By MAXWELL D. SOLET and CHRISTIE MARTIN

In August, 2016, the IRS issued Revenue Procedure 2016-44, the first comprehensive revision of its management contract safe harbors since Revenue Procedure 97-13.  Rev. Proc. 2016-44 (see our description here) built upon and amplified principles laid out in private letter rulings issued over many years and in Notice 2014-67.  Now, less than six months later, the IRS has published Revenue Procedure 2017-13, which clarifies and supersedes Rev. Proc. 2016-44 but does not materially change the safe harbors described therein.  The clarifications are in response to questions received with respect to certain types of compensation protected under earlier safe harbors, incentive compensation, timing of payments, treatment of land when determining useful life, and approval of rates.

 

 

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Register on September 16, 2013, caused an uproar in the bond counsel community as being largely unworkable, they were withdrawn and re-proposed on June 24, 2015 (the “2015 Proposed Regulations”).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 D. SOLET

On November 13, the IRS issued Notice 2015-78, providing favorable guidance on topics of interest to providers of “supplemental” or “alternative” student loans financed with tax-exempt bonds and to underwriters of such student loan bonds. Such guidance confirms that loans financeable under such programs include (i) parent loans as well as student loans and (ii) loans that refinance or consolidate prior loans that were or could have been financed on a tax-exempt basis.

Tax-exempt bonds used to finance student loans, so-called “qualified student loan bonds,” come in two flavors under the Internal Revenue Code, those issued to finance federally-guaranteed loans made under the Federal Family Education Loan Program (“FFELP”) and those issued to finance certain loans issued under programs created by the states, generally known as “supplemental” or “alternative” loan programs. While the FFELP program, historically much larger, terminated in 2010, tax-exempt financing for new loans under state supplemental programs has continued in approximately fifteen states.

Notice 2015-78 appears to have been prompted by recent efforts by governmental issuers to provide refinancing of student loan debt through non-federally guaranteed “consolidation loans”, which presented questions on which the IRS had not previously provided guidance.  The IRS also used the notice as an opportunity to address selected other issues applicable to all tax-exempt financed supplemental loans, not just refinancing loans. The Notice clarifies the following:

  • Eligible Borrowers.  Notwithstanding the widespread practice of making higher education loans to parents, a practice provided for by statute under FFELP through the Parent Loan to Undergraduate Students (PLUS) program, the IRS had expressed concerns in the context of ruling request discussions about whether loans to parents were bond-financeable student loans.  Notice 2015-78 clarifies that the student, the parent, or both can be an eligible borrower of a bond-financed “student loan.”  The Notice attempts to provide a similar rule for refinancing loans, stating, “An eligible borrower of a refinancing loan … is the student or parent borrower of the original loan.”  In the refinancing loan context the Notice’s particular wording leaves unclear whether if the sole borrower on the original loan was the parent, the sole borrower on the refinancing loan can be the proud young graduate who wishes to take on the debt through a consolidation loan.  Such a fact pattern clearly satisfies the policy underlying this otherwise expansively drafted notice.
  • Nexus to State.  The Internal Revenue Code requires the student to be a resident of the state which provides the “volume cap” allocation for the bonds or enrolled at an educational institution in that state.  In the case of a refinancing or consolidation loan, there has been some question whether such “nexus” is required to be established at the time the original loan was made or at the time the refinancing loan is made.  The Notice provides the broadest rule, stating that a “refinancing loan,” including a loan which allows the borrower to consolidate prior debt, complies with the statutory nexus requirement either if that requirement was satisfied at the time of the original loan or if it is satisfied at the time of the refinancing loan.  If reliance is placed on nexus at the time the original loan is made,  in the case of a consolidation loan care may need to be exercised to establish nexus for all underlying loans.
  • Loan Size.  The Code limits supplemental loans to “the difference between the total cost of attendance and other forms of student assistance … for which the student borrower may be eligible.”  The “may be eligible” language has resulted in troublesome challenges in IRS audits, where IRS agents have suggested that issuers might be responsible for documenting that students actually had applied for all other potentially available student assistance, or obligated to downsize loans by the amount of other student assistance that was hypothetically available but not received by the student.  The Notice confirms that tax-exempt bond issuers may rely on certifications from the student’s school as to total cost of attendance and as to other student assistance.  Further, the school may rely on definitions provided under the Higher Education Act, including a definition of “estimated financed assistance” which looks only to assistance the student “will receive.”
  • Type of Loans Eligible for Refinancing.  The Notice states that supplemental student loan bonds can be used to refinance not only original loans which were themselves supplemental loans but also other loans, “for example, a FFELP loan or a student loan made by a private lender, provided that the refinancing loan meets all of the requirements for a State Supplemental Loan.”   Although not addressed by the Notice, it should be noted that tax-exempt bonds issued to refinance prior loans, including consolidation of prior loans, generally will require an allocation of state volume cap, which in some states is a scarce commodity.  The need for volume cap may be avoided to the extent the refinancing loans made with proceeds of a bond issue refinance loans financed with other tax-exempt bonds issued by the same issuer or a related issuer and the payoffs on the refinanced loans are applied to redeem such other tax-exempt bonds in a manner that qualifies for the volume cap exception for current refunding bonds.

As a general proposition, the national student loan market is growing and dynamic.  Notice 2015-78 will assist governmental issuers in fulfilling their intended role.

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 LEN WEISER-VARON and MAXWELL D. SOLET

In the aftermath of recent municipal bankruptcies in which issuers proposed and/or implemented bankruptcy plans involving partial discharges of the issuer’s payment obligation on insured bonds, there has been increased focus on whether municipal bond interest paid by a bond insurer after the bankruptcy plan’s effective date continues to be tax-exempt.

Market confusion as to the treatment of bond insurance payments in the discharged issuer context is at least partially attributable to an incomplete understanding of why bond insurer payments of municipal bond interest are deemed tax-exempt in other contexts. Although the IRS has not specifically addressed the tax status of bond insurer payments following the issuer’s partial (or full) discharge in bankruptcy, review of IRS rulings on bond insurance suggests that, in ordinary circumstances, interest on the insured bond continues to be tax-exempt notwithstanding that the only source of payment is the bond insurance.

The technical basis for the continued tax-exemption of post-discharge interest is discussed in detail below.  The analysis is rooted in one simple concept articulated in an IRS revenue ruling: in ordinary circumstances, a payment by a bond insurer is deemed, for tax purposes, to have been made by the issuer of the bonds.  For this reason, although a bankruptcy may, for non-tax purposes, discharge an issuer from further liability on all or a portion of bond payments, for tax purposes the bond payments made by the bond insurer continue to be treated as being made by the issuer.  All else is detail, for those with an interest in such detail.

And so, on to the technical discussion.

The tax-exempt treatment of interest paid by a municipal bond insurer is founded on a trio of favorable IRS revenue rulings, which, unlike private letter rulings, are statements of IRS policy on which the market can rely.

The first such ruling, Revenue Ruling 72-134, dealt with the situation where the issuer pays for bond insurance when the bonds are issued, and concluded that “defaulted interest paid by the independent insurance company is excludable from the gross income of the bondholders.”

Revenue Ruling 72-575 extended such favorable treatment to a bond insurance policy purchased by the underwriter, and Revenue Ruling 76-78 went a substantial step further, upholding the tax-exemption of interest payments received under secondary market bond insurance purchased by a bondholder.

These three rulings state a favorable result without discussing the rationale. The technical basis for the tax-exemption of bond insurance payments is illuminated in Revenue Ruling 94-42, an adverse ruling involving a bondholder that purchased secondary market bond insurance on zero coupon bonds, rerated the bonds AAA and resold the bonds.  The bond insurance premium for the secondary market insurance was an amount sufficient to fund the bond insurer’s purchase of a high-yielding portfolio of Treasury securities that economically defeased most of its insurance obligation. In the ruling, the IRS expressed concern that treating such bond insurance interest payments as tax-exempt would effectively permit a secondary market arbitrage bond, and set about distinguishing the scenario under review from “customary” bond insurance payments treated as tax-exempt in the earlier rulings.

In the 1994 ruling, the IRS noted that customarily bond insurance enhances marketability and reduces interest rates, which is consistent with the IRS’s objective of preventing overburdening of the market with tax-exempt interest. The ruling stated that such tax-exempt treatment is accomplished by “integrating the insurance contract with the obligation of a political subdivision” instead of treating the bond insurer’s obligation as a separate debt instrument.

According to this key ruling, “an insurance contract or similar agreement is treated as both incidental to bonds and not a separate debt instrument … only if, at the time it is purchased, the amount paid is reasonable, customary, and consistent with the reasonable expectation that the issuer of the bonds, rather than the insurer, will pay debt service on the bonds.” The ruling concluded that at the time the bond insurance policy under review was purchased, the insurance premium was not reasonable and customary and reflected an expectation of default by the issuer.  The IRS ruled that because the insurance purchaser looked primarily to the insurer for payment of the debt service on the bonds, the bond insurance was not incidental and should be treated as a separate non-municipal obligation rather than integrated with the insured bonds.  The conclusion that the interest payments by the bond insurer were taxable followed from the treatment of the bond insurance as a non-municipal obligation.

Two significant concepts are articulated in Revenue Ruling 94-42. First, the technical basis for treating bond insurance interest payments as tax-exempt is that, for customary bond insurance transactions, the bond insurance is integrated with and treated as the same debt instrument as the insured municipal bond. Second, the treatment of bond insurance as integrated with the insured bond versus as a separate debt instrument that is not a municipal bond is determined based on reasonable expectations at the time the bond insurance is purchased.

In other words, provided the bond insurance is “customary” at the time it is purchased, it becomes another source of payment by the issuer of the insured bonds, albeit one that, at the time the insurance is purchased, is not expected to be needed. If circumstances change and defaulted interest is paid from the bond insurance, it is deemed a payment by the municipal issuer on the insured bond, not a separate payment by the bond insurer.

Nothing in the revenue rulings on the tax-exemption of interest payments sourced to a bond insurer makes the integration of the bond insurance with the bond dependent on the continuing legal obligation of the issuer to make the insured debt service payment. The above-summarized favorable revenue rulings describe customary bond insurance as including provisions under which a bond insurer’s payment to a bondholder does not discharge the bondholder’s payment claim against the issuer, to which the insurer becomes subrogated. But such revenue rulings do not suggest that if a bondholder has no claim against the issuer because the issuer has received a bankruptcy discharge, the worthlessness of the bond insurer’s subrogation claim alters the character of the bond insurance payment as an integrated tax-exempt payment on the municipal bond constructively made by the issuer, notwithstanding the issuer’s discharge as a source of payment for non-tax purposes.

The utility of bond insurance, and the reduction in bond interest rates and the aggregate amount of tax-exempt bond interest that have justified its tax treatment, would be substantially eroded if the IRS were to rule (which it never has) that the tax-exempt nature of bond insurance payments hinges on abstract distinctions between whether non-payment from other sources is due to the issuer’s financial condition or to the legal discharge in bankruptcy of the issuer’s duty to make such payments. Bond insurance is purchased for the precise purpose of insuring against default by the issuer, foreseeably and prominently including the possibility of the issuer’s bankruptcy and the potential legal discharge of part or all of its legal obligation to pay debt service.

The cause of non-payment of the bonds from sources other than the bond insurance is immaterial for tax-exemption purposes once the bond insurance payment is recognized as integrated with and indistinguishable from the other sources of payment of the bond.  Moreover, the line between an issuer’s lack of a legal obligation to pay and factual insolvency is often vague, and if such a distinction affected tax-exemption of bond insurer payments, uncertainty would prevail.  For example, a conduit bond issuer whose obligation to pay is limited to loan or lease payments from a conduit obligor that is not making any payments could be characterized as lacking a legal obligation to pay and/or the financial ability to pay.  Similarly, an issuer that ceases to operate and is dissolved without assumption of its liabilities by another party could be characterized as legally non-existent and/or factually unable to pay.

The tax treatment of bond insurance should not, and the relevant revenue rulings support the view that it does not, depend on distinctions that are esoteric, unpredictable and impractical. Notably, in a slightly different context, the market does not doubt the continued tax-exemption of interest on innumerable “legally defeased” bonds payable solely from portfolios of Treasury securities, although the issuer is contractually discharged from making payments from other sources.

The tax impact of bankruptcy plan modifications of an issuer’s rights and duties on insured bonds are often an afterthought not adequately focused on in the plan or the plan disclosure. Documentation and characterizations of what is technically occurring to the insured bonds under the plan may be imprecise. A bankruptcy plan may suggest that portions of insured bonds that the issuer will be discharged from paying are being extinguished, when what is actually meant is that such bonds will remain outstanding and payable from bond insurance that for tax purposes is attributed as an issuer payment.

To be sure, some bankruptcy plans may purport to make changes to insured bonds beyond the full or partial discharge of the issuer’s liability.  Presumptively, a modification of the issuer’s contractual duties under a bankruptcy plan does not change the payment obligations insured by the bond insurer. Nonetheless, to avoid muddying the waters plan language should be crafted in a manner that ensures that any portion of the original insured bond from which the issuer is discharged remains outstanding for tax purposes as well as for purposes of claiming against the bond insurer.

Any purported changes by a bankruptcy plan to the terms of the bonds beyond a reduction or elimination of the issuer’s liability require separate tax analysis. The devil is frequently in the details, and the debtor and its representatives may not be focused on or impacted by the tax treatment of insured future bond payments from which the issuer has been discharged. Holders of insured tax-exempt bonds that are being modified in any manner by a bankruptcy plan may wish to obtain input from tax counsel experienced in bankruptcy-related tax-exemption issues in time to impact the plan wording and structure relating to such bonds. But, although the IRS has not directly addressed the topic, there is no reason to presume that interest paid by a bond insurer on an outstanding municipal bond will be taxable simply because the issuer will have no remaining legal obligation to make the insured payment from another source.