Three score and thirteen years (and one day) after D-Day (June 7, 2017, for the non-history-buffs), the new regulations that prescribe the methods for determining the issue price of tax-advantaged bonds take effect. Of the various methods for determining the issue price of tax-advantaged bonds, the hold-the-offering-price method is the only one that allows an issuer of such bonds in an underwritten transaction to know with certainty in advance of the sale date of the bonds that the issue price of the bonds will be established on the sale date. As discussed below, however, this method will come at a cost to issuers of tax-advantaged bonds.
The question thus becomes, which federal tax circumstances warrant the increased cost of the hold-the-offering-price method to be assured that the issue price of the bonds will be established on the sale date? For the answer, read on.
To satisfy the hold-the-offering-price method, the underwriter must, among other things, agree that, during the “hold-the-offering-price period,” it will not sell a maturity of bonds at a price that exceeds that maturity’s initial offering price. The hold-the-offering-price period for a maturity begins on the sale date of the bonds (i.e., the date on which the issuer and underwriter enter into a written, binding agreement for the underwriter to purchase the bonds from the issuer), and runs until the earlier of (i) five business days after the sale date or (ii) the date on which the underwriter sells at least 10% of that maturity at a price that does not exceed the initial offering price of the applicable maturity. If the hold-the-offering-price method of establishing issue price is satisfied for each maturity of the issue, the initial offering price of each maturity on the sale date will be the issue price of that maturity for federal income tax purposes. Consequently, if the issuer and the underwriter have agreed to this method, the issuer is assured that the issue price (and, thus, the yield and weighted average maturity) of the issue of tax-advantaged bonds will be established on the sale date of the bonds.
The hold-the-offering-price method does, however, present some financial risk to the underwriter. If prevailing market rates fall during the hold-the-offering-price period, the underwriter will not be able to take advantage of the market movement by selling any maturities during that period at prices that exceed the initial offering prices, even though the market value of the maturities will then exceed their initial offering prices because their interest rates will at that time exceed prevailing market rates. To compensate for this risk, underwriters will very likely impose some charge on issuers (in the form of either paying less to the issuer for the bonds or setting higher coupon rates on the bonds) who wish to avail themselves of this method. Unfortunately, then, the hold-the-offering-price method presents issuers with real economic costs, but largely non-economic benefits, other than tax planning certainty.
The following federal tax circumstances are those in which sensitivity to issue price might be more acute. In these situations, an issuer of tax-advantaged bonds might be willing to bear the additional cost the hold-the-offering-price method entails to be assured that the issue price, yield and weighted average maturity of the bond issue will be established on the sale date of the bonds.
1. Advance Refundings (Yield Restriction and the Excess Gross Proceeds Limit) – Investments purchased with the proceeds of an advance refunding issue of tax-exempt bonds and held in an advance refunding escrow cannot have a yield that exceeds the yield of the advance refunding issue by more than 0.001 percent. With certain limited exceptions, yield reduction payments are not available to aid in compliance with this yield restriction. If the issuer does not comply with this yield restriction, the interest on the bonds is subject to federal income taxation. To ensure compliance with this yield restriction, it is preferable that the issue price and yield of the advance refunding bonds be known on the sale date so that investments to be held in the advance refunding escrow can be secured at a price that does not cause the yield of the advance refunding escrow to exceed the yield of the advance refunding bond issue by more than 0.001 percent.
One might say that, given the amount of negative arbitrage that has prevailed on advance refunding escrows for the past decade, there presently isn’t as much issue price sensitivity in respect of tax-exempt advance refunding bonds. There is, however, an additional, stringent requirement that applies to tax-exempt advance refunding issues. Such issues cannot have “excess gross proceeds.” An advance refunding issue has excess gross proceeds if more than one percent of the issue’s gross proceeds are used for purposes that are not specified in Treas. Reg. § 1.148-10(c). If the hold-the-offering-price method of establishing issue price is not available, and the advance refunding bonds were not underwritten pursuant to a competitive bidding process that attracts at least three bids, the issue price of the bond issue will be the aggregate price at which the first 10% of each maturity is sold to the public. If the issue price of the issue exceeds the aggregate of the initial offering prices by more than one percent, and the IRS does not treat this excess amount as additional issuance costs of the bonds, this excess amount would likely constitute excess gross proceeds, and the interest paid on the advance refunding bonds would be subject to federal income tax. Such a position by the IRS would be unduly harsh, but this specter militates in favor of applying the hold-the-offering-price method in the case of advance refunding bonds.
2. Bank Qualified Bonds/Qualified Tax-Exempt Obligations – To avoid a double tax benefit, the Internal Revenue Code disallows a deduction to a financial institution for interest paid by the financial institution on its obligations to the extent that the financial institution received tax-exempt interest. In other words, a financial institution cannot deduct interest paid on debt it incurs to purchase bonds that pay tax-exempt interest. Qualified tax-exempt obligations (“QTEOs”) are enticing to financial institutions because, subject to the 20% haircut in Section 291 of the Internal Revenue Code, a financial institution does not take QTEOs into account with other tax-exempt bonds in determining the extent to which the interest deduction is disallowed.
To be QTEOs, the issuer must not issue more than $10,000,000 of tax-exempt bonds during the calendar year, and the issuer must not designate more than $10,000,000 of tax-exempt bonds as QTEOs during the calendar year. These $10,000,000 limitations can turn on the issue price of the bonds. Accordingly, the sensitivity to issue price in the case of QTEOs can be amplified, and the issuer might prefer to have the hold-the-offering-price method available to ensure that the issue price of the bonds will be established on the sale date.
3. Weighted Average Maturity Limitations – The weighted average maturity (“WAM”) of an issue of tax-exempt bonds is calculated by adding together the products of the issue price of each maturity of bonds and the years to final maturity and then dividing this sum by the issue price of the bond issue. The WAM of an issue of tax-exempt bonds is inextricably linked to the issue price of the bond issue.
The federal tax laws place various limits on the length of the WAM of an issue of tax-exempt bonds. For example, qualified private activity bonds cannot have a WAM that exceeds 120% of the weighted average economic life of the assets financed and refinanced by those bonds. To qualify for a safe harbor against the creation of “other replacement proceeds,” the investment of which must be yield restricted, the WAM of the issue of tax-exempt bonds (of any type – even bonds that are governmental use bonds and not qualified private activity bonds), cannot be greater than 120% of the weighted average economic life of the assets financed and refinanced by those bonds. An issue of tax-exempt bonds can be treated as an abusive arbitrage device, and therefore can be recharacterized as taxable bonds, if that issue overburdens the market by being outstanding longer than necessary. A tax-exempt bond issue will not, however, be treated as outstanding longer than necessary if the WAM of the issue is not greater than 120% of the weighted average economic life of the assets financed and refinanced by that issue. Finally, certain federal tax benefits can obtain if the WAM of a current refunding issue does not exceed the remaining WAM of the refunded bonds (e.g., an exception to the TEFRA notice, hearing, and approval requirements that otherwise apply to qualified private activity bonds, the ability to treat current refunding bonds as “deemed designated” as QTEOs and/or to qualify for the small issuer exception to rebate, and satisfaction of certain refunding transition rules, including several transition rules that allow bonds issued prior to the Tax Reform Act of 1986 to continue to be subject to the Internal Revenue Code of 1954, rather than the Internal Revenue Code of 1986).
If the WAM of the issue will approach any of these limits, if applicable, then the issuer might consider bearing the additional cost of the hold-the-offering-price method to ensure compliance with the applicable WAM limitation.
4. Limitation on Issuance Costs Financed by Qualified Private Activity Bonds – No more than two percent of the proceeds of an issue of qualified private activity bonds (including qualified 501(c)(3) bonds) can be used to pay issuance costs. If the issue price of the tax-exempt qualified private activity bonds is established based on the sum of the first prices at which at least 10% of each maturity of the bond issue was sold to the public, and these prices exceed the initial offering prices of the maturities, compliance with this limitation on the financing of issuance costs can be difficult to maintain if this excess, which obtains to the benefit of the underwriter, is treated as additional compensation to the underwriter and, thus, as an issuance cost financed with proceeds of the bond issue. (Diabolically, this possible treatment of “excess” issue price as a cost of issuance is a bad thing for purposes of the two percent limit, even though it’s a good thing for purposes of the excess gross proceeds rule for advance refundings, described above in paragraph 1.) To avoid this concern, an issuer might want to use the hold-the-offering-price method of setting issue price.
5. Volume Cap and Other Matters – Certain qualified private activity bonds can be issued only if they receive an allocation of volume cap for their issuance. Likewise, to the extent that the amount of proceeds of tax-exempt governmental use bonds or qualified 501(c)(3) bonds used for a private business use will exceed $15,000,000, such excess amount can be issued only pursuant to an allocation of volume cap. Volume cap allocations are based on issue price. Similarly, certain tax-advantaged bonds (such as bondholder tax credit bonds and direct payment subsidy bonds) must satisfy allocation limits, which are likewise based on issue price. Finally, the satisfaction of certain refunding transition rules, including those in the Tax Reform Act of 1986, requires that the issue price of the refunding bonds not exceed the amount of the refunded bonds, and certain issue price limits must be satisfied for an issue of bonds to satisfy the small issuer exception to rebate. To ensure compliance with these issue price limitations, an issuer facing one of these situations might want to avail itself of the hold-the-offering-price method of determining issue price.
This is quite a list. There are obviously many federal tax circumstances in which sensitivity to issue price will be more acute and in which the issuer will have some motivation to incur the added cost of having available the hold-the-offering-price method of establishing issue price. Even in the absence of any of the foregoing circumstances, an issuer might crave finality and certainty when it comes to issue price. Each issuer should, when planning its issuance of tax-advantaged bonds, be advised of all methods for determining issue price and their relative cost, regardless of whether the establishment of issue price has added significance, so the issuer can make an informed decision of whether to seek the underwriter’s agreement to have available the hold-the-offering-price method.