The American Bar Association’s tax group is urging the Treasury Department and Internal Revenue Service to publish guidance confirming that bond counsels’ long-standing practices for bonds issued to finance grants comply with tax law requirements.
The guidance should address the terms of the bonds as well as private-activity bond and arbitrage issues. It would affect billions of dollars of debt already outstanding as well as new issues, including some Build America Bonds, according to a letter the ABA section of taxation sent to IRS commissioner Douglas Shulman and other regulatory officials on Jan. 5.
The ABA group decided to seek the guidance after Treasury and IRS officials suggested, in informal discussions and at conferences, that bond-financed grants might be treated as working capital financings, which are short-term and subject to certain restrictions, said Maxwell “Mike” Solet.
Solet, a partner at Mintz Levin Cohn Ferris Glovsky and Popeo PC in Boston, was the primary author of the letter.
The suggestions may stem from the fact that while few current rules apply to the bonds, one arbitrage rule states that the proceeds from bonds that finance grants should be treated as if they were spent on the date the grants are made.
However, it makes no sense to treat bonds financing grants as working capital financings because grants mostly fund long-term capital projects, according to Solet and other members of the group.
In working capital financings, the proceeds can only be used if the issuer has no other funds available. In addition, the proceeds typically must be spent within two years to avoid any question of whether the bonds were outstanding longer than was needed to accomplish their governmental purpose.
Under arbitrage rules, bonds cannot remain outstanding “longer than is reasonably necessary for the governmental purposes of the issue.”
The rules contain a safe harbor under which, if the proceeds are spent within two years, the bonds will not be considered outstanding longer than necessary. As a result, working capital financings typically involve bonds with terms of two years or less.
However, for bonds financing grants, “most bond counsel 'look through’ to the grantee’s use of the bond proceeds in determining the appropriate term of the bonds,” the ABA group told the regulators. “This practice probably results from a sense of the intent of the code and regulations rather than because that approach is specifically authorized.”
But according to Solet, it makes sense for 20- or 25-year bonds to finance a grant to fund the construction of a school that is expected to have a life of at least 40 years.
Bond-financed grants sometimes are used to fund operating as well as capital expenses, the letter pointed out.
When this occurs, the issuer should be permitted to determine the term of the bonds by blending the shorter term applicable to working capital finances with the longer term of the capital projects to be financed.
The “look through” analysis is especially important for direct-pay BABs and recovery zone economic development bonds because their proceeds must be used to finance capital expenditures in order to qualify as BABs and RZEDBs.
Also, qualified school construction bonds must be used to finance the rehabilitation and construction of school facilities, so if QSCBs are issued to finance grants, the grants also must fund school construction.
The ABA group said that generally, bonds financing grants should not be considered private-activity bonds because they typically fail the private payment test. Bonds are PABs if more than 10% of the proceeds are used by a private entity and more than 10% of debt service is paid by a private party.
“Grants ordinarily fail the private security or payment test,” the letter stated, while adding that this analysis “remains subject to general anti-abuse restrictions.”
For arbitrage purposes, the tax rules provide that the proceeds of an issue used to make a grant are considered to be spent on the date the grant is made, the letter said. “This analysis also remains subject to general anti-abuse restrictions,” the group told the regulators.
The anti-abuse restrictions permit IRS commissioner to “take any action to reflect the substance of [a] transaction” after determining the principal purpose of the transaction was to transfer the significant benefits of tax-exempt bonds to nongovernmental persons or entities, the ABA letter said.