Treasury's Cross weighs in on advance refunding proposals
WASHINGTON – The Treasury Department and Internal Revenue Service would need Congress to authorize state and local governments to advance refund bonds and make payments to the federal government to cover its revenue losses or tax concerns, a Treasury official said this week.
John Cross, associate tax legislative counsel at Treasury, made the statement in responding to two commentaries recently published in The Bond Buyer that propose allowing issuers to do advance refundings as long as they compensate the federal government for the cost of either the loss of tax revenues or having two tax-exempt bond issues outstanding at the same time.
“There’s a good basis for doing it, but I think we’d need legislation that authorizes that,” Cross said when asked about the proposals.
Congress prohibited issuers from doing advance refundings after the end of 2017 in the Tax Cuts and Jobs Act that was enacted in December. The Joint Committee on Taxation calculated the prohibition would result in $17 billion in savings to the federal government over 10 years and lawmakers used those estimated savings to help offset the estimated cost of the new tax provisions.
The two commentaries propose basically the same idea, but differ on the basis for figuring the issuer payments to the federal government and on how these transactions could be implemented.
The proposal made in a March 27 commentary by Steven Gortler, a San Francisco-based municipal advisor and former vice president at Piper Jaffray & Co., is for a “hold harmless” approach. An issuer would advance refund outstanding bonds on a tax-exempt basis to reap the savings from lower interest rates and pay Treasury an amount equal to the “tax expenditure,” in other words the estimated revenue loss to the federal government from the tax exemption.
“While not an exact science, it’s pretty easy to estimate the hold-harmless payment for advance refunding bonds,” Gortler said in his piece, suggesting it would be “fairly modest.” He estimated that, if an advance refunding would generate 10% net present value (NPV) savings, the hold-harmless payment would be about 2% of the refunded amount, measured on a NPV basis. The issuer would still get 8% NPV savings, just not the full 10%.
Gortler suggested the IRS would have the regulatory authority to carry out these refundings under its Voluntary Closing Agreement Program. VCAP allows issuers to resolve certain tax law violations they voluntarily disclose. He said the Internal Revenue Manual for IRS auditors cites an “impermissible advance refunding” as one of the tax law violations that can be remedied by a closing agreement.
The other proposal published in an April 2 commentary by Charles Almond, of counsel at Bracewell in Houston, is for issuers of tax-exempt advance refunding bonds to pay a “toll charge” to the federal government at issuance that is based on the amount of time the two issues of tax-exempt bonds would be outstanding. The shorter the so-called “double-up” period, the lower the toll charge would be.
Almond doesn’t think Gortler’s proposal to amend the VCAP process would work. “I would be very surprised if the IRS would ever agree to allow an impermissible advance refunding bonds, whose impermissibility is knowingly and deliberately planned before the bonds are issued, to remain outstanding tax-exempt with a modest hold-harmless payment,” he said in the preface to his commentary.
Almond said Congress would probably need to authorize such a program.
The proposals have generated a lot of interest among municipal market participants, although there is debate about whether they could be implemented without legislation.
One source who did not want to be identified said Treasury has the regulatory authority to implement such a program under Section 149(d)(3) of the Internal Revenue Code on advance refundings. That section states: “The [Treasury] Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this subsection.”
“If you ask me, I would say Treasury could do both of those suggestions without legislation,” the source said.
Mike Bailey, a partner at Foley & Lardner in Chicago, disagreed. He said he’s heard anecdotally that Treasury and the IRS have had these kinds of proposals before, stemming from 1986 Tax Reform Act’s limiting governmental and 501()(3) bond issuers to one advance refunding and prohibiting private activity bonds from being advance refunded at all.
“This has been proposed before and [the regulators] said, ‘No, We can’t do that. We don’t have the authority to do that,’” he said.
Bailey and several other lawyers said that such a program could not be run through the VCAP program because the VCAP rules specify that VCAP requests can only be “accepted when the IRS has a reasonable basis to believe there has been a federal tax law violation.”
One idea, Bailey said, might be to try to get a closing or settlement agreement from the IRS chief counsel for these kinds of advance refundings.
Most market participants favor Almond’s approach over Gortler’s and agree with Cross that legislation would be needed.
There have been several proposals from administration officials and lawmakers for getting rid of advance refundings over the last several years – Treasury in 1985, JCT in 2005, and former House Ways and Means Committee chairman Dave Camp, R-Mich., in 2014. In each case, the stated reason for prohibiting them was the criticism that advance refundings result in two tax-exempt bond issues being outstanding in the market for some period of time. This is why Almond suggests issuers pay for the period they have two sets of bonds outstanding.
“It’s going to be hard to get Treasury to do anything about this unless there is some legislation or some other direction from Congress because I think, [while] you’d be paying for it, … you’d be allowing an advance refunding to occur in the face of Congress barring advance refundings,” said Perry Israel, a tax lawyer with his own practice in Sacramento, Calif. “These may be fine ideas, but they’re not what Congress said.”
John Hutchinson, a partner at Squire Patton Boggs in New York who also thinks legislation would be needed, prefers Almond’s approach and doesn’t think going through the IRS VCAP program would work.
“We’ve always thought that, assuming you had a statutory change, a better approach would be to deal with this through the existing remedial action regulations,” he said. These rules allow issuers whose bonds have violated the tax laws to take remedial actions.
Once you get agreement on the formula for the issuer’s payment, “It ought to be as simple as cutting a check to Treasury,” Hutchinson said, adding that Treasury and the IRS already have the mechanics to allow issuers to send in checks with Forms 8038-T to make arbitrage rebate payments, even though arbitrage rebate is different than refundings.
Carol Lew, a shareholder at the Stradling firm in Newport Beach, Calif., said she likes Almond’s proposal, adding, “It has a lot of potential merit.”
Issuers are concerned about rising interest rates, she said. Market participants have talked about alternatives to advance refundings. One idea is Cinderella Bonds – issuing taxable bonds that flip into tax-exempt bonds with the tax-exempt rates specified in the bond documents for the taxable bonds. But that has raised concerns about whether the rates would be market rates, and whether from flipping from taxable to tax-exempt bonds would cause a reissuance after tax laws have changed in the interim. They have also talked about doing taxable refundings, which would raise borrowing costs.
“If we don’t solve this problem, we’re going to have a lot more governmental issuers doing taxable debt with call protection, at higher borrowing costs,” Lew said. “It’s in everyone’s interest to keep borrowing costs low overall.”
“I think these are all creative ideas,” she said about the Almond and Gortler proposals. They’re aimed at “trying to get a more efficient structure” for issuers to be able to advance refund their debt “but also address concerns about two tax-exempt issuers being outstanding at the same time.”
The question is would Congress consider authorizing these kinds of transactions?
Several lawyers said the chances are very “slim” that Congress would take the issue up any time soon.
Congress just got rid of advance refundings, said Tom Vander Molen, a partner at Dorsey & Whitney in Minneapolis who chairs the tax committee of the National Association of Bond Lawyers. “I don’t see a lot of support in Congress for revisiting this” right now, he said.
Some sources said this whole discussion is academic if issuers believe that they can eventually get Congress to reinstate tax-exempt advance refundings.
Emily Brock, director of the federal liaison director for the Government Finance Officers Association said, “We certainly would not put this at a higher priority than bringing back advance refundings.”
“Issuers are very confident that they can communicate to Congress that refundings are viable, that they ought not to have been included in tax reform because they provide substantial savings for infrastructure,” she said.
But Brock added, “I don’t want to discount the face that [Almond, Gortler and other market participants] are thinking creatively about alternative approaches.”
Brock said she expects Congress will continue to discuss infrastructure proposals, even if it’s after this year. That will be an opportunity to discuss bonds again.
But Hutchinson said, now that Congress has prohibited advance refundings, “Isn’t it better to have half a loaf than none at all?”
Discussing these kinds of proposals is good, he said, adding, “Doing something to address the overlap concern [of two tax-exempt issues outstanding at once] is a good way to at least get your foot in the door” to get Congress to start thinking about it.
Michael Decker, managing director and co-head of the municipal securities division at the Securities Industry and Financial Markets Association agreed. He noted SIFMA has no formal position on these proposals, but said, “It’s an interesting discussion.”
“We do encourage market participants … to try to address the prohibition on advance refundings,” he said. “It’s useful to talk about creative and thoughtful ways to address this hole now that’s in the financing toolbox that’s available to state and local governments.”
Asked about Congress, Decker said, “I can’t predict whether Congress would go along with these ideas, but it’s constructive to have the conversation.”