A refunding issue means an issue of obligations the proceeds of which are used to pay principal, interest or redemption price on another issue, including the issuance costs, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund or similar costs, if any, properly allocable to that refunding issue (Section 1.150-1(d) of the Regulations; See also 2009 BAW).
Under the “steps in the shoes” rule, the regulations treat the use of proceeds of the original bonds as the ultimate use of proceeds of any refunding bonds. Treas. Reg. 1.103-7(d)(1), which memorializes this rule, states as follows:
This list identifies certain matters that must be reviewed prior to closing an “advance refunding” obligations issue. The list will be updated periodically.
If an issue is not considered a refunding (e.g., because of different obligors or certain acquisitions), it is a new money issue for federal income tax purposes. Therefore, the issue must satisfy all applicable tax requirements to establish tax-exemption, such as requiring PAB volume cap, meeting rehabilitation requirements or subjecting the project and proceeds to more stringent requirements than may have applied with respect to the prior issue.
PLR 200230039: State authority bonds won’t be treated as “refunding issue” of city bonds under Treas. Reg. § 1.150-1(d) where authority isn’t obligor of city bonds nor related party with respect to city bonds.
In reviewing transferred proceeds matters for refundings, be sure to look for the possibility of cascading transferred proceeds, which are proceeds that transfer through several generations of refundings. This can occur, for example, if refunded bonds effected a current refunding of a prior generation of refunding bonds, and the prior generation refunding bonds created an escrow for refunding purposes that still exists. That escrow transfers all the way up to the refunding bonds and must be taken into account for yield restriction purposes. In this example, the yield on the remaining escrow will have to be restricted to the yield on the refunding bonds as the proceeds transfer (as the refunding bonds pay the refunded bonds0. That yield restriction is typically accomplished through the payment of a transferred proceeds penalty calculated at the time the bonds are priced or structured by the underwriter. The main reason for a transferred proceeds penalty is because the escrow may be invested in SLGS that were originally structured to correspond to the escrow needs – and it may be impossible to change those SLGS to fit a lower yield restriction of the refunding bonds. Notiz 20120429.
Transferred proceeds are calculated as described in Section 1.148-9(b). “Principal amount” for purposes of the calculation is the stated principal amount for “plain par bonds” or the present value for bonds that are not “plain par bonds.” One characteristic of a plain par bond is that it is issued with not more than a de minimis amount of original issue discount or premium.
See Treas. Reg. 1.148-9(c)(2). When issuer revenues or unspent prior issue proceeds are included in an escrow fund, together with refunding bond proceeds, the technical rules for mixed escrow funds become applicable. The mixed escrow rules are necessary because amounts from different sources have different tax attributes. For example, proceeds of the refunding issue and issuer revenues have the following differing tax attributes:
The issuer’s incentive is to keep proceeds subject to whatever provides the highest yield limitation. For example, if remaining bond fund moneys (from the prior issue) are invested in investments with a yield that is higher than the refunding yield (plus spread) but below the prior issue yield limit, the issuer will want to make sure these bond fund investments remain allocated to the prior issue for as long as possible. The issuer might therefore want to allocate these bond fund moneys to the very last maturities of the refunding.
- Any of the proceeds of the advance refunding issue are invested in a refunding escrow in which a portion of the proceeds are invested in tax-exempt bonds and a portion in nonpurpose investments;
- The yield on the tax-exempt bonds exceeds the yield on the advance refunding issue;
- The yield on all investments (including the tax-exempt bonds and nonpurpose investments) in the refunding escrow exceeds the yield on the advance refunding issue; and
- The WAM of the tax-exempt bonds is more than 25% greater or less that the WAM of the nonpurpose investments in the refunding escrow, and the WAM of the nonpurpose investments in the refunding escrow is greater than 60 days.
See Treas. Reg. 1.149(d)-1(b)(3). [More to come]
Advance Refunding of a Taxable Obligation:
Treas. Reg. § 1.149(d)-1(e)(1) provides that the limitation on advance refundings set forth in I.R.C. § 149(d)(3)(A)(i) does not take into account an advance refunding of a taxable issue unless the taxable issue is a conduit loan of a tax-exempt conduit financing issue. Note, however, that the refunding obligation still constitutes an advance refunding issue. This regulation section simply exempts the issue from being considered in the advance refunding limitation rule. For purposes of other rules, however, the “normal” advance refunding rules still apply. Therefore, e.g., the materially higher definition of 0.001% applies to the escrow.
April 29, 2013: What will happen to SLGS subscriptions if the debt ceiling is not increased or the limit is not suspended by May 19, 2013? Will SLGS subscriptions submitted to the Bureau of Public Debt prior to May 19, 2013 be honored or will the BPD cancel the subscriptions? Under the suspension act signed into law by President Obama in February 2013 (No Budget, No Pay Act), the debt ceiling limit was suspended. Once the suspension period ends, the debt limit existing on May 19 goes back into effect. At that point, it appears the debt limit will have been exceeded. Technically, the Treasury Department may take extraordinary measures to attempt to keep debt below the limit, similar to what was done in January 2013 when debt levels were nearing the ceiling. It is unlikely, however, that enough measures can be taken to permit the BPD to continue SLGS issuances. Further guidance from the Treasury Department is needed to understand what the likely approach will be.
SLGS and Rev. Proc. 95-47:
The SLGS program permits issuers to structure advance refunding escrows to achieve maximum efficiency within the yield limit. Issuers may either (1) fully fund the refunding escrow with SLGS earning yields at a level permissible under the yield restriction rules or (2) combine SLGS with open market securities. In the second scenario, the refunding escrow is typically funded with open market securities (taxable Treasury securities) first because open market securities often provide a higher yield than the bond yield. The escrow agreement will direct the escrow trustee at some point to roll over proceeds from sale of escrow securities into zero percent SLGS to blend down the overall yield of the escrow to avoid yield restriction problems.
See “The SLGS Compliance Initiative: A Correspondence Examination Initiative of Advance Refunding Bonds,” by Peter J. Mazarakos and Steven A. Chamberlin.
In November 1995, the Treasury Department provided guidance in Rev. Proc. 95-47 (1995-2 C.B. 417, 1995-47 I.R.B. 12) on how to address rollovers into zero percent SLGS during periods in which the sale of SLGS is suspended. The Procedures states that an issuer may make special yield reduction payments (usually not permitted under Treas. Reg. § 1.148-5(c)(3)(ii) for advance refunding investments) if the following requirements are satisfied:
- The alternative investment (the investment purchased in lieu of the zero percent SLGS) is purchased on a date when the issuer is unable to purchase SLGS in lieu of the alternative investment because the Department of the Treasury has suspended sales of SLGS.
- The issuer reasonably expected on the issue date of the bonds that it would use bond proceeds to purchase SLGS on a date described in section 4.01(1) of the Procedure.
- The maturity date of the alternative investment is not more than 90 days from the date of purchase (trade date, not settlement date) of the alternative investment.
- The issuer exercises reasonable diligence to use the proceeds of the maturing alternative investment to purchase SLGS, if available, for the remainder of the term that was reasonably expected on the issue date.
- The payment to the United States is made not later than 180 days after the date of purchase of the alternative investment.
- The purchase price of the alternative investment does not exceed the fair market value of the alternative investment, and the issuer maintains books and records relating to the establishment of the purchase price.
- The payment to the United States is equal to the difference between the purchase price of the alternative investment on the date of purchase and the amount of all receipts from the alternative investment.
The special yield reduction payment is made in the same manner as normal yield reduction payments. The following statement must be noted in the top margin of Form 8038-T: “Special Yield Reduction Payment Made Pursuant to Revenue Procedure 95-47.”
Query why the Treasury Department included a 90-day investment limitation. Some bond counsel believe this period was chosen as a belt and suspenders limit – at that time, there had been no suspensions that had lasted longer than about 30 days. The 90-day period was viewed as sufficient to cover all suspension periods.
Consider REG-106143-07, which would make Rev. Proc. 95-47 obsolete. Making Rev. Proc. 95-47 probably means that the special 90-day holding limitation goes away. Query whether the 180-day yield reduction payment requirement also goes away. If the requirement goes away, the YRP will be due at the same time all other YRPs are due. Some bond counsel believe that the 180-day requirement is eliminated along with the 90-day holding limitation.
If the escrow is rolled from one alternate investment to another alternate investment, how quickly does the second alternate investment need to be made after the first alternate investment matures?
Assume an issuer district (“District A”) issued Series 2002 Bonds to finance public improvements. In 2013, another district (“District B”) will issue “refunding” bonds (the “Series 2013 Bonds”) to refinance the public improvements. Assume also that prior to the refinancing District A has legal title to the improvements and after the refinancing District B will have legal title. Will the Series 2013 Bonds be a refunding issue within the meaning of Treas. Reg. 1.150-1(d)(1)?
Treas. Reg. 1.150-1(d)(1) defines a “refunding issue” as an issue of obligations the proceeds of which are used to pay principal, interest or redemption price on a “prior issue,” including the issuance costs, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund, or similar costs, if any, properly allocable to that refunding issue.
Treas. Reg. 1.150-1(d)(5) defines a “prior issue” as an issue of “obligations” all or a portion of the principal, interest or call premium on which is paid or provided for with proceeds of a refunding issue.
A special rule in Treas. Reg. 1.150-1(d)(2)(ii)(A) provides that an issue is not a refunding issue if the “obligor” of one issue (e.g., the proposed Series 2013 Bonds) is neither the obligor of the other issue (e.g., the Series 2002 Bonds) nor a related party with respect to the obligor of the other issue. Under Treas. Reg. 1.150-1(d)(2)(ii)(B), “obligor of an issue” means the actual issuer or, in conduit financings, the conduit borrower.
Assume District A and District B have the same members of the governing board. Are District A and District B “related parties”?
Treas. Reg. 1.150-1(b) defines “related party” as any member of the same controlled group (if with respect to a governmental unit or a 501(c)(3) organization). In Treas. Reg. 1.150-1(e), “controlled group” is defined as a group of entities controlled directly or indirectly by the same entity or group of entities. Direct control is determined based on all facts and circumstances. One entity or group of entities (the controlling entity) generally controls another entity or group of entities (the controlled entity) if the controlling entity possesses either of the following rights or powers and the rights or powers are discretionary and non-ministerial: (1) the right or power both to approve and to remove without cause a controlling portion of the governing body of the controlled entity; or (2) the right or power to require the use of funds or assets of the controlled entity for any purpose of the controlling entity. (There is a special rule for indirect control, and there is a special exception for general purpose governmental entities.)
Based on this definition and under the assumption described above, District A and District B would be related parties. The Series 2013 Bonds would likely be a refunding issue.
(Some bond counsel, however, believe “control” – the right to approve or remove and the right to require use of funds or assets – must be more than merely momentary power due to board composition. Instead, the power should be set forth in agreements between the two districts or in statutes.)
Assume, however, that District A and District B do not have any overlapping boards and are not part of the same controlled group. In this case, the Series 2013 Bonds do not qualify as a refunding issue. Instead, the Series 2013 Bonds are new money bonds, the proceeds of which are probably characterized as financing the acquisition of District A’s public improvements.
(But, query whether in a taxing district (District A)/issuing district (District B) where issuing district bonds are paid from taxes levied by the taxing district the true obligor isn’t District B from the start such that upon refunding there is no change in obligors.)
See AM2012-004, released 6/1/2012, in which the Office of Chief Counsel determines that there is no reissuance of tax-exempt or build America bonds where the State of California, by legislative act, dissolved all of its redevelopment agencies and vested all of their authority, rights, powers, duties and obligations in successor agencies.
Integrated Asset Acquisitions:
See PLR 201326007 and The Bond Buyer, IRS Rules Issuance of New Bonds is a Refunding, July 2, 2013. Does a refunding followed by a sale of partnership interests in the conduit borrower cause the refunding bonds to be new money bonds (to which volume cap and other requirements may apply) or are the refunding bonds a “refunding issue” under Treas. Reg. 1.150-1?
“An issue is not a refunding issue if the obligor of the would-be refunding issue is not the obligor of the other issue. Thus, if County X financed a water and sewage facility with tax-exempt bonds in 1994 and in 1998 sells it to unrelated County Y, which finances such purchase with a tax-exempt bond issue, the transaction will be treated as an acquisition of the facility and not as a refunding, even though County X used the proceeds from the sale to discharge its tax-exempt bond issue.” (From a Bond Attorneys’ Workshop outline)
Refunding of ARRA Bonds:
There is no statutory language on refundings for any of the disaster relief bonds or ARRA bonds, including the Recovery Zone Facility Bonds and Recovery Zone Economic Development Bonds and Build America Bonds. There are “common law” principles that might support current refundings, but there has been no guidance, except to the extent described below.
For difficulties regarding legal defeasance of such bonds in advance refundings, see IRM 184.108.40.206.2 and Treas. Reg. 1.1001-3(e)(5)(ii)(A) and (B). The defeasance may be a reissuance of the defeased bonds.
A. Gulf Opportunity Zone bonds (“GO Zone Bonds”); Midwestern Disaster Area Bonds; and Hurricane Ike Disaster Area Bonds
In Notice 2012-3 (2012-3 IRB 289) (January 17, 2012), the IRS permits the current refunding of GO Zone Bonds originally issued prior to the termination date of December 31, 2011, and the Midwestern Disaster Area Bonds and Hurricane Ike Disaster Area Bonds, issued under Sections 702(D)(1) and 704(a) of the Heartland Disaster Tax Relief Act of 2008, issued prior to the scheduled termination of December 31, 2012 (collectively, the “Disaster Area Bonds”). The IRS supports its conclusion that current refundings of these bonds are permitted based on discussion by the Joint Committee on Taxation in “Technical Explanation of the Revenue Provisions of H.R. 4440, the ‘Gulf Opportunity Zone Act of 2005,’ as Passed by the House of Representatives and the Senate,” 5-6, JCX-88-05 (December 16, 2005).
Under the Notice, a current refunding is permitted after the termination date if the issue price of the current refunding issue is no greater than the outstanding principal amount of the refunded bonds. If the refunded bonds were issued with more than a de minimis amount of OID or OIP, the present value of the refunded bonds is used instead of the outstanding stated principal amount to determine the maximum issue price of the current refunding issue.
There is an express prohibition of advance refundings of GO Zone Bonds (See JCX explanation, page 6).
Notice 2012-3 specifically states that no inference may be drawn from the Notice that bonds issued to refund other types of bonds, such as Build America Bonds under I.R.C. 54AA, after their statutory deadline for issuance meet the qualifications for such types of bonds. Therefore, the Service does not appear willing to extend the ability to currently refund bonds after the applicable termination date without express language similar to the statement in the JCX explanations.
See Notice 2010-10 for special reimbursement (official intent) rules relating to disaster area bonds.
B. Recovery Zone Facility Bonds (Exempt Facility Bonds)
See Notice 2014-09 for special current refunding guidance for Recovery Zone Facility Bonds.
C. Build America Bonds
See PLR 201149017 (December 2011), which concludes that the remarketing of BABs described in the ruling did not trigger a reissuance.
There is still no guidance or permission to refund Build America Bonds on either a current or an advance refunding basis with proceeds of a new Build America Bonds issue.
There is also no guidance on whether the IRS would continue to pay Build America Bonds subsidies during any escrow period if the Build America Bonds are current or advance refunded with proceeds of a new tax-exempt issue.