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.
- 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.
- 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).
- 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).
- 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.
- 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).
- 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.
- 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.
- 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.
- 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:
- 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.
- 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.
- 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:
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:
- Any of the proceeds of the advance refunding issue are invested in a refunding escrow in which a portion of the proceeds are invested in tax-exempt bonds and a portion in nonpurpose investments;
- The yield on the tax-exempt bonds exceeds the yield on the advance refunding issue;
- The yield on all investments (including the tax-exempt bonds and nonpurpose investments) in the refunding escrow exceeds the yield on the advance refunding issue; and
- The WAM of the tax-exempt bonds is more than 25% greater or less that the WAM of the nonpurpose investments in the refunding escrow, and the WAM of the nonpurpose investments in the refunding escrow is greater than 60 days.
See Treas. Reg. 1.149(d)-1(b)(3). [More to come]
Advance Refunding of a Taxable Obligation:
Treas. Reg. § 1.149(d)-1(e)(1) provides that the limitation on advance refundings set forth in I.R.C. § 149(d)(3)(A)(i) does not take into account an advance refunding of a taxable issue unless the taxable issue is a conduit loan of a tax-exempt conduit financing issue. Note, however, that the refunding obligation still constitutes an advance refunding issue. This regulation section simply exempts the issue from being considered in the advance refunding limitation rule. For purposes of other rules, however, the “normal” advance refunding rules still apply. Therefore, e.g., the materially higher definition of 0.001% applies to the escrow.
April 29, 2013: What will happen to SLGS subscriptions if the debt ceiling is not increased or the limit is not suspended by May 19, 2013? Will SLGS subscriptions submitted to the Bureau of Public Debt prior to May 19, 2013 be honored or will the BPD cancel the subscriptions? Under the suspension act signed into law by President Obama in February 2013 (No Budget, No Pay Act), the debt ceiling limit was suspended. Once the suspension period ends, the debt limit existing on May 19 goes back into effect. At that point, it appears the debt limit will have been exceeded. Technically, the Treasury Department may take extraordinary measures to attempt to keep debt below the limit, similar to what was done in January 2013 when debt levels were nearing the ceiling. It is unlikely, however, that enough measures can be taken to permit the BPD to continue SLGS issuances. Further guidance from the Treasury Department is needed to understand what the likely approach will be.
SLGS and Rev. Proc. 95-47:
The SLGS program permits issuers to structure advance refunding escrows to achieve maximum efficiency within the yield limit. Issuers may either (1) fully fund the refunding escrow with SLGS earning yields at a level permissible under the yield restriction rules or (2) combine SLGS with open market securities. In the second scenario, the refunding escrow is typically funded with open market securities (taxable Treasury securities) first because open market securities often provide a higher yield than the bond yield. The escrow agreement will direct the escrow trustee at some point to roll over proceeds from sale of escrow securities into zero percent SLGS to blend down the overall yield of the escrow to avoid yield restriction problems.
See “The SLGS Compliance Initiative: A Correspondence Examination Initiative of Advance Refunding Bonds,” by Peter J. Mazarakos and Steven A. Chamberlin.
In November 1995, the Treasury Department provided guidance in Rev. Proc. 95-47 (1995-2 C.B. 417, 1995-47 I.R.B. 12) on how to address rollovers into zero percent SLGS during periods in which the sale of SLGS is suspended. The Procedures states that an issuer may make special yield reduction payments (usually not permitted under Treas. Reg. § 1.148-5(c)(3)(ii) for advance refunding investments) if the following requirements are satisfied:
- The alternative investment (the investment purchased in lieu of the zero percent SLGS) is purchased on a date when the issuer is unable to purchase SLGS in lieu of the alternative investment because the Department of the Treasury has suspended sales of SLGS.
- The issuer reasonably expected on the issue date of the bonds that it would use bond proceeds to purchase SLGS on a date described in section 4.01(1) of the Procedure.
- The maturity date of the alternative investment is not more than 90 days from the date of purchase (trade date, not settlement date) of the alternative investment.
- The issuer exercises reasonable diligence to use the proceeds of the maturing alternative investment to purchase SLGS, if available, for the remainder of the term that was reasonably expected on the issue date.
- The payment to the United States is made not later than 180 days after the date of purchase of the alternative investment.
- The purchase price of the alternative investment does not exceed the fair market value of the alternative investment, and the issuer maintains books and records relating to the establishment of the purchase price.
- The payment to the United States is equal to the difference between the purchase price of the alternative investment on the date of purchase and the amount of all receipts from the alternative investment.
The special yield reduction payment is made in the same manner as normal yield reduction payments. The following statement must be noted in the top margin of Form 8038-T: “Special Yield Reduction Payment Made Pursuant to Revenue Procedure 95-47.”
Query why the Treasury Department included a 90-day investment limitation. Some bond counsel believe this period was chosen as a belt and suspenders limit – at that time, there had been no suspensions that had lasted longer than about 30 days. The 90-day period was viewed as sufficient to cover all suspension periods.
Consider REG-106143-07, which would make Rev. Proc. 95-47 obsolete. Making Rev. Proc. 95-47 probably means that the special 90-day holding limitation goes away. Query whether the 180-day yield reduction payment requirement also goes away. If the requirement goes away, the YRP will be due at the same time all other YRPs are due. Some bond counsel believe that the 180-day requirement is eliminated along with the 90-day holding limitation.
If the escrow is rolled from one alternate investment to another alternate investment, how quickly does the second alternate investment need to be made after the first alternate investment matures?
Assume an issuer district (“District A”) issued Series 2002 Bonds to finance public improvements. In 2013, another district (“District B”) will issue “refunding” bonds (the “Series 2013 Bonds”) to refinance the public improvements. Assume also that prior to the refinancing District A has legal title to the improvements and after the refinancing District B will have legal title. Will the Series 2013 Bonds be a refunding issue within the meaning of Treas. Reg. 1.150-1(d)(1)?
Treas. Reg. 1.150-1(d)(1) defines a “refunding issue” as an issue of obligations the proceeds of which are used to pay principal, interest or redemption price on a “prior issue,” including the issuance costs, accrued interest, capitalized interest on the refunding issue, a reserve or replacement fund, or similar costs, if any, properly allocable to that refunding issue.
Treas. Reg. 1.150-1(d)(5) defines a “prior issue” as an issue of “obligations” all or a portion of the principal, interest or call premium on which is paid or provided for with proceeds of a refunding issue.
A special rule in Treas. Reg. 1.150-1(d)(2)(ii)(A) provides that an issue is not a refunding issue if the “obligor” of one issue (e.g., the proposed Series 2013 Bonds) is neither the obligor of the other issue (e.g., the Series 2002 Bonds) nor a related party with respect to the obligor of the other issue. Under Treas. Reg. 1.150-1(d)(2)(ii)(B), “obligor of an issue” means the actual issuer or, in conduit financings, the conduit borrower.
Assume District A and District B have the same members of the governing board. Are District A and District B “related parties”?
Treas. Reg. 1.150-1(b) defines “related party” as any member of the same controlled group (if with respect to a governmental unit or a 501(c)(3) organization). In Treas. Reg. 1.150-1(e), “controlled group” is defined as a group of entities controlled directly or indirectly by the same entity or group of entities. Direct control is determined based on all facts and circumstances. One entity or group of entities (the controlling entity) generally controls another entity or group of entities (the controlled entity) if the controlling entity possesses either of the following rights or powers and the rights or powers are discretionary and non-ministerial: (1) the right or power both to approve and to remove without cause a controlling portion of the governing body of the controlled entity; or (2) the right or power to require the use of funds or assets of the controlled entity for any purpose of the controlling entity. (There is a special rule for indirect control, and there is a special exception for general purpose governmental entities.)
Based on this definition and under the assumption described above, District A and District B would be related parties. The Series 2013 Bonds would likely be a refunding issue.
(Some bond counsel, however, believe “control” – the right to approve or remove and the right to require use of funds or assets – must be more than merely momentary power due to board composition. Instead, the power should be set forth in agreements between the two districts or in statutes.)
Assume, however, that District A and District B do not have any overlapping boards and are not part of the same controlled group. In this case, the Series 2013 Bonds do not qualify as a refunding issue. Instead, the Series 2013 Bonds are new money bonds, the proceeds of which are probably characterized as financing the acquisition of District A’s public improvements.
(But, query whether in a taxing district (District A)/issuing district (District B) where issuing district bonds are paid from taxes levied by the taxing district the true obligor isn’t District B from the start such that upon refunding there is no change in obligors.)
See AM2012-004, released 6/1/2012, in which the Office of Chief Counsel determines that there is no reissuance of tax-exempt or build America bonds where the State of California, by legislative act, dissolved all of its redevelopment agencies and vested all of their authority, rights, powers, duties and obligations in successor agencies.
Integrated Asset Acquisitions:
See PLR 201326007 and The Bond Buyer, IRS Rules Issuance of New Bonds is a Refunding, July 2, 2013. Does a refunding followed by a sale of partnership interests in the conduit borrower cause the refunding bonds to be new money bonds (to which volume cap and other requirements may apply) or are the refunding bonds a “refunding issue” under Treas. Reg. 1.150-1?
“An issue is not a refunding issue if the obligor of the would-be refunding issue is not the obligor of the other issue. Thus, if County X financed a water and sewage facility with tax-exempt bonds in 1994 and in 1998 sells it to unrelated County Y, which finances such purchase with a tax-exempt bond issue, the transaction will be treated as an acquisition of the facility and not as a refunding, even though County X used the proceeds from the sale to discharge its tax-exempt bond issue.” (From a Bond Attorneys’ Workshop outline)
Refunding of ARRA Bonds:
There is no statutory language on refundings for any of the disaster relief bonds or ARRA bonds, including the Recovery Zone Facility Bonds and Recovery Zone Economic Development Bonds and Build America Bonds. There are “common law” principles that might support current refundings, but there has been no guidance, except to the extent described below.
For difficulties regarding legal defeasance of such bonds in advance refundings, see IRM 188.8.131.52.2 and Treas. Reg. 1.1001-3(e)(5)(ii)(A) and (B). The defeasance may be a reissuance of the defeased bonds.
A. Gulf Opportunity Zone bonds (“GO Zone Bonds”); Midwestern Disaster Area Bonds; and Hurricane Ike Disaster Area Bonds
In Notice 2012-3 (2012-3 IRB 289) (January 17, 2012), the IRS permits the current refunding of GO Zone Bonds originally issued prior to the termination date of December 31, 2011, and the Midwestern Disaster Area Bonds and Hurricane Ike Disaster Area Bonds, issued under Sections 702(D)(1) and 704(a) of the Heartland Disaster Tax Relief Act of 2008, issued prior to the scheduled termination of December 31, 2012 (collectively, the “Disaster Area Bonds”). The IRS supports its conclusion that current refundings of these bonds are permitted based on discussion by the Joint Committee on Taxation in “Technical Explanation of the Revenue Provisions of H.R. 4440, the ‘Gulf Opportunity Zone Act of 2005,’ as Passed by the House of Representatives and the Senate,” 5-6, JCX-88-05 (December 16, 2005).
Under the Notice, a current refunding is permitted after the termination date if the issue price of the current refunding issue is no greater than the outstanding principal amount of the refunded bonds. If the refunded bonds were issued with more than a de minimis amount of OID or OIP, the present value of the refunded bonds is used instead of the outstanding stated principal amount to determine the maximum issue price of the current refunding issue.
There is an express prohibition of advance refundings of GO Zone Bonds (See JCX explanation, page 6).
Notice 2012-3 specifically states that no inference may be drawn from the Notice that bonds issued to refund other types of bonds, such as Build America Bonds under I.R.C. 54AA, after their statutory deadline for issuance meet the qualifications for such types of bonds. Therefore, the Service does not appear willing to extend the ability to currently refund bonds after the applicable termination date without express language similar to the statement in the JCX explanations.
See Notice 2010-10 for special reimbursement (official intent) rules relating to disaster area bonds.
B. Recovery Zone Facility Bonds (Exempt Facility Bonds)
See Notice 2014-09 for special current refunding guidance for Recovery Zone Facility Bonds.
C. Build America Bonds
See PLR 201149017 (December 2011), which concludes that the remarketing of BABs described in the ruling did not trigger a reissuance.
There is still no guidance or permission to refund Build America Bonds on either a current or an advance refunding basis with proceeds of a new Build America Bonds issue.
There is also no guidance on whether the IRS would continue to pay Build America Bonds subsidies during any escrow period if the Build America Bonds are current or advance refunded with proceeds of a new tax-exempt issue.
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.