WASHINGTON - Warning the Internal Revenue Service that its proposed issue price rules would disrupt the muni bond marketplace, increase regulatory complexity, and drive up compliance and borrowing costs, Bond Dealers of America is proposing that the agency instead make modest changes to its current rules and then enforce them.
BDA issued the warning and proposed the modifications in a five-page letter on the IRS and Treasury Department's 2015-2016 priority guidance plan that was sent to the agencies late Friday and signed by the group's chief executive officer Mike Nicholas.
"The BDA greatly appreciates the efforts undertaken by the IRS and Treasury to clarify issue price rules and to solicit public comments on priority issues," Nicholas said. "We believe that the opportunity to comment on the proposed rules and an ongoing dialogue between the federal government and industry participants is necessary to ensure that a workable set of rules is promulgated. The BDA offers its assistance in this process."
The rules, which the IRS proposed in September 2013, would dramatically change the way the "issue price" for a bond is determined. The issue price is used to help determine the yield on the bonds and whether the issuer is complying with arbitrage rebate or yield restriction requirements. It is also used to determine the level of subsidy payments in the case of direct-pay bonds, such as Build America Bonds. Issue price plays a role in complying with other rules such as the 2% limit on issuance costs for private-activity bonds and the size of debt service reserve funds.
Under current tax rules, the issuer price is determined based on reasonable expectations. The price for each maturity of bonds publicly offered is the first price at which a substantial amount of bonds is reasonably expected to be sold to the public, with substantial defined as 10%. Sales to underwriters and wholesalers are not considered to be to the public and are therefore not counted toward the 10%.
But IRS officials have become concerned that the 10% test does not always produce a representative price for the bonds. They worry that underwriters sometimes execute the first 10% of sales of bonds with the lowest prices, and therefore the highest yields, causing the issue price to be lower than the prices of the remaining bonds that are sold. A higher bond yield would allow the issuer to have a higher investment yield.
In its issue price proposal, the IRS ditched the reasonable expectations standard and the 10% test and instead said the issue price would be based on actual sales, with a 25% safe harbor.
"The issue price on tax-exempt bonds issued for money is the first price at which a substantial amount of the bonds is sold to the public," the IRS said in the proposal. "The proposed rules provide a safe harbor under which an issuer may treat the first price at which a minimum of 25% of the bonds in an issue (with the same credit and payment terms) is sold to the public as the issue price, provided that all orders at this price received from the public during the offering period are filled (to the extent that the public orders at such price do not exceed the amount of bonds sold)."
"The public" would mean person other than an underwriter, it said.
BDA and other market groups vigorously oppose the proposed rules, warning they are unworkable.
In this most recent letter, Nicholas said that removing the reasonable expectations standard would "ignore the foundational characteristics of the municipal securities marketplace."
"To comply with the safe harbor, an issuer and its underwriters must establish a yield that is high enough (or a price low enough) to sell at least 25% of each maturity in the issuance," Nicholas said. "This problem would be magnified in the not-infrequent instance in which an issuer was having trouble selling a particular maturity."
"Rather than impose an unworkable rule, the IRS should use its available enforcement tools to ensure that abuses are not occurring and should work with the [Securities and Exchange Commission, Financial Industry Regulatory Authority, and Municipal Securities Rulemaking Board] to enforce the existing municipal securities regulations," he said.
The BDA urges the IRS and Treasury to keep the reasonable expectations standard and the 10% test. It said reasonable expectations should be defined "at the time of sale" for a competitively sold bond transaction and "at final pricing" for a negotiated deal. It asked the IRS to provide greater detail on the requirements for the making of a "bona fide public offering" and to clarify both who a dealer would be, as well as the length of the underwriting period.
BDA also asked the IRS come up with de minimis rules that take into account special considerations for small issues of bonds and small maturities within a longer issue, where it can be difficult to establish actual sales of a substantial percentage of the bonds.
"BDA believes that the best approach for IRS to employ would include modest changes to current rules and appropriately targeted enforcement action of those modified rules," Nicholas concluded.
