating the related Put Fee Agreement or Swap Agreement without acquiring direct ownership of the related Bond.

The easier analytical case concerns termination fees paid with respect to a Par Put. In general, such fees are added to the RIC's basis in the the Bonds under the "married put" rules of Section 1233(c). ¹⁰⁵ Because amounts paid for puts are generally treated as capitalizable and would be added to the RIC's basis in the Bonds, this expenditure is unfavorable since it does not reduce the amount that must be distributed under the 90% Income Distribution Test. Thus, such fees must be monitored to ensure compliance with the test. Of course, termination fees added to the basis of a Bond will reduce any capital gain or increase any capital loss recognized by the RIC upon a disposition of the Bonds.

The more complicated analysis involves the treatment of termination fees paid with regard to the Swap Structure. Prop. Treas. Reg. Section 1.446-3(e)(6)(ii) provides that the parties to a notional principal contract ("NPC") will recognize in the year the termination payment is made (1) income, if the payment is received from the swap counterparty of third party assignee, or (2) a loss, if the payment is made to the swap counterparty or third party assignee. The character of such income or loss will be capital pursuant to Section 1234A, which provides that gain or loss attributable to the termination of a right or obligation with respect to personal property which is a capital asset in the hands of the taxpayer (the Bonds) shall be treated as gain or loss from the sale of a capital asset. This assumes that the RIC's interest in the Swap Agreement constitutes an interest in personal property under Section 1092.

If a capital loss arises, the RIC could have problems satisfying the 90% Income Distribution Test if recognition of the capital loss is postponed beyond the current year under the excess capital loss rules of Section 1211(a). If a RIC disposes of its interest in the Bonds at a gain in the same year, no problem would arise under the 90% Income Distribution Test since any capital gain recognized on the Bond could be used to offset any capital loss incurred on the termination of the RIC's interest in the swap. On the contrary, if the RIC continues to hold its interest in the Bonds, all or a portion of the loss may be deferred until disposition of the Bonds pursuant to the straddle rules of the Code (this assumes that the Bond constitutes an offsetting position to the RIC's interest in the Swap Agreement and that there is unrecognized gain in the RIC's position in the Bond). ¹⁰⁶ Thus, the amount that a RIC must distribute in order to satisfy the 90% Income Distribution Test would not be reduced by the amount of the loss and the RIC may need to distribute cash from other sources in order to satisfy the test.

CONCLUSION: This concern is not likely to arise under either the Put Structure or Swap Structure while a money market fund holds the Certificate because of Rule 2a-7 requirements that may restrict the fund's ability to acquire a direct interest in the related Bond. However, in the event of the payment of termination fees with respect to a Par Put, such an expense must be capitalized and thus will not reduce the amount that must be distributed in order to satisfy the 90% Income Distribution Test, potentially creating a problem thereunder. The results pertaining to the Swap Structure under the proposed NPC regulations and the straddle rules will depend on whether the underlying Bond is disposed of in the same year and whether sufficient capital gains will exist at that time to absorb any capital loss attributable to payment of a termination fee.

C. PUT FEES

1. THE PUT AS A SINGLE INSTRUMENT

ISSUE: Whether the amounts paid to the Put Provider should be characterized as capital expenditures or as currently deductible expenses for purposes of the 90% Income Distribution Test.

DISCUSSION: Due to practical considerations, chiefly the maturity requirements of Rule 2a-7, a money market fund's interest in the Par Put and the related Bond usually will be disposed of at the same time. Therefore, the straddle rules of Section 1092 discussed above in Part V generally will not affect the timing of the recognition of income or loss upon disposition of the Bond. Due to the rule contained in Temp. Treas. Reg. Section 1.1092(b)-2T(a)(1) which suspends the holding period of any position in a straddle (e.g., the Par Put and the Bond), any recognized capital gain or loss on the Bond will be short-term. Thus, the treatment of the underlying Bond upon disposition will have no effect on the RIC's ability to meet the 90% Income Distribution Test.

The treatment of amounts paid to the Put Provider on an ongoing basis with respect to the Par Put out of distributions received by the Issuing Entity on the Bond (or Bonds) will vary depending on how the put fee is characterized. There are two possible treatments of the put fee: (1) capitalizable or (2) deductible. Capitalization treatment follows from section 263(g) or the previously issued ruling positions of the Service relating to exchange traded options. ¹⁰⁷ Deductibility follows from characterizing the fee as similar to an insurance premium payment. The characterization chosen will affect the impact of the put fee in determining compliance with the 90% Income Distribution Test.

As discussed in more detail below, we believe that capitalization treatment of the put fees in these structures results in the creation of capital losses that could be used to offset capital gains, a result that could have a potential adverse revenue impact (compared to the treatment of such amounts as a non-deductible item that merely reduces the amount of tax-exempt interest received by the investor).

Looking first at the capitalization argument, the first step in the analysis is to determine whether the straddle rules of Section 1092 and the regulations thereunder treat the Par Put and the related Bond as positions in a straddle. As set forth above in Part V, the Par Put and the related Bond would appear to constitute a straddle. The next step is to determine whether Section 263(g) applies, with the key issue being whether the put fees constitute "carrying charges" under Section 263(g)(2).

Section 263(g)(1) provides that no deduction shall be allowed for interest and carrying charges properly allocable to personal property which is part of a straddle and that any amount so disallowed must be charged to the capital account with respect to the personal property to which the disallowed amount relates. This rule was enacted as part of the Economic Recovery Tax Act of 1981. ¹⁰⁸ The relevant legislative history makes it clear that this provision was intended to cover the treatment of "cash and carry" transactions involving purchases of a physical commodity offset by forward sales of an equal amount of the physical commodity. ¹⁰⁹ Section 263(g) of the Internal Revenue Code of 1954, as then amended (the "1954 Code"), defined carrying charges as ". . . amounts paid to insure, store, or transport the personal property."

Section 105(b)(1) of the Technical Corrections Act of 1982 added Section 263(g)(2)(A)(ii) to the 1954 Code, expanding the definition of carrying charges to include charges ". . . for temporary use of personal property borrowed in connection with a short sale." ¹¹⁰ Based upon the relevant legislative history, there is no indication that the revised language of Section 263(g) of the 1954 Code was intended to broaden the scope of carrying charges beyond those relating to carrying physical commodities except in the specific context of expenses incurred in connection with respect to short sales. ¹¹¹

The definition of carrying charges was again amended by the Deficit Reduction Act of 1984, which eliminated the reference in Section 263(g)(2)(A)(ii) of the 1954 Code to "charges for the temporary use of personal property." ¹¹² It appears that this change was due to the addition of Section 263(h) of the 1954 Code, which was intended to require the capitalization (instead of the deduction) of certain "in lieu of dividend" payments in connection with short sale transactions. ¹¹³ Even though Section 263(h) of the 1954 Code expanded the scope of carrying charges subject to capitalization, the General Explanation to the Deficit Reduction Act of 1984 appeared to limit the scope of expenditures subject to capitalization under Section 263(g) to ". . . interest on indebtedness incurred or continued to purchase or carry property, as well as amounts paid or incurred for the temporary use of property in a short sale, or insuring, storing, or transporting the property." ¹¹⁴

After amendments made by the Deficit Reduction Act of 1984, the language of Section 263(g)(2)(A)(ii) of the 1954 Code generally parallels the current language of Section 263(g)(2)(A)(ii). Thus, based upon the relevant legislative history, it appears that "carrying charges," for purposes of Section 263(g), should generally be limited to those items specifically listed therein. Accordingly, it appears inappropriate to treat the ongoing put fees paid relating to the Par Put as "carrying charges" subject to capitalization under Section 263(g).

Moreover, the Par Put and the Bond are the offsetting positions in the straddle. Thus, based upon the relevant legislative history relating to carrying charges, an even stronger argument can be made that it is simply inappropriate to treat one of the legs of the straddle (the Par Put) as a "carrying charge" of the other leg of the straddle (the Bond).

Capitalization of the put fee pursuant to the positions set forth in the Service's prior rulings related to exchange traded options ¹¹⁵ will not reduce the amount that must be distributed under the 90% Income Distribution Test because the expenditures was not disallowed under Section 265 or Section 171(a)(2). Therefore, a problem could arise in meeting the 90% Income Distribution Test as to the year of payment of the put fees.

Regarding the year in which the Par Put and Bond are disposed of, since the put's basis increases with the payment of each put fee, ¹¹⁶ the potential exists for a capital loss on the Par Put which is substantially larger than any capital gain on the Bond. This could give rise to a problem meeting the 90% Income Distribution Test in the year of disposition if an insufficient amount of capital gains are available against which to deduct the capital loss recognized on the termination of the RIC's interest in the Par Put. The excess capital loss rules of Section 1211(a) would postpone recognition of the excess of capital losses over capital gains, thereby not reducing the amount that must be distributed under the 90% Income Distribution Test. Assuming that the ownership of the Par Put and Bond constitutes a straddle, disposition of the Par Put will produce short-term capital loss due to the holding period totalling rules of Temp. Treas. Reg. Section 1.1092(b)-2T(a)(1).

It should be noted that the capitalization of these costs could be viewed as potentially adverse to the fisc for two reasons. First, such amounts, which economically reduce the RIC's earnings on its investments, would not reduce the amount of tax-exempt income that it could designate and distribute to its investors on a current basis under Section 852(b)(5). Second, this effect could be viewed as akin to the transformation of the capitalized amounts from a reduction of tax-exempt interest into a potentially fully deductible capital loss.

The deductibility argument relies upon the rationale that the Par Put provides credit enhancement (i.e., "insurance" in a broad sense) by maintaining the liquidity of the Certificate. That is, the Par Put protects the Holder against changes in the value of the Bond caused by changes in market interest rates.

As indicated above, Section 162(a) provides in part, that there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Treas. Reg. Section 1.162-1(a) provides, in general, that business expenses deductible from gross income include insurance premiums paid to protect business assets. ¹¹⁷

Rev. Rul. 81-160 ¹¹⁸ holds that commitment fees or standby charges incurred pursuant to a bond sale agreement under which funds for construction are made available in stated amounts over a specified period are deductible ratably over the term of the loan.

It could be argued that the Par Put should be treated in a manner similar to the commitment fees and standby charges described in Rev. Rul. 81-160 in that it generally insures the availability of principal and interest payment son the underlying Bond throughout the period a RIC holds the Certificates, subject to certain specified limitations. It could be further argued that amounts paid for the Par Put should be treated as ordinary and necessary expenses under Section 162 and the regulations thereunder since they are directly connected with carrying on the RIC's trade or business, essentially being the equivalent of paying insurance premiums on fund assets (i.e., the Certificates). If the put fees are treated as ordinary and necessary expenses and not capital expenditures, such fees would reduce the amount that a RIC is required to distribute for purposes of computing the 90% Income Distribution Test and would not create a problem thereunder.

RECOMMENDATION: The technically better view, consistent with existing law related to exchange traded options, is to treat the put fees as capitalizable. However, this approach creates a risk that a money market fund will not satisfy the 90% Income Distribution test while at the same time permitting a RIC to designate exempt-interest dividends in excess of its economic net tax-exempt income and subsequently converting such amounts into capital losses. Accordingly, a majority of the Task Force believe that for the sake of both the fisc and manageable compliance with the 90% Income Distribution Test, such put fees should be treated as deductible in a manner similar to insurance premiums which provide liquidity since the fees insure the availability of principal and interest payments, subject to the limitations set forth in the applicable Put Fee Agreement.

2. THE PUT STRUCTURE AS TWO INSTRUMENTS: A PUT AND A NOTIONAL PRINCIPAL CONTRACT ("NCP")

ISSUE: Whether viewing the Par Put as also including a notional principal contract element produces a result more sound than the single instrument/capitalization analysis.

DISCUSSION: This approach bifurcates the Par Put into two instruments, one being the put right held by the Holder and the other a NPC, and produces a result which is almost identical to the single instrument analysis when the put fee is treated as capitalized as discussed in Part VII.C above. Under this analysis, all income or deductions will be allocated to the NPC instrument, which it is also assumed likely constitutes a straddle position.

A NPC is a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount ("NPA") in exchange for specified consideration or a promise to pay similar amounts. ¹¹⁹ A floor is a type of NPC, being a contract in which one party (the Put Provider) makes an initial payment (agreeing to provide the put) to a counterparty (the Issuing Entity) in exchange for an agreement by the counterparty to make cash payments at specified future dates equal to the product of a NPA (the principal amount of the Bonds) and the excess, if any, of a fixed interest rate (the floor rate) over a specified index (the spread between the fixed rate on the Bond and the Variable Rate on the Certificate). ¹²⁰

It is questionable, at best, that the NPC instrument could qualify as an interest rate floor because the "up-front payment in an on-market Par Put will essentially be zero. Furthermore, it is unclear whether the put index used in the typical synthetic structure would qualify as a specified index under Prop. Treas. Reg. Section 1.446-3(c)(2)(iii) or (v). ¹²¹

If the payment obligation on the Par Put could be treated as a NPC, Prop. Treas. Reg. Section 1.446-3(e)(1) provides that the net income or deduction generated by the NPC is included in or deducted from gross income for that taxable year, and that net income or deduction attributable to the NPC equals the net total of all "periodic" and "nonperiodic" payments recognized from the NPC. Periodic payments are payments made or received at fixed periodic intervals of one year or less throughout the entire term of the contract, and the amounts of which are based on a single specified index. ¹²² The put fee would therefore constitute a periodic payment.

Under Prop. Treas. Reg. Section 1.446-3(e)(3)(i), a nonperiodic payment is any payment made or received which is not a periodic payment or a termination payment. If the NPC is a floor, the Swap Regulations provide two methods in which the initial value of the Par Put (i.e., the amount paid by the Put Provider for the floor contract) can be allocated as a nonperiodic payment. One method is to allocate the payment over the term of the agreement in accordance with the values of a series of cash-settled option contracts that reflect the specified index and the NPA. ¹²³ The taxpayer must recognize as income or deduction the ratable daily portion of the purchase price that is allocated to the option contracts that expire during the year (straight-line and accelerated amortization methods are not permissible). ¹²⁴

As an optional method, the taxpayer may use the "level payment constant yield to maturity method (the "LPCYM method") of Prop. Treas. Reg. Section 1.446-3(e)(3)(ii)(D) to allocate the initial value of the Par Put over the term of the agreement. The LPCYM method assumes that the up-front payment represents the present value, determined under a constant yield to maturity basis, of a series of equal payments made throughout the term of the swap contract. The up- front payment is allocated by dividing each equal payment into its principal recovery and time value components, with the principal recovery components being treated as periodic payments that are deemed to be made on each date on which the put fee is paid.

The analysis produced here is almost identical to the analysis in Part VII.C.1. above, regarding the single instrument/ capitalization discussion, albeit much more complicated. The Par Put's initial value, if any, will be amortized over the term of the NPC, and will offset the deductible expense represented by the put fee. Because of the manner in which amounts must be amortized under the Swap Regulations, this approach may make the amortized amount (which would be deductible) slightly less than the amount of the ongoing put fee expenditures for a particular tax year. This shortfall may be offset in subsequent years to the extent the amortizable amount for such years exceeds the ongoing put fees for such years or would otherwise be deductible when the Par Put is disposed of (because the increase in the basis of the Par Put which occurs under the NPC analysis increases the loss recognized on the Par Put when it is disposed of or expires). When the Par Put is terminated, any resulting loss will be short-term capital loss, which is deductible only to the extent of the fund's capital gains, as discussed above.

RECOMMENDATION: We do not recommend this approach because of its complexity and impracticality. It reaches essentially the same result as the single instrument/capitalization approach at a cost of much greater complexity, which is inconsistent with current Service regulatory policy. Instead, as set forth above, we believe that the single instrument/insurance approach should be adopted.

3. THE PUT AS MULTIPLE INSTRUMENTS

ISSUE: If the Par Put is treated as a succession of puts, how will this affect the determination of whether the RIC satisfies the 90% income Distribution Test?

DISCUSSION: If the Par Put is analyzed as a series of separate puts, the Section 1092 straddle rules would apply to the expiration of each Successive Put. ¹²⁵ Temp. Treas. Reg. Section 1.1092(b)- 1T(a) provides that, in the case of the disposition of less than all of the positions of a straddle which do not constitute a stock or security (which the Par Puts do not), any loss sustained with respect to the position disposed of (each Par Put) shall be disallowed to the extent of any unrecognized gain calculated as of the close of the taxable year in the offsetting position (the Bond) or successor position (the Successive Put) to the position disposed of (the expired put). Therefore, with respect to each taxable year, only put fees for the current year in excess of the unrecognized gain in the Bond and the current put would be deductible. Under Temp. Treas. Reg. Section 1.1092(b)-1T(b), any disallowed put fee amount is treated as a loss in the succeeding taxable year subject in that year to the limitation of paragraph (a) of the regulation.

The amount of put fees disallowed each year under Temp. Treas. Reg. Section 1.1092(b)-1T(a) will not reduce the amount that a RIC must distribute in order to satisfy the 90% Income Distribution Test since they are disallowed under the straddle rules and not the rules of Sections 265 or 171. Thus, the disallowed amounts potentially can create problems for a RIC attempting to comply with the 90% Income Distribution Test. The amount of put fees not disallowed each year under the regulation will constitute short-term capital losses. These amounts can also create a problem under the 90% Income Distribution Test to the extent that adequate capital gains do not exist against which to offset the capital losses. ¹²⁶

CONCLUSION: As stated above, the Par Put should generally not be treated as a series of puts, but should be treated as a single put with multiple payments.

D. SWAP PAYMENTS

1. GENERAL RULE

ISSUE: Whether net swap expense is deductible in the current year or must be capitalized under Section 263 (g).

DISCUSSION: The Issuing Entity and the Swap Counterparty will typically net their payment obligations on each interest payment date, which will result in a net payment to the Swap Counterparty in the normal situation in which the Net Fixed Rate exceeds the Variable Rate. The net payment to the Swap Counterparty should generally constitute a periodic swap pursuant to Prop. Treas. Reg. Section 1.446-3(e)(2)(i)(A), which is netted against any amortized Swap Premium for the taxable year to determine the net income or deduction from the NCP. ¹²⁷ Absent the intervention of some other provision, any net deduction for the year is deducted from gross income, presumably pursuant to Section 162. ¹²⁸ Thus, no problems should arise in this context for purposes of determining whether the RIC has satisfied the 90% Income Distribution Test.

However, as stated above in Part V.B regarding the swap analysis for purposes of the 30% Test, a swap, along with a Par Put, can be viewed as offsetting positions to the Bond, with all three positions constituting a straddle. Furthermore, it is arguable, although (for the reasons discussed in Part VII.C.1) most likely technically incorrect, that any net swap expense otherwise deductible under Prop. Treas. Reg. Section 1.446-3(e)(1) could be treated as a carrying cost allocable to a straddle position (see Part VII.C.1, above), thereby invoking the capitalization rules of Section 263(g). Such a result could present problems in meeting the 90% Income Distribution Test since the RIC's net tax-exempt interest will not be reduced by the amount of the net swap expense which has been capitalized.

RECOMMENDATION: A RIC's net swap obligations relating to a Swap Agreement (determined under the netting rules of the Swap Regulations), if any, for the tax year should be deductible, thereby permitting the RIC to take into account amounts in determining with the 90% Income Distribution Test.

VIII. EARNINGS AND PROFITS

ISSUE: What is the effect on earnings and profits of disallowed deductions or capital expenditures incurred in connection with owning the Certificates?

DISCUSSION: Calculation of the dividends-paid deduction ("DPD") is important for purposes of determining whether the income distribution requirement of section 852(a)(1) (the "90% Income Distribution Test") has been met. As is stated in Part VII.A, above, satisfaction of the 90% Income Distribution Test actually depends on the amount of the DPD. In order to determine the amount of the DPD, both the current and accumulated earnings and profits ("E&P") of the fund must be computed. The E&P of a RIC is computed in accordance with the rules of Section 312, modified as stated below. ¹²⁹

Section 852(c)(1) provides that the current E&P of a RIC, but not its accumulated E&P, shall not be reduced by any amount which is not allowable as a deduction in computing its taxable income. The purpose of the rule is to ensure that current E&P is large enough to characterize distributions as dividends, which in turn will not impair the ability of a fund to satisfy the 90% Income Distribution Test. In the absence of Section 852(c)(1), a disallowed deduction would reduce current E&P (and thereby the fund's dividend-paying ability), but not the fund's income which must be distributed as a dividend.

Disallowed amounts do not reduce current E&P, but such amounts do reduce accumulated E&P. ¹³⁰ As discussed above in Part VII, regarding the 90% Income Distribution Test, various expenses and losses incurred in connection with the Put Structure and the Swap Structure may not be allowed as current deductions, principally under the rules of Sections 265, 1092, and 1211(a). In the year in which such expenses are incurred, they in effect create "phantom" E&P for that year which will vanish at the end of the year (since accumulated E&P does include such expenses). The only potential problem created by not reducing current E&P by the amount of disallowed deductions would be to turn an intended return of capital ("ROC") distribution into a taxable dividend. If a fund intends to make a ROC distribution, it needs to monitor the effect on current E&P under Section 852(c)(1) of the deferred deductions related to holding the Certificates.

CONCLUSION: The holding of the Certificates may influence a fund's distribution policy if it intends to make ROC distributions, it must monitor the effect on current E&P under Section 852(c)(1) of the various expense and loss deferral rules which relate to the Certificates.

IX. SECTION 4982 -- EXCISE TAX

ISSUE: How will the Swap Agreement impact the excise tax liability of a RIC for purposes of Section 4982?

DISCUSSION: Under the Swap Regulations, parties to a Swap Agreement are required to estimate their expected net payment entitlement or obligation by reference to the applicable variable rate under the Swap Agreement determined as of the close of the last day of their respective tax years. ¹³¹ During the succeeding tax year the parties to the Swap Agreement must recognize an adjustment to their net payment obligations and receipts under the swap to account for the difference between the actual variable rate and the estimated variable rate for the prior tax year.

This rule does not address the computation of taxable income by a RIC for excise tax purposes under Section 4982, which is based upon the CALENDAR year rather than the RIC's TAX YEAR. Section 4982 imposes an excise tax on RICs that fail to distribute substantially all (98%) of their income during the CALENDAR year in which it is earned. Although the Swap Regulations allow a taxpayer to estimate its periodic swap payment at the end of its TAXABLE year, its excise tax liability is computed at the end of the CALENDAR year. The Swap Regulations do not provide any guidance for purposes of computing Section 4982 excise tax liability. Section 4982(e)(1)(C) provides that for purposes of computing the excise tax, a RIC should compute ordinary income for the calendar year by treating the calendar year as the company's tax year. It is reasonable that a RIC should be allowed to rely on this provision to apply the rule on a calendar year basis.

RECOMMENDATION: For purposes of computing its excise tax liability, a RIC should be permitted to estimate its periodic swap payment at the end of the calendar year.

X. PROPOSED FORM OF REVENUE RULING [attached as Exhibit I]

² 17 C.F.R. Section 270.2a-7(c)(2)(i) (1991).

³ This report is not intended to address the necessary analysis under Rule 2a-7 and federal securities laws that must be made to determine whether a particular instrument constitutes a "floating rate instrument" or a "variable rate instrument" for purposes of the rule or whether a demand feature or put right qualifies as a "demand feature" within the meaning of Subsection (a)(4) of Rule 2a-7.

⁴ "Short-term" will be used to refer to any instrument that is deemed to have a maturity of less than 397 days for purposes of Rule 2a-7.

⁵ Faced with Supply Problems, Many T-F MFs Turn to Synthetic Floaters, IBC's Money Market Insight, May 1991. For purposes of this report, "tax-exempt" refers to either interest or bonds the interest on which is excludable from gross income for federal income tax purposes pursuant to Section 103. It should be noted that tax-exempt income may, in certain cases, be taken into account (1) as a specific item of tax preference pursuant to Section 57(a)(5) for alternative minimum tax purposes; (2) in computing "adjusted current earnings" for purposes of the alternative minimum tax imposed by Section 55 and the "environmental tax" imposed by Section 59A in the case of most corporations; (3) in computing the "branch profits tax" under Section 884; and (4) in computing "passive income" for certain S corporations under Section 1375. The receipt of tax-exempt interest may also have a number of collateral federal income tax consequences.

⁶ At the end of 1981, tax-exempt money market funds had approximately $5 billion of assets under management. In April 1985, tax-exempt money market funds managed approximately $34 billion in assets. By February 1991, the dollar amount of assets under management by tax-exempt money market funds had grown to more than $90 billion. Federal Reserve Bank, Flow of Funds (Feb. 28, 1991); Proposed Amendments to Rule 2a-7, 50 Fed. Reg. 27,982, 27,984 n.13 (July 9, 1985).

⁷ Jasen, Your Money Matters: Stiffer Rules for Tax-Free Money Funds?, Wall St. J., July 12, 1991, at Cl.

⁸ The term "Issuing Entity" is not intended to infer that the custodial account or trust must necessarily be classified as a separate entity for federal income tax purposes. Custodial accounts, nominee relationships and various arrangements in the nature of security devices do not necessarily create trusts under Treas. Reg. Section 301.7701-4. See e.g., Rev. Rul. 76-265, 1976-2 C.B. 448.

⁹ The Bond may not qualify as an eligible security under Rule 2a-7 if the Par Put is terminated; however, a money market fund could sell the Certificate at a profit to a party other than a money market fund. The other party could terminate the Par Put and sell the Bond, thereby permitting the money market fund to recognize the built-in gain associated with the security.

¹⁰ The notional principal amount may be adjusted over time to reflect principal payments on the Bonds and, if the notional principal amount is based upon the Bond's fair market value, the amortization of any difference between the initial fair market value of the Bonds and their related principal amount.

¹¹ In the case of an Issuing Entity structured to qualify as a partnership for federal income tax purposes, if the Issuing Entity is not the "owner" of the Bond, or if the investor does not "own" an equity interest in the partnership, then the transaction may be recharacterized as a loan by the money market fund to the Put Provider. Interest on the loan when the obligor is an entity other than a governmental unit does not qualify as tax-exempt.

¹² First Nat'l Bank in Wichita v. Commissioner, 19 B.T.A. 744 (1930), aff'd, 57 F.2d 7 (10th Cir. 1932); Bank of California v. Commissioner, 30 B.T.A. 566 (1934), aff'd, 80 F.2d 389 (9th Cir. 1935); American Nat'l Bank of Austin v. United States, 421 F.2d 442 (5th Cir. 1970), rev'g 296 F. Supp. 512 (W.D. Tex. 1968); Union Planters Nat'l Bank of Memphis v. United States, 426 F.2d 115 (6th Cir. 1970), rev'g 295 F. Supp. 1151 (W.D. Tenn. 1968); Third Nat'l Bank in Nashville v. United States, 71-1 U.S.T.C. para. 9248 (M.D. Tenn. 1971), aff'd, 454 F.2d 689 (6th Cir. 1972); First American Nat'l Bank of Nashville v. United States, 467 F.2d 1098 (6th Cir. 1972), aff'g 327 F. Supp. 675 (M.D. Tenn. 1971); Citizens Nat'l Bank of Waco v. United States, 551 F.2d 832 (Ct. Cl. 1977); and American Nat'l Bank of AUstin v. United States, 573 F.2d 1201 (Ct. Cl. 1978); Rev. Rul. 74-27, 1974-1 C.B. 24; Rev. Rul. 73-27, 1973-1 C.B. 46; and Rev. Rul. 82-144, 1982-2 C.B. 34.

¹³ Although no absolute rule can be established to determine which party to a transaction will be considered the owner of the property involved in all situations because of the factual nature of the issue, as a general rule the party to the transaction that bears the economic burdens and benefits of ownership will be considered the owner of the property for federal income tax purposes. Rev. Rul. 82- 144, supra note 11, at 35.

¹⁴ 1983-2 C.B. 572.

¹⁵ 1992-1 I.R.B. 55.

¹⁶ This report assumes that the underlying Bond qualifies as tax-exempt and, as previously indicated, does not address whether the Bond is treated as reissued. Supra note 1.

¹⁷ Treas. Reg. Section 301.7701-4(c)(1). These regulations are commonly referred to as the "Sears Regulations."

¹⁸ Under the grantor trust rules, distributions from the trust to the investors are essentially ignored for federal income tax purposes because the investor is already deemed the owner of a pro rata portion of any assets held by the trust. Accordingly, a distribution from the trust to the investor should have the same tax significance as the transfer by an investor of its investments from its bank checking account to its savings account.

¹⁹ 1988-2 C.B. 386.

²⁰ Id. at 387.

²¹ 74 T.C. 1377 (1980), rev'd, 670 F.2d 785 (8th Cir. 1982).

²² 74 T.C. at 1430-31.

²³ 670 F.2d at 787.

²⁴ 67 T.C. 71 (1976).

²⁵ Id. at 81 n.1 (citing Rev. Rul. 58-234, 1958-1 C.B. 279, 283).

²⁶ It should be noted that the precise terms of the Par Put may vary among structures. These variations may impact the appropriateness of treating the Par Put as a single renewable put. Note also that derivative interest rate products such as caps and floors are apparently treated as unified instruments under the recently issued proposed regulations relating to notional principal contracts, even though any payment that relates to the purchase and sale of such contracts are taken into account by allocating such payments in accordance with a series of separate european style options. See, Prop. Reg. Section 1.446-3(e)(3)(ii)(C).

²⁷ Rev. Rul. 71-521, 1971-2 C.B. 313, 314 and Rev. Rul. 78- 182, 1978-1 C.B. 265, 267. Note that Rev. Rul. 78-182 was written to pertain to options transactions on the Chicago Board Options Exchange. However, it is widely relied upon for guidance outside of that context.

²⁸ Rev. Rul. 78-182, supra note 26.

²⁹ Rev. Rul. 78-182, supra note 26, at 268 and Treas. Reg. Section 1.1234-1(b). Any gain to the grantor of an option arising from the failure of the holder to exercise it is characterized as capital gain. Section 1234(b).

³⁰ Rev. Rul. 78-182, supra note 26, at 268, and Rev. Rul. 71- 521, supra note 26.

³¹ See Part V. infra, for a discussion on the 30% test imposed by Section 851(b)(3).

³² Supra note 26, at 268.

³³ This report does not discuss the precise rules relating to the amortization of bond premium applicable to tax-exempt bonds.

³⁴ Section 1288.

³⁵ Section 1272. This discussion ignores special "grandfathering" provisions excepting certain bonds from current law or the rules of Section 1281 of the Code applicable to certain debt instruments with a maturity of one year or less.

³⁶ The special federal income tax consequences relating to "embedded loans" are discussed separately. Except as otherwise specified, the discussion relating to other tax issues concerning interest rate swaps assumes that none of the swap payments are recharacterized as an embedded loan or payments thereon.

³⁷ Prop. Treas. Reg. Sections 1.446-3 and 1.1092(d)-1, 56 Fed. Reg. 31,350 (July 10, 1991). The Committee on Financial Transactions has previously submitted comments regarding the Swap Regulations. See Breen, Conlon, Connors, Eichen, Harter and Neilson, American Bar Association, Section of Taxation, Committee on Financial Transactions, "Comments Regarding Proposed Treasury Regulations 1.446-3, 1.446-4, 1.512(b)(1)(a)-1 and 1.1092(d)-1; Proposed Regulations Regarding Accounting for Notional Principal Contracts" (1992) (available as Document 92-5836 from Tax Analysts).

³⁸ Prop. Treas. Reg. Section 1.446-3(e)(1).

³⁹ Prop. Treas. Reg. Section 1.446-3(e)(2)(ii)(B).

⁴⁰ The Swap Regulations may also be relevant if the Put Provider paid any amounts relating to the excess of the value of the Bonds as of the date the Issuing Entity was formed over their then outstanding principal amount and the Put Fee Agreement provides for any "netting" of such amounts upon termination.

⁴¹ See Prop. Treas. Reg. Section 1.446-3(c)(2).

⁴² 1989-1 C.B. 651.

⁴³ Prop. Treas. Reg. Section 1.446-3(e)(3)(ii)(A).

⁴⁴ Prop. Treas. Reg. Section 1.446-3(e)(3)(ii)(B) and (D)(1).

⁴⁵ Id.

⁴⁶ Prop. Treas. Reg. Section 1.446-3(e)(ii)(A).

⁴⁷ Prop. Treas. Reg. Section 1.446-3(e)(1).

⁴⁸ Prop. Treas. Reg. Section 1.446-3(e)(4)(iii).

⁴⁹ Prop. Treas. Reg. Section 1.446-3(e)(4)(v), Example (2).

⁵⁰ Prop. Treas. Reg. Section 1.446-3(e)(4)(v), Example (3).

⁵¹ Prop. Treas. Reg. Section 1.446-3(e)(6)(ii).

⁵² Prop. Treas. Reg. Section 1.446-3(e)(6)(iii).

⁵³ Id.

⁵⁴ Prop. Treas. Reg. Section 1.446-3(e)(6).

⁵⁵ See Prop. Treas. Reg. Section 1.1092(d)-1; Section 1234A.

⁵⁶ See H.R. Rep. No. 1192, 94th Cong., 2d Sess. 10-11 (1976); Priv. Ltr. Rul. 8322054 (Feb. 28, 1983); G.C.M. 39207 (Dec. 14, 1983); G.C.M. 39295 (Mar. 30, 1984).

⁵⁷ See Rev. Rul. 71-521, 1971-2 C.B. 313, 314; Rev. Rul. 78- 182, 1978-1 C.B. 265, 268; Rev. Rul. 58-234, 1958-1 C.B. 279.

⁵⁸ Section 1234(a)(2).

⁵⁹ Treas. Reg. Section 1.851-2(b); Rev. Rul. 63-118, 1963-1 C.B. 121.

⁶⁰ Section 851(b)(3) includes special rules that effectively exclude gains relating to foreign currency transactions (or options, futures, or forward contracts on foreign currencies) that are directly related to the RIC's principal business activities.

⁶¹ Treas. Reg. Section 1.851-2(b)(1).

⁶² Moreover, although the application of the test creates concerns in monitoring RIC qualification, it appears unlikely, absent significant market swings, that the disposition of the Bond upon exercise of the Par Put would result in gain.

⁶³ Sections 1092(c)(1) and (d)(1).

⁶⁴ Section 1092(d)(2).

⁶⁵ Prop. Treas. Reg. Sections 1.1092(d)-1(a) and (b)(6).

⁶⁶ See Part III.D.1, supra, regarding the analysis of the Put Structure as a single put with multiple payments.

⁶⁷ See Part III.D.1, supra.

⁶⁸ This is because the first put would be a married put and therefore the short sale rules of Section 1233(b) would not apply.

⁶⁹ Section 1233(b), flush language.

⁷⁰ Rev. Rul. 74-434, 1974-2 C.B. 195.

⁷¹ Sections 1092(c)(1) and (d)(1).

⁷² Prop. Treas. Reg. Sections 1.446-3(d)(1) and 1.1092(d)- 1(c)(1)(ii).

⁷³ Prop. Treas. Reg. Sections 1.1092(d)-1(c)(1)(i) and -1(b)(6).

⁷⁴ The extent to which the Par Put constitutes an offsetting position relating to the Bond must take into account the fact that the Par Put will typically relate to the Certificate itself, which takes into account both the Bond and the Swap component.

⁷⁵ It should be noted that the Swap Regulations include a provision that would treat the assignment of either counterparty's rights in a notional principal contract as a termination of the swap for the non-assigning counterparty. This aspect of the Swap Regulations has been criticized by some commentators.

⁷⁶ Section 851(g)(2)(A)(i).

⁷⁷ More liberal diversification requirements apply to RICs that invest in development corporations. Section 851(e).

⁷⁸ Government securities for this purpose is, in general, defined under the 1940 Act and would not include state or local tax- exempt bonds.

⁷⁹ Section 851(b)(4)(A).

⁸⁰ Section 851(b)(4)(B). In determining the value of the RIC's investment in the securities of any one issuer for purposes of the 25% diversification requirement, the RIC's proper proportion of the investment of any other corporation, a member of a controlled group, in the securities of such issuer is included. Section 851(c)(1); Treas. Reg. Section 1.851-3. For purposes of the diversification requirements, control means ownership of 20% or more of a corporation's stock, measured by voting power. Section 851(c)(2).

⁸¹ Section 851(c)(4).

⁸² Section 851(c)(5).

⁸³ This assumes that the RIC holds no cash or cash items (including receivables), Government securities, or securities of other RICs.

⁸⁴ Section 851(c)(5). See text accompanying note 55, supra, for the definition of a security for purposes of the 1940 Act.

⁸⁵ G.C.M. 39207 (Dec. 14, 1983); Priv. Ltr. Rul. 9122006 (June 15, 1990); and Priv. Ltr. Rul. 9203008 (Jan. 31, 1991). The RIC's proportionate ownership of the partnership's assets presumably would be based on the RIC's capital interest in the partnership by analogy to the rule applicable to REITs under Treas. Reg. Section 1.856-3(g).

⁸⁶ Sections 671-679; but see G.C.M. 39626 (Apr. 29, 1987) (government-backed mortgage pass-through certificates that represented grantor trust interests under general federal income tax principles are considered Government securities, despite the fact that the underlying mortgage loans were neither securities nor guaranteed by the U.S. government). Even though the custodial arrangement may not be organized as a state law trust, there is a risk that if it is used as an investment vehicle the Service may take the view that it must be analyzed and classified as a grantor trust, partnership or association taxable as a corporation.

⁸⁷ As stated above, we believe that the determination of whether the various components are securities under the 1940 Act is beyond the scope of this report. However, we will assume that the Bond, Par Put and Swap Agreement are each separate securities under the 1940 Act.

⁸⁸ We are not recommending that the Service modify its current ruling position with respect to investments by RICs in partnerships that are not synthetic tax-exempt securities.

⁸⁹ Section 851(c)(5).

⁹⁰ 15 U.S.C. Section 80a-2(a)(22) (1981).

⁹¹ See G.C.M. 39626, supra note 85; G.C.M. 39456 (June 21, 1985) (when an industrial development bond is issued by a state agency or municipality for the benefit of a private user, the private user is the issuer of the obligation for purposes of the diversification requirements as long as interest and principal on the bond are payable solely out of revenues from the project financed and the assets of the user).

⁹² See, e.g., G.C.M. 39456, supra note 90.

⁹³ See G.C.M. 37233 (Aug. 25, 1977) (exchange traded options), MODIFIED BY G.C.M. 39700 (Nov. 16, 1987) (over-the-counter options); G.C.M. 39708 (Mar. 4, 1988), MODIFYING G.C.M. 39316 (July 31, 1984), G.C.M. 39526 (Feb. 14, 1986), and G.C.M. 39447 (Dec. 5, 1984) (options, futures contracts, and options on futures contracts on stock indexes; futures contracts on municipal bond indexes; futures contracts on domestic and Eurodollar certificates of deposit). As a theoretical matter, the treatment of the issuer of the underlying security as the issuer of the option could be questioned as inconsistent with the purpose of the diversification test because the risk that the option writer will be UNABLE to honor the put is not addressed by this approach (but would be addressed if the option writer was treated as the issuer of the option). However, this issue was squarely before the Service at the time it issued the aforementioned ruling and memoranda.

⁹⁴ As discussed above, the issuer of the Bond would either be the governmental unit issuing the Bond or, in the case of certain private activity bonds and industrial development bonds, the underlying obligor.

⁹⁵ G.C.M. 39700, supra note 92; Priv. Ltr. Rul. 8823067 (Mar. 11, 1988). Note that the Service's position is different from that adopted by the SEC in Section (c)(4)(iii)(A) of Rule 2a-7 which, depending upon certain factors, may treat the option writer as the issuer.

⁹⁶ Section 851(c)(4). In the case of securities of majority- owned subsidiaries that are investment companies, fair value shall not exceed market value or asset value, whichever is higher. Id.

⁹⁷ Adoption of Amendments to Rule 2a-7, Investment Company Act Release No. 14,983, [1985-1986 Transfer Binder] Fed. Sec. L. Rep. (CCH) Section 83,972, at 88,051 n.13 (Mar. 12, 1986).

⁹⁸ G.C.M. 39316 (July 31, 1984). If a RIC writes an option, its potential loss is unlimited, so the measure of its investment should be the value of the security upon which it wrote the option. Id. If, however, the RIC writes a call option or enters a short (selling) position in a futures contract and owns the identical security to "cover" the option or futures contract, the risk is limited and the security should only be counted once in applying the diversification requirements. Id.

⁹⁹ See 17 C.F.R. Section 270.2a-7(c)(4)(ii) (1991) (money market fund's investments are limited with respect to securities issued by or subject to puts from the same institution).

¹⁰⁰ If the Issuing Entity has insufficient funds to pay the fees of the service providers because the Variable Rate exceeds the Net Fixed Rate, the Put Provider would be obligated to pay those service fees. The possibility that the Put Provider may be required to pay the service fees could be viewed as an asset to the Holders, but the remoteness of the payment obligation makes its value nominal.

¹⁰¹ Section 265(a)(3).

¹⁰² Section 265(a)(1) includes two rules; a rule that disallows deductions of any taxpayer, including corporations, that relates to production of exempt income OTHER THAN INTEREST and a rule that disallows deductions otherwise deductible under a Section 212 relating to tax-exempt interest. Section 212 only applies to individuals. Thus, Section 265(a)(1) DOES NOT limit deductions of corporations relating to the production of tax-exempt interest.

¹⁰³ See generally Treas. Reg. Sections 1.162-1(a) and (b)(2) which cross references Sections 261-276 for items that are not deductible. Section 263 provides in relevent part that no deduction is allowed for amounts paid for permanent improvements or betterments to increase the value of any property estate.

¹⁰⁴ The circumstances under which a termination can be expected to occur include when (1) the Variable Rate exceeds the Net Fixed Rate and (2) the conditional put expires upon a default of the Bonds or upon a determination of taxability of the Bonds.

¹⁰⁵ See also Rev. Rul. 78-182, 1978-1 C.B. 265, 268.

¹⁰⁶ Section 1092(a)(1); Prop. Treas. Reg. Sections 1.446- 3(e)(6) and 1.1092(d)-1.

¹⁰⁷ See supra note 26.

¹⁰⁸ Section 502, Pub. L. No. 97-34 (1981).

¹⁰⁹ See S. Rep. No. 97-144, 97th Cong., 1st Sees. 153-54 (1981).

¹¹⁰ Section 105, Pub. L. No. 97-448.

¹¹¹ S. Rep. No. 97-592, 97th Cong., 2d Sess. 25 (1982)

¹¹² Section 102(e)(7), Pub. L. No. 98-369 (1984).

¹¹³ See Section 56(a), Pub. L. No. 98-369 (1984).

¹¹⁴ See Staff of the Joint Committee on Taxation, 98th Cong., 2nd Sess., General Explanation to the Deficit Reduction Act of 1984 (H.R. 4170, 98th Cong., P.L. 98-369) at 304 (1985).

¹¹⁵ See supra note 26.

¹¹⁶ See supra Part III.D.1.

¹¹⁷ We acknowledge that the "business insurance" rationale may have its limitations, based upon Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988). Its scope is currently under revisitation in Federal National Mortgage Ass'n v. Commissioner, T.C. Docket No. 21557-86 and Ralston Purina v. Commissioner, T.C. Docket 4799-92.

¹¹⁸ 1981-1 C.B. 312.

¹¹⁹ See Part II.B, supra.

¹²⁰ Prop. Treas. Reg. Section 1.446-3(d)(7).

¹²¹ See Comment letter to the Service from Aquilino and Conlon of Chapman and Cutler, dated Sept. 10, 1991 (available as Document 91-7801, 91 TNT 195-32 from Tax Analysts).

¹²² Prop. Treas. Reg. Section 1.446-3(e)(2)(i)(A).

¹²³ Prop. Treas. Reg. Section 1.446-3(e)(3)(ii)(C).

¹²⁴ Id.

¹²⁵ See Part V, supra, for a discussion of the straddle rules.

¹²⁶ See Section 1211(a).

¹²⁷ Prop. Treas. Reg. Section 1.446-3(e)(1).

¹²⁸ Id.

¹²⁹ Rev. Rul. 76-299, 1976-2 C.B. 211; G.C.M. 39570 (Nov. 12, 1986)

¹³⁰ Section 852(c)(1); Treas. Reg. Section 1.852-5(b).

¹³¹ Prop. Treas. Reg. Section 1.446-3(e)(2)(ii)(B)

SECTION OF TAXATION AMERICAN BAR ASSOCIATION

PROPOSED REVENUE RULING

INTERNAL REVENUE CODE REFERENCES: Sections 851, 852, 1223, and 4982.

Guidance has been requested concerning the federal income tax issues that arise under Subchapter M of the Internal Revenue Code of 1986, as amended (the "Code"), when a regulated investment company (a "RIC") invests in "tax-exempt synthetic securities." Although tax- exempt synthetic securities are not identical, they generally have the following features: (i) they represent interests in long-term fixed-rate tax-exempt bonds ("Bonds"), (ii) the holder of the security (the "Holder") has a liquidity feature that permits the Holder to tender the security for purchase at a price of par plus accrued interest (the "Par Put") under certain circumstances, and (iii) there is a mechanism that effectively converts the fixed rate on the Bonds into a short-term variable rate in order to permit the security to be treated as having a permitted term under Rule 2a-7 of the Investment Company Act of 1940. Synthetic tax-exempt securities ("Certificates") typically represent an interest in a custodial account or trust (an "Issuing Entity"). The Issuing Entity is intended to be treated as a mere security device that is not treated as a separate entity for federal income tax purposes, or is designed to qualify as a grantor trust or partnership for federal income tax purposes. Depending upon the interest rate conversion mechanism employed, the Certificates generally are classified in one of the following two structures.

The first structure ("Put Fee Structure") entitles the Holder to all principal payments received on the Bonds and interest distributions at a variable rate that corresponds to a market index for comparable short-term tax-exempt obligations (the "Variable rate"). The fixed rate on the Bonds, net of ongoing expenses, (the "Net Fixed Rate"), is converted to the Variable Rate by the Issuing Entity entering into a fee agreement (a "Put Fee Agreement") with one of the sponsors of the transaction (The "Put Provider"). Under the Put Fee Agreement, the Holders pay the Put Provider an amount equal to any positive difference between the Net Fixed Rate and the Variable Rate multiplied by the outstanding principal balance of the Bonds (the "Floating Rate Spread". The Floating Rate Spread varies inversely with the Variable Rate and is zero whenever the Variable Rate equals or exceeds the Net Fixed Rate. If the Variable Rate exceeds the Net Fixed Rate, the Put Provider is required to pay the Issuing Entity an amount equal the difference between the two rates multiplied by the outstanding principal amount of the Bonds. Under the Put Fee Structure, however, because the Variable Rate typically is not permitted to exceed the fixed rate on the Bonds, the Put Provider generally not obligated to fund interest distributions on the Certificates. The Put Provider's only potential liability is its obligation to pay fees owed to other service providers (e.g., custodial, trustee, liquidity, remarketing, and credit enhancement fees) to the extent that the Issuing Entity has insufficient funds to pay such fees because the Variable Rate exceeds the Net Fixed Rate. The Floating Rate Spread paid to the Put Provider often is denominated as a "put fee" paid as compensation for the Put Provider's ultimate obligation to fund any exercise by a Holder of his Par Put. The Put Provider normally obtains a bank letter of credit to secure its obligation to fund any exercise of the Par Put.

The Par Put received by a Holder in the Put Fee Structure generally is designed to impose on the Holder certain risks of loss relating to the Bond. Accordingly, the Par Put often terminates automatically if (i) there is a default on the Bonds, (ii) the Bonds' ratings fall below investment grade, or (iii) an event of taxability occurs with respect to the Bonds. In certain variations of the Put Fee Structure, the term of the Par Put expires significantly before the maturity date of the Bonds and ordinarily cannot be renewed. Holders often have the right to cancel both the Par Put and their obligation to pay the Floating Rate Spread to the Put Provider. Upon exercise of such a right, the Holder would receive direct ownership of its interest in the Bond or interest distributions on its Certificate at the Net Fixed Rate. In many cases, the Holder who elects to cancel the Par Put must make a termination payment to the Put Provider.

Under the second structure (the "Swap Structure"), the Issuing Entity enters into an interest rate swap agreement (the "Swap Agreement") with a third party (the "Swap Counterparty"). The Swap Agreement incorporates a notional principal amount equal to the outstanding principal balance on the Bonds (or the fair market value of the Bonds as of the date the structure is formed) and obligates the Issuing Entity to pay the Net Fixed Rate accruing on the Bonds to the Swap Counterparty in exchange for the Variable Rate determined with respect to the Certificates. On each interest payment date, the payment obligations of the two parties are netted against each other, resulting in a net payment to the Swap Counterparty as long as the Net Fixed Rate exceeds the Variable Rate. If, however, the Variable Rate rises so that it exceeds the Net Fixed Rate, the Swap Counterparty would be required to make a net payment to the Issuing Entity.

In many cases, the value of the Bonds at the time the Certificate is created (which is when the Swap Agreement is executed) and the terms of the Swap Agreement require one of the parties to make an up-front payment (a "Swap Premium") to the other at closing. The Swap Premium may be paid to compensate the Issuing Entity for the fact that it is more likely to make than to receive payments under the Swap Agreement. The amount of the Swap Premium (and who receives it) also may bear a relationship to the amount of market premium or discount (and accrued interest), if any, with respect to the Bonds as of the time that the Certificate is created.

As is the case with the Put Fee Structure, the Par Put typically expires if there is a default, decline in rating, or event of taxability with respect to the Bonds. Like the Put Fee Structure, a bank usually issues a letter of credit to the Put Provider to secure the Put Provider's obligation to fund any exercise of the Par Put. A Holder often is permitted to elect to terminate the interest in the Swap Agreement that relates to the Certificate, thereby permitting the Holder to receive directly either its share of the Bonds represented by the Certificate or interest on the Certificate at the Net Fixed Rate. If the Holder makes that election, it typically is required to either make or receive a terminating payment with respect to the termination of the related portion of the Swap Agreement. The terminating payment typically is determined in the same manner that terminating payment for other types of interest rate swaps are determined (i.e., by reference to the present value of the cost or benefit of replacing the terminated side of the swap at the then- applicable market rate). The Holder may recognize an offsetting gain or loss on his interest in the Bonds. The Swap Counterparty also has the right to terminate the Swap Agreement, but, if that right is exercised, the Holders typically have the option to retain ownership of the Bonds free of the Swap Agreement and Par Put.

ISSUES:

1. Whether the amounts paid to the Put Provider reduce the RIC's net tax-exempt income for purposes of section 852(a)(1) of the Code.

2. Whether the holding period rules of section 1223 of the Code apply to a RIC that owns a Certificate.

3. Whether the net swap expense in the Swap Structure reduces the RIC's net tax-exempt income for purposes of section 852(a)(1), of the Code.

4. Whether the recurring fees that a RIC incurs in connection with owning the Certificate (other than put fees and swap payments) reduce the RICs net tax-exempt income for purposes of section 852(a)(1) of the Code.

5. Whether the Certificate is a security for purposes of section 851(b)(4) of the Code.

6. Whether the issuer of the Certificate is the same entity that is the issuer of the Bond for purposes of section 851(b)(4) of the Code.

7. Whether the Certificate is valued at par for purposes of section 851(b)(4) of the Code.

8. whether the periodic and non-periodic payments recognized by a RIC under the Swap Agreement constitute qualifying income under section 851(b)(2) of the Code.

9. Whether a RIC can estimate its periodic swap payment at the end of the calendar year for purposes of computing its excise tax liability under section 4982 of the Code.

RELATED AUTHORITIES:

a. Code References --

Sections 162, 171, 263, 265, 671-679, 851, 852, 1092, 1223, 1233, and 4982.

b. Statutory & Legislative History References --

Staff of Joint Comm. on Taxation, General Explanation of the Deficit Reduction Act of 1984, Pub. L. No. 369, 98th. Cong., 2d Sess. 304 (1984).

c. Regulation References --

Treas. Reg. section 1.162-1.

With increasing frequency, tax-exempt money market mutual funds ("Tax-Exempt Funds") have turned to Certificates as a means of satisfying their need for high quality short-term tax-exempt investments. The Certificates raise several fundamental federal income tax issues, such as (i) the impact of the Par Put on the Holder's status as the owner of the Bonds, (ii) the impact of the investment arrangement on the continued tax-exempt status of the Bonds, and (ii) the status of the Issuing Entity as a mere security device or flow-through entity for federal income tax purposes (i.e., a grantor trust or partnership). Those and other federal income tax issues, although important, require an analysis of the particular facts and circumstances relating to a specific issue of Certificates and accordingly are not addressed in this revenue ruling. Instead, this ruling assumes that a certificate-holder receives tax-exempt income on its investment therein and strictly provides guidance concerning the federal income tax issues that arise under Subchapter M of the Code when a RIC, such as a Tax-Exempt Fund, invests in a Certificate.

LAW AND ANALYSIS:

In order for a Tax-Exempt Fund to qualify as a RIC, it must meet certain tests relating to the nature of the income that it earns, the diversification of its investments, and the amount and timing of its distributions to its shareholders. If a Tax-Exempt Fund fails to satisfy those tests during a taxable year, it may be subject to tax and its distributions to its investors may be reclassified as taxable, rather than tax-exempt dividends.

Issue # 1

The first issue is whether the amounts paid to the Put Provider reduce the RIC's net tax-exempt income for purposes of section 152(a)(1) of the Code. Section 263(g) of the Code provides that no deduction is allowed for interest and carrying charges properly allocable to personal property which is part of a straddle as defined in section 1092(c) of the Code). The term interest and carrying charges includes amounts including charges to insure, store, or transport the personal property paid or incurred to carry the personal property. I.R.C. section 263(g)(2)(A)(ii). The legislative history of the predecessor to section 263(g) of the Code indicates that carrying charges include amounts paid or incurred for the temporary use of property in a short sale, or insuring, storing, or transporting the property. Staff of Joint Comm. on Taxation, General Explanation of the Deficit Reduction Act of 1984, Pub. L. No. 369, 98th. Cong., 2d Sess. 304 (1984). Since a RIC does not incur put fees to carry the Bonds, they are not required to be capitalized under section 263(g) of the Code, regardless of whether the Par Put and the Bonds constitute a straddle under section 1092(c) of the Code.

Several Revenue Rulings concerning exchange traded options have ruled that the cost of acquiring a put option is carried in a deferred account as a capital expenditure made in an incomplete transaction entered into for profit. Rev. Rul. 71-521, 1971-2 C.B. 313; Rev. Rul. 78-182, 1978-1 C.B. 265, 267. Revenue Ruling 81-160, 1981-1 C.B. 312, however, ruled that commitment fees of standby charges incurred pursuant to a bond sale agreement under which funds for construction are made available in stated amounts over a specified period are deductible ratably over the term of the loan. The payments to the Put Provider largely represent fees to protect the RIC against changes in the value of the Bond caused by changes in market interest rates. Thus, the put fees more closely resemble insurance payments that are ordinary and necessary expenses connected directly with the RIC's trade or business. Treas. Reg. section 1.162- 1(a). Accordingly, the put fees reduce the RIC's net tax-exempt income for purposes of section 852(a)(1) of the Code.

Issue # 2

The second issue is whether the holding period rules of section 1223 of the Code apply to a RIC that owns a Certificate. Determining which holding period rules apply to the RIC important because section 851(b)(3) of the Code provides that a RIC must derive less than 30 percent of its gross income from the sale or disposition of stock, securities, options, futures, or forward contracts which have been held for less than three months (the "30% Test"). The holding period of a Certificate for purposes of the 30% Test generally is determined under section 1223 of the Code. Treas. Reg. section 1.851-2(b)(1). Under that general rule, a RIC would not need to take into account any gain derived from the disposition of a Certificate under the 30% Test unless the RIC disposed of the Certificate, the Par Put or Bond at a gain within three months of acquiring the Certificate.

In certain circumstances, the general holding period rules are modified by sections 1092 and 1233 of the Code. The special holding period rule under section 1092 of the Code, however, does not apply to a RIC for purposes of the 30% Test. Temp. Treas. Reg. section 1.1092(b)-2T(d). The special holding period rule of section 1233(b) of the Code applies to a RIC for purposes of the 30% Test if that section would have applied to the positions of the straddle (without regard for sections 1233(e)(2)(A) and 1092(b) of the Code). Id. Thus, for purposes of applying the 30% Test to a RIC that holds a Certificate, section 1223 of the Code determines the holding period of the Certificate, unless section 1233(b) of the Code applies to the Certificate (without regard for sections 1233(e)(2)(A) and 1092(b) of the Code).

Section 1233(b) of the Code generally does not determine the holding period of property if (i) an option to sell property at a fixed price and the property to which the option relates are acquired on the same day and (ii) the option is exercisable only through the sale of the related property (the "Married Put Exception"). I.R.C. section 1233(c). Since the Par Put should normally be treated as a single put option with multiple payment dates, the Par Put will generally meet the requirements of the Married Put Exception and, consequently, the general holding period rules of section 1223 of the Code apply to a RIC that holds a Certificate.

Issue # 3

The third issue is whether the net periodic and non-periodic payments recognized with respect to the swap embedded in the Swap Structure reduces the RIC's net tax-exempt income for purposes of section 852(a)(1) of the Code. The Issuing Entity and Swap Counterparty typically net their payment obligations on each interest payment date, resulting in a net payment to the Swap Counterparty as long as the Net Fixed Rate exceeds the Variable Rate. The net payment to the Swap Counterparty is a periodic payment under the swap, which is netted against any amortized Swap Premium for the taxable year to determine the net income or deduction from the Swap Agreement. Prop. Treas. Reg. sections 1.446-3(e)(2)(i)(A), (e)(1). Since the net swap expense, like the put fees, are not carrying charges under section 263(g) of the Code, the net swap expense reduces the RIC's net tax- exempt income for purposes of section 852(a)(1) of the Code.

Issue # 4

The fourth issue is whether the recurring fees that a RIC incurs in connection with owning the Certificate (other than put fees and swap payments) reduce the RIC's net tax-exempt income for purposes of section 852(a)(1) of the Code. Section 852(a)(1) of the Code requires that a RIC's dividends-paid deduction for a taxable year (without regard to capital gain dividends) must at least equal the sum of (i) 90 percent of its investment company taxable income (determined without regard to the dividends-paid deduction and (ii) 90 percent of its net tax-exempt income, the "90% Income Distribution Test". The measure of a RIC's net tax-exempt income is the excess of (i) its interest income excludable from gross income under Section 103(a) of the Code over (ii) its deductions that are disallowed under sections 265 and 171(a)(2) of the Code. I.R.C. section 852(a)(1)(B). There are, however, other sections of the Code that disallow expenditures as deductions. Thus, for example, a deduction is allowed only for ordinary and necessary expenses which are paid or incurred during a taxable year in carrying on a trade or business and do not constitute capital expenditures. See generally Treas. Reg. sections 1.162-1(a), (b)(2). If a Tax-Exempt Fund has its expenditures disallowed, the net tax-exempt income generated by a Certificate may exceed the amount of cash received by the Tax-Exempt Fund. In that case, the Tax-Exempt Fund could be forced to distribute capital, rather than earnings, in order to satisfy the 90% Income Distribution Test for a taxable year.

A RIC that owns a Certificate incurs certain types of recurring fees (other than put fees or swap payments), including custodial, trustee, liquidity, remarketing, or credit enhancement fees (the "Service Fees"). The Service Fees are paid or incurred by the RIC for the management or insurance of the RIC's interest in the Bonds and other assets held by the Issuing Entity (as represented by the Certificate). Assuming that the Service Fees are reasonable, the Service Fees should be treated as ordinary and necessary in carrying on the RIC's business, rather than capital expenditures. As a result, such Service Fees should be allowable as deductions under section 162 of the Code and, consequently, reduce the RIC's net tax-exempt income to the extent they are disallowed under sections 265 and 171(a)(2) of the Code.

Issue # 5

The fifth issue is whether the Certificate is a security for purposes of section 851(b)(4) of the Code. Section 851(b)(4) of the Code provides that a RIC must satisfy a two-pronged asset diversification test (the "Asset Diversification Test"). The first prong of the Asset Diversification Test is that at least 50 percent of the value of the RIC's total assets must be represented by (i) cash and cash items (including receivables), (ii) Government securities, (iii) securities of other RICs, and (iv) other securities limited in respect of any one issuer to an amount not greater in value than 5 percent of the value of the total assets of the RIC and to not more than 10 percent of the outstanding voting securities of such issuer. I.R.C. section 851(b)(4)(A). The second prong of the Asset Diversification Test is that not more than 25 percent of the value of the RIC's total assets can be invested in the securities (other than Government securities or the securities of other RICs) of (i) any one issuer or (ii) two or more issuers that the RIC controls and are determined to be engaged in the same or similar trades or businesses or related trades or businesses. Id. section 851(b)(4)(B).

For purposes of the Asset Diversification Test, the term security has the same meaning as when used in the Investment Company Act of 1940, as amended (the "1940 Act"). Id. section 851(c)(5). In certain instances, a look-through approach has been applied to identify the assets that a RIC owns for purposes of the Asset Diversification Test. Accordingly, if a RIC owns an interest in a partnership, the RIC has been treated as owning a proportionate interest in each of the assets of the partnership, regardless of whether the partnership interest constitutes a security for purposes of the 1940 Act. See G.C.M. 39207 (Dec. 14, 1983); Priv. Ltr. Rul. 9122006 (June 15, 1990); and Priv. Ltr. Rul. 9203008 (Jan. 31, 1991). Similarly, if a RIC is the beneficiary of a grantor trust or owns a beneficial interest in a custodial arrangement, the RIC may be treated as owning a proportionate interest in each of the assets of the trust or custodial arrangement. I.R.C. sections 671-679; but see G.C.M. 39626 (Apr. 29, 1987) government-backed mortgage pass-through certificates that represented grantor trust interests under general federal income tax principles are considered Government securities, despite the fact that the underlying mortgage loans were neither securities nor guaranteed by the U.S. government).

Due to the complex valuation issues that arise when a look- through approach is applied to a Certificate, the Certificate is treated as a single security for purposes of the Asset Diversification Test, regardless of whether the Certificate constitutes a security under the 1940 Act. A look-through approach, however, will continue to be applied to investments by RICs in partnerships that are not synthetic tax-exempt securities.

Issue # 6

The sixth issue is whether the issuer of the Certificate is the same entity that is the issuer of the Bond for purposes of section 851(b)(4) of the Code. Under section 2(a)(22) of the 1940 Act, an issuer is defined as a "person who issues or proposes to issue any security, or has outstanding any security which it has issued." Because the Certificate is likely to be treated as a single security for purposes of the 1940 Act, the "issuer" of the Certificate is similarly likely to be the Issuing Entity. Such a mechanical application, however, ignores the economic reality that the Issuing Entity simply acts as a conduit, forwarding interest and principal payments on the Bonds (net of certain expenses) to the Holders. Thus, for purposes of the Asset Diversification Test, the issuer of a Certificate is the same person that is treated as the issuer of the Bonds (or issuers of the Bonds in the case that the Issuing Entity holds multiple Bonds) if the Bond (or Bonds) were held directly by the RIC. A municipal bond normally is issued by the state agency or municipality that issues the bond. A private activity bond or industrial development bond that is issued by a state agency or municipality for the benefit of a private user, however, is treated as issued by the private user if the interest and principal on the Bonds is payable solely out of revenues from the project financed and the assets of the private user. G.C.M. 39456 (June 21, 1985). Thus, the issuer of Certificate is the issuer of the underlying Bond (or Bonds) or, in the case of industrial development bonds and private activity bonds, the private business that is obligated to make payments to the issuer corresponding to the issuer's payments on the Bonds.

Issue # 7

The seventh issue is whether the Certificate is valued at par for purposes of section 851(b)(4) of the Code. For purposes of the Asset Diversification Test, value means, with respect to securities (other than those of majority-owned subsidiaries) for which market quotations are readily available, market value of such securities and with respect to other securities and assets, fair value as determined in good faith by the RIC's board of directors (or trustees). I.R.C. section 851(c)(4). Although market quotations for the Certificates are not available, they generally are valued at par for purposes of the Asset Diversification Test because they are issued with the Par Puts and because the Variable Rates on the Certificates periodically are reset to approximate or equal market interest rates. If, however, the RIC's board of directors (or trustees) believes that valuing the Certificate at par is inappropriate due to the fact that the Par Put has been extinguished (or otherwise is unlikely to be available) or the Variable Rate does not approximate a market rate, the board of directors (or trustees) should determine the Certificate's fair value.

Issue # 8

The eighth issue is whether the periodic and non-periodic payments received by a RIC under the Swap Agreement are qualifying income under section 851(b)(2) of the Code. Section 851(b)(2) of the Code requires that at least 90 percent of a RIC's gross income be derived from dividends, interest, payments with respect to securities loans, and gains from the sale or other disposition of stock or securities or foreign currencies, or other income (including but not limited to gains from options, futures, or forward contracts) derived with respect to its business of investing in such stock, securities, or currencies (the "90% Income Test"). Even though the net payments received by a RIC under the Swap Agreement are not listed specifically as qualifying income for purposes of the 90% Income Test, those payments qualify for the 90% Income Test because they are related to the Swap Agreement, which is an integral component of the Certificate and is used as a hedge against interest rate fluctuations (and therefore qualifies as income derived with respect to the RIC's business of investing in stocks, securities or currencies).

Issue # 9

The ninth issue is whether a RIC can estimate its periodic swap payment at the end of the calendar year for purposes of computing its excise tax liability under section 4982 of the Code. Parties to a Swap Agreement are required to estimate their expected net payment entitlement or obligation by reference to the applicable variable rate under the Swap Agreement determined as of the close of the last day of their respective taxable year. Prop. Treas. Reg. section 1.446-3(e)(2)(ii)(B). During the succeeding taxable year, the parties to the Swap Agreement recognize an adjustment to their net payment obligations and receipts under the swap to account for the difference between the actual variable rate and the estimated variable rate for the prior taxable year. Id. Section 4982 of the Code generally imposes an excise tax on RICs that fail to distribute 98 percent of their income during the calendar year in which the income is earned. For purposes of computing the excise tax, a RIC computes ordinary income for the calendar year by treating the calendar year as its taxable year. Thus, for purposes of computing its excise tax liability, a RIC that owns a Certificate in the Swap Structure is permitted to estimate its periodic swap payment at the end of the calendar year.

HOLDINGS

Based on the authorities set forth above, the Internal Revenue Service holds as follows:

1. The amounts paid to the Put Provider reduce the RIC's net tax-exempt income for purposes of section 852(a)(1) of the Code.

2. If the Par Put is treated as a single instrument with periodic payment dates, the holding period rules of section 1223 of the Code apply to a RIC that owns a Certificate.

3. The net swap expense in the Swap Structure reduces the RIC's net tax-exempt income for purposes of section 852(a)(1) of the Code.

4. The recurring fees that a RIC incurs in connection with owning the Certificate (other than put fees and swap payments) reduce the RIC's net tax-exempt income for purposes of section 852(a)(1) of the Code.

5. The Certificate is a security for purposes of section 851(b)(4) of the Code.

6. The issuer of the Certificate is the same entity that is the issuer of the Bond for purposes of section 851(b)(4) of the Code. Thus, the issuer of a Certificate is the issuer of the underlying Bond (or Bonds) or, in the case of industrial development bonds and private activity bonds, the private business that is obligated to make payments to the issuer corresponding to the issuer's payments on the Bonds.

7. The Certificate generally is valued at par for purposes of section 851(b)(4) of the Code. If, however, the RIC's board of directors (or trustees) believes that valuing the Certificate at par is inappropriate due to the fact that the Par Put has been extinguished (or otherwise is unlikely to be available) or the Variable Rate does not approximate a market rate, the board of directors (or trustees) should determine the Certificate's fair value.

8. The periodic and non-periodic payments recognized by a RIC under the Swap Agreement are qualifying income under section 851(b)(2) of the Code.

9. A RIC can estimate its periodic swap payment at the end of the calendar year for purposes of computing its excise tax liability under section 4982 of the Code.

CONTACT PERSON

For further information regarding this proposed ruling, you may contact Steven D. Conlon, Esq. or Suzanne M. Russell, Esq. of Chapman and Cutler, 111 West Monroe Street, Chicago, Illinois, 60603 (312- 845-3000; fax 312-701-2361).