Riddle me this, Batman: To whom does this memo matter?
Consequences to the State or Local Government Borrower – Current vs. Advance Refundings
As we’ve discussed many times before, the memo of course matters to the state or local government borrower. Where the borrower uses tax-exempt bonds to refund BABs in a current refunding, the effect of a deemed reissuance of the BABs on the borrower will be that the borrower will lose the ability to claim interest subsidy payments for BABs that have been defeased, which usually will involve a period of around 30 days of interest.
Some BABs have extraordinary optional call provisions that allow the issuer to call the BAB immediately if the federal direct subsidy is reduced, as it was by sequestration, and many refundings of such BABs have already occurred. But, for BABs that do not have such an extraordinary optional call provision, the BAB reissuance memo could matter to the holder in the context of an advance refunding of a BAB with the proceeds of a tax-exempt bond. An advance refunding would occur here when proceeds of the tax-exempt refunding bond are used to retire the BAB and the refunding bond is issued more than 90 days prior to the date the BAB is retired. The proceeds of the tax-exempt advance refunding bond are typically held in escrow for an extended period of time, normally a few years. The amounts held in escrow are used to redeem the BAB on the first optional call date, which is generally about 10 years from issuance. It’s still a bit early to be worried about advance refundings of BABs because BABs could only be issued in 2009 and 2010, so they generally won’t be callable until 2019 at the earliest. Four years from the issue date is generally too far into the future for an advance refunding to make sense economically. But, if interest rates remain low, the trickle of advance refundings of BABs could soon begin to swell.
So, in light of the BAB reissuance memo, what happens in a year or two from now, or perhaps even sooner, if market conditions are such that a borrower could save money with an advance refunding? The borrower shouldn’t be hurt because a well advised borrower should know about the treatment of an advance refunding of a BAB in light of the BAB reissuance memo, and therefore wouldn’t ordinarily enter into one unless it made economic sense. While the borrower will lose the subsidy after the tax-exempt bonds defease the BABs, the lower debt service on the new tax-exempt bonds will more than make up the difference and the borrower will have aggregate savings above any transaction costs. Of course, in rare instances, a borrower may need to redeem a bond for some reason other than debt service savings.
“Holy unwanted reissuances, Batman!” – Consequences to the Holder of the BAB
What about the holder? The BAB reissuance memo might matter to a holder for two reasons involving tax consequences and additional administrative burdens.
Because a reissuance is considered to be a “sale or exchange” for federal tax purposes, a holder is normally required to pay taxes on the difference between the holder’s basis in the prior bond and the fair market value (FMV) of the bond on the reissuance date, which is also the amount that the holder is deemed to pay to purchase the “exchanged” bond.
Let’s consider a simplified example. Please note the applicable tax regulations are far more complex, but we will stick with a simplified example so as not to put our readers to sleep even faster than we normally might. Suppose a $1,000 BAB was initially issued at par in 2010 with a 6% taxable interest rate. Like most BABs, this BAB is callable after ten years in 2020. Assume the holder purchased the bonds at issuance for par. Seven years pass by.
In 2017, interest rates have fallen to 4% for tax-exempt bonds and 5% for taxable bonds. If the borrower wanted to refund the BAB with tax-exempt bonds, the refunding escrow funded with the proceeds of the tax-exempt bonds would have to hold about $1,060 of escrow securities earning not more than the permitted advance refunding escrow yield – which is basically the bond yield, or 4%, at the rates prevailing in 2017 in our example. Unless the borrower also contributed other funds, the borrower would have to issue $1,060 of tax-exempt bonds to pay off the $1,000 BAB. This amount represents $1,000 of 4% bonds and a little extra (about $60, or $20 per year, equal to the 2% spread between the rates) to match the difference in interest rates under the old bonds (6%) and the new bonds (4%) for the three year period from the 2017 defeasance to the 2020 redemption.
Things work slightly differently for the holder because the borrower is now borrowing at a tax-exempt rate, but that is irrelevant to the holder. Under the BAB reissuance memo, the BAB is treated as reissued on the date that the tax-exempt advance refunding bonds are issued and the proceeds are used to defease the BAB. Upon the deemed exchange caused by that defeasance, the holder would be treated as receiving the difference between the holder’s basis in the “old” BAB and the FMV of the “new,” deemed reissued BAB. The holder purchased the BAB at par for $1,000, so the holder’s basis in the old BAB is likely $1,000. The FMV of the new BAB, which is the same as the FMV of the old BAB, is the value of a $1,000 bond with a 6% interest rate in a market where taxable interest rates are lower; as noted above, we’ve assumed that taxable rates have fallen to 5%. Because the holder is holding a bond that is bearing above-market interest, a buyer would have to pay a premium (in other words, something more than the $1,000 face amount of the BAB) to buy it and reap the benefit of the above-market interest rate. So the holder is deemed to have sold a $1,000 bond and received, let’s say, $1,030 (the $10 per year representing the 1% difference in the rates).
The difference is $30 and tax would be owed at that time on that difference. But, over the next three years, the holder will amortize the premium ($30) and be deemed to earn $10 per year less, effectively reducing the 6% interest to 5% interest. Putting aside the actual complexity of the applicable regulations, the difference is therefore a cash flow problem. The holder pays tax on $30 in 2017, and then takes a deduction to recoup this tax in 2018, 2019 and 2020. If the holder is a corporation paying the maximum corporate income tax, and it owned $10,000,000 of the BABs, this cash flow differential is 35% of $300,000, or $105,000, paid in taxes in 2017 and then recouped over the next 3 years. BABs are often held in big blocks, so the amount of money involved can be of this order of magnitude.
Of course, this only matters if the holder is subject to federal income taxes. Some holders of BABs, such as pension funds, are not subject to federal income taxes.
The other potential burden is simply the administrative hassle. The paying agent on the bonds will have to send the holders of the reissued BABs a 1099 and the holders will have to work with their tax advisors to process the consequences.
And away we ride in the “BABmobile.” More to come?
So, here we are. The IRS has read the exception in the reissuance regulations to apply literally only to bonds on which the interest is excludable from gross income and not to include types of state and local bonds that bear taxable interest but are subject to all the rules applicable to tax-exempt bonds. Will we see any changes to avoid the adverse consequences that will result from this interpretation (and to ameliorate the adverse consequences that have already resulted from this interpretation)? The private sector certainly hopes so, but nothing is yet on the horizon. As they used to say back in the 60’s, tune in next week, same Bat Time, same Bat Channel.