Munis Face Uphill Battle in Congress

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WASHINGTON — Municipal market groups next year will face an uphill battle trying to get Congress to resurrect the Build America Bond program and other bond-related tax incentives that expire Dec. 31.

Instead, the groups are likely to find themselves spending more time trying to prevent lawmakers from considering new restrictions for muni bonds as they begin discussing how to cut the federal deficit and reform the federal tax code.

This is the outlook for tax legislation in the muni market, according to most market participants.

After two years of frenetic, mostly positive legislative activity, next year looks relatively slow and possibly even dangerous for munis, they said.

The die was cast for the coming year with the enactment of a tax law that extended the Bush tax cuts and several tax incentives for two years, but failed to continue the issuance of new BABs and other key muni bond-related incentives authorized by the American Recovery and Reinvestment Act of 2009.

Muni market groups have vowed to push the lawmakers to reconsider extending those programs next year.

But Republicans, who will control the House and wield much more power in the Senate starting in January, oppose BABs and all other measures authorized by the stimulus law. They have criticized BABs, claiming they generate high underwriting fees for Wall Street banks and reward issuers with poor credit by providing them with higher subsidy payments from the government.

Incoming House Ways and Means Committee chairman Dave Camp, R-Mich., earlier this year called BABs "a heavily subsidized spending program." And Sen. Jon Kyl, R-Ariz., the minority whip and top Senate Republican negotiator for the new tax law, kept BABs and most other ARRA bond provisions out of that law, sources said.

"I don't know if there's going to be an effort to resurrect BABs," said Bill Daly, senior vice president of government relations for Bond Dealers of America. "I think that's going to be an uphill fight."

But BDA plans to work on getting an extension of the bank-qualified provision that expires Friday, Daly said, adding, "That had bipartisan support in the Senate."

The ARRA provision temporarily raises to $30 million from $10 million the small issuer limit for bank-qualified bonds so that banks can deduct 80% of the cost of buying and carrying the bonds of issuers whose annual bond issuance was $30 million or less per year.

Sen. Jeff Bingaman, D-N.M., introduced a bill in May that would permanently codify the provision into law. It was co-sponsored by Sens. Mike Crapo, R-Idaho, and Chuck Grassley, R-Iowa.

The Government Finance Officers Association is also pushing for an extension of that provision as well as the alternative minimum tax exemption for private-activity bonds. Susan Gaffney, director of the GFOA's federal liaison center, points out that the $10 million limit, which was set in 1986, only equals about $5 million in today's dollars and therefore benefits just the smallest of governments.

But even if muni market groups can garner bipartisan support for some of these provisions, will there be a tax bill next year to which they can be added?

Congress typically considers a tax bill every year, but the tax law that was just enacted contains two-year extensions of the Bush tax cuts and many other provisions.

"I expect we've got the next two years before we confront the question of what to do about the Bush tax cuts again," Daly said. "Until then there will be an awful lot of talk and perhaps some movement on tax reform."

"Enacting legislation is harder than not enacting legislation. So if you had to guess where we'd be a year from now, probably a good guess is that there would not be much change to the tax law as it relates to tax-exempt bonds," said Michael Decker, managing director and co-head of the Securities Industry and Financial Markets muni bond division.

Deficit Reduction, Tax Reform
Two big-picture issues — deficit reduction and tax reform — have been teed up for discussion in Congress next year, but it is unlikely they will result in legislation, Decker, Daly, and other sources said.

"Split control of Congress will make it hard to achieve consensus on big issues," Decker said, referring to the Republican-controlled House and Democratic-controlled Senate next year. "Congress will devote lots of attention to issues like tax policy and the deficit but I'm not sure that will result in a lot of legislation being enacted."

Tax-exempt bonds are not likely to fare well in connection with any discussion or action on deficit reduction or tax reform, which typically lead to proposals for cuts in federal spending, a broadening of the tax base, and a simplified federal tax code that lowers rates and eliminates many special tax preference items.

"A lot of programs that state and local governments rely on, they're going to be under an awful lot of pressure," Daly said.

The report issued late last month by President Obama's deficit reduction commission contained an "illustrative proposal" for ending tax-exempt interest for all new municipal bonds as part of a comprehensive effort to reform the federal tax code, cut discretionary spending, contain health care costs, and reform the Social Security system.

A majority of the bipartisan commission, led by Democrat Erskine Bowles, former chief of staff to President Bill Clinton, and former Republican Sen. Alan Simpson from Wyoming, voted to approve the report. But the commission failed to get a supermajority of the votes needed to push forward with the report in Congress. Still, it is expected to spur debate in Congress, as Republicans in particular have vowed to control the growing deficit.

A Bipartisan Policy Center debt-reduction task force issued a report earlier in November that does not appear to contain any specific proposals for munis. But the staff at the Brookings Institution, which sponsored the report, said it envisions ending tax exemption by Jan. 1, 2012, for newly issued private-activity bonds such as single-family housing bonds, hospital bonds, and small-issue industrial development bonds.

Tax reform proposals typically center around simplifying the tax code and lowering income tax rates. Lower rates would dampen the need for individuals in higher tax brackets to purchase tax-exempt bonds, sources said.

Regulatory Initiatives
On the regulatory front, even though the BAB program is set to expire on Dec. 31, that should not deter the Treasury Department and the Internal Revenue Service from working on guidance or rules as to what constitutes issue price, a subject of controversy surrounding BABs.

"BABs will continue to be an issue because there are so many of them out there," said Perry Israel, who has his own law practice in Sacramento, Calif.. "The IRS is going to be challenging whether the issue price was a good price" in some cases, he said.

Under current tax rules, the issue price is determined by the first price at which a substantial amount of the bonds are sold to the public, with 10% defined as a substantial amount. Underwriters typically certify as to the issue price of the bonds, which is key to determining the bond yield for arbitrage purposes.

But IRS officials became concerned that, with some BAB issues, there was a run-up in price after they were first issued, leading to questions about whether their stated issue prices were correct. The ARRA, which created BABs, stipulates that they cannot be sold with more than a de minimis amount of premium. In addition, the Treasury wants to make sure that it is making the appropriate BAB subsidy payments, which are supposed to equal 35% of interest costs.

Four major market groups urged the Treasury in August to issue guidance confirming that the existing rules for issue price for tax-exempt bonds also apply to BABs. They said that if issuers follow long-standing practices, they should be confident they are complying with the rules in this area.

But John Cross 3rd, the Treasury's associate tax legislative counsel, told lawyers meeting in Toronto in September that they should not expect the Treasury to simply rubber-stamp the existing issue price rules for BABs and that the department is working on guidance to "improve" the existing rules.

Nevertheless, market participants are hoping that with most of the stimulus programs expiring, the IRS and the Treasury, which spent much of this year on guidance on stimulus programs, will get back to long-standing, very much delayed tax-exempt bond regulatory projects.

"Hopefully, they can return to the nuts-and-bolts regulations that make tax compliance easier now that the stimulus is over," said Michael Bailey, a partner at Foley & Lardner LLP in Chicago, adding, "They've done a great job with guidance on these new stimulus programs."

Priority Guidance Plan
The priority guidance plan that the Treasury and the IRS issued earlier this month lists six sets of pending rules or guidance that would cover: solid waste disposal facilities; public approval requirements for private-activity bonds; rules on arbitrage investment restrictions; bond reissuance; qualified zone academy bonds; and direct-pay bonds other than BABs.

The solid waste rules would be a final version of rules proposed in September 2009, which generally were praised as being much more workable than heavily criticized rules proposed in 2004.

The 2009 proposed rules would define what constitutes solid waste and would identify specific waste categories that would not fall within that definition. They also would eliminate the so-called "no-value test" proposed in 2004, which stated that solid waste would have to be property that had no market or other value at the place it was located. That test generally was considered by bond lawyers to be unadministrable.

The rules on public approval requirements for private-activity bonds would be a final version of those proposed in September 2008. The proposed rules would update and significantly ease the requirements for muni issuers to obtain public approval for PAB-financed projects. The requirements were mandated by the Tax Equity and Fiscal Responsibility Act of 1982, and the first rules the IRS wrote to implement them predated the age of the Internet.

The proposed updated rules would allow an issuer to provide a notice of a public hearing about a bond-financed project on its website if it posts the information online and provides an alternative method of informing members of the public without computer access.

"I would feel a huge relief to get those simplified public-approval requirements for PABs," Bailey said.

"I would love to see them finalize those," Israel agreed.

The rules on bond reissuance would essentially codify into law three notices that the Treasury released beginning in 2008 to address the collapse of auction rate securities.

The initial Notice 2008-41, released in March 2008, provided temporary guidance that stated that governmental issuers could purchase their own auction-rate bonds and hold them for 180 days without running afoul of any tax laws or extinguishing the debt, provided the bonds were purchased before Oct. 1, 2008. Notice 2008-88, issued on April 14, 2008, expanded on that guidance. Notice 2010-3, published in the Internal Revenue Bulletin on Jan. 19 of this year extended the expanded guidance.

The forthcoming rules on arbitrage investment restrictions could be fairly broad and address a range of issues, sources said. Generally the rules will focus on how investments should be restricted to avoid violating arbitrage requirements, they said.

The rules on qualified zone academy bonds would be a final version of rules published in July 2007. Those rules were highly technical and led some QZAB advocates to predict they would create headaches for small schools. QZABs are taxable tax-credit bonds that muni issuers issue to finance renovations and repairs at existing school facilities. They cannot be used for new school construction, and they provide holders with an income tax credit rather than tax-exempt interest payments.

The priority plan also includes guidance on tax-credit bonds that were permitted to be sold as BAB-style bonds with direct subsidy payments from the Treasury under the Hiring Incentives to Restore Employment Act enacted in March. They include qualified school construction bonds, clean renewable energy bonds, qualified energy conservation bonds, and QZABs.

The tax rule enacted earlier this month provides $400 million of additional authority for QZABS, but only if they are issued as tax-credit bonds. However, market participants said the tax act would not prevent muni issuers from issuing QZABs and the three other types of bonds as direct-pay bonds to the extent they were already allocated or could still be allocated under the ARRA.

The priority guidance fails to include some rules bond lawyers were hoping to see.

Bailey said he wants the IRS to finalize allocation and accounting rules for mixed-use facilities that are financed partly with bonds and partly with equity.

He also is hoping the IRS will follow up on advisory committee recommendations and provide safe harbors for record retention that would require issuers to keep detailed bond-related records for a minimum of six years, but only summary records after that, for no longer than three years after the bonds are retired.

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