On December 9, 2016, the Internal Revenue Service (the IRS) released new regulations under Section 148 of the Internal Revenue Code of 1986, as amended, (referred to herein as the code) regarding the determination of the issue price of tax-exempt bonds. The new regulations put additional restrictions on the ability of issuers to rely on the initial public offering price to determine issue price, and contain special rules for competitively sold issues and private placements; they more clearly define the “public” as used in determining eligible sales for establishing issue price.
The code generally requires that the investment yield on proceeds of tax-exempt and certain tax credit bonds (together referred to herein as bonds) not materially exceed the yield on the bond issue, and, for certain proceeds that are allowed to be invested at a higher yield, requires rebate of excess earnings to the U.S. Treasury (subject to certain exceptions). Integral to determining the yield of an issue of bonds is establishing the issue price at which the bonds were sold. Issue price may also be important for compliance with certain other restrictions under the code.
The IRS has expressed concerns with the definition of issue price in the current regulations under Section 148 of the code; in particular, it has focused on the ability to determine the issue price based on the reasonable expectations of the underwriter on the sale date. It can be important (particularly in advance refundings) to determine the issue price on the sale date; however, the IRS has felt that the current regulations encouraged “flipping” of bonds — the sale of bonds to a fund or other institutional investor that almost immediately resells the bonds at a profit. This concern led the IRS to propose new regulations regarding issue price in 2013 that received significant criticism. These were withdrawn, and regulations were again proposed in 2015. The new regulations are a refinement of the 2015 proposed regulations based on comments received by the IRS.
The new regulations provide, among other things:
- The general rule of determining issue price based on actual sales to the public remains largely unchanged.
- The definition of public is expanded to only exclude persons with a contractual agreement to sell bonds as part of the initial offering.
- Determining issue price on the sale date using the initial offering price is permitted, but subject to new restrictions; notably, sales by the underwriting syndicate cannot exceed the issue price for a period of up to five days after the sale date.
- A special rule for competitive sales allows for reliance on reasonable expectations without the underwriting syndicate needing to hold the issue price past the sale date.
- For bonds sold to a single buyer in a private placement, the issue price is the price paid by the buyer.
The issue price is the first price at which a substantial amount (10 percent) of the bonds is sold to the public.
Definition of Public
The public is as any person other than an underwriter or a related party to an underwriter. An underwriter is: (A) any person that agrees pursuant to a written contract with the issuer (or with the lead underwriter to form an underwriting syndicate) to participate in the initial sale of the bonds to the public; and (B) any person that agrees pursuant to a written contract directly or indirectly with a person described in clause (A) above to participate in the initial sale of the bonds to the public (for example, a retail distribution agreement between a national lead underwriter and a regional firm under which the regional firm participates in the initial sale of the bonds to the public).
Issue Price Based on Initial Offering Price
The issuer may treat the initial offering price to the public as of the sale date as the issue price of the bonds if: (A) the underwriters offered the bonds to the public for purchase at a specified initial offering price on or before the sale date, and the sole underwriter or the lead underwriter in the underwriting syndicate or selling group certifies to the issuer to that effect on or before the issue date and provides reasonable supporting documentation (such as a copy of the pricing wire or equivalent communication); and (B) each underwriter agrees in writing that it will neither offer nor sell the bonds to any person at a price that is higher than the initial offering price to the public during the period starting on the sale date and ending on the earlier of the (1) the close of the fifth business day after the sale date or (2) the date on which the underwriters have sold a substantial amount (10 percent) of the bonds to the public at a price that is no higher than the initial offering price to the public.
In a competitive sale, an issuer may treat the reasonably expected initial offering price to the public as of the sale date as the issue price of the bonds if the issuer obtains from the winning bidder a certification of the bonds’ reasonably expected initial offering price to the public as of the sale date upon which the price in the winning bid is based. A competitive sale is one where: (A) the issuer disseminates a notice of sale to potential underwriters in a manner that is reasonably designed to reach potential underwriters (for example, through electronic communication that is widely circulated to potential underwriters by a recognized publisher of municipal bond offering documents or by posting on a website or other electronic medium that is regularly used for such purpose and is widely available to potential underwriters); (B) all bidders have an equal opportunity to bid; (C) the issuer receives bids from at least three underwriters of municipal bonds which have established industry reputations for underwriting new issuances of municipal bonds; and (D) the issuer awards the sale to the bidder who submits a firm offer to purchase the bonds at the highest price (or lowest interest cost).
If a bond is issued in a private placement to a single buyer that is not an underwriter or a related party thereto, the issue price of the bond is the price paid by that buyer.
Different Methods for Determining Issue Price
The issuer is not required to apply the same rule to determine issue price for all of the bonds in the issue. Also, if more than one rule for determining the issue price of the bonds is available, at any time on or before the issue date, the issuer may select the rule it will use to determine the issue price of the bonds. This could, for example, allow an issuer to use the general rule if it does not receive enough bids to fit the definition of a competitive sale; however, it may not have the required agreements with the underwriter to allow use of a different method (i.e., an agreement to hold the offering price for unsold maturities). The issue prices of bonds in an issue that do not have the same credit and payment terms are determined separately.
The new regulations apply to bonds that are sold on or after June 7, 2017. The new regulations do not permit issuers to rely on them before such effective date.