Refunding of Conduit Financing Issues

February 22, 2013

General Discussion:

Treas. Reg. 1.150-1(d)(2)(iii) provides the following:

(A) Refunding of a conduit financing issue by a conduit loan refunding issue. Except as provided in paragraph (d)(2)(iii)(B) of this section, the use of the proceeds of an issue that is used to refund an obligation that is a purpose investment (a conduit refunding issue) by the actual issuer of the conduit financing issue determines whether the conduit refunding issue is a refunding of the conduit financing issue (in addition to a refunding of the obligation that is the purpose investment).

Example Applications:

Assume on date X the governmental authority (the “Authority”) issues bonds (the “Authority Bonds”) and uses the proceeds thereof to fund a loan (the “Loan”) to a town (the “Town”).  On the same date, the Town issues its “governmental agency bond” to the Authority to secure the Loan.  Many years later, on date Y, the Town decides to pay off the Loan.  To do so, it issues refunding bonds (the “Refunding Bonds”) and uses the proceeds to redeem the governmental agency bond.

Under Treas. Reg. 1.150-1(d)(2)(iii), when the Town uses proceeds of the Refunding Bonds to redeem the governmental agency bond, the Authority can either (1) use those proceeds to refund its own Authority Bonds or (2) “recycle” those proceeds to make future Loans if certain conditions are satisfied.

Now, assume the Authority Bonds aren’t callable within 90 days and the Authority can’t “recycle” the proceeds.  In this case, the Authority will need to advance refund the Authority Bonds.  This could be a problem if the Authority theretofore already advance refunded the Authority Bonds once.  By permitting the Town to pay off the governmental agency bond with cash only (and not with a Refunding Bond issue), the Authority is protecting its ability to conduct advance refundings of the Authority Bonds.

Commercial Paper Provisions

December 12, 2012

Provisions Relevant to Commercial Paper Financings:

Treas. Reg. 1.150-1(c)(4)(ii):  Special rule to determine an “issue” of commercial paper

Treas. Reg. 1.149(e)-1(e)(2)(ii):  Special rule for determining what the issue of commercial paper is for purposes of information reporting

Notice 2011-63:  Discusses issue date determination for draw down loans and commercial paper (among others)

Notice 2011-63:

Under Notice 2010-81, the IRS determined that bonds are considered issued on the “issue date” of the particular bond, not the “issue date” of the issue of bonds.  The IRS subsequently received comments stating that this definition of issue date for purposes of, e.g., volume cap administration, is not workable and is inconsistent with prior interpretation of the issue date rules.  For instance, it is impractical for draw-down loans and commercial paper, which might be issued in various years – each time a draw is made or each time the commercial paper is issued.  In Notice 2011-63, the IRS corrects its determinations in Notice 2010-81 and provides that an issuer may now treat a bond as issued in either of the following cases:

  1. on the issue date of the bond under the general (problematic) interpretation of Notice 2010-81; or
  2. on the issue date of the issue so long as the issuer meets the following additional requirements:
    • all of the bonds of the issue must be issued no later than the earlier of:
      • the statutory deadline for issuing the bonds; or
      • the end of the maximum carryforward period for unused volume cap under the applicable statute, treating all of the unused volume cap for the issue as volume cap arising in the year in which the issue date of the issue occurs.

If the second alternative is used, the issuer must make a special marking on the IRS Form 8038/-G information return to identify the use of the alternative for, e.g., draw-down bonds or commercial paper.

Note that, for example, “if the bonds were small issue bonds under § 144(a), the alternative option would not be available because under § 146 there is no carryforward period for unused volume cap for small issue bonds.”

Single Issue

February 7, 2012

General Rules:

The single issue determination addresses “substance over form” concerns.  The issue determination is primarily relevant for determining whether bonds can be included in a single-yield computation. Bonds treated as part of a single issue under the test below will be so treated for purposes of the arbitrage rules and for purposes of the limits on issue size for small issues of IDBs under Section 144.

Under Treas. Reg. 1.150-1(c), “issue” means two or more bonds that meet all of the following requirements:

  1. Sold at substantially the same time;
  2. Sold pursuant to the same plan of financing;
  3. Payable from the same source of funds.
Note that all of these requirements must be met in order to treat two or more bonds as the same issue.  This test applies for all purposes of the tax laws relating to tax-exempt bonds (i.e., also for purposes of the arbitrage rules and limits on issue size for small issues of IDBs under Section 144 of the Code).
TAM 200424003:  Whether Series A Bonds and Series B Bonds are a single issue under Treas. Reg. 1.150-1(c).  The Service concludes that the series must be treated as one issue to clearly reflect the economic substance of the transaction and prevent avoidance of Section 148 of the Code.

Sold at Substantially the Same Time:

Bonds are treated as sold at substantially the same time if they are sold less than 15 days apart.  The sale date is not the issue date.  Instead, it is the date on which there is a binding contract in writing for the sale or exchange of the bonds (e.g., signing of the bond purchase agreement).  See this report for a discussion of sale date and related matters for private placements:

Sold Pursuant to Same Plan of Financing:

Factors material to the plan of financing include the purposes for the bonds and the structure of the financing.  The regulations provide the following examples:

  • Bonds to finance a single facility or related facilities are part of the same plan of financing;
  • Short-term bonds to finance working capital expenditures and long-term bonds to finance capital projects are not part of the same plan of financing;
  • Certificates of participation in a lease and general obligation bonds secured by tax revenues are not part of the same plan of financing.

Payable from the Same Source of Funds:

The bonds must be reasonably expected to be paid from substantially the same source of funds, determined without regard to guarantees from parties unrelated to the obligor.

Separate Issue Election:

Treas. Reg. 1.150-1(c)(3) contains a separate election provision under which a single issue under the general rule can be treated as separate issues for certain purposes.  This separate issue election does not apply for purposes of I.R.C. 141, 144(a) (Qualified small issue bond), 148 (Arbitrage), 149(d) (Advance refundings) and 149(g) (Treatment of hedge bonds).

Until the proposed regulations in Treas. Reg. 1.141-13 came out, there was a concern that Treas. Reg. 1.141-13(d) did not permit a multipurpose issue allocation of an issue consisting of PABs and governmental bonds.  The fourth sentence in Treas. Reg. 1.141-13(d)(1) states that (1) the issue to be allocated, and (2) each of the separate issues under the allocation, must consist of tax-exempt bonds.  While the second part of the sentence is “workable” since the intent of the allocation is to prove that each portion can be its own issue of tax-exempt bonds, the first part of the sentence does not seem to make sense.  The election is made precisely because the issue as a whole cannot be a tax-exempt bond issue.  The proposed regulations revise the sentence to read as follows, which clarifies the rule: “Each of the separate issues under the allocation must consist of one or more tax-exempt bonds.”

Tax-Advantaged Bonds:

Each type of tax-advantaged bond that has a different structure for delivery or the borrowing subsidy or different program eligibility requirements is treated as part of a different issue under Treas. Reg. 1.150-1(c).  See proposed regulations issued September 16, 2013, REG-148659-07.

Discussions of Frequently Asked Questions:

  • Taxable Bonds:  Are taxable bonds and tax-exempt bonds part of the same issue? Under paragraph (2) of the regulations, taxable bonds and tax-exempt bonds are not part of the same issue. The issuance of tax-exempt bonds in a transaction (or series of transactions) that includes taxable bonds, however, may constitute an abusive arbitrage device under Treas. Reg. 1.148-10(a) or a device to avoid other limitations, and as a result, the IRS could determine that a single issue exists despite the taxable and tax-exempt natures of the separate bonds.
  • Draw Down Bonds:  What are the special “issue” rules for draw down bonds? See Treas. Reg. 1.150-1(c)(4) and see the draw down bonds entry elsewhere in this blog.
  • Senior Lien vs. Junior Lien Bonds; Separate Purposes:  If a series of Senior Lien and a series of Junior Lien Bonds are issued within 15 days of one another, should these bonds be considered one issue for federal income tax purposes, considering the following: (1) both series of bonds are paid from a pledge of the same revenues; and (2) one series is intended as a current or advance refunding issue and the other series is intended as a new money project issue? It would be reasonable to conclude that these series would constitute a single issue.
  • BABs (direct pay), “traditional” taxables, tax-exempts:  Three issues or one, assuming same source of funds and plans of finance?  This was subject of a lengthy discussion in June 2009 among Section 103 tax attorneys.  See that discussion.
  • Refunding Bonds and New Money Bonds Sold on the Same Day:  [To come]


See MtF “Single Issue” (20120625)

Draw-Down Bond Matters

January 25, 2011

Issues Re: Draw-Down Loans:

A.  Information Reporting Requirements (1.149(e)-1(e)):

Generally, interest on a bond is included in gross income unless proper information reporting is accomplished with respect to the issue of which the bond is a part.  In a draw-down situation, the relevant question becomes: “what is the issue?”

Under (e)(2), the issue is defined, for information reporting purposes only (!), as bonds issued during the same calendar year. However, under (e)(2)(ii)(B), if the bonds issued pursuant to a draw-down loan meets the requirements of the first sentence of (B) (equally and ratably secured under a single indenture, etc.), bonds may be treated as the same issue even if issued during different calendar years, so long as all amounts to be advanced pursuant to the draw-down loan are reasonably expected to be advanced within three years of the date of issue of the first bond.

Note the special information reporting rules described in IRS Notice 2011-63 for bonds and draw-down loan bonds that have volume cap assigned to them.  The issue date for these bonds may be either the issue date of the bond or the issue date of the issue. If the election is made to use the issue date of the issue, the 8038 should include the phrase “FILED IN ACCORDANCE WITH NOTICE 2011-63 STATE AND LOCAL BONDS: VOLUME CAP AND TIMING OF ISSUING BONDS.”

B.  What is the “issue” and “issue date” of bonds issued pursuant to a draw-down loan?

Section 1.150-1(c)(4)(i) states that bonds issued pursuant to a draw-down loan are treated as part of a single issue.  The issue date of that issue is the first date on which the aggregate draws under the loan exceed the lesser of $50,000 or 5 percent of the issue price.  Notice 2010-81 clarifies that this is the approach to use to determine the issue date of bank qualified (QTEO) and 2% de minimis bonds.

C.  Are draws after 2010 on QTEO issued in 2009 or 2010 eligible for QTEO status ?

There has been discussion concerning what constitutes the issue date of bonds for determining BABs status or QTEO (bank qualification) status of draws made on such bonds after the ARRA provisions expired.  In Notice 2010-81, the IRS determined that, for purposes of determining whether a draw qualifies for BABs treatment, the applicable “issue date” is the date of the actual draw (i.e., the date of the bond resulting from the draw).  However, for purposes of determining whether such a draw qualifies for bank qualification under the ARRA rules, the IRS permits the issuer to use the issue date of the total issue (vs. issue date of the bond resulting from the draw). This means, if a draw-down loan and the related issue is properly issued in 2010, but a subsequent draw occurs in 2011, for purposes of determining that the draw falls within the ARRA QTEO rules, one looks to the issue date of the “issue,” and not the bond resulting from the draw.  See the McGuire Woods discussion of Notice 2010-81 linked here.

D.  In connection with a refunding/new money financing, may a draw-down for refunding establish the issue date, or does the draw-down need to be in respect of new money?

Some bond counsel have determined that the draw-down must be in respect of the new money portion.  A draw to cover the refunding is not sufficient. The 5 percent or $50,000 test is calculated using the full issue price, however (not the portion of the issue price allocable to the new money project).  Other bond counsel read the rule as permitting the initial draw with respect to the refunding without the need to draw on the new money portion as well.

E.  When you make the first draw, and also pay all costs of issuance, those COI may exceed 2% of the first draw. Is this a problem?

This topic was discussed at the 2011 TSLI in Austin, Texas. A March 11 NABL Weekly Wrap had the following to report concerning the matter: “The panel also focused on the requirements for filing Form 8038 when a bond is set up for draw-downs, as in a construction finance situation, and has a volume cap, and addressed the broad concern about Notice 2010-81, issued late last year. Panel Chair Linda Schakel, noted that in a construction situation, when the drawdown is in increments, the costs of the issuance would exceed two percent. Co-panelists John Cross of the IRS Office of Tax Policy, and Clifford Gannett, manager of the TEB Division at IRS, reassured the audience that the IRS and Treasury are working to clarify this before the filing season to avoid amended returns.”

While it may be safest not to permit more than 2% of each draw to be used for costs of issuance, facts and circumstances may suggest that increased percentages from initial draws are acceptable.    Factors to consider are whether a given draw will attempt to include the full 2% costs of issuance amount calculated based on the aggregate of all draws or whether the costs of issuance “overage” for a particular draw is small.  One might also include a covenant in the tax document requiring consultation with bond counsel in the event all expected draws do not occur to facilitate timely final allocation of bond proceeds away from costs of issuance.

F.  Issue date for QTEO draw-down bonds and Volume Cap: Conflicts in interpreting issue date?

From a recent IRS future guidance notice of December 2010: “Notice 2010-81 provided guidance regarding when State and local bonds are considered issued for purposes of various timing deadlines on issuing bonds. Issuers who entered into draw-down loans or commercial paper programs in 2010 before the release of Notice 2010-81 on November 23, 2010 or in earlier years and who acquired private activity bond volume cap under section 146 for the entire loan or program under the assumption that all of the bonds were issued in the year that draws under the loan or program exceeded $50,000 or larger, have expressed to the IRS and Treasury Department concerns that States have taken different approaches towards the treatment of such draws for volume cap purposes under section 146.  States and issuers have indicated that changing the different approaches to volume cap in this area presents administrative difficulties.  A complicating issue with respect to such volume cap awards is that the awards in 2008, 2009, and 2010 may include volume cap from the temporary $11 billion increase in annual private activity bond volume cap established under the Housing Assistance Tax Act of 2008 (See Notice 2008-79).  That temporary volume cap is not available after 2010.”

Relevant Private Letter Rulings and other Publications:

PLR 200147015: The issue date of a bond pursuant to a draw down is the date the interest actually begins accruing. The total project issue will not be issued earlier than necessary for purposes of 1.148-10(a)(4) (overburdening the tax-exempt market). In this letter ruling, the IRS approved the issue date determination and draw-down structure where funds were going to be drawn down over a five-year period.

Rev Rul 89-70 (1989) 1989-1 CB 88: Draw-down note is considered issued, for purposes of 26 USCS § 265(b), on date that more than de minimis amount is first advanced under note; amount of draw-down note is its stated principal amount.

Issue Date

December 21, 2010

IRS Guidance Regarding Issue Date for Draw Down Loans

In November 2010, the IRS released Notice 2010-81 (the “Notice”) relating to “Build America Bonds and Other State and Local Bonds: Timing of Issuing Bonds.” The Notice divides the treatment of issue date for drawdown loan purposes into two categories:

  1. Draw down loans for which the statute specifies an issue date for a bond; and
  2. Draw down loans for which the statute specifies an issue date for an issue.

Build America Bonds (and similar bonds), which depend on the issue date for a bond, must therefore be drawn down by December 31 to retain treatment as build America bonds.

Bonds relying on the non-AMT provision in ARRA are bonds subject to the issue date for a bond rule in that Section 56(g)(4)(B)(iv) refers to “bond” issue.  Therefore, draws before January 1, 2011 would be non-AMT, while draws after December 31, 2010 would be subject to AMT.

Section 265, on the other hand, which depends on the issue date for an issue, will be covered by the law applicable when an amount at least equal to the lesser of $50,000 or 5% of the bonds are drawn down.

Harbor Bancorp “Issue Date” Case

In the Harbor Bancorp case (105 T.C. No. 260), the tax court addresses whether bonds were issued on December 31, 1985 or in 1986.  The court cites Treas. Reg. 1.103-13(b)(6), which states that ‘”Date of issue” is defined as the date on which there is a physical delivery of the evidence of indebtedness in exchange for the amount of the issue price.  For example, obligations are issued when the issuer physically exchanges the obligations for the underwriter’s (or other purchaser’s) check.’  In Harbor Bancorp, on December 31 the parties drew up documents evidencing the indebtedness, but the obligations did not have substance behind them until February 1986 when actual funds were transferred from the bondowners.  The court concluded that “mere” documents evidencing the indebtedness are not necessarily enough if the facts and circumstances show that the exchange hasn’t truly occurred.  “Neither the share drafts nor the investment agreements had substance behind them.  These items fell embarrassingly short of representing actual payment for the Bonds within the meaning of the Commissioner’s regulations.  Accordingly, the date of issue of the Bonds was not December 31, 1985, but rather February 20, 1986, when actual funds were transferred from Security Pacific Bank to Chase Manhattan Bank and subsequently to Heritage, to the credit of the developer partnerships and then to Unified.  Because the Bonds were issued after December 31, 1985, section 148(f) applies.”

Matthews & Wright “Issue Date” Case

In SEC v. Matthews & Wright proceedings from the mid-1980s, the SEC found that $300 million of tax-exempt multifamily rental housing for the Territory of Guam had not been “issued” when claimed by the parties in late 1985 because payment had been made in the form of a check by a credit union which had insufficient funds to cover the check.  The finding in that case was that the bonds were truly issued in 1986 when the funds to honor the check were available.  The issue in that case was that the underwriter retained positive arbitrage earnings and the bonds from the construction escrow, which would have been permitted under pre-1986 rules but not under post-1985 rules) were declared taxable arbitrage bonds.

Draw Down Bond Concern

Assume the issuer would like to issue a series of bonds in December 2010 and another series of bonds in January 2011, and the bonds are sold pursuant to the same offering document.  Also also that both series of bonds are sold to the same purchaser, but that one series is delivered in December 2010 and the other in January 2011.  The series are being issued in separate years in order to achieve “qualified tax-exempt obligation” status (I.R.C. 265(b)(3)) for each series.  For purposes of 103 and 141-150, under Treas. Reg. 1.150-1(c), the series are treated as a single issue.  It is not clear that this treatment, however, flows to the I.R.C. 265(b)(3) designation limitations.  I.e., despite the single issue treatment under sections 103 and 141-150, are they nevertheless separate designations for I.R.C. 265(b)(3) purposes? There would be a concern in this situation that both series are treated as a draw down bond even for I.R.C. 265(b)(3) purposes with an issue date/designation date in the same year.  To avoid this issue, bond counsel might still allow sale pursuant to the same offering document and sale on the same date as long as the purchasers in negotiated deals are different (i.e., not the same purchaser, who might agree to buy the 2011 series when issued).  This matter is not relevant in a competitive transaction since there the facts more clearly indicate that a draw down structure is not contemplated.

[Other materials to be added, as necessary]

Refundings (Advance and Current)

October 19, 2010

General Rules:

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).

Current Refunding: When proceeds are used to retire or call other bonds within 90 days after the date of issuance of the refunding bonds.

Advance Refunding: When proceeds are used to retire or call other bonds more than 90 days after the date of issuance of the refunding bonds.  If the refunded bonds were issued before a certain date, 180 days applies instead of 90 days.  If any of the bonds of a refunded issue are called or retired more than 90 days (or 180 days, if applicable) after the date of issuance, the entire refunding becomes an advance refunding.

“Steps in the Shoes” Rule:

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:

In the case of an issue of obligations issued to refund the outstanding face amount of an issue of obligations, the proceeds of the refunding issue will be considered to be used for the purpose for which the proceeds of the issue to be refunded were used.  The rules of this subparagraph shall apply regardless of the date of issuance of the issue to be refunded and shall apply to refunding issues to be issued to refund prior refunding issues.

Advance Refunding Checklist:

This list identifies certain matters that must be reviewed prior to closing an “advance refunding” obligations issue.  The list will be updated periodically.

  1. SLGS:  SLGS (State and Local Government Series securities) must be ordered at least five to seven days [previously up to 15 days] prior to the closing.  (Note: If the issuer purchases open market Treasuries instead of SLGS in order to reduce the negative arbitrage that is inherent in SLGS, and if the Treasuries result in excess yield, the issuer must invest in other permitted investments, e.g., roll over into SLGS in order to blend the yields to an acceptable level permitted by the arbitrage rules.  However, when the SLGS window is closed, investment must be made in other permitted investments. The issuer must then make special yield reduction payments to the Treasury.  Not investing the money is not an option – the IRS imputes interest earnings on uninvested bond proceeds.)  Regulations concerning SLGS are found in Part 344 of Title 31 of the Code of Federal Regulations.  Once SLGS are subscribed, there is generally no opportunity to cancel or amend (with some exceptions) the subscription without incurring a six-month black-out penalty or certain penalty assessment fees.  The regulations do not describe a process for notifying the Bureau of Public Debt of a SLGS cancellation.  A written notice signed by the issuer specifying the Treasury Identification number and acknowledging the penalty may need to be faxed to the Bureau of Public Debt.  See Notiz 20130114 for details.
  2. First Call Date:  If the refunding of prior bonds may produce present value savings, the prior bonds must be called on the first call date (the “First Call Rule”). Section 149(d)(3)(A)(ii) and (B)(i).
  3. No Advance Refunding for Most PABs:  Private Activity Bonds may NOT be advance refunded unless they are qualified 501(c)(3) bonds. Section 149(d)(2).
  4. No Inheritance of Bank Qualification:  Bank qualification may be “inherited” under certain circumstances described in Section 265(b)(3)(C) and (D).  Such inheritance, however, is not permitted for advance refunding bonds.
  5. One Advance Refunding:  Bonds that may be advance refunded may generally be advance refunded only once. Section 149(d)(3)(A)(i). But note that an advance refunding issue that is not tax-exempt is not taken into account for that rule unless such advance refunding is pursued to avoid the limits of Section 149(d).  Section 1.149(d)-1(e)(1).
  6. Yield Restriction:  The yield on investment of proceeds of an advance refunding issue cannot be more than 0.001 percent above the yield on the refunding issue.  In other words, such proceeds are subject to the yield on the refunding issue, not the refunded issue.  If the refunding issue is a variable rate issue, one would generally use the lowest possible rate for the limitation.  If, however, the initial rate on the refunding issue is fixed for the period until discharge of the refunded bonds, that fixed rate can be the limitation.
  7. Unspent Proceeds:  Any unspent proceeds of the prior issue become “transferred proceeds” of the refunding issue when the prior issue is retired in the case of either an advance refunding or a current refunding.
  8. Excess Gross Proceeds:  Treas. Reg. 1.148-10(c) proscribes “excess gross proceeds” in connection with an advance refunding.  Existence of excess gross proceeds gives rise to an abusive arbitrage device and causes the refunding bonds to be arbitrage bonds, unless certain conditions in paragraph (2) of the regulations section are met.  Usually, bond counsel cover this aspect in the tax document by stating that all gross proceeds will be used in the manner described in the relevant section of the tax document.  Other bond counsel have proposed that the text of the regulation be summarized as a certification of the issuer. Notiz 20120125.  See also “Questions and Answers” below.
  9. Mixed Escrows:  There are several mixed escrow rules. See chapter 8B of Ballard, ABCs or Arbitrage.  Revenues contributed to a mixed escrow from a bona fide debt service fund for the prior issue must be “allocated to” – that is, treated as used to purchase – the earliest maturing investments in the mixed escrow (policy: funds originally held for a short-term purpose will continue to be used for essentially the same short-term purpose).  See the mixed escrow note below.

Types of Refundings:

  1. Net Refunding/Defeasance: This is the most common form of refunding.  Here, the original proceeds plus income from investments pays the interest on the prior bonds and their principal at maturity or on redemption.  Government obligations (usually treasuries) are bought in the open market (if they can be purchased at FMV at or below the bond yield) or SLGS, if available.
  2. Crossover Refunding:  Here, the income from investment of the refunding proceeds pays interest on the refunding bonds until a crossover date.  Before the crossover date, the debt service on the prior bonds is paid from the issuer’s revenues, and the debt service on the refunding bonds is payable from the income from investment of the refunding proceeds.  On the crossover date, the refunding proceeds pay the principal of the prior issue.  A crossover refunding might be beneficial if the investment yield permitted to the issuer is not available in the current market in any form of investment that would be eligible to defease the prior bonds in a net refunding (e.g., the escrow fund needs to be funded with money market funds, while outside of the escrow fund the refunding proceeds might be invested at a higher yield).  [This is a strategy to address contractual requirements – not to circumvent a federal tax requirement.]  Note that the crossover refunding structure is an exception to the excess gross proceeds restriction in Treas. Reg. 1.148-10(c)(5).  Excess gross proceeds may be used to pay interest that accrues on the refunding issue before the prior issue is discharged.  No gross proceeds of any refunding issue may be used to pay interest on the prior issue or to replace funds used directly or indirectly to pay such interest.
  3. Gross Refunding/Full Cash Defeasance:  Here, the refunding proceeds pay both principal and interest on the prior bonds without using investment income from the refunding proceeds, and the investment income pays debt service on a portion of the refunding bonds.  There is an excess gross proceeds issue with such gross refundings.  A gross defeasance is usually undertaken only if a defeasance of the refunded bonds is required and typically only if the prior bond resolution requires an initial deposit to the escrow of the full amount of the principal of and interest and call premium on the prior bonds, disregarding any interest that may be earned on the refunding escrow.  This method is not used frequently anymore because of complex investment and issuance rules that limit the benefits of such a transaction.  A full cash defeasance under post-November 1992 documents requires a ruling from the IRS.  (Note that this rule comes from Treas. Reg. 1.103-15(c), which was removed by the 1993 regulations.  So, if you don’t have bonds subject to these old regulations, this ruling requirement should not apply.)

Reasons to Refund:

  • To achieve debt service or interest cost savings: E.g., if rates in the market have dropped;
  • To restructure cash flow to obtain benefits;
  • To eliminate restrictive covenants in indentures or other documents: This may not be relevant for general obligation bonds which often don’t have any meaningful covenants.

Consequences of Not Being a Refunding:

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.

Transferred Proceeds:

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.

Mixed Escrows:

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:

  • Refunding issue proceeds are subject to yield restriction based on the yield of the refunding issue.  When these proceeds are used to pay debt service on the refunded issue, they will “trigger a transfer of any unspent proceeds of the prior issue.” (Ballard 171)
  • Prior issue proceeds are subject to yield restriction based on the yield of the prior issue, unless and until they transfer to the refunding issue, at which point they become subject to the yield of the refunding issue.
  • Revenues become replacement proceeds of the prior issue if the issuer contributes them to be used to pay off the prior issue, which means that these revenues are subject to yield restriction at the yield of the prior issue.

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.

The mixed escrow rules provide for the following requirements:

  • Revenues contributed to a mixed escrow from a bona fide debt service fund for the prior issue must be allocated to (treated as used to purchase) the earliest maturing investments in the mixed escrow.
  • Prior issue proceeds contributed to a mixed escrow from a project fund for the prior issue are subject to the same requirement of allocation to the earliest maturing investment.
  • Prior issue proceeds contributed to a mixed escrow from a reserve fund for the prior issue must be spent “ratably” with the refunding issue proceeds as to both sources and uses.
  • Revenues contributed to a mixed escrow fund from sources other than a bona fide debt service fund must be spent at least as fast as the refunding issue proceeds.

Advance Refunding Issues that Employ Abusive Devices:

An advance refunding escrow is an abusive device, if, among other things:
  1. 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;
  2. The yield on the tax-exempt bonds exceeds the yield on the advance refunding issue;
  3. 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
  4. 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.

SLGS Matters:

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. The payment to the United States is made not later than 180 days after the date of purchase of the alternative investment.
  6. 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.
  7. 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?

Different Obligors:

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 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.

Questions and Answers:

  • Using refunding bond proceeds to pay the conduit issuer’s annual fee and a penalty fee: Payment of the annual fee is treated as interest, and the penalty fee (e.g., one year of annual fees) is simply a cost of completing the refunding. Both can be paid with proceeds of the refunding bond. Notiz 20111227.
  • What is a typical abusive transaction:  Fundamentals of Municipal Bond Law – 2007, on page 84, explains the issue as follows: “If an advance refunding issue is issued on a taxable basis, then such issue generally is not treated as an advance refunding issue for purposes of the Section 149(d) restriction on the number of advance refundings, unless such taxable issue is issued to avoid such limitation.  For example, if the taxable advance refunding issue is part of a series of refundings, is succeeded by a tax-exempt current refunding issue, and such tax-exempt current refunding issue and another tax-exempt issue in the series remain outstanding more than 90 days after the issuance of the tax-exempt current refunding issue, then the taxable advance refunding issue will be counted for purposes of the Section 149(d) restriction.”  In other words, if the first tax-exempt issue is advance refunded by the taxable loan, and within the escrow period a new tax-exempt current refunding refunds the taxable loan, the taxable advance refunding is counted as a “refunding” for purposes of Section 149(d).
    • See TAM 200424003:  Addresses the anti-abuse rules under Treas. Reg. 1.148-10 and the abusive transactions prohibition in Section 148(d)(4) of the Code relating to advance refundings.
  • Advance refunding of bonds originally issued in, e.g., 1983: Assume improvement bonds were issued in 1983, advance refunded in late 1986, current refunded in 1992 and current refunded in 2004.  May the 2004 bonds allocated to the 1983 bonds be advance refunded? Yes, because, under Section 149(d)(3)(A), the advance refunding in 2004 would be the “2nd” advance refunding of a bond that was issued before 1986.  See also Module C (“IRC Section 149”) of the Phase I IRS Tax Manual.
  • What to do with left over debt service funds of the prior issue: Consider the excess gross proceeds discussion in TAM 201538013.
  • How long may moneys be left uninvested:  Assume in a current refunding the issuer does not want to purchase investments because the purchase fee is too high, and instead wants to leave the moneys uninvested in the escrow fund until payment.  How long may the moneys be left uninvested?  If moneys are left uninvested too long, the IRS will impute interest.  Imputed interest could cause problems for the 2% costs of issuance limitation (if the imputed interest causes the 2% limit to be exceeded), or could be considered to be imputed working capital.  Some bond counsel prefer that moneys not be left uninvested for more than 15 days.  A 15-day period may be okay considering the need for moneys on monthly basis to pay interest.  Longer periods should be avoided.  See also the tax rules on abusive arbitrage devices including overissuance concerns.