We have already blogged about many of the direct impacts that the Tax Cuts & Jobs Act has had on the municipal bond market, such as the elimination of advance refundings for governmental bonds and the elimination of qualified tax credit bonds. Today, we would like to discuss one of the indirect impacts. The reduction of the maximum corporate tax rate to 21% from 35% in and of itself immediately lessened the value of tax-exempt bonds to entities affected by that change. Even more significant for municipal issuers and conduit borrowers that placed bonds directly with banks is a provision included in the vast majority of those transactions that results in an increase in the interest rate on the bonds in the event of a reduction in the corporate tax rate in order to compensate the bank for its decreased return. In some instances, this bump up in interest rate is optional, but in many instances it is automatic. Banks have been requiring these “gross up” provisions for several years, and this development, coupled with the increase in direct purchases of tax-exempt bonds by banks in recent years, has resulted in many municipal issuers and conduit borrowers going back to their bonds and loan agreements to determine whether their borrowing costs have gone up (potentially as of January 1, 2018).
If you are a municipal issuer or conduit borrower that discovers that your bonds contain such a gross up provision, what do you do next? Whether the “gross up” is at the option of the bank or automatic, you will no doubt engage the bank in discussions about how to handle the “gross up.” While the primary consideration for a municipal issuer or conduit borrower in these discussions is its ultimate borrowing costs, all of the parties must also consider whether the result of any negotiations causes a reissuance of the bonds for federal tax purposes. The 1.1001-3 regulations tell us that a reissuance of a bond results when there is a “significant modification” to the bond, and that “a modification is a significant modification only if, based on all facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant.” The 1.1001-3 regulations also give us specific rules for determining the significance of certain types of modifications. For purposes of analyzing changes resulting from “gross up” interest rate provisions triggered by the reduction in the corporate tax rate, the most significant of these specific rules is the rule that tells us that a change in the yield of more than the greater of (a) 25 basis points or (b) 5 percent of the annual yield of the unmodified instrument is a significant modification. Thus, any adjustment to the interest rate on a bond or loan that results from negotiations between the municipal issuer or conduit borrower and the bank holding the bond must be tested to determine whether such bond has been reissued for tax purposes. Note that if the negotiations result in other changes to the bond, e.g., extension of a mandatory tender date, such other changes could also impact the reissuance analysis.
The significance of a reissuance varies depending on the circumstances. Essentially, a reissuance is the retirement of the existing bond and the issuance of a new bond, i.e., a current refunding. In the case of any reissuance, a new 8038-G or 8038 must be filed with respect to the reissued bond. In addition, because the existing bond is treated as being retired, a final rebate calculation must be performed and any final rebate payment must be paid. Other more serious consequences could apply if there has been a change in law since the issuance of the existing bond. For example, had the provision of the House version of the Tax Cuts and Jobs Act that eliminated exempt facility private activity bonds with no exception for current refundings become law, any reissuance of exempt facility private activity bonds after 2017 would have resulted in those bonds losing their tax-exempt status. Note also that Section 1.150-1 of the regulations tell us that if, within six months before or after a person assumes obligations of an unrelated party in connection with an asset acquisition, the assumed issue is refinanced, the refinancing is treated as a new money acquisition rather than a refunding issue. In many instances the Internal Revenue Code excepts current refundings from many requirements that apply to new money bonds. Thus, if a conduit borrower were to negotiate a reprieve from the bank in connection with an automatic gross up of the interest rate that causes a reissuance, and then transfers the financed asset five months later, the reissuance would be treated as a new money acquisition financing. Such treatment could trigger certain unintended and adverse consequences, such as construction and rehabilitation obligations with respect to a project, the need to go through a new round of the TEFRA public approval process, the need for additional volume cap, or, in the case of categories of exempt facility bonds for which statutory authority has expired (e.g., GO Zone Bonds), the loss of eligibility for tax exemption.
Authored by: Michael J. Bradshaw, Jr.