By CHRISTIE MARTIN and MAXWELL D. SOLET

After two sets of proposed regulations, Treasury and IRS have now released final regulations on the definition of “issue price” for purposes of arbitrage investment restrictions that apply to tax-advantaged bonds (the “Final Regulations”) and it appears that the third time’s the charm. Practitioners are particularly praising the addition of a special rule for determining issue price for competitive sales and clarification on determining issue price for private placements.  The Final Regulations were published in the Federal Register on December 9, 2016 and can be found here.

Several years ago, tax regulators became concerned that the longstanding practice of allowing an issue price to be calculated based on reasonable expectations could lead to abuse in that “reasonably expected” issue prices for bonds sometimes differed from the prices at which bonds were actually being sold to retail investors. A determination by the IRS that the “issue price” has been erroneously calculated can have ramifications for the calculation of arbitrage yield that could ultimately cause loss of tax-advantaged status.  A clear and predictable definition of issue price is therefore essential for the tax-advantaged bond community.

After the first set of proposed regulations, published in the Federal Register on September 16, 2013, caused an uproar in the bond counsel community as being largely unworkable, they were withdrawn and re-proposed on June 24, 2015 (the “2015 Proposed Regulations”). The 2015 Proposed Regulations were subject to a comment period followed by a public hearing.  These Final Regulations build on the 2015 Proposed Regulations with certain changes in response to the public comments.

The Final Regulations look to actual facts as the general rule for determining issue price. Generally, the issue price of bonds is the first price at which a substantial amount (at least 10%) of the bonds is sold to the public.  For bonds issued in a private placement to a single buyer, the Final Regulations clarify that the issue price of the bonds is the price paid by that buyer.

In recognition of the need in the tax-advantaged bond community for certainty as of the sale date (particularly in the case of advance refundings), the Final Regulations offer a special rule in the event a substantial amount of bonds has not been sold to the public as of the sale date. The special rule allows reliance on the initial offering price to the public if certain conditions are satisfied including evidence that the bonds were actually offered at the initial offering price and the written agreement of each underwriter that it will not offer or sell the bonds to any person at a price higher than the initial offering price during the period starting on the sale date and ending on the earlier of (i) the close of the 5th business day after the sale date, or (ii) the date on which the underwriters have sold at least 10% of the bonds to the public at a price that is no higher than the initial offering price.

Procedures for satisfying the conditions for use of this special rule will have to be developed but it is reasonable to expect that changes will need to be made to bond purchase agreements and underwriter selling agreements to comply with these requirements.

The special rule for competitive sales provides that in a competitive sale meeting certain requirements, an issuer may treat the reasonably expected initial offering price to the public as of the sale date as the issue price if the winning bidder certifies that its winning bid was based on this reasonably expected initial offering price as of the sale date. This special issue price rule for competitive sales has been repeatedly requested by practitioners and is a welcome improvement over the prior proposed regulations which treated both negotiated sales and competitive sales in the same manner.

The Final Regulations will be effective for obligations that are sold on or after June 7, 2017 and there is no option to rely upon the Final Regulations with respect to obligations that are sold prior to that date. This delayed effective date should allow bond counsel and underwriters time to develop effective and hopefully uniform procedures and documentation to implement the new regulations.

By MAXWELL SOLET and CHRISTIE MARTIN

Treasury and IRS today announced a decision to withdraw the much-criticized portion of the notice of proposed rulemaking published in the Federal Register on September 16, 2013 (the “2013 Proposed Regulations”) related to the definition of issue price for tax-advantaged obligations and to propose a revised definition of issue price in its place. A determination by the IRS that the “issue price” has been erroneously calculated can have ramifications, including for the calculation of arbitrage yield, that could ultimately cause loss of tax-exempt status in the case of tax-exempt bonds and loss of federal subsidy in the case of Build America Bonds (BABs), hence the importance to the tax-exempt bond community of a clear and predictable definition.

The new proposed regulations (the “2015 Proposed Regulations”) are scheduled to be published in the Federal Register on June 24, 2015 and can be found here. A 90-day comment period will be followed by a hearing on October 28, 2015.

The 2015 Proposed Regulations eliminate most of the troublesome features of the 2013 Proposed Regulations, including maintaining a 10% standard rather than the 2013 Proposed Regulations 25% standard for what constitutes a “substantial amount” of obligations sold to the public. However, the 2015 Proposed Regulations do not maintain the long-established “reasonable expectations” standard for establishing issue price. Instead, the 2015 Proposed Regulations look to actual facts as the general rule.

In recognition of the need in the tax-advantaged debt world for certainty as of the sale date (particularly in the case of advance refundings), the 2015 Proposed Regulations helpfully provide an alternative method in the event a substantial amount of bonds have not been sold to the public as of the sale date. The alternative method allows reliance on the initial offering price if certain conditions are satisfied.

Procedures for satisfying the conditions for use of this alternative method will have to be developed, and underwriters may conclude that compliance will be difficult. In particular, a preclusion of sales at prices above the initial offering price unless it can be demonstrated that the differential is based on market changes could be problematic.

The 2015 Proposed Regulations will be effective for obligations that are sold on or after 90 days after final regulations are published in the Federal Register. However, issuers may rely upon the 2015 Proposed Regulations with respect to obligations that are sold on or after June 24, 2015, the date the 2015 Proposed Regulations will be published in the Federal Register.

BY JEREMY SPECTOR

Following the advent of Build America Bonds (BABs) in 2009 and securities law rulemaking that has resulted in the posting of virtually instantaneous trading data on the EMMA website (msrb.emma.org) hosted by the Municipal Securities Rulemaking Board (MSRB), the IRS has repeatedly expressed concerns about how initial offering prices (a/k/a “issue prices”) on municipal bonds are determined on the primary market and whether certifications of such prices for tax purposes are correct.

Why the concern? Why has this concern been exacerbated in recent years? Why hasn’t the IRS addressed its concern by publishing new regulations?

The “issue price” determines the yield, for tax purposes, on the bonds. The lower the issue price for bonds bearing a stated interest rate, the higher the yield. IRS regulations specify that the issue price for tax-exempt bonds is, for each maturity, the first price at which ten percent of bonds is sold to parties other than underwriters. For a bona fide public offering of all of the bonds, issue price can be established based on reasonable expectations on the sale date. Typically, issuers rely upon issue price certifications provided at closing by the underwriters.

An erroneous issue price can cause the US Treasury to lose tax revenues. In the case of tax-exempt bonds, an erroneously low issue price may create an erroneously high bond yield and result in the issuer retaining impermissible arbitrage on taxable investments made with tax-exempt bond proceeds. In the case of BABs, a requirement of the federal subsidy is that the issue price cannot be higher by more than a de minimis amount than the par amount of the bonds. Accordingly, a determination by the IRS that the “issue price” was erroneously calculated could cause loss of tax-exempt status in the case of tax-exempt bonds and loss of subsidy in the case of BABs.

The IRS’s concerns with issue price first surfaced in the context of 32 BAB audits. Two factors account for the concern. First, a correct issue price is particularly critical in the context of BABs, because of Code Section 54AA(d)(2)(C)’s limitation on the amount of premium. Second, the relatively recent availability of live trade data on EMMA has made it increasingly feasible to spot what may appear to be discrepancies between issue price certifications delivered by underwriters upon issuance of bonds and the prices at which bonds are traded shortly after, and sometimes shortly before, such certifications are delivered.

In some of the BAB audits, the IRS observed suspicious trading activity which it still appears to be investigating. The suspicious activity included situations where (1) a portion of a maturity is sold at the initial offering price and another portion is sold at higher prices; (2) a portion of a maturity remains unsold by the underwriter with the rest sold at prices above the initial offering price; and (3) dealers purchase all or a portion of a maturity and quickly resell at higher prices in what appears to be the primary market. A common theme seems to be a trend of increasing prices when the public buys on the secondary market, sometimes on the same day the bond purchase agreement is signed by the underwriter.

In response to its concerns the IRS has launched two compliance check initiatives to educate issuers and learn more about how issuers “due diligence” the issue price on their bonds. In addition, the IRS has reached an agreement with the MSRB, announced on October 24 (see the MSRB press release), to allow the IRS access to the MSRB’s internal regulatory website, with its up-to-date trade data, and to other information available to enforcement agencies (such as FINRA) that the MSRB works with to regulate the municipal market. The IRS’s agreement with the MSRB regarding such access includes an acknowledgment that the MSRB’s regulatory website is designed to help administer the securities laws and not the tax laws and that its market data may be incomplete for federal tax purposes. For example, the data reported to the MSRB does not always distinguish between sales to dealers and sales to the “public.”

So far, the IRS seems to have learned that most issuers rely on the issue price certificate provided by the underwriters to establish issue price without further due diligence. The IRS’s compliance check initiatives contain questions relating to procedures an issuer uses to review available trading data to confirm compliance with federal tax requirements. These questions appear to encourage issuers to look behind the issue price certificate and to use publicly available municipal market data, such as data available on EMMA, to spot problems. In light of this increased scrutiny by the IRS of trade data, issuers, out of an abundance of caution, are well advised to review trading data on EMMA and to raise any questions with their underwriters and bond counsel whenever such data shows a quick uptrend on and immediately after the sale date and before the bond closing. Downtrends in issue price would tend to indicate that an issuer received excellent pricing on the sale date, a scenario the IRS is unlikely to question.

At this time, there is confusion about how much and what type of diligence an issuer must do on issue price, as well as on the facts about which sales are meaningful for purposes of issue price determinations. The bond community is still waiting for the IRS to solve these issue price conundrums by writing more manageable regulations which will help issuers more easily identify the line between the primary and secondary market and any requirements for testing issue price certifications.