The Internal Revenue Service yesterday released guidance clarifying that Jan. 1 is the deadline for issuers to receive tax benefits on “draw-down bonds” that are eligible for temporary bond programs, including Build America Bonds.
Issuers sometimes enter into a private-placement transaction with a bank wherein issuers agree to sell bonds up to a certain amount and “draw down” the amount in smaller transactions over time. The issuer pays only the interest on the amounts that it has drawn.
The deals are analogous to a consumer receiving a credit card, borrowing on that credit in increments up to a previously agreed-upon limit, and paying interest on the amounts that are borrowed instead of on the entire amount that could be borrowed.
But market participants have questioned how tax rules would apply to draw-down bonds that are issued as part of temporary programs.
The question was especially relevant to issuers that have entered or plan to enter into draw-down transactions relying on temporary tax provisions, but who might make draws from those transactions after the provisions expire.
The IRS in its nine-page release said that, for such transactions and for commercial paper programs, the “issue date” is the date that the draw or commercial paper is received and interest begins to accrue on it.
The guidance will apply to programs that include BABs, recovery zone economic development bonds, Gulf Opportunity Zone bonds, and private-activity bonds exempt from the alternative minimum tax, according to market participants.
For BABs that are structured as draw-down loans or commercial paper programs, the IRS said only the draws or commercial paper that are taken by the issuer and start accruing interest before Jan. 1 will qualify as BABs, benefiting from the federal government’s direct payment to cover 35% of the interest costs on those bonds.
Draw-down bonds are frequently used by smaller issuers but not as often by larger ones, like major cities, a market participant said.
The source added that guidance could have an immediate effect on existing draw-down and commercial paper deals between issuers and banks.
Because issuers will lose the subsidy that encouraged them to sell debt with taxable interest rates instead of typically lower tax-exempt rates, they are likely to go back to their banks on Jan. 1 and ask for a new deal, the source said.
The IRS guidance added that it “does not apply” to draw-down loans using temporary provisions for bank-qualified bonds.
Under those provisions that expire at the end of this year, banks can deduct 80% of the costs of buying and carrying tax-exempt debt sold by borrowers who issue up to $30 million per year, an increase of $20 million over the previous limit on the eligible borrowers. The temporary provisions also allow banks to hold 2% of their assets in tax-exempt debt without being subject to certain restrictions on tax deductions.
The incentive for the bank-qualified bond tax perks “was to get the banks making loans,” one market participant said, “and if they’re just now starting to do that, [removing the benefit] would defeat the incentive.”
As a result, the government issuers and 501(c)(3) organizations that sell bonds under the bank-qualified provisions may be pleased with the guidance, while BABs issuers might not, the source said.
By applying the timing in its guidelines to BABs and similar programs, but not to bank-qualified bond provisions, the IRS “kind of split the baby,” said Thomas D. Vander Molen, partner at Dorsey & Whitney LLP in Minneapolis.
“I have trouble reconciling the distinction” that placed a Jan. 1 deadline on the BABs draw-downs, but “at least they spared the bank-qualified bonds from their change in distinction,” he added.
Bond attorneys have been “holding off and warning their clients that the IRS might come out with a different result” on the timing issue, “and they did,” Vander Molen said.