Reissuance of Tax Exempt Obligations: Some Basic Concepts
Tax Exempt Bonds (TEB) focuses on providing participants in the municipal bond industry with quality service to assist issuers and conduit borrowers in understanding their tax responsibilities. TEB has initiated an outreach and educational services program to increase understanding and compliance with tax law applicable to certain obligations issued by state and local governments. As part of this service, TEB is providing the following general information for issuers of tax-exempt bonds with respect to a reissuance. This information is not intended to be cited as an authoritative source on these requirements. TEB recommends that issuers of tax-exempt bonds review section 1001 of the Internal Revenue Code (Code) and the corresponding Income Tax Regulations (Regulations) in consultation with their counsel.
Generally, a reissuance occurs under federal tax law when there are significant modifications to the terms of a bond so that the bond ceases to be the same bond for tax purposes. A reissuance is a deemed exchange of the modified bond for the original bond.
In the current financial climate, some issuers are contemplating restructuring the debt service on their tax-exempt bonds by entering into certain contractual agreements that modify the terms of the bonds. The reissuance rules apply to all tax-exempt bonds from a large bond issue to a small lease entered into to purchase police cars or other equipment as well as a note held by a local bank.
Why does reissuance matter?
The consequences of a reissuance apply to issuers, conduit borrowers and to bondholders. Reissuance of a tax-exempt bond generally triggers retesting of all the various federal tax requirements that apply to a new issue. Specific potential consequences include, among other things, a change in yield affecting arbitrage investment restrictions, acceleration of rebate payments, new public approval requirements for qualified private activity bonds, deemed terminations of integrated interest rate swaps under the qualified hedge rules for arbitrage purposes, a need for volume cap, and a required filing of a new information return. Moreover, reissuance can present a problem for certain types of bonds which must be issued by a statutory deadline (i.e., Gulf Opportunity Zone Bonds which cannot be issued after December 31, 2011).
What causes a reissuance?
The standard for determining whether tax-exempt bonds are reissued, retired or modified significantly enough to trigger a retesting of the program requirements for new issues of tax-exempt bonds is based on the general federal tax standards for debt exchanges under section 1001 of the Code and the Regulations thereunder. Generally Regulation section 1.1001-3 employs a significant modification standard to determine whether modifications to a debt instrument are significant enough to cause the debt instrument to be treated as reissued for federal tax purposes. In general, a modification (or series of modifications) 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 is economically significant. However, there are special rules for specific types of modifications to determine if there has been a significant modification. Because the consequences of a reissuance may be important, TEB encourages issuers to contact their counsel before any of the following actions listed below are taken to modify the terms of any bond that it has issued.
Specific Types of Significant Modifications
Change in annual yield. Generally, a change in the annual yield of a tax-exempt bond by more than the greater of ¼ of one percent or 5% of the annual yield of the unmodified instrument will trigger a reissuance.
Change in timing of payments. Depending on the circumstances, a reissuance may occur if there is a change in the timing of the payments due under the tax-exempt-bond such as an extension of the final maturity or a deferral of payments prior to maturity.
Substitution of a new obligor or the addition or deletion of a co-obligor. If there is a change in payment expectations, the addition or deletion of a co-obligor on a tax-exempt bond may cause a reissuance. The substitution of a new obligor on tax-exempt bonds is not a significant modification if the new obligor is related to the issuer and the collateral for the bonds includes the original collateral.
Change in security or credit enhancement. If there is a change in payment expectations, the substitution of new collateral for existing collateral of a tax-exempt bond may cause a reissuance. Generally, however, the substitution of a similar commercially available credit enhancement contract on a nonrecourse tax-exempt bond will not cause a reissuance. See below for defeasances of tax-exempt bonds.
Change in priority of an obligation. If there is a change in payment expectations, the subordination of a tax-exempt bond to another obligation may cause a reissuance.
Change in the nature of a debt instrument. For example, changing a tax-exempt bond from a recourse obligation to a nonrecourse obligation or vice versa may cause a reissuance. Generally, a legal defeasance of a debt instrument in which the issuer is released from all liability to make payments on the debt instrument is a significant modification. However, there is an exception for tax-exempt bond defeasances under the circumstances described in Regulation section 1.1001-3(e)(5)(ii)(B).
Change in payment expectations. Depending on the circumstances, a change in payment expectations may cause a reissuance. A change in payment expectations may occur if there is a substantial enhancement or substantial impairment of an issuer’s capacity to meet its payment obligations. An issuer’s payment capacity for a bond issue includes all of its sources of payment on the bonds, including collateral, guarantees, or other credit enhancement.
Regulation section 1.1001-3(f)(6) provides special rules for certain tax-exempt bonds (for example, conduit loans).
Remedial Actions May Cause a Reissuance
Issuers and borrowers should take special note that, in addition to identifying those post-issuance changes to terms of bonds which could be a reissuance, a remedial action in connection with a change in use could cause a reissuance depending on the circumstances. Thus, a reissuance may occur if the issuer takes a remedial action which involves the alternative use of the disposition proceeds. For example, an issuer that uses cash proceeds from the sale of its tax-exempt bond financed facility to acquire another qualified facility may cause the bonds to have substituted collateral or may cause a change of payment expectations either or both of which could cause a reissuance (Note the special rule for 501(c)(3) organizations under Regulation section 1.141-12(e)(2) requiring disposition proceeds representing the nonqualified bonds to be treated as reissued qualified 501(c)(3) bonds).
A variety of guidance projects have focused on reissuance. See Regulation section 1.1001-3 regarding modifications of debt instruments, Notice 88-130, Notice 2008-27, Notice 2008-41, Notice 2008-88, Notice 2010-7, and Announcement 2011-19.
Notice 2008-41 provides special reissuance rules for certain eligible tax-exempt bonds that are “qualified tender bonds.” Notice 2008-41 amends and supplements Notice 2008-27 which modified certain special reissuance standards for “qualified tender bonds” under Notice 88-130 and modified certain aspects of the application of Regulation section 1.1001-3 as they apply to tax-exempt bonds.
Certain Tax Credit and Build America Bonds
Regulation section 1.1001-3 applies to modifications of debt instruments. Thus, the principles discussed above may also apply to certain other types of tax favored obligations including tax credit bonds issued under section 54A and build America bonds issued under section 54AA. Consequently, modifications of these debt instruments may also present problems to issuers. For example, issuers of build America bonds must avoid making significant modifications that result in a reissuance as build America bonds have a statutory deadline and cannot be issued after December 31, 2010. TEB recommends that issuers of tax credit bonds and build America bonds also consult with their counsel about the possible effects of a reissuance.