IRS: Issuer of Tax-Exempts, BABs, Can Reallocate Proceeds

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WASHINGTON -- An issuer of tax-exempt bonds and Build America Bonds can reallocate its proceeds, the Internal Revenue Service ruled.

The IRS also concluded that the issuer can use earnings on BAB proceeds in a reserve fund that accrue after the project is placed in service to pay debt service without becoming ineligible to receive subsidy payments.

The IRS' conclusions were made in a private-letter ruling that was dated May 21 and released last week. The ruling, which did not identify the issuer, was signed by Timothy Jones, senior counsel in the tax-exempt bond branch of the IRS chief counsel's office.

Bond lawyers view the ruling favorably.

"It seems like they've done the right thing," said Perry Israel, an attorney with his own practice in Sacramento, Calif.

The issuer mentioned in the ruling has an ownership interest in an electric generating facility and sold four tax-advantage bond issues to finance its portion of the facility. Two of the issues were of tax-exempt bonds and the other two were of taxable Build America Bonds.

The issuer now expects the cost of the project to be less than what was predicted at the time it issued one of the BAB issues. As a result, the issuer will have unspent proceeds from that BAB issue based on how it previously allocated its capital expenditures to proceeds of the four issues.

The issuer wants to revise its allocations of expenses to bond proceeds within a certain period of time -- no later than 18 months after the project was placed into service and 60 days after the fifth anniversary of the bonds' issuances. Bond lawyers said that the issuer probably wants to reallocate the proceeds so that all of the available ones from the BABs are used for capital expenditures, as is required for BABs. The issuer asked the IRS to rule on whether it can revise its allocations.

Under Treasury Department regulations, issuers can reallocate proceeds after issuance within a certain time period. They can reallocate proceeds no later than the latter of 18 months after the expenditure is paid or 18 months after the project financed is placed in service. Additionally, any reallocation has to be made before the earlier of, 60 days after the fifth anniversary of the bonds' issuance or 60 days after the issue retires.

"By not requiring allocations to be determined when the expenditure is paid or incurred, the arbitrage regulations acknowledge that day-to-day practicalities require some flexibility regarding the timing of an issuer's allocations," Jones wrote in the ruling. "We conclude that these practicalities also require flexibility to change allocations, so long as those changes are made within the time frame provided under [the regulations]." This issuer made its proposed reallocations in the allotted time frame.

Michael Bailey, a partner at Foley & Lardner LLP in Chicago and former IRS official said the ruling was unsurprising but helpful, since it acknowledged that the regulations give issuers flexibility about how proceeds can be spent. Bailey worked on the reallocation rule when he was at the IRS during the 1990s and said its purpose was to give issuers some ability to fix problems without giving them an unlimited amount of time to do so.

"This is a ruling… that is relevant to post-issuance compliance," he said. Generally, the IRS is encouraging issuers and borrowers to have post-issuance compliance procedures, and one best practice is to review expenditures within the permitted time period. The reallocation rule allows issuers to fix problems relating to how proceeds are allocated to expenditures, and the IRS ruling affirms that it is appropriate to use that rule, Bailey said.

The BAB issues and one of the tax-exempt issues are secured by a parity reserve fund that includes some proceeds from the BAB issues. The issuer proposed to use the investment earnings from the reserve fund that accrue after the project is placed in service to pay debt service. It asked the IRS to rule that doing so would not prevent the issuer to be able to receive subsidy payments for the BABs.

Under federal tax law, issuers of qualified BABs can receive subsidy payments equal to 35% of their interest costs. In order for BABs to be qualified, 100% of available project proceeds have to be used for capital expenditures, with the exception of proceeds that can be used in a reserve fund. The question was whether investment earnings on a reserve fund are considered available project proceeds.

The IRS concluded that earnings of BAB proceeds in a reserve that accrue after the project is placed in service are not available project proceeds and can be used to pay debt service without causing the BABs to be disqualified. "If earnings on sale proceeds of [the BAB issues] in a reasonably required reserve are included in 'available project proceeds'… then the issuer would be required to spend those earnings on capital expenditures long after the project is complete," Jones wrote.

Mike Larsen, a partner at Parker Poe Adams & Bernstein LLP in Charleston, S.C., said that this conclusion can give issuers who find themselves in a similar situation more comfort, though private-letter rulings are only supposed to apply to the issuers who request them.

Generally, bond proceeds are precluded from being used for working capital expenditures, but there is an exception for tax-exempt bonds for using investment earnings on reserve funds to pay debt service. The IRS in the ruling said that the exception also applies in this case for BABs.

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