The threat that Congress will eliminate the tax exemption on future municipal bonds poses a grim enough scenario for the municipal market, but some participants worry that the danger is even greater — that lawmakers will axe the exemption for outstanding bonds.
Eliminating the tax exemption on the roughly $3.5 trillion of outstanding debt would increase the savings for the federal government by many multiples over the simple elimination of the tax exemption for future debt, said market participants. That could be a tempting target for Republican lawmakers
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It's a question that the Bond Dealers of America hopes to answer when it heads to Capitol Hill Thursday. BDA members will be meeting with tax attorneys on the House Ways and Means and Senate Finance Committees as well as individual members on those committees, said Brett Bolton, the BDA's vice president of federal legislative and regulatory policy.
"There is not a lot of transparency on where that number came from," said Bolton. "The numbers should be coming from Ways and Means or Senate Finance, and meeting with those folks can provide some clarity," he said. "We will definitely be discussing that question thoroughly."
Bolton noted that the House document also targeted the tax exemption on Build America Bonds, a confusing provision since BABs are taxable.
The House number differs slightly from numbers floated by the Joint Committee on Taxation. The
It's not clear how JCT arrived at those figures. The JCT is a "black box" when it comes to its scoring methods, according to Bobby Kogan, senior director of federal budget policy at Center for American Progress who previously worked as head of budget scorekeeping and analysis on Senate Budget Committee.
If Congress did attempt to retroactively eliminate the tax exemption, it's unlikely that the IRS would seek to claw back money that bondholders owe for previous tax years, said Rich Moore, tax attorney at Orrick, Herrington & Sutcliffe LLP.
"I don't know that that's legally possible," Moore said.
"We're talking about in future tax years being able to tax interest — which probably is legally possible," he said.
Attorneys and other municipal market participants are "trying to get to the bottom" of the question of whether the House estimates apply to future or existing debt, Moore said.
"Lawyers like us are trying to find out what we can do behind the scenes to pass information to those in the best position to directly advocate Congress," he said. "I think that would be incredibly unfair to punish bondholders in that way when they in good faith thought they were buying tax-exempt instruments."
Nixon Peabody attorney Johnny Hutchinson said that in the past, when Congress has attempted to restrict tax-exempt financing, "it typically has done so prospectively."
Discussions around an early draft of the 2017 TCJA that cut the tax exemption on private activity bonds assumed the restriction would have been only for future debt. And the law's elimination of tax-exempt advance refunding applied only to future debt, prompting a year-end rush to market by cities and states looking to capitalize on the tax-exempt instrument.
Hutchinson believes it's unlikely that any restriction would apply to outstanding bonds.
"In addition, although the Supreme Court has typically been rather lenient in favor of Congress on the question of retroactive tax legislation (and in particular whether it violates the Due Process provisions of the U.S. Constitution), it is at least questionable whether retroactive limits on the tax exemption would be constitutional," he said. "And that is to say nothing of the political blowback Congress would face if it attempted to retroactively tax interest on outstanding bonds."
Jeffery S. Timlin, a managing partner at Austin, Texas-based investment management firm Sage Advisory, where he heads the municipal department, believes the chance of existing tax-exempt debt becoming retroactively taxable "is as close to zero as you can get without being zero."
Timlin estimates the probability of the municipal tax exemption going away under the current administration at less than 5% and the likelihood of debt issued as tax-exempt becoming taxable retroactively at virtually zero, he said.
If the Trump administration – or any administration – were to get legislation passed that allowed bonds issued as tax exempt to be taxed retroactively, there's the potential for "a legal Armageddon" due to the high number of lawsuits that would likely ensue, Timlin said.
For the federal government, passing legislation that rescinds that tax-exemption retroactively "would be the most difficult threshold to cross due to the lack of bipartisan support," he said, adding that the federal government would likely see litigation both from issuers over the loss of the tax-exemption as well as from investors suing over retroactively having the bonds they bought become taxable.
It's possible that ending the tax exemption and making it retroactive could "go through the courts and survive," Timlin said. However, if the goal is to save money, the cost of that litigation and how long it's likely to take would have to be considered, he said, adding that he suspects "Trump would be long gone before any of that got even slightly resolved."
"In my opinion, it's a non-starter," Timlin said of the idea that tax-exempt munis could become taxable retroactively.
