In Chief Counsel Advice Memorandum AM2014-09, dated December 8, 2014 (the “CCAM”), released publicly December 19, 2014, the IRS concludes that a legal defeasance of direct subsidy Build America Bonds (“BABs”)1 will trigger a reissuance of such BABs and, because such reissuance occurs after the sunset date for BABs, the issuer (the “Issuer”) will no longer be able to collect BABs subsidy payments from the federal government.2
While not specifically addressed by the CCAM, a reissuance of the BABs is treated as a taxable event for investors in the BABs, possibly resulting in gain or loss.
In the transaction described in the CCAM, the Issuer issued the BABs in July 2009. The Issuer elected to treat the BABs as “qualified bonds,” entitling it to receive semiannual subsidy payments equal to 35% of the interest on the BABs. As a result of sequestration, the Issuer’s July 2014 subsidy payment was reduced, triggering an optional redemption provision. The Issuer issued refunding bonds and established a defeasance escrow for the BABs. Upon establishment of the defeasance escrow, holders of the BABs were entitled to look only to the defeasance escrow and not to the Issuer for payment and security.3
Under the reissuance regulations, contained in Section 1.1001-3 of the Treasury Regulations, a significant modification of a debt instrument causes that instrument to be deemed reissued on the modification date.4 A legal defeasance of a debt instrument is generally a significant modification because the instrument has changed from a recourse (to the issuer) instrument to a nonrecourse instrument. Thus, unless an exception applies, a legal defeasance triggers a reissuance and a taxable event that can result in gain or loss for federal income tax purposes to the bond owner.
The reissuance regulations provide an exception for the legal defeasance of tax-exempt bonds. Under that exception, if the defeasance occurs by operation of the terms of the original bond and the issuer places in trust government securities (typically U.S. Treasury obligations or other debt guaranteed by the U.S.) or tax-exempt bonds the cash flow from which is reasonably expected to provide for the payment of debt service on the defeased tax-exempt bonds when due, the defeasance is not treated as a significant modification even though the issuer is released from liability to make payments on the tax-exempt bonds. Since there is no significant modification, the defeased tax-exempt bonds are not treated as reissued.
The reissuance regulations define “tax-exempt bond” to mean a state or local bond that satisfies the requirements of Code Section 103(a) of the Code. The Issuer in the CCAM contended that the BABs should qualify for the tax-exempt bond exception to reissuance because all BABs must satisfy the requirements of Code Section 103(a).
The IRS, however, noted that the purpose of the tax-exempt bond exception is to protect investors from a subsequent change in law that could “result in bonds that were tax-exempt when issued ceasing to be tax-exempt bonds” through no action by investors. “[W]ithout the special tax-exempt bond rules in § 1.1001-3, holders of tax-exempt bonds might, through no action of their own, suffer the loss of the benefits of the tax-exemption under § 103 for their tax-exempt bonds if the bonds were determined to be reissued and failed to qualify as tax-exempt under the version of § 103 in effect at the time of the reissuance. That same concern does not apply to the taxable direct pay BABs described above.”5
Based on the CCAM, issuers considering a legal defeasance of their BABs should be aware that they risk causing their BABs to be reissued for tax purposes and losing their subsidy payments as of the date of the defeasance. Further, because a reissuance of BABs is a taxable event to investors, resulting in possible gain or loss, issuers should review the offering and authorizing documents for their BABs to determine whether the tax consequences of a defeasance to BAB investors were disclosed, and whether there are conditions precedent to the defeasance, such as obtaining an opinion of counsel that defeasance of the BABs will not result in the reissuance of the BABs or the realization of gain or loss by the owners of the BABs.