As we told Naomi Jagoda of The Bond Buyer back in July ($), we are seeing many issuers that have become jaded with their BABs and want to refund them with tax-exempt bonds. Assuming that these issuers engaged a bond counsel firm that was wise enough – nay, truly heroic enough – to have foreseen this possibility and to have written into the bond documents an extraordinary mandatory redemption provision that would spring to life upon sequestration by Congress, then these issuers have their opportunity. Refunding BABs with tax-exempt bonds frees an issuer from the shackles of the many additional BAB rules. But, wouldn’t you know it, even the process of quitting BABs carries some complications. The biggest of those may be the possibility that the issuer will lose some or all of its subsidy payments after the issuer defeases the BABs with the tax-exempt bond proceeds, even before the issuer actually redeems the BABs. After the jump, we’ll walk through this problem and some things to think about.

Quitting BABs – How does this affect the subsidy?

Let’s use a simple example. An issuer – let’s call it the City of Jaded, Wyoming – issues BABs. The BABs pay interest semiannually in January and July.  The City – having engaged wise, heroic, and generally handsome bond counsel – has an extraordinary redemption option to redeem the BABs at any time after 30 days’ notice. As is common practice (although the fictional citizens of Jaded would no doubt chafe at being called “common”), the issuer wants to have the funds for the redemption on hand before it sends out the redemption notice to the bondholders. On August 1, the City issues tax-exempt bonds, deposits enough money to defease the BABs into a defeasance escrow, and sends out the redemption notice. On September 1, the City redeems the BABs. Interest on the BABs continues to accrue during July and August.

The question is: when the City files its final Form 8038-CP for the BABs, how big of a subsidy payment can the City request? Does it include only the July interest payments? July and August? Or none at all?  As Naomi pointed out in her article, this question involves yet another edition of everyone’s favorite party game from 2009 and 2010 – which of the tax rules that talk about “tax-exempt bonds” also apply to BABs, which are not technically tax-exempt bonds?

A Defeasance Escrow Can Cause a Reissuance

Under the reissuance regulations, Reg. 1.1001-3(e)(5)(ii)(A), if an issuer establishes a defeasance escrow, it can cause a “deemed reissuance” (basically a deemed current refunding) of the defeased bonds, on the defeasance date. This may come as a surprise, because we don’t often think of a defeasance escrow for tax-exempt bonds as having this effect. But the reason that we often ignore the defeasance escrow for this purpose is because Treasury graciously gave us an exception to the rule. “A defeasance of a tax-exempt bond is not a significant modification,” the Regulations say at 1.1001-3(e)(5)(ii)(B), “even if the issuer is released from any liability to make payments under the instrument if the defeasance occurs by operation of the terms of the original bond and the issuer places in trust government securities or tax-exempt government [sic] bonds that are reasonably expected to provide interest and principal payments sufficient to satisfy the payment obligations under the bond.” In almost every case, the defeasance escrow will meet these requirements, and no reissuance occurs.

Now, if we look at this from the perspective of the general tax logic that lies at the heart of the reissuance rules – which are concerned with when an investor must realize gain or loss on an investment – then there is no real difference between tax-exempt bonds and taxable bonds that would require this kind of an exception for tax-exempt bonds. Instead, Treasury recognized that the issuer of a tax-exempt bond can face nasty consequences when a tax-exempt bond is unexpectedly reissued and that these consequences don’t necessarily occur when a garden-variety corporate bond is reissued.

Does that sound familiar? The same logic should apply to BABs. But it is still unclear whether the establishment of a defeasance escrow causes a reissuance of the BABs before they are redeemed, because the language of the exception says “tax-exempt bonds,” and BABs, although they are similar to tax-exempt bonds for the reasons that matter for reissuance purposes, are certainly not tax-exempt bonds.

If the defeasance escrow causes the BABs to be reissued, then as of that date the reissued bonds are no longer eligible to receive a direct payment from the federal government, because they are no longer a “qualified bond” under Section 6431(e) of the Code. Because interest that accrued on the BABs prior to the defeasance date accrued on a good BAB, that interest should still be eligible for subsidy payments.

Back to the Example

Let’s return to the facts of our example. The issuer should be able to claim subsidy payments for at least the July interest because the BABs weren’t defeased until August 1. Our experience so far suggests that the IRS will accept this result. The City’s intrepid bond counsel  could certainly argue that the City has at least a reporting position-level of confidence that the exception for tax-exempt bond defeasance escrows applies to BABs, too, and claim a subsidy payment for the August interest. But it is also possible that the City would face a fight if the IRS noticed this point, particularly so because the IRS is likely quite sensitive to anything that remotely looks like a stealth extension of BABs in even the most limited sense.

Now, if one or two months of lost subsidy is all that is at stake, then issuers like the City might not even feel like risking a claim for post-defeasance interest (or even accrued but unpaid pre-defeasance interest). The goal, after all, is to quit BABs for good. But we can imagine other circumstances where an issuer might have a defeasance period of months or even years – an advance refunding, for example. In other words, we might be talking about months or years of lost subsidy payments. In those situations, it would be nice to have a clear answer.

Do we have any other clues? The IRS did apply the reissuance regulations in 1.1001-3 to BABs in PLR 201149017, but it did not need to reach the question of whether BABs are treated like tax-exempt bonds for purposes of these rules.  But we also have this little nugget, in the Internal Revenue Manual, Section  7.2.3.1.2.3(A): “Build America bonds, as taxable bonds, are not included in the exception from the significant modification rule for defeasance of tax-exempt bonds under [Reg. 1.1001-3(e)(5)(ii)(B). Therefore, defeasance of a build America bond may cause a reissuance and a bond reissued after December 31, 2010 is not a build America bond.” While that statement is not guidance, it may indicate that issuers intending to claim post-defeasance interest subsidies may be in for a fight.