Bond lawyers are urging the Treasury Department and the Internal Revenue Service to avoid issuing new guidance to address whether Build America Bonds issued by a state or locality would continue to exist, or be considered “extinguished,” if they were purchased by a related entity such as the public pension fund or state lottery.
Created under the federal stimulus program, BABs are taxable bonds whose issuers receive subsidy payments from the federal government equal to 35% of the interest costs. The advent of BABs led investors of taxable debt, including state pension funds and government-operated nonprofit entities, to become interested in investing in them.
However, this raised a conundrum: If a public pension fund buys BABs issued by its state or local government, has the government essentially loaned itself money with the federal government paying it a 35% subsidy rate?
In a 10-page June 6 letter, the National Association of Bond Lawyers maintains that any abuses that arise from such transactions, known as “related-party acquisitions,” can be policed under existing tax laws and rules without upsetting long-standing standards.
Last fall, the IRS started auditing BABs, asking about pricing and primary market purchasers, among other things. The IRS specifically asked if any public pension fund had bought its own government’s BABs.
The IRS “is still interested in this issue,” Cliff Gannett, the agency’s acting-director of government entities, said on Wednesday. He acknowledged that the tax-exempt bond office received a copy of the NABL letter and said the related-party acquisition issue “is something we’re taking a close look at.”
Bond lawyers are concerned that the IRS and the Treasury could roll out new regulations to address this “related-party acquisition” concern that state BABs bought by an entity operated by the governmental issuer are extinguished and technically do not exist, meaning the buyer would no longer qualify for the 35% subsidy.
“We understand that there is a concern with related-party acquisitions of [BABs], but we think that these issues can be resolved through the application” of current tax rules “as opposed to some new form of anti-abuse rules or regulation,” said Michael Larsen, a partner with Parker Poe Adams & Bernstein LLP and vice-chair of the NABL tax law committee.
“This is something that many people first became a bit nervous about,” when the IRS started asking about related-party acquisitions, he said. From NABL’s perspective “we think if you start taking a related-party analysis down the wrong road, you could end up with some inconsistent and troubling results,” Larsen said.
NABL agrees that cases of abuse could exist where a state or local government in effect takes money from one pocket and puts it in another. “We can see a situation where the IRS would be concerned about that,” Larsen said.
The group believes the IRS and the Treasury are looking at an “integral part” standard under federal tax law as one way to determine if a BAB issuer and buyer could be one in the same. Is a state pension fund considered an “integral part” of the state?
The BAB program expired at the end of 2010 so that no new BABs could be issued after the end of the year. But billions of dollars of BABs are still outstanding.
Applying the integral part test to BABs “would be nearly impossible to administer in light of ambiguity in the law,” NABL said in its letter.
Bond attorneys are worried the IRS could conclude those BABs were never issued, or were extinguished as a result of a related party acquisition, even though the obligations were underwritten and have supporting bond documents.
BABs “became fairly political” given concerns over the cost of the subsidy to the federal government and the IRS is trying to find its way “through that thicket,” said Chas Cardall, a partner with Orrick, Herrington & Sutcliffe. “There is a line somewhere here” between abusive and appropriate circumstance, he said. The IRS is trying to figure out, “Where does that line go?”
