Tax-exempt bonds may now be issued in connection with WIFIA loans. See FAST Act signed into law on December 4, 2015 (Sec. 1445, page 331).
A total rate of return swap (TRORS), sometimes called a Total Return Swap or TRS, is a financial contract that transfers both the credit risk and market risk of an underlying asset. One party makes payments based on a set rate (either fixed or variable) and the other party makes payments based on the return of the underlying asset (which includes income it generates and any capital gains). The underlying asset is usually a bond or loans or an equity index. TRORSs allow the party receiving the total return (the TRORS recipient or investor) to gain exposure and benefit from a reference asset without actually having to own it.
The key reason receivers of the total rate of return enter into this transaction is to take advantage of leverage. […] The payer in a TRS creates a hedge for both price risk and default risk of the reference asset, although the payer in the TRS is a legal owner of the reference asset. Investors who cannot short securities may be able to hedge a long position by paying the total rate of return in a TRS.
See Janet Tavakoli, Introduction to Total Return Swaps (available at http://www.tavakolistructuredfinance.com/trs/) for a good overview of TRORSs. See this video for a basic overview of Total Rate of Return Swaps.
TRORSs can be combined with tender option bond programs. For notes concerning tender option bond programs, see this posting.
See PLR 201502008 (May 21, 2014): Extension of the TRS is not an abusive arbitrage device and the TRS will not be integrated with the bonds under the authority of 1.148-10(e). The issuer/borrower agree to file a “cautionary” IRS Form 8038 just in case the IRS might mistake the bonds for having been reissued.
See “IRS Issues Favorable But Limited Ruling on Total Return Swaps” article in the January 27, 2015 edition of The Bond Buyer.
A TOB program is typically initiated by an institutional investor, such as a mutual fund, and is implemented by a bank. The bank provides credit enhancement and remarketing services for the short maturity variable rate securities that represent the initiating investor’s leverage. The initiating investor uses this borrowed capital to purchase a longer maturing, fixed-rate bond, which is placed in a TOB trust. The short-term variable rate debt, also known as a floater, is sold to money market mutual funds with daily or weekly interest rate resets. The residual amount of income (interest earned on the longer bond less interest and fees due on the shorter floater) is available to the institutional investor. The longer maturity security held by the investor is known as the inverse floater.
“Inverse floaters: Attractive yield but beware of the risks,” Columbia Management Investment Advisers, LLC, May 2013, available at https://www.columbiamanagement.com/market-insights/white-papers/InverseFloaters
A TOB program is a financing mechanism that allows investors to make a leveraged carry trade, borrowing at short-term rates and investing in higher-yielding long-term bonds, and then pocketing the spread.
Document Drafting Matters
- Ensure that the reimbursement agreement or letter of credit describes how the letter of credit may be cancelled, and what the process is when an optional redemption pursuant to the terms of the reimbursement agreement coincides with the date on which the letter of credit is cancelled. Should an optional redemption notice be provided or should the optional redemption be waived?
Payment of letter of credit fees might be considered capital expenditures, especially if paid during the project period. If the letter of credit fee is amortized beyond the project period, however, portions of the fee could be treated as working capital expenditures. Therefore, it may make sense to assume that the fee won’t be counted as a capital expenditure to test whether the 95/5 test is met.
Typical Lease Financing Structure
The lease purchase agreement (LPA) is entered into between the municipality, as lessee, and a lender or other lessor. Under the LPA, the lessor leases the equipment to the lessee, and the lessee rents, leases and hires the equipment from the lessor. The term of the LPA is for one year and is subject to renewal and appropriation by the lessee. In some jurisdictions, a built-in evergreen provision might be added to provide for automatic renewals of the IPA unless the lessee takes action to “not” appropriate.
The lessee, on behalf of the lessor, orders the equipment and installs the equipment, and only then leases the equipment.
Under the IPA, the lessee promises to make rental payments only to the extent appropriated therefore. In the event of a nonappropriation, the IPA is deemed terminated, and the lessee is required to deliver the equipment to the lessor.
Upon acceptance of the equipment by the lessee, title to the equipment and any and all additions, repairs, replacements or modifications will vest in the lessor, subject to the lessee’s rights under the IPA. The lessee has no right, title or interest in the equipment except its leasehold interest therein.
The lessee commonly has a purchase option under which it may be allowed to purchase the equipment from the lessor.
Typical Installment Purchase Agreement Structure
The installment purchase agreement (IPA) is entered into between the municipality, as borrower, and the lender. Under the IPA, the lender makes a loan to the municipality. Usually, the loan proceeds are deposited to an escrow fund. The municipality, with the consent of the lender, may make a draw from the escrow fund from time to time to use the loan proceeds to purchase the equipment (or energy conservation measures). The lender does not operate, control or have “possession” of such equipment or measures. The municipality is responsible for selecting the equipment and using, maintaining, operating and storing the equipment.
In the IPA, the municipality promises to make loan payments to the lender during the loan term, usually based on a payment schedule attached to the IPA. A portion of the loan payment is separately identified as the interest component, which is eligible for tax-exempt treatment. The lender may assign the loan payments to another person.
During the loan term, legal title to and “ownership” (vs. possession) of all equipment and any and all repairs, replacements, substitutions and modifications thereto is in the lender, and the municipality must take all actions necessary to vest such title and ownership in the lender. For instance, the municipality may need to mark or otherwise label the equipment to identify the lender as the owner. Upon termination of the loan by prepayment in full by the municipality or through payment by the municipality of all loan payments and other amounts relating thereto, the lender must convey its ownership interest in the equipment thereby terminating the lender’s ownership of the equipment.
The municipality may permit the lender to file financing statements and amendments thereto describing the equipment in order to evidence the lender’s ownership interests in the equipment. Such financing statements should reflect the lender’s legal title to the equipment and be designated as “filed for notice purposes only.”
Upon failure by the municipality to pay, the lender may declare the outstanding balance immediately due and payable and may be able to enter the municipality’s premises to disable the equipment or retrieve the equipment.
In certain states, depending on state law and other pertinent circumstances, it may not be possible to structure an IPA as an annually appropriated financing that would not be considered a multiple fiscal year debt of the municipality.
What’s the Difference Between an LPA and IPA?
There isn’t really a difference. The LPA may be more acceptable in certain jurisdictions in which there is an express prohibition of multiple fiscal year obligations. The lease, as such, is more easily understood as a structure that provides for annual renewals. Unlike the IPA structure where the municipality is considered the borrower of the loan, the LPA refers to the municipality merely as lessee, and there is no “loan” – instead, the lessee purchases the equipment on behalf of the lessor, and then leases the equipment. In some jurisdictions, these distinctions may not matter. In others, they are significant reasons for why the lease structure is preferred.
It is questionable whether a “true lease” can be structured as a tax-exempt obligation given the federal tax law requirement that the lessee build up equity in the leased property. See Rev. Rul. 55-540 and PLRs 8235056 and 8347058. See discussion in Bond Attorneys Workshop materials from 2008.
True lease vs. financing lease? See “When Is a Lease Not a Lease? Seventh Circuit Adopts ‘Substance Over’ Form Test for True Lease Determination,” David A. Hatch and Mark G. Douglas, Jones Day, available online.
Question 1: “I’m curious: What are your current business priorities?”
Question 2: “I’m interested in knowing: Where is the pain in your business? What keeps you up at night?”
Question 3: “I would be interested in knowing where the areas of growth are in your business. Where are the opportunities for gain?”
Last Question: “How can my firm and I support you?”
See David King Keller, 100 Ways to Grow a Thriving Law Practice.
A. Non-Substitution Clauses in Leases
The following is an excerpt from “Common Questions about Tax-Exempt Leases” published online by Municipal Funding of Zephyrhills, Florida, available at http://municipal-funding.com/tax-exempt_leasing_faq.htm:
A non-substitution clause is a provision in a 103 lease that prevents the government from non-appropriating and then acquiring equipment to perform the same function as the previously leased equipment.
Although non-substitution clauses still appear in 103 leases, the majority view (with which the author agrees) seems to be that having a non-substitution clause in a 103 lease actually damages the lessor’s interest. Here is the rationale: If the non-substitution clause prohibits the government from performing an essential government function, such a clause may be used to show that the lessor, while purporting to recognize the unrestricted right of the government to non-appropriate, nevertheless imposed coercive sanctions on the government in the event that the government exercised such right. The right to non-appropriate becomes illusory.
The non-substitution clause becomes the basis for an argument that the 103 lease creates debt. The government still has to perform the essential government function being served by the equipment. If it is unable to acquire new equipment to perform that function subsequent to a non-appropriation, non-appropriation is not a real option and the lease is essentially a multiyear hell or high-water obligation.
Courts in several states, including Texas, Oregon, Colorado, and Florida, have already found that including a non-substitution clause turns the 103 lease into debt. In each of these cases, because the procedures for incurring debt were not complied with, the 103 lease was void.
In light of this and because experience shows the clause is rarely if ever enforced, it offers no real benefit to lessors. Limiting its reach by the phrase “to the extent permitted by law” may mitigate some of the negative consequences, but it does little to make the provision more helpful.
B. Lessor Entities
For purposes of IRS Form SS-4, Application for Employer Identification Number (EIN), does the lessor entity check the “Corporation” box or the “State/local government” box on line 9a? Does the lessor entity need to file an income tax return?
Generally, if an entity is separate from (not an “integral part” of) the government, its income will be subject to tax unless an exclusion or exemption applies. If the income is subject to income tax, the entity may need to file a return. An exclusion in I.R.C. 115, however, excludes from gross income, income (1) derived from any public utility or the exercise of any essential governmental function, and (2) accruing to a state or political subdivision (including the District of Columbia).
The IRS Exempt Organizations training material provides the following discussion:
What activities involve exercise of an “essential governmental function” is generally decided on a case-by-case basis. Factors considered include whether the activity is one traditionally considered “governmental” (as opposed to private or proprietary), whether it involves the exercise of governmental (sovereign) powers, the extent of government control over the activity, and the extent of government financial interest in the activity. Qualifying activities may include public education; investment of public funds, Rev. Rul. 77-261, 1977-2 C.B. 45; operating a municipal insurance pool; operating a public hospital or other public health facilities; or providing public recreation facilities.
Income must be derived from a qualifying activity; it is not enough that it be paid over to or benefit a qualifying activity. For example, that a university uses income derived from operating a commercial television station to conduct educational programs does not render the income excludable; the income must have been derived from educational activities. See Iowa State University of Science & Technology v. United States, 500 F.2d 508 (Ct. Cl. 1974).
The second requirement under IRC 115(1) is that income “accrue to” a state or political subdivision. Income “accrues” where the state or subdivision has an unrestricted right to a proportionate share of the income. Rev. Rul. 77-261, 1977-2 C.B. 45. The “accrual requirement” may also be met by less direct means. What is required is a substantial degree of government dominance over the enterprise. While many organizations that are “instrumentalities” for employment tax purposes (discussed below) will also have income excluded under IRC 115, the two are conceptually distinct. It is therefore conceivable that an “instrumentality” may be subject to income taxation.
If the lessor entity constitutes an entity described in I.R.C. 115, bond counsel will generally identify the lessor entity as a “State/local government” entity on the SS-4 form. It is not entirely clear whether the lessor or the governmental lessee will need to file a tax return for the lessor. The IRS Exempt Organizations training material provides the following statement:
Return Requirements. Under Rev. Rul. 78-316, 1978-2 C.B. 304, states and political subdivisions (including their “integral parts”) are generally not required to file income tax returns with respect to activities they directly conduct. Separatelyorganized instrumentalities, however, are subject to the general rule requiring taxable corporations to file returns, regardless of whether they have income or owe tax. Rev. Rul. 77-261, 1977-2 C.B. 45. Specific provisions may require a return even if an entity is an “integral part” of a state or political subdivision. For example, if an entity is an “insurance company” for federal tax purposes, it must file a return even if it is not otherwise considered a taxable corporation. See Rev. Rul. 83-132, 1983-2 C.B. 270.
C. COP Matters
PLR 200314024: Bonds are issued “as certificates of participation” in an installment sale agreement with the City in which the City agrees to make payments to purchase the Center from the Corporation. Payments will equal the interest and principal due on the COPs.
PLR 9123058: In a COP financing, the underlying lease as well as the COPs were approved under 147(f), not just the COPs.