That is the question facing many state and local governments, hospitals, universities and other conduit borrowers across the United States as bond insurers are downgraded and thousands of auction rate securities suffer “failed auctions.” In response to the credit crisis, on February 19, 2008 the Internal Revenue Service issued Notice 2008 27 (2008 WL 427303) (the “Notice”) to provide interim guidance to issuers attempting to restructure existing debt to respond to rapidly changing market conditions.

What is reissuance?

Generally, a reissuance can occur under federal tax law when issuers, borrowers or other parties to a bond transaction alter or vary the terms pursuant to which a bond is held.

Why does reissuance matter?

A reissuance of tax-exempt bonds requires that all tax exemption requirements be retested at reissuance and may trigger various undesirable consequences, including among others: (i) changes in yield for purposes of arbitrage investment restrictions, (ii) acceleration of arbitrage rebate obligations, (iii) deemed terminations of integrated swaps, (iv) new TEFRA public approval requirements and (v) change of tax law risk. Additionally, a reissuance of bonds typically causes the recognition of gain or loss on the bonds in the hands of the taxpayer, and generally is treated as the equivalent of a current refunding of the bonds.

What does the Notice do?

In general, the Notice provides helpful, expanded guidance as to what can be treated as a “Qualified Tender Bond,” and confirms that changes from one interest rate mode to another interest rate mode will not trigger a reissuance if such changes were provided for in the original bond documents. The Notice provides that other types of changes to tax-exempt bonds are tested for reissuance under the “significant modification” standard of Treasury Regulation §1.1001 3. Additionally, the Notice provides special rules for certain issues that have arisen as a result of bond insurer downgrades and failed auctions.

How does the Notice work?

The Notice expands the protection afforded to Qualified Tender Bonds to provide that changes in interest rate modes and certain optional or mandatory tenders of bonds will not result in a reissuance. Most notably, the Notice clarifies that bonds issued in or converted to a mode in which interest is periodically reset pursuant to a Dutch auction process (i.e., auction rate securities), pursuant to the terms of the bonds, need not be treated as reissued whenever interest is so reset or whenever the bonds are so converted. Additionally, the Notice increases to a maximum of 40 years the term to maturity for any Qualified Tender Bond. The Notice accomplishes these tasks by clarifying or expanding the definitions of “Qualified Tender Bonds,” “Qualified Interest Rate Mode Changes” and “Qualified Tender,” as described below.

Qualified Tender Bonds

The Notice clarifies what constitutes a Qualified Tender Bond, which is a bond that has all of the following features:

  • For each authorized1 interest rate mode, the Bond bears interest during the term of such mode at either a fixed rate or a variable rate that constitutes a “qualified floating rate.”2
  • Interest on the bond is unconditionally payable at periodic intervals at least annually. (Therefore capital appreciation bonds are NOT treated as Qualified Tender Bonds.)
  • The final maturity is no longer than the lesser of 40 years after the date of issue or the latest date that is necessary to carry out the governmental purpose of the bond.3

Qualified Interest Rate Mode Changes

In general, a “qualified interest rate mode change” is a change in the interest rate mode that is authorized under the original terms of the bond. The Notice provides that in order to be a qualified interest rate mode change, the terms of the bond must require that the bond be resold at a price equal to par upon conversion to a new variable interest rate mode, except that, upon a conversion to a fixed interest rate for the remaining term to maturity the bond may be resold at a market premium or a market discount from the stated principal amount of that bond. Any such premium would be treated as additional proceeds of the bonds.

Qualified Tenders

A “qualified tender” is either a tender option or a mandatory tender requirement that is authorized under the terms of the bond upon its original issuance and that meets the requirements set forth below:

A bond is subject to a tender option or a tender requirement if the bondholder either has the option at specified times or the mandatory requirement upon specified occurrences (e.g., a mandatory tender upon conversion from one interest rate mode to a different interest rate mode) to tender the bond for purchase or redemption at a price equal to par (which may include any accrued interest) pursuant to the terms of the bond on one or more tender dates before the final stated maturity date. The Notice provides that a purchase of a bond pursuant to a tender option or mandatory tender requirement is treated as part of a qualified tender if the purchase occurs under the terms of the bond (regardless of whether the purchase is by the issuer, a liquidity provider, a remarketing agent, a bond trustee, a conduit borrower, or an agent of any of them), the terms of the bond require that best efforts be used to remarket the bond, and the bond is remarketed no later than 90 days after the date of such purchase.

Special Rule for Nonrecourse Debt

A modification of the security or credit enhancement on a tax-exempt bond that is a nonrecourse debt instrument is a significant modification, only if the modification results in a change in payment expectations as contemplated under Treasury Regulation §1.1001 3(e)(4)(vi). For example, a change from investment grade to non-investment grade and vice versa would be considered a significant modification.

Special Temporary Relief for Certain Waivers of Interest Rate Caps on Auction Rate Securities A temporary waiver, in whole or in part, of the terms of a cap on the maximum interest rate on auction rate securities is disregarded to the extent that any agreement to waive such a cap and the period during which such a waiver is in effect both are within the period between November 1, 2007 and July 1, 2008.

Certain Modifications of Qualified Hedges for Arbitrage Purposes

A modification of a qualified hedge is not treated as a termination of the hedge under Treasury Regulation §1.148 4(h) if both: (1) the modification is not reasonably expected as of the date of the modification to change the yield on the affected hedged bonds over the remaining term of such bonds by more than one quarter of one percent (.25 percent or twenty-five basis points) per annum; and (2) the payments and receipts on the qualified hedge, as modified, are fully taken into account as adjustments to the yield on those hedged bonds for arbitrage purposes.

Effective Dates of the Notice

Issuers and conduit borrowers may rely on the guidance provided by the Notice for any actions taken with respect to bonds on and after November 1, 2007 and before the effective date of regulations that implement the provisions of the Notice.