Where changes in the terms of an outstanding security are so material as to amount virtually to the issuance of a new security, the same income tax consequences should follow as if a new security were actually issued. Rev. Rul. 81-169, 1981-1 C.B. 429.
Section 1.1001-3 of the Regulations does not apply to tax exempt bonds that are qualified tender bonds. Notice 88-130 governs these bonds. Section 1.1001-3 of the Regulations also does not apply to exchanges of debt instruments between holders.
Significance of a Change in Yield:
In order to compare the yield of a variable rate debt instrument, see the special rule under Section 1.1001-3(e)(2)(iv) of the Regulations for coming up with the correct “annual yield” using the equivalent fixed rate debt instrument rules in Section 1.1275-5(e) of the Regulations. The following is a basic description of a debt instrument classified as a “Variable rate debt instrument that provides for a single fixed rate” under Section 1.1275-5(e)(4) of the Regulations.
Step 1: Calculate the “annual yield” for the unmodified instrument by replacing each fixed rate with a rate (the “market rate”) that will cause the instrument to have a FMV that it actually has as of the modification date. Then, calculate the fixed equivalent yield of the instrument by treating the instrument as bearing interest at that market rate through the fixed rate period and as bearing the “normal” (formulaic) variable rate during the other periods.
Step 2: For the modified instrument, use a PV equal to the principal amount of the instrument outstanding on the modification date and find the market rate for an instrument with the same future value and payment characteristics as the modified instrument. Finally, use that market rate, together with the formula rate to come up with a yield that can be compared to the yield of the unmodified instrument.
To apply the change in yield test to contingent payment debt instruments, see PLR 201546009 (August 12, 2015).
Changes in Recourse Nature of Debt Instrument:
IRM 22.214.171.124.2(3)(A): “Until specific remedial action provisions are provided in regulations or other published guidance, an issuer may remediate deliberate actions impacting build America bonds by taking remedial actions, other than defeasance of nonqualified bonds, under section 1.141-12 of the Regulations. Build America bonds, as taxable bonds, are not included in the exception from the significant modification rule for defeasance of tax-exempt bonds under ITR section 1.1001-3(e)(5)(ii)(B). Therefore, defeasance of a build America bond may cause a reissuance and a bond reissued after December 31, 2010 is not a build America bond pursuant to IRC section 54AA(d)(1)(B).”
Change in Obligor:
Whether or not a change in obligor on a bond is a significant modification depends on whether or not the debt is recourse or nonrecourse. An “obligor,” according to Treas. Reg. 1.1001-3(f)(5), is the issuer of bonds. The “obligor” is not the conduit borrower of proceeds, as provided by Treas. Reg. 1.1001-3(f)(6)(i). “Conduit loan” and “conduit borrower” have the same meanings as in Treas. Reg. 1.150-1(b). See Module G of the IRS training handbook (“Reissuances”) for a good description of the coordination of Treas. Reg. 1.1001-3 and Treas. Reg. 1.150-1, and change in obligors.
AM2014-009 (Dec. 9, 2014): Relies on the fact that a reissuance of tax-exempt bonds affects bondholders through no fault of their own, but a reissuance of direct pay build America bonds through defeasance is the “the issuer’s own fault” – so no preferred treatment seems to be warranted. Found that the tax-exempt bonds defeasance rule does not apply to taxable direct pay build America bonds.
Application of the Reissuance Rules to Qualified Tender Bonds:
IRS Notice 88-130 is the starting point for the reissuance analysis. Notice 88-130 states that, under regulations that were to be issued subsequent to Notice 88-130, a reissuance of bonds that are not qualified tender bonds occurs in certain specified instances, while a reissuance of bonds that are qualified tender bonds occurs in certain other specific instances. Thus, a reissuance analysis requires, as a first step, the determination of whether or not bonds are “qualified tender bonds.” The rules and regulations specific to qualified tender bonds must then be applied.
Notice 88-130 provided the initial definition of qualified tender bonds. That definition has been superseded by Section 3.2(1) of IRS Notice 2008-41, which redefines a qualified tender bond as a bond that has all of the following features: (1) for each interest rate mode authorized under the original bond terms, the bond bears interest at either a fixed interest rate or a variable interest rate (which must constitute a “qualified floating rate” under Section 1.1275-5(b) of the Regulations); (2) bond interest is paid unconditionally at periodic intervals at least annually; (3) the final bond maturity date is no longer than the lesser of 40 years or the latest date that is reasonably expected to carry out the governmental purpose of the bonds (this requirement is deemed met if the 120% rule is met under Section 147(b) of the Code); and (4) the bond is subject to an optional tender right or a mandatory tender requirement which allows or requires a bondholder to tender the bond for purchase in one or more prescribed circumstances under the terms of the bond.
Notice 88-130 refers to future regulations that are to more clearly address reissuance rules applicable to qualified tender bonds. Those regulations have not been established yet, even though regulations for non-qualified tender bonds were issued in 1997 as Treas. Reg. § 1.1001-3. Section (a)(2) of the regulations expressly provides that Treas. Reg. § 1.1001-3 does not apply for purposes of determining whether qualified tender bonds are reissued. Therefore, at least initially, the reissuance analysis for qualified tender bonds relies on the existing rules in Notice 88-130 (as amended or restated in subsequent notices, including Notice 2008-41).
Under Notice 2008-41, a qualified tender bond will not be treated as reissued or retired solely as a result of (1) a “qualified interest rate mode change” or (2) the existence or exercise of any “qualified tender.”
Notice 88-130 states that a qualified tender bond will be considered reissued or retired, among other reasons, if there is a change to the bond terms which would cause a disposition of the bond under Section 1001 of the Code without regard to the existence or exercise of the tender right. In addition, Notice 2008-41 points out that, in applying Treas. Reg. § 1.1001-3 to modifications of tax-exempt bonds, any interest variance directly resulting from a qualified interest rate mode change will not be treated as a modification under Treas. Reg. § 1.1001-3, and thus such interest rate variances need not be tested under the change in yield rule for determining significant modifications.
What the foregoing means is that: (1) while Treas. Reg. § 1.1001-3 initially does not apply to qualified tender bonds, the regulations are, in fact, relevant for qualified tender bond reissuance analysis; (2) Treas. Reg. § 1.1001-3 is applied to the qualified tender bonds by ignoring the existence or exercise of tender rights – whether mandatory or optional; (3) interest rate variances that result from qualified interest rate mode changes do not affect the reissuance analysis.
Qualified Floating Rate
Treas. Reg. 1.1275-5(b) defines the term “qualified floating rate” for purposes of the definition of “qualified tender bonds.” Under such subsection, a variable rate is a “qualified floating rate” if variations in the value of the rate can reasonably be expected to measure contemporaneous variations in the cost of newly borrowed funds in the currency in which the debt instrument is denominated. The rate may measure contemporaneous variations in borrowing costs for the issuer of the debt instrument or for issuers in general. For example, if at the end of one bank rate mode another bank rate mode is determined, such new bank rate mode would need to reflect the cost of newly borrowed funds at the time such new bank rate mode comes into effect. This could be established by some type of remarketing analysis under which a determination of the cost of newly borrowed funds is made.
Multiples: Note that the regulations state that a multiple of a qualified floating rate is not a qualified floating rate, except if the variable rate is equal to either:
- The product of a qualified floating rate and a fixed multiple that is greater than 0.65 but not more than 1.35; or
- The product of a qualified floating rate and a fixed multiple that is greater than 0.65 but not more than 1.35, increased or decreased by a fixed rate.
Caps, Floors, Governors: Also note that a variable rate is not a qualified floating rate if it is subject to a restriction on the maximum stated interest rate (cap), a restriction on the minimum stated interest rate (floor), a restriction on the amount of increase or decrease in the stated interest rate (governor) or other similar restrictions, unless the cap, floor or governor meets certain exceptions. For instance, a cap is permitted if the cap is fixed throughout the term of the debt instrument. This is often the case for municipal bonds that are subject to a certain maximum interest rate authorized by the issuer’s resolution. See Treas. Reg. 1.1275-5(b)(3) for more details.
Examples of “qualified foating rates”:
- The interest rate on the bonds (defined as the Bank Purchase Rate) is composed of (1) a qualified floating rate under (b)(1) of the regulations (e.g., LIBOR or the bank’s prime rate) * (2) fixed multiple of 67% (e.g., a tax factor) + (3) increased by a fixed rate (e.g., a ratings margin that is based on the then-current rating of the borrower). Is this a qualified floating rate under Treas. Reg. 1.1275-5(b)? Yes, it falls within the scope of subparagraph (b)(2)(ii).
- Another acceptable rate: LIBOR Index Rate = (a) product of (1) the Tax-Exempt Factor, multiplied by (2) the sum of (A) One-Month LIBOR plus (B) the Liquidity Premium, plus (b) the Credit Spread. This is a good floating rate assuming the Tax-Exempt Factor is within the 0.65 – 1.35 range. It is okay that the qualified floating rate component is increased by a fixed amount (the Liquidity Premium) if the fixed amount is needed to reflect cost of borrowing.
Alteration or Modification Results in Non-Debt:
A “modification” occurs if the alteration causes the instrument to no longer be debt for federal income tax purposes, even if the alteration occurs by operation of the original terms of the debt instrument. As described in Treas. Reg. 1.1001-3(e)(5)(i), such a modification is “significant.” For purposes of these rules, a deterioration in the financial condition of the issuer between the issue date and the date of the modification is NOT taken into account, unless there is a substitution of a new obligor or the addition or deletion of a co-obligor, as described in Treas. Reg. 1.1001-3(f)(7) and in the preamble to the final regulations (57 F.R. 32926 at 32929, T.D 8675). This provision is intended to soften the potential for an adverse income tax impact to a financially troubled issuer. (Note, however, that a deterioration should be taken into account for determining the status of a bond as “debt” where the bond is being refunded, not merely as a result of a reissuance but as a result of a true refinancing.)
The IRS has published proposed regulations Prop Regs 1.1001-3 to clarify the provision regarding deterioration in the financial condition of a debt instrument’s issuer. The proposed regulations explain how to analyze a change in yield in connection with the modification when part of the change in yield may be attributable to the change in financial condition of the issuer.
Change in Payment Expectations
A change in the reserve requirement for bonds may be a significant modification if there is a change in payment expectations.
Change in Timing of Payments:
In Rev. Rul. 73-160, 1973-1 C.B. 365, the IRS ruled that the extension of the maturity date of the debt instrument for an unspecified period coupled with an agreement by a holder to subordinate his claim to the claims of other holders was not a material modification constituting a taxable exchange. The IRS noted, however, that the formal means used to effect a change in terms is not controlling, so that material changes amounting virtually to the issuance of a new security will give rise to a taxable exchange whether or not a new security is issued.
An extension of a maturity date is not considered to be a significant modification unless it is a deferral of the timing of payments that is not within the safe harbor. This extension may affect the bond yield, however, and could result in a significant modification.
Under the safe harbor for deferral of payments, the deferred payments must be unconditionally payable by the end of the safe harbor period. The safe harbor period begins on the original due date of the first scheduled payment that is deferred and extends for a period equal to the lesser of five years or 50 percent of the original term of the bond.
Always test the yield of the modified instrument to determine whether the deferral causes a change in yield.
Impact on Issuers and Bondholders:
The reissued bonds will be subject to tax laws in effect at the time of reissuance. In a July 25, 2012 submission by NABL to the Treasury Department, NABL stated the following regarding impacts on bondholders: “Potential consequences of a reissuance include, among other things, a change in yield affecting arbitrage investment restrictions, acceleration of rebate payments, potentially new public approval requirements for qualified private activity bonds, deemed terminations for arbitrage purposes of integrated interest rate swaps under the qualified hedge rules and the required filing of a new information return. Moreover, reissuance can present a problem for certain types of bonds initially issued within a statutory deadline” such as bank qualified bonds under the special $30 million limit and build America bonds.
Bondholders will need to reflect the taxable exchange on their tax returns.
Questions and Answers:
- Forbearance Agreements: Under Treas. Reg. 1.1001-3(c)(4), notwithstanding the general rule regarding modification, “absent a written or oral agreement to alter other terms of the debt instrument, an agreement by a holder to stay collection or temporarily waive an acceleration clause or similar default right (including such a waiver following the exercise of a right to demand payment in full) is not a modification unless and until the forbearance remains in effect for a period that exceeds – (A) two years following the issuer’s initial failure to perform; and (B) any additional period during which the parties conduct good faith negotiations or during which the issuer is a title 11 or similar case.” Notiz 20120123
- Upon Reissuance, What is the Issue Price: Assuming a reissuance has occurred, someone will need to calculate the reissued bond’s yield in accordance with the basic yield rules in Treas. Reg. 1.148-4. Specific attention is required, however, in determining what issue price to use for the reissued bonds. Treas. Reg. 1.148-4(b)(1) says that the present value of the bonds is to be used for purposes of discounting. “Present value” is defined in subsection (e). Determination of present value is easy for plain par bonds – it is the outstanding stated principal amount. However, for bonds with, e.g., OID, present value must be determined under the economic accrual method taking into account various payments and OID allocated to past periods. In other words, one will need to go through the proper exercises to calculate the Adjusted Issue Price on the reissuance date. This means using Treas. Reg. 1.1275-1(b) and 1.1272-1(b)(4). The examples at 1.1272-1(j) are helpful. Notiz 20120202.
- Issue Price, generally, is defined in 1.148-1(b) as issue price as defined in sections 1273 and 1274. Section 1274 deals with debt instruments issued for property. “Debt instrument” obviously refers to the refunding bonds. “Property,” in the reissuance situation, constitutes the refunded bonds. Therefore, Section 1274 applies. See also Section 1273(b)(4). Bonds are intangible personal property under traditional law concepts. Under Treas. Reg. 1.1274-2(b), issue price is calculated in various ways, depending on whether or not there is adequate stated interest. As a rule of thumb, there is always adequate stated interest if the interest rate on the bonds is at least as much as the AFR.
- Assume bonds have a nominal maturity of 30 years. Cash flows show that the bonds are expected to actually mature in 20 years. The bondholders likely based their investment decision on the 20 year maturity. Assume the issuer wants to change the investment parameters to extend the actual maturity from 20 years to 24 years, and make some kind of compensation payment to the bondholders to prevent the yield from changing more than 25 basis points. Does this cause a reissuance? No, look to the facts and circumstances. It is reasonable to assume the 20-year maturity and then to apply the usual yield and deferral of payments rules.
- Upon reissuance, should feasibility studies be retested (to determine debt vs. equity questions)? Generally, in connection with refunding bonds, one would need to retest the debt equity matter to determine reasonableness of repaying the bonds. The original bonds must have satisfied the test and the refunding bonds must satisfy the test. However, if the reissuance occurs as a result of a modification that is significant, there is no need to retest under Prop. Reg. 1.1001-3 unless there is a substitution of the obligor or deletion of a co-obligor, or unless there is a guaranty that is being changed. See this Alston + Bird publication on retesting debt standards. The proposed regulations were finalized in 2011. See T.D. 9513 (February 22, 2011).
- Guarantee: Assume a bond issuer is experiencing trouble making debt service payments and a guarantee is called on to make payments. Assume also that the issuer decides to refund the bonds to a lower interest rate and that, for the initial periods, interest on the refunding bonds will continue to be paid from calls on the guarantee. Does the payment cause private loan financing problems? Is the interest paid with proceeds of the guarantee still eligible for tax exemption?
- Assuming the guarantee is provided by the developer/benefitted entity, the payment of the guarantee payments constitute repayments of a private loan.
- During the period that interest is paid with proceeds of the guarantee calls, the interest on the bonds is not eligible for tax exemption because it is not interest paid by a governmental issuer with respect to an obligation.
- Change in Optional Redemption Date: Is a modification of the optional redemption date a significant modification? In PLR 9844021, modifications involving interest, repayment, security and redemption rights conferred such legally distinct entitlements in the bondholders that the modifications results in an exchange of the bonds. All facts and circumstances probably need to be considered. In Emery v. Commissioner, 166 F.2d 27 (2d Cir. 1948), the court concluded that a reissuance had occurred based on the “different financial value” of the new obligations.
Rev. Rul. 81-169, 1981-1 C.B. 429: A reduction in interest rate from 9% to 8.5% coupled with a 10-year extension of the instrument’s maturity date constituted a material modification giving rise to a taxable exchange.
Rev. Rul. 89-122, 1989-2 C.B. 200: A material modification resulting in deemed exchange found where either: (1) reduction of annual rate of interest from 10% to 6.25%; or (2) reduction of principal amount of $1 million to $650,000.
AM 2012-004 (June 2012): In generic legal advice, the IRS concluded that the dissolution of a state’s redevelopment agencies and the transfer of all their authority, rights, powers, duties and obligations to successor agencies doesn’t result in a reissuance of tax-exempt bonds and BABs previously issued by the dissolved redevelopment agencies.
PLR 8714034 (Jan. 2, 1986): No reissuance upon change to amortization schedule under rulining preceding Notice 88-130.
PLR 201149017: Conversion of build America bonds to a new term rate won’t cause a reissuance.
FSA 200116012: Confusing facts, but generally helpful discussion of basic reissuance matters. The June 2001 edition of The Bond Lawyer summarized this advice as follows: “In FSA 200116012 (January 5, 2001), the IRS found that the financial benefit received by an issuer in connection with alterations of the terms of certain tax-exempt bonds, including payments received by the issuer from a bondholder through a below market price on a refunding escrow fund, were material changes in the bond yield that gave rise to a reissuance of the bonds under then-applicable law before the effective date of the present regulations under Reg. §1.1001-3. The changes to the bond terms included identification of certain specific bonds to be redeemed instead of leaving that to a lottery process. In this FSA, the IRS interpreted the longstanding general materiality standard for reissuance under Reg. §1.1001-1(a), which provides that whether an exchange of property is a disposition depends on whether the properties exchanged differ materially either in kind or extent. The IRS relied in part on the broad reissuance standard set forth by the Supreme Court in Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991). The unclear breadth of the Cottage Savings standard, often called a “hair trigger” reissuance standard, largely led to the present Section 1001 reissuance regulations under Reg. §1.1001-3. For anyone interested, this FSA has a good discussion of the applicable law on debt reissuance before such present Section 1001 regulations.”