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 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.

By Maxwell D. Solet

On October 24, 2014, the Internal Revenue Service issued Notice 2014-67 (the “Notice”), which provides important guidance and increased flexibility for issuers and conduit borrowers of tax-exempt bonds regarding contracting with private parties in a manner that avoids “private use” by such parties of bond-financed facilities. The Internal Revenue Code restricts private use of facilities financed by certain categories of tax-exempt bonds, including governmental bonds and bonds issued for the benefit of hospitals and other organizations that are tax exempt under Section 501(c)(3) of the Internal Revenue Code. The Notice addresses so-called “management contracts,” i.e., contracts (other than leases) with private parties that provide services with respect to bond-financed property, and, as discussed below, states that no private use will be deemed to arise from such contracts provided their term does not exceed 5 years and the compensation methodologies adhere to an expanded menu of permissible arrangements.

The Notice also addresses the treatment, for private use purposes, of Accountable Care Organizations (ACOs) established under the Affordable Care Act, and provides helpful guidance for participation in such organizations without creating “private use.”

The New 5-Year Safe Harbor

The Notice “amplifies” Revenue Procedure 97-13, which provides various safe harbors under which management contracts will not be treated as causing private use of bond-financed facilities. Both the National Association of Bond Lawyers and the American Bar Association have urged that this 1997 Revenue Procedure be updated to reflect substantial changes since its publication in the sorts of arrangements being proposed or used in connection with bond-financed facilities, including the use of ACOs.

The Notice’s new safe harbor for contracts with a term not exceeding five years improves on the existing safe harbor for contracts of similar length in several respects:

  • The new 5-year safe harbor permits a binding contract for the full 5-year term. The existing one required that the contract be terminable without penalty by the issuer or conduit borrower at any earlier date than their full term.
  • The existing 5-year safe harbor required that at least 50% of the compensation payable to the private party under the contract be fixed. The new 5-year safe harbor, as confirmed by informal conversations with the IRS, permits any combination of the permissible compensation methods outlined in the 1997 Revenue Procedure, including a 100% variable compensation methodology based on a percentage of revenues or a percentage of expenses (but not both, since that would be considered a proxy for participation by the private party in the bond-financed facility’s net profits, which is a third rail for “private use” purposes.)
  • While Revenue Procedure 97-13 allowed an annual “productivity award” based on achievement of revenue or expense goals, the Notice permits a new type of annual incentive payment keyed to satisfying quality performance standards.

IRS private letter rulings approving management contracts outside the safe harbors for some time have focused principally on the absence of an interest in net profits. The new safe harbor established under the Notice does the same, eliminating most of the detailed compensation rules under the existing 5-year and shorter safe harbors. The IRS can be expected at some point to promulgate a new Revenue Procedure which will eliminate those no longer necessary provisions.

While the Notice has a January 22, 2015 effective date, it specifically allows application to earlier bonds or contracts. Accordingly, the enhanced flexibility in compensation methodologies can be built into new contracts, and existing contracts can be amended if desired to take advantage of the new flexibility without jeopardizing tax-exemption of outstanding bonds.

Treatment of ACOs

The Notice also clarifies that hospitals or other health care organizations will not be treated as creating private use of bond-financed facilities through their participation in ACOs mandated by the Medicare Shared Savings Program under the Affordable Care Act.  The United States Treasury and the IRS have been focused on ensuring that federal tax policy not be inconsistent with federal health care policy, which has increasingly encouraged and in some cases mandated collaboration between tax-exempt 501(c)(3) organizations and for-profit entities. ACOs are a prime example. The IRS previously, in Notice 2011-20, provided favorable guidance on the effect of ACO participation on the tax-exempt status of such charitable organizations.

While an argument could be made that ACO arrangements are just a variation on third-party payment arrangements, and third-party payers have never been treated by bond counsel as “users” of bond-financed facilities, the need for this guidance arises, first, from the fact that ACOs must be distinct legal entities, frequently partnerships, which are separate from the health care provider and separate from insurers, and, second, from the fact that these arrangements provide for financial sharing between the exempt and non-exempt participants which might be viewed as problematic for the private use analysis. Under the Notice, upon satisfying multiple stated requirements, ACOs will not be treated as creating an impermissible net profits interest by the ACO or its private participants (such as doctors’ organizations) and therefore will not be treated as private use. This guidance is consistent with recommendations made by industry groups, including the National Association of Bond Lawyers. The major shortcoming of those recommendations and this guidance is the failure to deal with ACOs other than those which are created under the Affordable Care Act. In fact, health care providers are under increasing pressure to participate in ACOs to deal with other third-party payers, and such ACOs may include features which are not blessed under the Notice.

 

By LEN WEISER-VARON

Market commenters have suggested that billions of dollars in municipal bonds may be subject to par redemptions if the much-discussed “28% cap” on the value of certain federal income tax deductions or exclusions is enacted and if the capped items include municipal bond interest.  While such commenters flag an issue worthy of consideration, enactment of a 28% cap applicable to muni interest should not result in a wave of unanticipated tax calls.

Tax call language comes in a variety of permutations.  The language of most tax calls focuses on whether interest on the bonds is excluded from gross income.   Legislation implementing a 28% cap may or may not be written in a manner that directly includes a portion of the value of tax-exempt interest in gross income (versus, for example, using an alternative tax calculation methodology, as is used in calculating the AMT tax).

Even assuming that a 28% cap clearly includes a portion of municipal bond interest in gross income for higher tax bracket holders, it is far from clear that tax call language would apply.  Many variations of tax calls distinguish between taxability caused by the issuer/borrower versus by change in law.  Those that don’t make such a distinction typically are written (as is the case with the particular tax call language referenced in a recently disseminated article sounding the alarm on tax call risk) to require a redemption of all of the bonds upon an IRS or judicial (or in some cases bond counsel) determination that interest on “the bonds” is not excluded from gross income.  Such redemption language suggests a triggering event that affects all the interest on all the bonds – otherwise it is overkill.  It seems unlikely that a court would interpret such language as permitting or requiring an issuer to redeem all its bonds because a portion of interest on some of the bonds (those held by higher bracket bondholders) is or may be taxable.

It is possible that there are some specially negotiated tax call provisions among the billions of dollars of municipal bonds that are triggered by absence of full tax exemption on any of the bonds, but those would be outliers.  (Such specially negotiated provisions would likely be bondholder-friendly and therefore would likely involve a redemption premium rather than a par redemption.)

In any event, concerned holders will want to look at the specific tax call language in their bonds and perhaps seek a bond or tax lawyer’s interpretation if the language seems unclear in the context of a potential 28% cap.  But the odds are against tax calls being triggered on a widespread basis.     

By JEREMY A. SPECTOR

The IRS is planning on sending out letters (“Letters”) over the next few months to several hundred issuers who have experienced covenant or payment defaults from 2007 to the present. The Letters remind issuers of their tax compliance responsibilities in the context of a restructuring and encourage them to self-police compliance of their bond issues with federal tax rules. By sending these Letters, the IRS is signaling a new focus on the tax-exempt status of defaulted and restructured debt.

The Letters specifically focus on the types of debt modifications that can cause a “reissuance”. Generally, there is a reissuance for tax purposes when payment terms on bonds are significantly changed such that the original bonds are deemed exchanged for the restructured bonds. Issuers are directed in the Letters to an article on the IRS’s website describing the specific types of significant modifications to watch out for.

Generally, the “traps for the unwary” triggering a reissuance arise when there is (1) contractual forbearance beyond certain specified periods; (2) changes in yield greater than 25 basis points; (3) certain significant changes in timing of payments, such as extensions of maturity and deferral of payments; and (4) substitution of obligors, changes in security or credit enhancement, or changes in priority of the bonds that cause a change in payment expectations from adequate to primarily speculative or vice versa.

Whenever there is a reissuance an issuer typically must (i) “retest” the bonds for tax compliance as if they were newly issued under existing law; (ii) for certain types of bonds and under certain circumstances, obtain an additional volume cap allocation; (iii) under certain circumstances, obtain elected official approval; and (iv) file a new tax return. The inadvertent failure of an issuer to take any required action to preserve the tax status of the bonds upon a reissuance is referred to by the IRS as a “violation” and, if unaddressed, risks a future determination by the IRS that the reissued bonds are taxable from their reissuance date.

The IRS encourages any issuer who becomes aware of a tax rule violation to take advantage of its voluntary compliance program, which resolves non-compliance problems at a lesser cost than is the case if the IRS initiates an audit and determines that noncompliance exists.

For issuers, conduit obligors, bond trustees and bondholders, this IRS warning highlights the importance, in connection with any bond workout or restructuring, of consulting with qualified bond counsel to ensure that any agreements executed will not adversely impact the tax status of the bonds.