AMERICAN BAR ASSOCIATION SECTION OF TAXATION Committee on Tax-Exempt Financing. Proposal for Reform and Simplification [, 2011]

Transcription

1 Draft 5/3/11 WARNING: THIS IS A DISCUSSION DRAFT ONLY AND IS NOT AN ADOPTED POSITION OF THE COMMITTEE ON TAX-EXEMPT FINANCING, THE SECTION OF TAXATION, OR THE AMERICAN BAR ASSOCATION. WE ANTICIPATE THE POSSIBILITY OF SUBSTANTIAL CHANGES DURING REVIEW BY THE COMMITTEE AND OTHERS. PLEASE DO NOT QUOTE FROM THIS DRAFT OR TREAT IT AS THE POSITION OF THE COMMITTEE, THE SECTION, OR THE ASSOCIATION. AMERICAN BAR ASSOCIATION SECTION OF TAXATION Committee on Tax-Exempt Financing Proposal for Reform and Simplification [, 2011] 1. Permit tax-exempt bonds and tax-credit bonds to be current refunded as a continuation of the original bonds. Present Law. In general, tax-exempt governmental bonds may be issued for a wide range of governmental functions ranging from bridges and schools to municipal power plants. Taxexempt private activity bonds may be issued to finance an array of quasi-governmental facilities and functions such as ports, airports, low and moderate income housing projects, single family mortgages, student loans, small manufacturing facilities, and obligations for the benefit of section 501(c)(3) organizations among other purposes. In recent years, Congress has introduced several new financing tools for State and local governments. One new category of financing tools consists of "tax-credit bonds" which generally provide an annual tax-credit to the holders of the bonds in lieu of tax-exempt interest. A number of tax-credit bond programs also permit the issuer to receive a direct cash payment from the Treasury equal to the amount of the interest rate subsidy in lieu of providing a tax-credit to the bondholder. Generally, tax credit bonds, like the majority of qualified private activity bonds, are subject to volume cap and are limited to financing a limited range of purposes. Tax credit bonds include New Clean Renewable Energy Bonds, Recovery Zone Economic Development Bonds, Qualified Energy Conservation Bonds, Qualified Zone Academy Bonds and Build America Bonds among others. Tax-credit bonds generally provide an interest rate subsidy to State and local government issuers ranging from 35% to 100%. Substantial contributions to this project were made by Frederic L. Ballard, Jr., Ronald A. Bell, Faust Bowerman, Todd L. Cooper, Matthias M. Edrich, Edwin G. Oswald, Jeremy A. Spector, John Swendseid, Stefano Taverna, and Carla Ann Young ~1~

2 Generally, all types of tax-exempt bonds may be currently refunded (refinanced) with tax-exempt bonds, which means that the new refunding bonds are used to retire the prior bonds within 90 days of the date of issue of the refunding bonds. Under present law, tax credit bonds (which are generally structured with bullet principal maturities) can be refunded with tax-exempt debt, however, it is unclear whether tax credit bonds can be refunded with tax-credit bonds. Reason For Change. Under present law, at the time refunding bonds are issued to retire outstanding bonds, the refunding bonds constitute a "new debt issue" for federal tax purposes. In the municipal market, the issuance of a new debt issue will trigger a number of compliance responsibilities for the State and local government issuer and give rise to a number of costs. The issuance of a bond will require a new approving opinion and tax opinion of bond counsel. As part of that process, significant due diligence (and related matters) must be undertaken by the issuer and other municipal professionals. In addition, a new Form 8038 will need to be filed with the Internal Revenue Service in connection with the new bond issue and a final arbitrage rebate report for the refunded bonds must be undertaken and any rebate owed to the Treasury must be paid. We suggest that in cases in which the outstanding bonds are currently refunded, with no increase in the weighted average maturity of the bonds and no increase in the amount of the refunding bonds above the amount of the refunded bonds, that the refunding bonds be treated as a continuation of the prior issue solely for purposes of sections 103 and 141 through 150. Such a convention would relieve the issuer from incurring a range of costs and expenses, administrative staffing and time. The general notion of a refunding bond being a continuation of a refunded bond has been recognized in similar areas governing municipal bonds. Treasury Regulations regarding private activity bonds generally treat a refunding bond as a continuation of the prior bond for purposes of measuring private use. Moreover, section 147(f)(2)(D) (regarding public approval requirements for private activity bonds), treats a refunding bond as a continuation of the refunded bond in cases involving a current refunding with no extension of maturity. Importantly, in this time of significant budget constraints at both the State and Federal level, having clear refunding rules regarding the ability to refund tax credit bonds with tax credit bonds, tax-exempt bonds with tax-credit bonds and tax-credit bonds with tax-exempt bonds will save money. Generally, lowering the debt service on all types of tax-subsidized bonds is a "winwin" proposition. For example, in many ways, the Build America Bond program is a partnership between the Federal and State governments with respect to financing infrastructure improvements. Under this program, the Federal government pays 35% of the actual interest rate on the bonds. In the event market interest rates decrease during life of the bonds, providing issuers with the ability to refund such obligations will deliver immediate cash savings to both the issuer and the US Treasury. A similar savings argument can be made for many other categories of tax-subsidized bonds. 2. Increase the threshold for determining whether an issuer is a small issuer for purposes of issuing bank qualified bonds. The proposal would apply to all new issues (and any subsequent current refunding issues) of small issuers. Simplify the analysis by making the determination of small issuer status uniform for arbitrage rebate and bank qualification purposes. Apply the threshold for bank qualification at the borrower level. ~2~

3 Present law. Present law disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from tax. In general, an interest deduction is disallowed only if the taxpayer has a purpose of using borrowed funds to purchase or carry tax-exempt obligations; a determination of the taxpayer s purpose in borrowing funds is made based on all of the facts and circumstances. In the absence of direct evidence linking an individual taxpayer s indebtedness with the purchase or carrying of tax-exempt obligations, the Internal Revenue Service takes the position that it ordinarily will not infer that a taxpayer s purpose in borrowing money was to purchase or carry tax-exempt obligations if the taxpayer s investment in tax-exempt obligations is insubstantial. The American Recovery and Reinvestment Act of 2009 ( Recovery Act ) provided for a two percent safe harbor for this purpose with respect to any bonds originally issued during 2009 and 2010, and any bonds that refund such original bonds. In addition, financial institutions may deduct interest expense allocable to investments in bank qualified bonds, subject to the 20 percent disallowance under section 291(a)(3). Bank qualified bonds are bonds that are so designated (or deemed designated in the case of certain current refunding issues) by an issuer of tax-exempt obligations that are issued for governmental or section 501(c)(3) purposes to the extent that the issuer reasonably expects that the amount of its tax-exempt obligations to be issued in a calendar year will not exceed $10 million. Among various clarifications and modifications, the Recovery Act provided for a temporary increase of these $10 million limits to $30 million. Example. If a bank purchases bonds issued to construct a city office building, and if the principal amount of bonds is $10 million or less (taking into account other bonds issued by the same issuer in the calendar year), then the prohibition against deduction of interest on loans to carry tax-exempt bonds does not apply. If, however, the principal amount of the bonds is $10.1 million (or if the issuer previously issued bonds that, together with the office building bonds, exceed $10 million), the issuer is less likely to be able to market the bonds to a financial institution because the deductibility limitation applies to the bank and makes the bonds less attractive to a bank as a potential purchaser. Reason for Change. The purpose of the small issuer bank purchase exception to bank nondeductibility is to preserve the ability of small issuers, with limited access to the capital markets, to place bonds with local banks and without undue complexity. The $10 million limit, which was adopted by Congress in 1986, has not increased since. Because the cost of capital projects and, as a consequence, the principal amount of bonds necessary to fund capital projects, has increased dramatically since 1986, the principal amount of the exception which was increased only temporarily with the Recovery Act should be increased permanently. Also, the eligibility requirements for the exception should be conformed to those for the small issuer exception from the rebate requirement, as the slight differences between the statutory language of the two provisions are a trap for the less sophisticated issuers for whom the provisions were designed. Here, in short, it would be much simpler if a single definition of a small issuer were used for both the rebate exception and the bank nondeductibility exception. Some have suggested that the small issuer bank purchase exception is no longer necessary because of the access to capital markets provided by state-level bond banks and pooled loan programs. Pool programs, however, are not necessarily available in all states or if they are ~3~

4 available, they may not be available for all governmental purposes. Many small issuers continue to rely heavily on local banks as their main source of financing. Since the economy began receding in 2007, many municipal issuers have struggled accessing the tax-exempt market in a cost-efficient manner. The temporary increase in the $10 million limits to $30 million provided by the Recovery Act resulted in a meaningful interest rate cost savings by many issuers of tax-exempt obligations, because they were able to increase liquidity. Moreover, as a matter of federal policy, this proposal is not about providing an unfair advantage to financial institutions vis-a-vis other corporations, but it is about reducing the interest rate costs to the governmental issuer. Banks and other financial institutions would remain subject to the 20 percent disallowance under section 291(a)(3). Finally, in the case of a qualified financing issue (i.e., a composite, pool or conduit financing issue) the Recovery Act applied the $30 million volume limitation at the borrower level (rather than at the level of the pooled financing issuer). This provision has likewise expired and should be made permanent. 3. Make all tax-exempt bonds uniformly exempt from alternative minimum tax and adjustment to corporate earnings in determining alternative minimum taxable income. Present law. Present law imposes an alternative minimum tax ( AMT ) on individuals and corporations. AMT is the amount by which the tentative minimum tax exceeds the regular income tax. The tentative minimum tax is computed based upon a taxpayer s alternative minimum taxable income ( AMTI ). AMTI is the taxpayer s taxable income increased by certain preferences and adjustments. One of the preference items is tax-exempt interest on private activity bonds other than qualified 501(c)(3) bonds, or bonds issued prior to August 8, 1986 (or refundings of such pre-86 bonds) (sec. 57(a)(5)). Also, in the case of a corporation, an adjustment based on current earnings is determined, in part, by taking into account 75 percent of items, including tax-exempt interest, that are excluded from taxable income but included in the corporation s earnings and profits (sec. 56(g)(4)(B)). The Recovery Act provided that tax-exempt interest on private activity bonds issued in 2009 and 2010 (and any bonds refunding original bonds issued in 2009 and 2010) is not an item of tax preference for purposes of the AMT and is not included in the corporate adjustment based on current earnings. Also, the Housing Assistance Tax Act of 2008 provided similar relief for private activity bonds for rental or owner-occupied housing; this relief remains in effect at the present time. Example. If a holder of qualified tax-exempt private activity bonds receives $100,000 of interest on the bonds in a year, that amount is not included in the holder's Federal adjusted gross income for computing the holder's Federal regular income tax. That interest, however, is required to be added to the holder's Federal adjusted gross income base in determining whether the holder is subject to the Federal alternative minimum tax. Reason for Change. The repeal of the alternative minimum tax on tax-exempt qualified private activity bonds will simplify the tax-exempt interest exclusion, enhance market demand for these bonds, and increase market efficiency. In the municipal market, private activity bonds ~4~

5 which are subject to the alternative minimum tax carry a higher interest rate. This higher interest cost adds to Federal tax expenditures without a corresponding increase in Federal tax revenues because investors subject to the alternative minimum tax do not purchase these bonds. The proposed repeal of the alternative minimum tax on tax-exempt bonds will have increasing market significance as an increasing number of taxpayers are expected to be subject to this tax in future years. The increased demand for tax-exempt private activity bonds from this proposed change should have the effect of lowering the interest rates on private activity bonds by an estimated 10 to 25 basis points. This proposed change should decrease the burden on the tax-exempt bond market and increase Federal revenues. Moreover, in the case of a multi-year large project, which began during 2009 and 2010 and requires the issuance of multiple new money bonds, there is no sound policy justifying the difference in tax cost between a private activity bond originally issued in 2009 and 2010 (or any such applicable refunding bonds) and one originally issued for the same project in 2011 and thereafter. 4. Repeal the 5% unrelated and disproportionate private business use limit on governmental bonds. Present law. If private business use is not related or is disproportionate to the governmental use of tax-exempt bond proceeds, then a 5% private business use restriction applies to tax-exempt governmental bonds instead of the general 10% private business restriction on such bonds. Example. If a governmental bond is issued to finance a courthouse facility which includes a staff cafeteria operated by a private business, a 10% private business use restriction applies to such bond issue because the cafeteria use is treated as related to the courthouse use. If, however, a governmental bond is issued to finance a courthouse which includes office space for lawyers, a 5% private business use restriction applies to such bond issue because the law office use is treated as unrelated to the governmental courthouse use. Reason for change. The unrelated or disproportionate use test is cumbersome, inappropriately intricate, and difficult to understand and to apply. The determination of whether a particular use is related or unrelated to a governmental use or whether a use is proportionate or disproportionate to a governmental use can be vague and arbitrary. The application of the test is especially complex in the case of bond issues financing multiple facilities. Out of an abundance of caution, some issuers automatically reduce their otherwise-permitted level of private business involvement from 10% to 5% in governmental tax-exempt bond issues just to avoid the interpretative difficulty of this requirement which seems contrary to the intent of the private business restrictions. The penalty for an erroneous determination is loss of tax-exemption for the entire bond issue. The general 10% private use limit effectively controls excess private business use of governmental tax-exempt bond issues. 5. Eliminate the 10 year redemption provision for qualified mortgage bonds. Present Law. Under present law, qualified mortgage bonds are tax-exempt bonds used to finance owner-occupied residences. Among other requirements, these bonds are subject to income and purchase price limitations, as well as a requirement that the homebuyer not have an ownership interest in a principal residence in the preceding three years. ~5~

6 Generally, in order for a bond to be a qualified mortgage bond, the mortgagor s family income cannot exceed 115 percent of the applicable median family income. Adjustments are made for targeted area residences, for areas that have high housing costs in relation to income, and for family size. Further, 95 percent or more of the net proceeds of qualified mortgage bonds must be used to finance residences for homebuyers not having an ownership interest in their principal residence for the preceding three years with the exceptions of financings of targeted area residences, qualified home improvement loans, and qualified rehabilitation loans. A residence financed with a mortgage loan provided by qualified mortgage bonds may not have a purchase price in excess of 90 percent of the average area purchase price for that residence. Adjustments are made for residences located in certain low-income or economically distressed areas and for two to four family residences. The imputed interest subsidy provided by qualified mortgage bonds is subject to a recapture tax if the mortgagor experiences substantial increases in income and disposes of the subsidized residence within nine years after purchase. The annual volume limitations imposed on most qualified private activity bonds limits the aggregate amount of, among others, qualified mortgage bonds that may be issued. Except for a $250,000 de minimis amount, repayments of principal of mortgage loans provided by an issue of qualified mortgage bonds received after 10 years from the date of issue must be used to redeem outstanding bonds which are part of such issue not later than the close of the 1 st semiannual period beginning after the date the prepayment (or complete repayment) is received (the 10-year Rule ). In the case of refunding bonds, the 10 years is measured from the issue date of the original bonds. The 10-year Rule generally applies to qualified mortgage bonds issued after December 31, 1988 and (under a transition rule) with respect to a post-1988 refunding of pre-1989 qualified mortgage bonds, only to repayments received on or after the issue date of the refunding bonds, including payments on mortgage loans purchased before the issue date of the refunding bonds. The internally inconsistent aspect of the 10-year Rule resulting from the statute s use of the terms (italicized above) repayments, prepayment and complete repayment (i.e., there are principal repayments that are neither prepayments nor complete repayments) is seemingly addressed by the legislative history to the 10-year Rule, which indicates that the 10-year Rule applies to regular mortgage loan repayments and prepayments. Qualified mortgage refunding bonds that do not constitute advance refunding bonds (i.e., current refunding bonds where the issuance of the refunding bonds precedes the redemption of the prior bonds by more than 90-days) are permitted and do not require volume cap upon the satisfaction of certain requirements, specifically: (1) the maturity date of the refunding bond must be not be later than the later of the average maturity date of the refunded qualified mortgage bonds or the date 32 years after the date on which the refunded qualified mortgage bonds were issued (or, in the case of a series of refundings, the date on which the original bonds were issued) and (2) the amount of the qualified mortgage refunding bonds does not exceed the outstanding amount of the refunded qualified mortgage bonds. Example. The intent of the 10-year rule was to permit issuers of qualified mortgage bonds to recycle all mortgage loan principal repayments and prepayments (i.e., originate ~6~

7 additional mortgage loans) for 10 years after the issuance of the original bonds. Refundings of qualified mortgage bonds after the initial origination period are also used to recycle moneys for additional mortgage loans by refunding scheduled principal repayments, which otherwise would be used to pay maturing bond principal or redeem bonds, and principal prepayments, which would otherwise be used to redeem bonds. In other words, one of the universally accepted sources of refunding may be bonds scheduled to mature or bonds to be redeemed from repayments and prepayments (subject to the 10-year Rule). Following the refunding, the monies that would have been used to pay principal on the refunded bonds are used to make new mortgage loans that secure and provide a source of revenue to pay debt service on the refunding bonds. Simply stated, repayments and prepayments of one qualified mortgage bond issue become the lendable transferred proceeds of another qualified mortgage bond issue, namely, a current refunding issue. This is accomplished without increasing the long-term amount of bonds outstanding. The 10-year Rule has a substantial impact on the ability of issuers to engage in such recycling refundings, which are also known as replacement refundings or prepayment refundings. For example, if in 1994 an issuer issued a replacement refunding issue for one or more pre-1988 qualified mortgage bond issues, then beginning in calendar year 1998 all principal receipts for the mortgage loans for the 1994 issue are deemed allocated by the 10-year Rule to issues more than 10 years old. Therefore, none of the 1994 issue may now be refunded as a means to generate funding authority for mortgage loans. In contrast, a refunding for savings would be permitted, but all mortgage loan repayments and prepayments received would be required to be used to redeem the refunding issue. Also, after the 10-year period, issuers are effectively neither permitted to cross-call (i.e., redeem) bonds of one issue from principal repayments and prepayments on mortgage loans funded by another issue nor permitted to use principal repayments and prepayments allocable to tax-exempt qualified mortgage bonds for paying principal on any paired taxable bonds. Reasons for Change. The 10-year Rule negatively impacts an issuer s ability to recycle principal repayments and prepayments into new mortgage loans, which in turn limits the issuer s funding authority for mortgage loans and ability to reduce mortgage loan interest rates for program mortgagors to competitive levels. Such is the case with replacement refundings, which are affected by variables such as the availability of volume cap and declining interest rates. In a market where volume cap is scarce, a replacement refunding, subject to the 10-year Rule, can provide additional monies to finance new mortgage loans without requiring a volume cap allocation. Thus, one primary impact of the 10-year Rule has been to require increasing amounts of volume cap in order for issuers to continue the operation of their single-family programs. For purposes of tax compliance and administration, the tracing of the chronology of all post-1988 replacement refundings is complex and costly, with the effective result that only a fraction of post-1988 issues are being refunded, as illustrated by the example above. A typical issue of qualified mortgage bonds may refund portions of several different prior issues, each of which may itself have refunded portions of prior issues. In general, issuers often deal with this circumstance by tracing the use of proceeds of the new issue back to the original financing issues on a proportionate basis and then assigning separate 10-year dates to various percentages of the new issue. This table of dates and percentages is used to determine what percentage of the repayments and prepayments received in any particular period must be used for redemptions. In ~7~

8 planning the refunding issue, this analysis is used to determine what amount of repayments and prepayments is available for refunding. Once the refunding bonds are issued, the same method of analysis is used to determine which prepayments are available for future refundings. The difficulties in applying the 10-year Rule become apparent in the typical case of bond indentures where more than one series of qualified mortgage bonds are outstanding, where revenues are applied on a parity basis, and where mortgage loans may be made from the participation of numerous sources of funds. Moreover, most issuers now combine new money and refundings in one qualified mortgage bond issue. The application of the 10-year Rule is most difficult and time consuming when, as is the case for many, if not most, State housing issuers, the tracing required to ascertain applicable restrictive dates involves multi-generations of qualified mortgage bond issues, each which may have refunded portions of multiple prior issues. The concern that recycling or replacement refundings would result in avoidance of income and purchase price limitations due to bonds having been issued prior to the imposition of such rules or due to transition rules applicable to current refundings is now irrelevant due to the passage of Section 1313(d) of the Tax Reform Act of 1986, which now requires such limitations on all mortgage loans, including those related to recycling or replacement refundings. Finally, recycling, including replacement refunding, provides additional funding authority for mortgage loans to satisfy demand for mortgage loans to low and moderate income first-time homebuyers without overburdening the tax-exempt bond market. With recycling during the 10-year period, the qualified mortgage bonds remain outstanding no longer than the period of time for which they were structured and with recycling through a replacement refunding, the refunding bonds, which are subject to certain maturity limits, merely replace prior bonds, dollar for dollar, while still be subject to certain maturity limitations applicable to current refundings of qualified mortgage bonds. In summary, over multiple years, the lost funding authority for mortgage loans by State housing issuers across the country easily amounts to the lost opportunity to make thousands of mortgage loans with no increase in the amount or extension of the life of bonds. Therefore the 10-year Rule should be repealed. 6. Eliminate the 25 percent limit on ancillary costs in small issue private activity bonds for manufacturing facilities and reenact the provision of the Recovery Act providing for the functionally related and subordinate test. Present Law. A manufacturing facility is eligible for tax-exempt financing under the qualified small issue bond provisions of the Code if, among other things, the facility is used in the manufacturing or production of tangible personal property. Under present law, facilities that are directly related and ancillary to a manufacturing facility are considered a part of the manufacturing facility and may also be financed with proceeds of qualified small issue bonds if (1) such facilities are or will be located on the same site as the manufacturing facility (the location requirement ) and (2) not more than 25 percent of the net proceeds of the issue will be used to provide such facilities (the 25 percent limitation ). For bonds issued in 2009 and 2010, the Recovery Act temporarily replaced the 25 percent limitation with a requirement that such facilities be functionally related and subordinate to the actual manufacturing facility (the functionally related and subordinate test ). ~8~

9 Example. Assume a municipal issuer issued bonds to finance the acquisition of a manufacturing facility, including forklift trucks used to move raw material or the products resulting from the manufacturing process. In addition, assume that more than 25 percent of the net proceeds of the bonds were allocated to the acquisition of the forklifts. Under present law, the bonds could not be qualified small issue bonds because the 25 percent limitation is exceeded. Under the Recovery Act, however, such use of proceeds did not automatically disqualify the bonds so long as the requirements of the functionally related and subordinate test were met. Or, assume that the building housing the manufacturing facilities also included a room that held computers used to process orders, calculate raw material needed to fill the orders, and prepare billings for the items manufactured to fill the orders. It is not clear whether this portion of facilities could be financed with qualified small issue bonds as functionally related and subordinate to the manufacturing facilities, which may not be subject to the 25 percent limitation, or as directly related and ancillary to such facilities, subject to the 25 percent limitation. Reason for Change. The directly related and ancillary rule has historically been difficult to apply, in part because of inconsistent drafting, legislative interpretation and application. Prior to the adoption of this language in 1988, practitioners had relied on the regulations governing qualified facility bonds (and before that, qualified industrial development bonds), which had included as part of "qualified facilities," facilities that were functionally related and subordinate to the qualified facilities themselves. The Reports from the House of Representatives indicated that the addition of the term "directly related and ancillary" was intended to make a distinction between what constitutes core manufacturing facilities (i.e., facilities actually causing the transformation or processing of the manufactured product), facilities that are subordinate and integral to the manufacturing facilities (i.e., facilities essential for the manufacturing process to operate) and ancillary facilities (e.g., facilities not integral to the manufacturing or production process). While the location requirement of the rule was to apply to subordinate and integral facilities as well as to ancillary facilities, the 25 percent limitation was to apply only to ancillary facilities. Unfortunately, the Conference Report relating to the codification of the rule equated ancillary facilities with subordinate and integral facilities, and thereby appears to misinterpret Congressional intent with respect to these two types of facilities. As a result, it has been argued that under present law the 25 percent limitation applies not only to ancillary facilities but also to subordinate and integral facilities. The functionally related and subordinate test, while it remained applicable to qualified small issue bonds until December 31, 2010 under the Recovery Act, provided reasonably clear guidance regarding the distinction between core manufacturing and other facilities that could be financed with qualified small issue bond proceeds. Such guidance existed by analogy to the functionally related and subordinate test found in the regulations relating to qualified exempt facility bonds. Eliminating the 25 percent limitation and keeping only the functionally related and subordinate test is not likely to lead to indiscriminate financing of non-core manufacturing facilities, any more than permitting the financing of functionally related and subordinate facilities has lead to indiscriminate financing of qualified exempt facilities. There still must be a manufacturing facility being financed to which the functionally related and subordinate facility is an adjunct. Furthermore, qualified small issue bonds continue to be subject to both the limits to the overall size of a small issue bonds and to capital expenditures. Finally, small issue bonds, like qualified exempt facility bonds, are also subject to the overall state volume cap limitations. ~9~

10 7. Reenact provisions for refundable tax credit Build America Bonds at a 28 percent subsidy payment rate with expanded authorization to include current refundings, governmental working capital financings and financings for section 501(c)(3) nonprofit entities. Present Law. Under the refundable tax credit Build America Bonds program, which expired on December 31, 2010, state and local governments were able to issue taxable bonds and elect to receive payments (the refundable tax credits) from the Treasury in the amount of 35 percent of their interest costs. Use of Build America Bond proceeds was generally limited to financing public capital projects for which the issuer could otherwise have issued tax-exempt governmental bonds. Example. Assume a municipal issuer issued bonds in 2010 to construct a new courthouse. If the bonds had been issued as tax-exempt bonds, interest on the bonds would generally have been excludible from gross income of the registered owners of the bonds for federal income tax purposes. However, if the bonds had been issued as refundable tax credit Build America Bonds, interest would have been payable based on taxable bond rates and would not have been excludible from gross income. Instead, over the term of the bonds, the issuer will receive payments from the Treasury covering 35 percent of the interest on the bonds. Reason for Change. The Committee on Tax Exempt Financing proposal to reenact and expand the refundable tax credit Build America Bonds program mirrors President Obama s 2012 budget. The budget proposes to permanently resurrect Build America Bonds at a lower 28 percent direct-payment rate, which is designed to be approximately revenue neutral in comparison to the federal tax losses from traditional tax-exempt bonds. The budget proposal would also expand the eligible uses for Build America Bonds to include current refundings of prior public capital project financings for interest cost savings, governmental working capital financings, subject to a 13-month maturity limitation, and financing for section 501(c)(3) nonprofit entities, such as nonprofit hospitals and universities. Build America Bonds have proven to be successful. In 2009 and 2010, refundable tax credit Build America Bonds provided a crucial new financing vehicle for state and local issuers. By incorporating refundable tax credits in lieu of providing tax exemption on interest, the program opened up the municipal securities market to nontraditional investors, including pension funds, life insurance companies and foreign investors, who are generally not interested in receiving tax-exempt interest. This helped assure a more stable source of demand for state and local debt and improved the under-capitalization of the tax-exempt market by decreasing the supply of tax-exempt bonds and lowering borrowing costs to state and local governments. According to a Treasury Department report accompanying the President s budget, refundable tax credit Build America Bonds also efficiently deliver federal subsidies directly to state and local governments. In connection with traditional tax-exempt or tax credit bonds, such subsidies must be provided indirectly through third-party investors. At the same time, access to a robust conventional tax-exempt market remains necessary as an alternative to Build America Bonds. Allowing tax-exemption as an alternative means that issuers can look broadly for the best place to sell their bonds, and it also offers a financing ~10~

11 method that may be more workable in the case of smaller financings where the compliance costs of reporting and claiming the Build America Bonds credits can be disproportionate. 8. Extend the three-year spending exemption from arbitrage rebate provided for tax credit bonds to tax-exempt bonds, and further simplify the exception. Present law. Generally, interest earnings on investments of tax-exempt bond proceeds in excess of the bond yield must be rebated to the Federal government. There are existing spending exceptions which permit an issuer to avoid rebate on construction fund moneys if spent within 6- month, 18-month and 2-year periods. The 2-year spending exception is only available for governmental and qualified 501(c)(3) bonds issued to finance certain construction projects. The 2-year exception is complicated to apply, with semi-annual spending targets, rules that require an issuer to exclude non-construction expenditures, and complex penalty elections that are rarely used. Similarly, interest earnings on investments of tax credit bond proceeds in excess of the bond yield are subject to rebate to the Federal government. A spending exception from yield restriction and rebate is provided if the issuer reasonably expects to spend 100 percent of the proceeds within 3 years of the date of issue and enters into a binding commitment with a third party to spend at least 10 percent of the proceeds within 6 months of the date of issue. The 3- year spending period can be extended by the IRS if the issuer establishes that the failure to spend is due to reasonable cause and the projects will continue to proceed with due diligence. To the extent that 100 percent of the proceeds are not spent within the 3-year period (or the end of any period for which the IRS has granted an extension), the unspent proceeds must be used to redeem bonds within 90 days of the end of the period. Examples. Tax-exempt bonds. Assume $40 million of tax-exempt bonds are issued by a local school district to construct a public school. The issuer plans to use the two-year rebate spending exception and has sized the issue to meet the spending benchmarks, including expenditure of all investment earnings. The issuer meets the first two semiannual spending benchmarks, but unusual inclement weather causes the issuer to fall short of the third benchmark. Under current law, the issuer loses the total benefit of the rebate exception and must rebate any excess investment earnings over the yield on the tax-exempt bonds to the Federal government, even though the issuer had sized the issue to spend all earnings on the project. To further illustrate some of the conditions and complexities relating to the existing 2- year exception, suppose the school district additionally finances costs that are not construction expenditures such as land acquisition and equipment for the school. Here, the issuer would not be entitled to the two-year exception if the land acquisition and equipment exceeds 25 percent of the issue. If these costs are less than 25 percent the issuer would be required to make a complex election to divide the issue into construction and non-construction components and separately analyze each for rebate purposes. ~11~

12 Tax credit bonds. By contrast, assume $40 million of qualified school construction tax credit bonds are issued by a local government to acquire land on which it will construct and equip a public school. The issuer has sized the issue with the expectation that it will spend all sale proceeds, including expected investment earnings, within 3 years of the date of issue. The issuer enters into a construction contract pursuant to which it agrees to spend more than 10 percent of the proceeds within 6 months of the date of issue of the bonds, and in fact spends 100 percent of the proceeds including investment earnings within 2 ½ years of the date of issue. Under current law, the issuer is not subject to yield restriction or rebate. Alternatively, assume the same facts as above, but that unusual inclement weather results in the issuer spending only 90 percent of the proceeds (including expected investment earnings) by the end of the 3-year period. The issuer expects to spend all amounts within the following year. The issuer in this case has two options in order to maintain the status of the bonds as tax credit bonds. It can use the unspent proceeds to redeem bonds, which could result in insufficient funds to complete the construction. Or it can file a ruling request with the IRS requesting an extension of the 3-year period, which is a timely and expensive process. Reason for Change. The present two-year rebate spending exception provides for unrealistic spending periods, complex bifurcation procedures, difficult and repetitive computations, and unclear multipart definitions. The exception should be modified to be simple in its application and to permit issuers and conduit borrowers three years (rather than two) to meet the applicable spending requirements. In addition, this exception should be expanded to include both private activity bonds and governmental bonds, as well as to include bonds for any capital project (encompassing both acquisition and construction purposes). The simplification of this provision could be accomplished by providing all tax-exempt bonds with a 3-year rebate exception similar to the one available for tax credit bonds, with certain modifications to further simplify its application. The Administration has proposed a similar streamlined 3-year spending exception for tax-exempt bonds as part of its FY 2012 Revenue Proposals. In contrast to the existing spending exception for tax credit bonds, the proposed spending benchmarks should contain a de minimis exception (such as 5 percent as the Treasury Department suggests) to broaden the availability of the exception to cover the many circumstances in which minor amounts of bond proceeds remain unspent for bona fide reasons. Also in contrast to the existing spending exception for tax credit bonds, the streamlined exception should provide that if an issuer who otherwise expected to meet the spending benchmarks fails to do so, the issue will become subject to yield restriction and rebate as of the end of the 3-year period, as opposed to requiring the use of unspent proceeds to redeem bonds. We further suggest that the tax credit bond spending exception be modified to include the de minimis exception and remove the redemption requirement in order to simplify and conform the application of spending exceptions for issuers who issue both tax-exempt bonds and tax credit bonds. The simplification of this provision would provide meaningful administrative relief from complex arbitrage calculations to a broad number of tax-exempt bond issuers. The three-year spending exception should apply as broadly as possible, particularly given that limited arbitrage potential exists for short-term investments in most long-term tax-exempt bond issues. This spending exception should be limited to fixed rate tax-exempt bonds to recognize one area in ~12~

13 which some arbitrage potential may exist under a 3-year spending period in normal yield curves, which involves tax-exempt floating rate bonds with short-term tender options. The Treasury Department proposes that it be limited to fixed-rate bonds with a minimum weighted average maturity of at least 5 years, and we concur with this proposal. We also concur with the Treasury Department s proposal to exclude bonds issued mainly for advance refundings and working capital. 9. Increase the small issuer exception from rebate to $10 million, index it for inflation and remove the general taxing power eligibility requirement. Present law. Generally, interest earnings on investments of tax-exempt bond proceeds above the yield on the tax-exempt bonds must be rebated to the Federal government. Under the small issuer exception, the rebate requirement does not apply to governmental units with general taxing powers where the amount of bonds issued by the unit in the calendar year is not reasonably expected to exceed $5 million (excluding private activity bonds and most current refunding bonds with a principal amount not exceeding the principal amount of the refunded bonds). Example. If an issuer with general taxing powers issues bonds to construct a library, and if the principal amount of bonds is $5 million or less (taking into account other bonds issued by the issuer in the calendar year), then the rebate requirement does not apply to the bonds. If, however, the principal amount of bonds is $5.1 million, or if the issuer does not have general taxing powers, such as a public building authority which is an instrumentality of a governmental unit with general taxing powers, then the rebate requirement applies to the bonds. Reason for Change. With one exception, the small issuer exception to the rebate requirement has remained at $5 million since its inception in Thus, while all other costs associated with capital expenditures (construction, acquisition, administrative, etc.) have increased, the $5 million limitation has remained stagnant. Increasing the amount and providing for future inflation adjustments will broaden the availability of this exception and alleviate administrative burdens on small issuers. The Administration has included this simplification measure as part of its FY 2012 Revenue Proposals. The Treasury Department indicates that increasing the small issuer exception will substantially reduce the administrative burden imposed on a large number of small issuers by the rebate requirement while affecting a disproportionately smaller amount of tax-exempt bond dollar volume. For example, as the Treasury Department discusses, in 2008, tax-exempt issuers of $10 million or less of bank purchase qualified bonds issued 4,195 bond issues out of 10,830 total tax-exempt bond issues, representing approximately 39 percent of the total number of tax-exempt bond issues. The dollar volume of those bond issues, however, was only $15.3 billion out of $389.6 billion of total tax-exempt bond dollar volume, representing only about 3.9 percent of the total dollar volume. At the $10 million level, the difference between the large number of small bond issuers who could be relieved of administrative burdens (39 percent) and the small dollar volume affected (3.9 percent) is compelling support for simplifying this provision. ~13~

14 In addition to the foregoing, and similar to the Administration s proposal, we suggest that the general taxing power requirement for eligibility be removed. If an issuer is a governmental unit authorized to issue bonds, it should be eligible for the small issuer exception to the rebate requirement even if it does not have general taxing powers. The requirement for the existence of general taxing powers unfairly narrows the benefit of the exception. State or local governments commonly use public instrumentalities without general taxing powers to carry out tax-exempt bond programs, and issuers in those cases should also be able to utilize the spending exception if annual bond issuance is within the $10 million limit. 10. Allow all yield restrictions, including advance refunding escrows, to be satisfied by yield reduction payments calculated in a manner similar to arbitrage rebate. Present law. Generally, yield on investments of tax-exempt bond proceeds are subject to certain arbitrage rebate yield limitations. The economics of some transactions will result in the yield on investments of tax-exempt bond proceeds to exceed the arbitrage rebate yield limitations applicable to such investments. When such excess yield occurs, the bonds may be characterized as arbitrage bonds, resulting in elimination of the bonds favorable tax status, unless corrective steps are taken. The law allows an issuer to make yield reduction payments to the United States in an amount necessary to reduce the yield on such tax-exempt bond proceeds investments to or below the arbitrage rebate yield limitations to avoid the bonds being treated as arbitrage bonds. Yield reduction payments, however, are not available for all types of investments and are limited to covered investments only. Such covered investments include: certain nonpurpose investments (e.g., money market funds) allocable to tax-exempt bond proceeds during an applicable temporary period (none of which applies to advance refunding bond proceeds and the temporary period of such is only 30 days); purpose investments and nonpurpose investments for certain variable yield tax-exempt bonds; purpose investments allocable to certain student loan bonds; and nonpurpose investments allocable to transferred proceeds of (i) a current refunding bond issue to the extent necessary to reduce the earnings yield to satisfy the arbitrage yield rebate limitations or (ii) an advance refunding bond issue to the extent that investment of the refunding escrows allocable to the proceeds, other than transferred proceeds, of the refunding issue in zeroyielding nonpurpose investments is insufficient to satisfy the arbitrage rebate yield limitations. Yield reduction payments for the benefit of an advance refunding issue is not permissible to resolve excess yield issues for investments allocable to the gross proceeds except for nonpurpose investments allocable to the transferred proceeds described in the preceding sentence, nonpurpose investments allocable to replacement proceeds of the refunded bond issue because of the application of the universal cap rules to amounts in a refunding escrow and nonpurpose investments allocable to transferred proceeds in a fund that, except for its failure to satisfy the size limitation for reasonably required reserve or replacement funds ( 4R fund ), would qualify as a 4R fund, but only if certain conditions are satisfied. Example. Assume a local government issued tax-exempt governmental bonds in 2001 to finance the construction of a new school building and that the bonds are not callable until the last calendar quarter of Because of current low rates, the issuer desires to refund the 2001 bonds in 2011 with fixed rate bonds (the 2011 bonds ). The issuer issues the 2011 bonds in the third quarter of 2011 and establishes an advance refunding escrow to redeem the 2001 bonds in ~14~