WASHINGTON — Market participants are concerned that issuers of draw-down bonds with tax benefits provided by temporary stimulus provisions could lose some benefits if the provisions expire at the end of the year as scheduled.

Bond lawyers have been pushing for the Internal Revenue Service to clarify how Build America Bonds and bank-qualified bonds with draw-down structures would fare if the stimulus provisions expire. The IRS could issue guidance as early as next week, sources said.

Draw-down bonds are a popular way for smaller issuers to finance construction projects with bonds without having to make initial interest payments on the entire issue.

Typically, an issuer agrees to sell a certain amount of the bonds to a bank in a private-placement transaction. The bank, in turn, agrees to loan the bond proceeds to the issuer in several small periodic amounts. The issuer is only obligated to pay interest on the amounts that have been tapped, which allows it to save money on lengthy construction projects where all the proceeds are not needed up front.

This contrasts with a traditional tax-exempt bond deal, in which the underwriter pays the issuer for the bonds up front.

Draw-down bonds have become a hot topic of debate among bond attorneys due to the possibility that the temporary provisions enacted under the American Recovery and Reinvestment Act may expire at the end of the year. Specifically, the attorneys are worried that BABs or bank-qualified bonds issued under the stimulus provisions, but not drawn down before the Dec. 31 expiration date, would no longer qualify as BABs or for the higher $30 million small-issuer exemption.

The small-issuer exemption in the stimulus law allows banks to deduct up to 80% of the costs of buying and carrying tax-exempt debt sold by borrowers whose annual issuance is no greater than $30 million, up from the normal $10 million limit. It also allows for the $30 million limit to be applied to individual borrowers participating in conduit deals, rather than just at the conduit-issuer level.

The stimulus law created BABs, allowing issuers to receive subsidy payments from the federal government equal to 35% of their interest cost. But issuers could lose those payments for BABs that have been structured as draw-down bonds but not yet drawn down. And even if the BAB and other bond-related stimulus law provisions are extended, issuers of draw-down BABs could run into trouble. They may not be able to continue receiving the 35% payment if Congress passes pending legislation reducing the subsidy payments to 33% in 2011 and 30% in 2012.

The tax issue with draw-down bonds that has sparked concern is whether the debt can be considered issued after the first big chunk is drawn, or whether each draw constitutes a separate issue date.

“I probably get a telephone call once a week from people about this issue,” said Perry Israel, an attorney with his own firm in Sacramento who chairs the tax committee for the National Association of Bond Lawyers. “There’s been some very heavy discussion.”

An IRS revenue ruling and Treasury rules suggest that the issue date for draw-down bonds can be determined early on when the issuer first receives a big chunk of the bond proceeds.

The IRS revenue ruling, which was issued in 1989, states that, for purposes of section 265(b) of the tax code, a draw-down bond is considered issued on the date that more than a de minimis amount of the proceeds is first advanced under the issue. Some bond attorneys point to that ruling, although two decades old, as particularly relevant considering it applies to section 265(b). That section details the deductions financial institutions can take on tax-exempt interest, and was modified as part of the federal stimulus for the expanded small-issuer exemption.

In addition, Treasury regulations that provide a definition of issue include a special rule for draw-down bonds, which states that they must be treated as part of a single issue, the date of which is set once the lesser of $50,000 or 5% of the issue price is drawn. A separate section of Treasury regulations state that draw-down bonds issued in different calendar years can be considered part of the same issue so long as it can be reasonably expected that all the proceeds will be advanced within three years of the first draw.

However, the IRS took a different stance in private-letter ruling 200147015, which was issued in November 2001. That ruling focused on an unidentified borrower that planned to use tax-exempt bonds to build a continuing care retirement community.

Due to market conditions, the borrower planned to construct the community in five phases over five years, and planned to use draw-down bonds to finance the project. The IRS determined that “each advance made should be treated as a bond of the project issue, [and] the issue date of which is the date that the advance is actually made.”

The IRS makes clear in its private-letter rulings that its decisions are applicable only to the issuers that request them and their particular facts and circumstances. It explicitly states that they cannot be cited or used as precedent in other tax matters. Nevertheless, bond lawyers look at PLRs for insights into the agency’s thinking, particularly on issuers where there is little or conflicting guidance.

Market participants contend the IRS effectively has two choices in its forthcoming guidance — allow the issue date of draw-down bonds to be set at the first draw, or require that every draw constitute its own issue date.

Some argue that if the IRS takes a hard line on draw-down bonds and insist that each draw constitutes a separate issue date, this will disincentivize small issuers and borrowers from taking on projects that could stimulate the economy, and that it would discourage projects just as banks are beginning to offer loans again.

“The thing that’s the saddest about this is that the banks are finally coming around to making loans,” said Linda Schakel, a partner at Ballard Spahr LLP here.

Furthermore, an issuer can protect against draw-down concerns by simply drawing the full issue amount before the provisions expire. Market participants have pointed out that if issuers do this with BABs, not only will they pay more in interest, but so will the federal government, since its payments to the issuer are subsidizing the interest.

But others worry that a more flexible draw-down arrangement could lead to abuse. State and local officials could issue a large amount of draw-down BABs before the expiration date and then, through a number of prolonged draws, effectively extend the BAB program if Congress fails to do so.

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