IRS Issues Notice 2008-27 modifying and expanding the rules under which a change in the interest rate mode for tax-exempt bonds, including conversion of auction rate bonds, will not be considered a deemed retirement and reissuance of the bonds for federal income tax purposes.
Background. Under Section 1001 of the Internal Revenue Code of 1986, as amended (the "Code"), a modification to the terms of a debt instrument may result in the debt instrument being treated as retired and reissued as a deemed new debt instrument for federal income tax purposes. IRS Notice 88-130, 1988-2 C.B. 530, provided guidance on the circumstances under which certain "qualified tender bonds" providing multiple interest rate modes would be considered retired and reissued upon a change in the interest rate mode on the bonds. Recent turmoil in the market for tax-exempt auction rate bonds has resulted in many issuers wishing to convert out of auction rate mode, often accompanied by changes in the credit enhancement for the bonds. This has resulted in questions being raised regarding the proper treatment of auction rate bonds under Notice 88- 130, and calls for the IRS to provide guidance that such conversions of auction rate bonds generally not be treated as a reissuance. Treatment of such a conversion as a reissuance may have adverse tax consequences to issuers, including acceleration of arbitrage rebate payment obligations, deemed terminations of integrated interest rate swaps under the qualified hedge rules, changes in bond yield for purposes of arbitrage yield restrictions, and change in law risk.
Notice 2008-27. The new IRS Notice generally expands the definition of "qualified tender bond" to include any tax-exempt bond having all of the following features: (i) each interest rate mode provided for under the terms of the bond is either a fixed rate or a "qualified floating rate" as defined under Treasury Regulations issued under the original issue discount provisions of the Code; (ii) interest on the bond is unconditionally payable at least annually; and (iii) the term to final maturity of the bond is not longer than the lesser of 40 years or 120 percent of the weighted average economic life of the financed facilities.
The general rule of the Notice is that, for purposes of the tax-exempt provisions of the Code only, any "qualified interest rate mode change" on a qualified tender bond will not be treated as a reissuance. For this purpose, a qualified interest mode change generally means a change in interest rate mode that is authorized under the terms of the bond upon its original issuance, provided that the terms of the bond require that the bond be resold at par upon conversion to the new interest rate mode. The only exception from the requirement that the bond be remarketed at par is for bonds converted to a fixed interest rate to final maturity, in which case the bond may be resold at a market premium or discount. The Notice further provides that the existence or exercise of any optional or mandatory tender requirement that is authorized under the original terms of the bond, referred to in the Notice as a "qualified tender," also will not be treated as a reissuance, provided that the purchase or redemption price upon such tender is at par and the terms of the bond require that best efforts be used to remarket the bond and that the bond actually be remarketed no later than 90 days after the date of purchase.
The Notice generally provides that, other than a qualified interest rate mode change or a qualified tender, all other modifications to the terms of a qualified tender bond are tested under the general requirements of Treasury Regulations § 1.1001-3 for determining whether the modification results in a reissuance. Treasury Regulations § 1.1001-3 provides specific rules for determining whether certain changes to the terms of a debt instrument, including changes in yield or changes in security or credit enhancement, will result in a deemed reissuance for federal income tax purposes. The Notice further provides, however, that any change in the interest rate as a direct result of a qualified interest rate mode change will not be treated as a modification to the bond and therefore will not need to be tested under Treasury Regulations § 1.1001-3.
For example, assume that an issuer has issued multi-modal tax-exempt bonds bearing interest at an auction rate that are backed by municipal bond insurance. Because of a downgrade of the insurer from AAA to AA, issuer converts the bond from an auction rate mode to an interest rate that is fixed to maturity. In connection with such change, issuer replaces the downgraded bond insurer with a letter of credit from a bank with an AAA rating. If the bonds meet the definition of a qualified tender bond and the conversion is a qualified interest rate mode change under the original terms of the bonds, the change in interest rate mode generally will not be treated as a reissuance for purposes of the tax-exempt bond provisions of the Code. Moreover, the change in interest rate resulting from the change in mode will not need to be tested under Treasury Regulations § 1.1001- 3. However, the change in credit enhancement still must be tested under Treasury Regulations § 1.1001-3. Under those rules (as modified by the Notice as described further below), a change in credit enhancement on a tax-exempt bond generally will not result in a reissuance unless the issuer's payment capacity, taking into account any credit enhancement, changes from speculative to adequate or vice-versa. In this case, both the downgraded insurance before the change and the new letter of credit after the change are investment grade, so payment capacity is clearly adequate both before and after the change in credit enhancement, and therefore the change does not result in a reissuance.
Notice 2008-27 also provides several other special rules to deal with issues arising as a result of current market conditions. First, as noted above, the Notice provides that for purposes of applying the tax-exempt bond provisions of the Code only, a modification of the security or credit enhancement on a tax-exempt bond will result in a reissuance only if the modification results in the issuer's payment capacity, taking into account credit enhancement, changing from speculative to adequate or vice-versa. This new rule changes the standard for non-recourse tax-exempt obligations, making it less likely that a change in credit enhancement on such bonds will result in a reissuance. Second, the Notice provides that certain temporary waivers of interest rate caps on the maximum rate on auction rate bonds will not be taken into account in determining whether there has been a significant modification to the yield on the bonds under § 1.1001-3. Finally, the Notice provides that certain modifications to qualified hedges, such as interest rate swaps, will not be treated as a termination of the hedge provided that (i) the modification is not expected to change the integrated bond yield by more than 25 basis points, and (ii) all payments made and received on the hedge are taken into account in computing bond yield under the arbitrage rules.
Effective Date. Notice 2008-27 is generally intended to provide interim guidance until Treasury Regulations are issued. Issuers may rely on the Notice for any action taken with respect to taxexempt bonds on or after November 1, 2007, and before the effective date of any new Treasury Regulations implementing the guidance in the Notice. Thus, application of the new Notice is optional, and issuer's may instead continue to rely on Notice 88-130 until the effective date of the future Treasury Regulations.