WASHINGTON - An Internal Revenue Service memorandum concluding that a local government's Build America Bonds were reissued when they were defeased is drawing criticism from bond lawyers.
A reissusance means the defeased bonds are not BABs and the issuer cannot get subsidy payments. Also, bondholders could be deemed to have exchanged their bonds for new ones and, as a result, could have taxable gains, some lawyers said.
Helen Hubbard, associate chief counsel for financial institutions and products, sent the
Several bond lawyers said they think the IRS' reasoning in the memo is incorrect.
National Association of Bond Lawyers president Tony Martini said the ruling may have gone off in the "wrong direction" and that NABL's tax-law committee may provide the IRS with comments about it.
BABs are taxable, direct-pay bonds that state and local governments could issue in 2009 and 2010. BAB Issuers initially were supposed to receive federal subsidy payments equal to 35% of their interest costs. However, subsidy payments processed since March 2013 have been reduced because of spending cuts known as sequestration.
The reductions in subsidy payments have triggered extraordinary optional redemption provisions in some issuers' documents for their BABs, allowing the issuers to redeem the BABs.
Such was the case for the local government that was the focus of the advice memo. The government, which was not identified by name, issued BABs in July 2009 with a 6% interest rate payable semiannually. The issuer initially received subsidy payments equal to 35% of its interest costs, but its July 2014 payment was reduced due to sequestration. The reduction triggered the extraordinary optional redemption provision for the BABs, so the government decided to issue refunding bonds whose proceeds would be used to redeem the BABs, according to the memorandum.
The issuer did not redeem the BABs on the same day it issued the refunding bonds. Instead, the proceeds of the refunding bonds were deposited in a defeasance escrow and were used to purchase government securities. These securities were to be used to pay the debt service on the defeased BABs. After the proceeds were deposited in the escrow, holders of the bonds could only look to the escrow for the payment and security of their bonds.
Under the reissuance regulations, a reissuance occurs if there is a "significant modification" to the terms of the bonds. When there is a reissuance, for tax purposes the original bonds are retired and new bonds take their place.
"A legal defeasance of a debt instrument in which the issuer is released from all liability to make payment on the debt instrument generally is a significant modification," the memo said. However, the regulations state that defeasances don't cause reissuance in the case of tax-exempt bonds, which are defined as state or local bonds that satisfy the requirements of section 103(a) of the Internal Revenue Code.
The local government issuer argued that the "tax-exempt bond defeasance exception" also applies to taxable, direct-pay BABs, because bonds have to meet requirements under section 103(a) of the tax code in order to qualify as BABs, according to the memo.
However, the IRS chief counsel's office said that the exception doesn't apply to BABs.
The memo pointed out that the definition of tax-exempt bonds in the reissuance rules does not explicitly state that the bonds have to be tax-exempt. But the drafters of the 1996 reissuance regulation intended the definition of tax-exempt bonds to refer to bonds that were tax-exempt, because they were concerned that investors could have their bonds lose their tax-exempt status due to a reissuance, according to the memo. Since the issuer's BABs are taxable, "that same concern does not apply," Hubbard wrote.
Since the authority to issue BABs expired on Dec. 31, 2010, the local government's reissued bonds do not qualify as BABs, and the issuer is not eligible for subsidy payments related to the reissued bonds, the memo said.
Several bond lawyers questioned the reasoning in the memo.
"I think it's wrong," said Tom Vander Molen, a partner at Dorsey & Whitney in Minneapolis.
The IRS said the drafters said in the preamble to the reissuance rules that they were concerned about the loss of tax-exemption to bondholders. However, Vander Molen said, the preamble to the regulations actually stated that some commenters thought that reissuance rules should not apply to tax-exempt bonds in order to protect bond holders' tax-exempt interest. The drafters of the regulations said in the preamble that they provided bond-related rules that were in addition to the tax-exempt bond defeasance exception to better coordinate the rules with municipal finance practices.
Dave Caprera, an attorney at Kutak Rock in Denver, said the IRS didn't look at the legislative history of the Build America Bond program. BABs were intended to be a substitute for traditional tax-exempt bonds, and issuers were supposed to be better off by issuing BABs.
Bond lawyers suspect the memo came about as a result of an audit. Under the Internal Revenue Manual, advice memos from the chief counsel's office cannot be referred to as precedent. However, it may indicate how the IRS would analyze other BAB defeasances, said Matthias Edrich, a shareholder at Greenberg Traurig.
Johnny Hutchinson, a senior associate at Squire Patton Boggs, said the IRS' conclusion is consistent with what he and his colleagues had been hearing from field agents. While the memo provides some clarity because it answers the question of whether BAB defeasances cause a reissuance, it does not answer the question of whether the issuer can receive a subsidy payment for interest accrued prior to the defeasance that had not yet been paid, he said.
David Cholst, a partner at Chapman and Cutler in Chicago, said that the amount of subsidy payment money at stake in the case the memo mentioned is likely very small. When BABs are redeemed because of sequestration cuts to the subsidies, the time between when the bonds are defeased and when they are redeemed tends to be short.
