Earlier this year, we wrote about issuers that are weary of losing interest subsidies to sequestration and that have paid off their direct pay bonds with tax-exempt bonds. We noted two main questions where the issuer doesn’t pay off the direct pay bonds immediately, but instead puts the refunding bond proceeds into a defeasance escrow and pays off the direct pay bonds later:

  1. Would the funding of the escrow cause a reissuance of the direct pay bonds, which would probably cause the issuer to lose direct subsidy payments?
  2. If the escrow causes a reissuance, can the issuer still claim subsidy payments for any interest that accrued before the funding of the escrow?

We now have the answer to the first question, but do not have a clear answer to the second question.

On December 8, 2014, the Office of Chief Counsel (Chief Counsel) of the Internal Revenue Service sent Memorandum Number AM 2014-009 (Memo) to the Director of Tax Exempt Bonds providing advice regarding the defeasance of direct pay Build America Bonds (BABs).  The Memo was publicly released last Friday, December 19, 2014.

The Memo concludes that a legal defeasance of BABs does cause the BABs to be reissued.  This means the BABs are deemed to be newly issued as a refinancing of the previously existing BABs.  The Code does not permit new BABs to be issued after December 31, 2010 for any purpose, including a refinancing.  Thus, the deemed new issuance is an impermissible issuance and the BABs lose their direct subsidy.  The Memo leaves open the question of exactly how the amount of lost subsidy will be determined.

AM 2014-009 concludes that BABs are reissued when an issuer establishes an escrow to defease them.

In the Memo, the Chief Counsel describes a fact pattern where BABs were issued by a local government in July of 2009 with an interest rate of 6%, payable semiannually.  Initially, the issuer received a 35% subsidy from the federal government for each interest payment.  Later, because of sequestration, that subsidy payment was reduced. In addition, interest rates fell and the issuer then decided to refund the BABs in July of 2014.  The issuer issued tax-exempt bonds, the proceeds of which will be used to redeem the BABs.  But the BABs could not be redeemed on the same day the tax-exempt refunding bonds were issued so the issuer invested the tax-exempt bond proceeds in an escrow fund to legally defease the BABs until they could be redeemed.  The Memo does not provide the date of issuance of the refunding bonds or the date that the BABs were redeemed.

The Chief Counsel then reviews the applicable law regarding reissuance.   As we noted inour post from September 24, 2014, a defeasance of a debt instrument generally results in a reissuance of the debt instrument.  When a bond is defeased, it changes from a recourse bond to a nonrecourse bond because the bondholder no longer has any right to be paid by the issuer.  At that point, the bondholder will only be paid from the defeasance escrow, so the bonds become nonrecourse as to the issuer.

But the reissuance regulations have a special exception to this rule for “tax-exempt bonds” that says the defeasance of a tax-exempt bond will not trigger a reissuance.  This special rule allows the interest on a tax-exempt bond to remain tax-exempt even after it is defeased.

The problem is that, while a BAB is subject to the same federal tax rules as a tax-exempt bond, nonetheless a BAB is not technically a tax-exempt bond because interest on BABs is taxable.  The Chief Counsel argues that the exception for tax-exempt bonds doesn’t apply to taxable bonds like BABs because the bondholder is already receiving taxable interest and does not need the assurance that the interest will not suddenly become taxable.

The Memo cites the Preamble to the reissuance regulations in Treasury Regulations 1.1001-3 to justify its conclusion that the tax-exempt bond defeasance exception does not apply to direct pay bonds. The Memo says that “[a]s explained in the preamble to the final [reissuance] regulations, the drafters added these rules because of concerns that certain practices typical in tax-exempt bond financings, such as defeasance, could trigger a significant modification.” Presumably the Memo means that the final regulations included the defeasance exception for tax-exempt bonds for this reason. But the statement from the Preamble regarding “certain practices typical in tax-exempt bond financings” has nothing at all to do with the defeasance exception. The Preamble says: “In response to other comments, a number of changes have been made to better coordinate the final regulations with municipal financing practices.” T.D. 8675, 61 Fed. Reg. 32926, 32930 (June 26, 1996). It then lists these coordinating changes, none of which have anything to do with the defeasance exception or protecting bondholders.

The Memo then quotes directly from the Preamble: “If there was an intervening change in law following issuance, a significant modification could ‘result in bonds that were tax-exempt when issued ceasing to be tax-exempt bonds.’” 61 Fed. Reg. at 32929. But this language is describing the position taken by some commentators, which the final regulations rejected, who argued that the reissuance regulations shouldn’t apply at all to tax-exempt bonds. So it is odd to cite this phrase as support for the conclusion that the exception for tax-exempt bond defeasance exception is only designed to protect bondholders and thus should not also apply to direct pay bonds.

Neither of these quotations from the Preamble seems to support the conclusion that the only function of the defeasance exception for tax-exempt bonds is to protect bondholders from unexpectedly having to pay tax on the interest on their bonds, so that the exception shouldn’t apply to direct pay bonds. And in fact, the defeasance exception doesn’t protect just bondholders – it also protects issuers. If tax-exempt bonds are declared taxable, the bondholders likely will sue the issuer, and the issuer will end up holding the bag. Even more so, if direct pay bonds lose their tax-advantaged status, the result is the same – the burden falls on the issuer.

While the bondholder may not need to protect the nature of the interest paid on the BAB, the issuer would certainly like protection of the subsidy payment.  But, relying on the fact that the reissuance regulations use the phrase “tax-exempt bond,” and the fact that interest on BABs is not tax-exempt, the Chief Counsel concludes that the issuer is not entitled to that protection and that the issuer can no longer collect the subsidy payment if it defeases its BABs.

AM 2014-009 does not answer the question of what happens to interest during an interest payment period that accrues before the issuer defeases direct pay bonds.

The Memo answers the first question we raised in our original post – the reissuance occurs on the date that the escrow fund is created and the direct pay bonds are legally defeased.  But, frustratingly, the Memo does not answer the second question – whether the issuer loses the subsidy for any interest during the six-month interest payment period during which the reissuance occurs.  Presumably the lost subsidy would only be the amount due for the time period starting on the date of the defeasance, and the issuer could still claim subsidy payments for interest that accrues before the defeasance.  But it is possible that the IRS would take the position that the lost subsidy would be the entire amount for that six month interest payment period because subsidy payments are requested as each interest payment is made.

So, until the IRS answers the second question, here’s a practice pointer:  everything else being equal, issuers should try to time the creation of a defeasance escrow with an interest payment date for the BABs being refunded. This will minimize the time period before the defeasance, during which interest is accruing, but for which the issuer hasn’t requested a subsidy payment.   Of course, an issuer would not want the tail to wag the dog, so if the value of the lost subsidy is much smaller than the savings achieved by completing the refunding in a more timely fashion, it may not make sense to time the creation of the defeasance escrow to match the subsidy period.