WASHINGTON — The National Association of Bond Lawyers is asking the Internal Revenue Service to modify or withdraw a memorandum about defeasances of Build America Bonds.
NABL made its request Monday in a letter to Helen Hubbard, IRS associate chief counsel for financial institutions and products.
The IRS chief counsel advice memorandum, released in December, concludes that the legal defeasance of Build America Bonds causes them to be reissued.
"NABL believes that this conclusion is contrary to the plain language of the Treasury [Department] Regulation and the intended meaning of the regulatory exception from reissuance for legal defeasances of tax-exempt obligations, and does not take into account the special role of BABs as alternative municipal financing tools," the group said.
BABs are taxable, direct-pay bonds that state and local governments could issue in 2009 and 2010. BAB Issuers initially were supposed to receive federal subsidy payments equal to 35% of their interest costs. However, subsidy payments processed since March 2013 have been reduced because of spending cuts known as sequestration.
The reductions in subsidy payments have triggered extraordinary optional redemption provisions in some issuers' documents for their BABs, allowing the issuers to redeem the BABs. The BABs are frequently not redeemed on the same day that refunding bonds are issued. Instead, the proceeds of the refunding bonds are deposited into defeasance escrows, and the debt service on the BABs is paid from the money in the escrows until the BABs are redeemed. The BABs are typically redeemed a short period of time after they are defeased.
If BABs are reissued when they are defeased, issuers may not receive subsidy payments for the period from when the bonds are defeased to when they're redeemed. Also "the reissuance result causes bondholders to realize gain or loss on BABs not only upon the final redemption of the bonds, but also upon defeasance. This may cause income to be shifted to different taxable years and, in any case, leads to burdensome tax compliance for holders of BABs," NABL said.
Under the reissuance regulations, a reissuance occurs if there is a "significant modification" to the terms of the bonds. When there is a reissuance, for tax purposes the original bonds are retired and new bonds take their place.
Generally, a significant modification occurs when there's a "legal defeasance under which an issuer is relieved of all further obligations to make payment on the debt once sufficient cash and investments have been placed into an escrow to pay debt service on that debt," according to the letter. However, the regulations provide that there is no significant modification if a tax-exempt obligation is legally defeased.
In the memo, the IRS chief counsel's office said that the exception for tax-exempt bonds does not apply to BABs. The memo, quoting a partial sentence from the preamble to the reissuance regulations, states that the purpose of the exception is to protect tax-exempt bond holders from having the interest on their bonds taxed.
However, NABL said it thinks "that this is not an accurate reading of the preamble." The argument the memo referenced was actually rejected in the preamble, and the preamble goes on to state that the purpose of the tax-exempt bond defeasance exception is to better coordinate the rules with municipal financing practices.
"This rationale applies to BABs in the same manner as it applies to tax-exempt bonds because municipal financing practices for BABs are in most ways the same as those for tax-exempt bonds," NABL said. The group pointed out that defeasance escrows are established for BABs and tax-exempt bonds for the same reasons, tax-exempt bonds are used to refund both BABs and tax-exempts, and many BABs have call provisions that are similar to those for tax-exempt bonds.
Even if the purpose of the tax-exempt bond defeasance exception was to protect bondholders, the exception should still apply to taxable municipal bonds, NABL said. The IRS' rationale is that bondholders shouldn't have to suffer consequences for actions over which they have no control. But bondholders of any debt instrument "might suffer tax consequences such as realization of gain upon an event that triggers a reissuance," NABL said.
NABL argued that BABs are "tax-exempt bonds" under the reissuance regulations. The regulations define tax-exempt bonds as state or local bonds that satisfy the requirements of section 103(a) of the Internal Revenue Code, and BABs have to meet those requirements.
The IRS memo admits that the plan language of the regulations supports treating BABs as tax-exempt bonds under the regulations. NABL argued that if the IRS intends to apply the regulations in a manner that's inconsistent with the wording of the regulations, it should propose an amendment to the rules and solicit comments.
The memo applies to legal defeasances, but NABL pointed out that many escrows for BABs and tax-exempt bonds do not result in full legal defeasances because the issuer is not relieved from all requirements to make debt service payments.
NABL said that it is "particularly concerned that reissuance treatment even for short call escrows will be unexpected and disruptive to issuers and purchasers of BABs."
Short escrows that could be considered legal defeasances are often created in the normal course of a bond financing, such as when cash is deposited with a paying agent a short time before a debt service payment is due. As a result, the conclusion in the memo could create confusion in connection with short escrows, NABL said.
The organization asked that if the IRS provides further guidance on the topic, that it specify that escrows of less than 90 days not give rise to reissuance. NABL also said that further guidance "should not distinguish between BABs and tax-exempt bonds and should indicate that the exercise of a unilateral issuer option is effective for avoiding a reissuance."
