This issue snapshot addresses the rules applicable to costs of issuance for private activity bonds.
Internal Revenue Code Section and Treasury Regulation
Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)
Private Letter Ruling (“PLR”) 200813022
Field Service Advice Memoranda from Assistant Chief Counsel (Field Service) of January 6, 1994
Costs of issuance (or “issuance costs”)
Issuance costs are defined as “costs to the extent incurred in connection with, and allocable to, the issuance of an issue within the meaning of Section 147(g)” (Treas. Reg. 1.150-1(b)).
Limitations on issuance costs
IRC Section 147(g) prevents a private activity bond from being treated as a qualified bond if the issuance costs (other than certain costs attributable to financing of credit enhancement fees) financed by the issue of which the bond is a part exceed 2 percent of the proceeds of the issue (or 3.5 percent for an issue of qualified mortgage bonds or qualified veterans' mortgage bonds if the proceeds of the issue do not exceed $20 million). The 2 percent (or 3.5 percent) limitation on bond-financing of certain private activity bond issuance costs is applied to the proceeds, not the aggregate face amount, of an issue. In addition, amounts used to finance costs of issuance are not treated as spent for the exempt purpose of the borrowing, and may be financed only from the 5 percent (or less) of private activity bonds that are not used for the exempt purpose of the issue (see Senate Committee Report 100 S, Rpt. 445, p. 345, explaining the cost of issuance provisions of the Technical and Miscellaneous Revenue Act of 1988, P.L. 100-647).
Prior to August 15, 1986, the effective date of the Tax Reform Act of 1986, there was no overall limitation on the amount of costs of issuance (Conf. Rep. No. 841, 99th Cong. 2d Sess. p. II-728). Even today, private activity bonds are not disqualified under Section 147(g) if issuance costs exceed 2 percent of bond proceeds if the costs in excess of 2 percent are paid with the issuer’s own funds or from other taxable loans payable by the issuer or a conduit borrower. The law limits the federal subsidy for financing costs, not the financing costs themselves (see 1994 FSA Lexis 253, p. 12 (I.R.S. January 06, 1994)).
Examples of issuance costs
The Joint Explanatory Statement of the Committee of Conference, House Conference Report No. 99-841, defined private activity bond costs of issuance as “all costs that are treated as costs of issuance under the present  Treasury Department regulations and rulings.” It then said that issuance costs subject to the two-percent limitation “include (but are not limited to)” the following:
- “underwriters' spread (whether realized directly or derived through purchase of the bonds at a discount below the price at which they are expected to be sold to the public);
- counsel fees (including bond counsel, underwriter's counsel, issuer's counsel, company counsel in the case of borrowings such as those for exempt facilities, as well as any other specialized counsel fees incurred in connection with the borrowing);
- financial advisor fees incurred in connection with the borrowing;
- rating agency fees;
- trustee fees incurred in connection with the borrowing;
- paying agent and certifying and authenticating agent fees related to issuance of the bonds;
- accountant fees (e.g., accountant verifications in the case of advance refundings) related to issuance of the bonds;
- printing costs (for the bonds and of preliminary and final offering materials);
- costs incurred in connection with the required public approval process (e.g., publication costs for public notices generally and costs of the public hearing or voter referendum); and
- costs of engineering and feasibility studies necessary to the issuance of the bonds (as opposed to such studies related to completion of the project, but not to the financing).”
Treas. Reg. 1.150-1(b) adds the following fees not enumerated in the Joint Explanatory Statement: “fees paid to an organization to evaluate the credit quality of an issue,” “bond registrar, certification, and authentication fees,” “guarantee fees, other than for qualified guarantees (as defined in § 1.148–4(f)); and similar costs.”
Treas. Reg. 1.150-1(b) states that a cost is an issuance cost “only to the extent incurred in connection with, and allocable to, the borrowing.” PLR 200813022 states that the “borrowing” referred to throughout Section 1.150-1(b) is “the borrowing by the Issuer as evidenced by the Bonds and not the borrowing of the Bond proceeds by the Borrower.”
Exceptions to the 2 percent of proceeds rule
Some issuance cost expenditures can be characterized as interest expense, exempting them from the 2 percent of proceeds rule. For example, “bond insurance premiums and certain letter of credit fees may be treated as interest expense under the arbitrage restrictions. To the extent of their treatment as interest, the initial cost of these types of costs of issuance may be financed in addition to the two-percent limit on financing other costs of issuance” (Joint Explanatory Statement of the Committee of Conference, House Conference Report No. 99-841, Tax Reform Act of 1986, p. 4818).
While Section 1.150-1(b) mentions guarantee fees as a cost of issuance, Section 1.148-4(f)(1) provides that fees properly allocable to payments for a “qualified” guarantee for an issue (as determined under Section 1.148-4(f)(6)) are treated as additional interest on that issue under Section 148. A qualified guarantee must satisfy Section 1.148-4(f)(2) (“interest savings”), Section 1.148-4(f)(3) (“guarantee in substance”), and Section 1.148-4(f)(4) (“reasonable charge”). Section 1.148-4(f)(4)(i) requires that the fee for a qualified guarantee not exceed a reasonable, arm's-length charge for the transfer of credit risk. If the guarantee is a qualified guarantee, it is additional interest rather than an issuance cost.
In addition, Section 1.148-4(f)(4)(ii) says that “fees for the transfer of credit risk include fees for the guarantor's overhead and other costs relating to the transfer of credit risk.” PLR 200813022 held that to the extent that attorneys' fees are incurred by a credit enhancer with respect to the provision of the credit enhancement on the bonds, such fees “are other costs for the transfer of credit risk within the meaning of Section 1.148-4(f)(4)(ii) and therefore are fees for a qualified guarantee.” As qualified guarantee fees, they are included as additional interest on the bonds under Section 1.148-4(f)(1) and are not subject to the 2 percent cost of issuance limitation of Section 147(g). (However, PLR 200813022 found a mortgagee policy fee incurred by the conduit borrower to get a loan financed by the bond proceeds to be neither a fee for a qualified guarantee within the meaning of Section 1.148-4(f)(1), nor a cost of issuance subject to the 2 percent cost of issuance limitation described in Section 147(g), nor a qualified administrative cost within the meaning of Section 1.148-5(e)(3)(ii)).
Section 1.148-4(f)(4)(ii) warns that a fee for a guarantee must not include any payment for a direct or indirect service other than the transfer of credit risk, unless the compensation for those other services is separately stated, reasonable, and excluded from the guarantee fee.
Issue Indicators or Audit Tips
- Verify the amount of actual issuance costs:
- Request and review source documents (trustee statements, invoices, etc.) for costs of issuance.
- Identify any additional costs that should be included as costs of issuance.
- Verify the amount of “Proceeds” for the issue:
- Sale proceeds.
- Investment proceeds (during the project period).
- Calculate the 2 percent allowable costs of issuance. If the limit is exceeded, the bonds could be taxable.
- If the issuer asserts that excess costs of issuance has been paid by a conduit borrower, ensure the payment came from the conduit’s funds and isn’t traceable to bond proceeds.
- Compare the computed amount with the amount reported on Form 8038.