FSA forgoes conventional wisdom in characterizing a remarketing payment under a callable/puttable bond.

• Author: Sair, Edward A.
• Position: Field Service Advice

In Field Service Advice (FSA) 200142005, the IRS addressed the tax treatment of a payment received by an issuer of a callable/puttable bond. The payment was made by an investment bank for the right to purchase and remarket the bond. The FSA concluded that the remarketing payment was an integral part of the bond and, as such, was included in the amount received by the issuer as bond proceeds. Thus, the issue price exceeded the stated redemption price at maturity (SRPM), resulting in a bond-issuance premium amortizable under Regs. Sec. 1.163-13.

The conclusion of the FSA, however, is inconsistent with the current general treatment of these payments by issuers of these types of bonds. Many issuers treat the remarketing payment as an option premium received in connection with a hedging transaction (the call right) that relates to the yield on the remarketed bond. The issuers then generally defer recognition of the premium under the hedge-timing rules of Regs. Sec. 1.446-4. Although the FSA does not constitute authority binding on either the Service or taxpayers, it reflects a potential IRS litigation position.

Background

Corporations issue bonds that allow the holders to "put" the bonds back to the issuer after a stated period. Because of the put right, holders accept lower interest rates than on other bonds. In the past several years, investment banks developed the callable/puttable bond structure, which further lowered interest costs. These callable/puttable bonds effectively bundle an interest rate option with a puttable debt instrument. The investment bank effectively exercises the option when it exercises its right to remarket the bond.

While the corporate issuer benefits from lower interest costs, the dealer benefits by the purchase of the embedded-interest-rate option at a lower premium (cost) than if it purchased a separate option in the derivatives market. These bonds have been issued under several names, such as Remarketable or Redeemable Securities, Puttable Reset Securities and Mandatory Puttable/ Redeemable Securities. Callable/puttable bonds are issued with a stated maturity of 10 to 15 years. The bonds, however, provide for a "reset" or "remarketing" date two to five years out. At this date, an investment bank (i.e., the dealer) has a call right to purchase the bonds from the holders at the face amount (i.e., call right) and remarket them.

If interest rates have decreased since issuance, the bonds' value would exceed the face...