New Money Capital Expenditures and Reimbursement
Unlike Tax Credit BABs which generally can be issued to fund any purpose for which tax-exempt governmental (not PAB) bonds could be issued under the Code, the uses of Direct Pay BABs are limited to new money capital expenditures. They may not be issued to refinance capital expenditures in refunding issues. However, under Notice 2009-26, proceeds of Direct Pay BABs may be used (a) to reimburse otherwise eligible capital expenditures and (b) to refinance temporary short-term capital expenditure governmental financings issued after February 17, 2009. See Kutak Rock, Release Concerning Build America Bonds Notice 2009-26. In other words, the rule appears to be as follows:
- General Rule: Proceeds of Direct Pay BABs must be used for a “governmental purpose” for which tax-exempt governmental bonds can be used, and proceeds must be used only for capital expenditures and to fund a 4-R fund. Working capital cannot be financed (but can be financed, in a de minimis amount, with Tax Credit BABs). “Capital expenditures” includes the reimbursement of capital expenditures under the usual reimbursement rules of Section 1.150-2 of the Regulations.
- Limitation: Notwithstanding the general rule, Direct Pay BABs may not refinance a prior issue even if the prior issue financed capital expenditures, except that Direct Pay BABs may refinance prior temporary short-term financing (a) issued after February 17, 2009 for (b) capital expenditures paid or incurred after February 17, 2009. There is no clear guidance on what constitutes “short-term financing,” but there are indications that such short-term financing includes financing that has a maturity of no greater than one year.
Calculating the Maximum Debt Service Reserve Fund Amount
The Recovery Act provides that a “qualified bond,” for purposes of the direct payment provision under section 54AA(g)(2) of the Code, is a “Build America Bond” (under section 54AA(d) of the Code) issued as part of an issue if (A) 100 percent of the excess of (i) the available project proceeds (as defined in section 54A) of such issue, over (ii) the amounts in a reasonably required reserve (within the meaning of section 150(a)(3) of the Code) with respect to such issue, are used for capital expenditures, and (B) the issuer makes an irrevocable election to have such section apply. Section 6431(g) of the Code, relating to the mechanics of the direct payment, provides that the yield on a qualified bond must be reduced by the amount of the direct payment for purposes of the arbitrage rules in section 148 of the Code. Therefore, the conservative approach to calculating the maximum DSRF amount would be to deduct the direct payment amounts from debt service for purposes of determining the lowest of the prongs under the three-prong test in section 1.148-2(f)(2)(ii) of the Regulations. Also, Notice 2009-26 provides that in determining a reasonably required reserve fund, the rules under Section 148(d)(2) apply such that a Build America Bond (Direct Payment) would be an arbitrage bond if the amount of sale proceeds that is part of any reserve or replacement fund exceeds 10% of the proceeds. (Last reviewed and confirmed: April 26, 2010)
The more recent approach to evaluating this scenario, however, is to note that the subsidy payments are considered “tax credits” and as such, based on a literal reading of 1.148-2(f), there may not be a need to exclude such credits from debt service.
Costs of Issuance Limitation
Under Section 54AA(g) of the Code, build America bonds are “qualified bonds” if 100% of the excess of (a) the available project proceeds of the issue over (b) the amounts in a 4-R fund are to be used for capital expenditures and the issuer makes an irrevocable election to have Section 54AA(g) apply.
Available project proceeds is defined in Section 54A(e)(4) of the Code and means (A) the excess of (a) the proceeds from the sale of an issue, over (b) the issuance costs financed by the issue (to the extent that such costs do not exceed 2% of such proceeds), and (B) the proceeds from any investment of the excess described in (A).
What this means is that BAB proceeds may finance up to 2% of the costs of issuance (similar to the 2% rule with respect to private activity bonds). Therefore, under the general 2% rule, certain transaction costs are not considered issuance costs, including fees allocable to qualified guarantees such as bond insurance premiums and certain letter of credit fees (see IRS Priv. Ltr. Rul. 200813022 (March 28, 2008) and Section 1.148-4(f)(2) through (4) of the Regulations).
For BAB-DPs, it was initially unclear whether certain qualified guarantees (such as bond insurance premiums) are considered “capital expenditures” to meet the 100% capital expenditures rule in Section 54AA(g)(2). In November 2009, the Treasury Department indicated that it believed Congress did not intend to change the 2% limitation from what it is for private activity bonds, and that there was no intent to state implicitly in 54AA(g) that bond insurance premiums are not to be considered capital expenditures. In October 2012, in Chief Counsel Advice of June 2012 (AM 2012-005), the IRS finally concluded that such bond insurance premiums are considered capital expenditures for purposes of the 100% of available project proceeds requirement under I.R.C. 54AA(g)(2)(A). The conclusion is based on the fact that prepaid expenses are generally capitalized.
Is a notice to the IRS required when BABs are refunded and cancelled? Probably not. The issuer must stop filing IRS Forms 8038-CP, of course. The last IRS Form 8038-CP must be adjusted for the final accrual period.
Available Project Proceeds
PLR 201702009 (Oct. 14, 2016): A ruling that the existence of unspent available project proceeds of BABs on the date that proceeds of bonds refunding the BABs are used to redeem the BABs in a current refunding will not retroactively cause the BABs to lose their status as “qualified bonds” within the meaning of section 54AA(g)(2) of the Internal Revenue Code, and therefore will not cause the issuer to lose any credit under section 6431 for the BABs. “We specifically express no opinion about whether the Bonds will be reissued upon the deposit of proceeds of the Refunding Bonds into an escrow fund to pay principal of and interest on the Bonds at redemption.”