The American Recovery and Reinvestment Act of 2009: New Financing Tools for State and Local Governments — "Build America Bonds"

18 February 2009 Publication
Authors: Michael G. Bailey Henry A. Gempeler Reed Groethe Chauncey W. Lever Jr

Legal News Alert: Financial Crisis Response Team

The American Recovery and Reinvestment Act of 2009 (ARRA) provides a number of important new financing tools and benefits to state and local governments. This alert summarizes and discusses Build America Bonds, a provision that could have a dramatic and immediate impact on the tax-exempt finance industry.

One important theme of the legislation is that “tax credit bonds” will become an increasingly important financing tool in addition to traditional tax-exempt bonds. Build America Bonds are the most important new type of tax credit bonds.

The Build America Bond provisions apply to state and local bonds issued after February 17, 2009. For that reason, these provisions are of immediate importance to state and local government issuers. We anticipate that the Internal Revenue Service (IRS) and the United States Department of the Treasury (Treasury) will give a high priority to publishing guidance interpreting the Build America Bond provisions. Pending the IRS’ guidance, we offer our initial reactions to this important new development.

Overview

Build America Bonds: A New “Taxable Bond Option”
The ARRA establishes Build America Bonds as a new taxable bond option for issuers of state and local governmental bonds. Under this provision, a state or local government can elect to issue bonds as:

  1. Traditional tax-exempt bonds.
  2. Taxable tax credit bonds, under which the bondholder receives a tax credit equal to 35 percent of the interest on the bonds.
  3. Taxable tax credit bonds, under which the tax credit is “stripped” from the bond and sold separately to investors.
  4. In addition, in the case of “Qualified Build America Bonds,” a state or local government has the option to issue bonds as taxable tax credit bonds, under which the state or local government receives payments from the Treasury equal to 35 percent of the interest payments on the bonds.

The taxable bond option is available only for bonds that otherwise would qualify as tax-exempt bonds, and is not available for bonds if the proceeds are loaned to or used by other persons such as 501(c)(3) organizations or for-profit conduit borrowers. In other words, Build America Bonds must be “governmental” bonds and cannot be “qualified private activity bonds.” The direct-payment option for Qualified Build America Bonds is only available if all of the available project proceeds are to be used for capital expenditures. This requirement appears to mean that Qualified Build America Bonds are limited to new-money bonds issued after February 17, 2009, or bonds that refund those bonds, although we understand that the IRS and Treasury are considering that point.

A Bigger Subsidy for the Direct-Payment Option (Qualified Build America Bonds)
Although not immediately evident from the legislation, issuing bonds as direct-payment Qualified Build America Bonds generally can be expected to result in a greater financial benefit to a state or local government issuer. The legislative history explains this difference with the following example. Suppose an issuer ordinarily could issue taxable bonds at par with an interest payment of $1,000. If the holder receives the tax credit, the issuer could expect to issue bonds with an interest payment of $741. This is because the tax credit applies to the actual reduced interest that is payable, after taking into account the benefit of the credit. On the other hand, if an issuer elects the direct-payment option for Qualified Build America Bonds, the net interest payment of the issuer would be $650 (that is, $1,000 less a $350 direct payment from the Treasury).

A New Era of Tax Credit Bonds
Build America Bonds are the most important new type of tax credit bonds. In recent years, the Internal Revenue Code has been amended to provide for a number of tax credit bonds. Build America Bonds are expected to be the most important of these tax credit bonds in part because, unlike other types of tax credit bonds, they are not subject to a national volume limitation. Like other types of tax credit bonds, Build America Bonds have a temporary authorization, but it is reasonable to expect that the U.S. Congress will consider extending the authorization for Build America Bonds and other tax credit bond provisions.

Other types of tax credit bonds exist, many of which are extended, and some created, by the ARRA. These types of tax credit bonds include qualified zone academy bonds, new clean renewable energy bonds, qualified forestry conservation bonds, qualified energy conservation bonds, the newly enacted recovery zone economic development bonds, and the newly enacted qualified school construction bonds. Each of these could possibly be an important financing tool for a state or local government issuer, but they are subject to detailed eligibility requirements that are not discussed in this alert, except that recovery zone economic development bonds are discussed below because they are in many respects similar to Qualified Build America Bonds.

Reasons for the Tax Credit Bond Legislation
The legislative emphasis on tax credit bonds, as opposed to traditional tax-exempt bonds, in part reflects a view that tax credit bonds are a more efficient way for the federal government to provide tax subsidies to state and local governments than traditional tax-exempt bonds. Among other things, an investor’s choice between a traditional tax-exempt bond and a tax credit bond usually depends on the investor’s marginal income tax rate, while an investor’s choice between a tax credit bond and a taxable corporate bond does not. In addition, tax credit bonds provide for a more flexible way for Congress to adjust the amount of the federal subsidy for different types of projects or uses of bond proceeds. For example, the federal subsidy (in the form of the tax credit) currently ranges from an amount intended to correspond to 100 percent of interest payments for qualified zone academy bonds to an amount equal to 35 percent of interest payments for Build America Bonds.

In large part for these reasons, tax credit bonds now are of central importance to state and local government finance.

Special Treatment of Tax Credits
Tax credit bonds are subject to a number of special rules that distinguish them from many other types of federal tax credits and make the tax credits usable by many types of investors, including individuals. First, in the case of tax credit bonds, the tax credit is treated as interest income to the holder, and the tax credit rate is set with the intent of compensating for taxability. Second, in the case of tax credit bonds, the tax credit is generally allowed against both regular and alternative minimum tax, and unused tax credits may be carried forward to succeeding taxable years. That is, the tax credit is “nonrefundable” (only usable to offset a holder’s federal income tax liability) but is not subject to the rules that apply to “general business credits.” If an issuer elects to receive direct payments from the Treasury, however, the tax credit becomes a “refundable” credit, because it is not limited by the amount of any holder’s federal income tax liability. Third, in the case of tax credit bonds, the tax credit is not restricted to certain types of investors. By contrast, the original authorization for qualified zone academy bonds generally limited the tax credit to use by banks, insurance companies, and corporations in the business of lending money.

Stripped Tax Credits
One of the most important provisions of the new legislation permits the tax credit to be stripped from a tax credit bond: that is, the tax credit bond and the right to the tax credit may be separated and sold separately either by an issuer or a bondholder. The provision permitting tax credits to be stripped was originally enacted in 2008 for limited types of tax credit bonds, but now may become much more important than in the past.

The provision permitting tax credits to be stripped has the potential to make entirely new financial structures and investments available to state and local government finance markets. For example, it is possible that stripped tax credits of tax credit bonds could be sold separately to investors or combined with other types of investments.

Among the policy choices facing a state or local government will likely be whether to strip tax credits at the time of issuance of Build America Bonds or to permit investors to strip the tax credits.

“Pass-Through” Treatment
The new legislation contains a number of provisions that are intended to permit the tax credit to be held by mutual funds, real estate investment trusts, partnerships, and other pass-through entities and to be passed through to investors. It is possible that these provisions will greatly enhance the market for stripped tax credits.

Build America Bonds and Their Effect on Financing
The Build America Bond provision may have a significant, and possibly dramatic, effect on state and local government finance.

Eligibility — Bonds Issued for Governmental Projects Before 2011
Build America Bonds are available only for governmental bonds and not for private activity bonds. That is, the Build America Bond options are in general not available for bonds if the proceeds are loaned to or used by (other than to the extent of permitted small amounts) persons other than state or local governments, so bonds that are issued to benefit nonprofit organizations or for-profit corporations are generally not eligible. In general, the applicable requirements that apply to traditional tax-exempt bonds (such as the arbitrage limitations on investment of bond proceeds and the private-business-use restrictions on use of bond-financed property) also apply to Build America Bonds. Build America Bonds must be issued after the date of enactment and before 2011.

Bonds will be eligible to be Qualified Build America Bonds (that is, bonds that qualify for the direct-payment option) only if 100 percent of the available project proceeds (other than amounts deposited into a reasonably required reserve fund) are to be spent on capital expenditures. That is, it appears the Qualified Build America Bonds must be new-money bonds that do not finance any working capital expenditures. It also appears that refunding bonds generally are not eligible to be Qualified Build America Bonds, unless the refunding bonds refinance new-money bonds originally issued after the date of enactment and before 2011. We understand, however, that the IRS and Treasury are considering whether Qualified Build America Bonds can include refunding bonds. In general, we believe that financing costs of issuance in an amount not greater than two percent of proceeds should be permitted. Because no de minimis rule applies to the capital-expenditure requirement, certain types of expenditures may need to be reviewed with particular care, including the financing of “internal” costs (such as employee salaries) relating to capital projects.

In addition, bonds will not be eligible to be Build America Bonds if they are issued with more than a de minimis amount of premium. For this purpose, a de minimis amount of premium is defined as 0.25 percent times the number of years to maturity, so a 10-year bond issued with a premium of 2.5 percent or less could qualify.

The state or local government issuer must make an irrevocable election to apply the Build America Bond provisions to particular bonds and a second election to apply the Qualified Build America Bond provisions to particular bonds.

Financial Benefit
The financial benefit of Build America Bonds generally is a tax credit equal to 35 percent of interest payable on the bonds. The legislative history to the ARRA indicates that Congress expects that this will enable state and local government issuers to issue bonds paying interest at rates approximately equal to 74.1 percent of comparable taxable bonds. As is noted above, however, the financial benefit of the direct-payment option is greater, and should enable issuers to issue bonds with a net interest cost equal to 65 percent of comparable taxable bonds.

Access to New Markets
Issuing Build America Bonds could permit state and local governments to access market sectors that have not regularly purchased tax-exempt bonds such as pension funds and foreign investors.

Differences From Other Qualified Tax Credit Bonds
Although many of the same rules now apply to all tax credit bonds, a number of special rules apply to Build America Bonds. Perhaps the most important difference is that a state or local government issuer can elect to receive a direct payment from the Treasury (equal to 35 percent of interest payable) in lieu of selling the tax credit to the bondholders or other investors. Also, in the case of most tax credit bonds, the tax credit rate is a uniform rate that is required to be periodically established by the IRS for each type of tax credit bond and that is applied on a quarterly basis. In the case of Build America Bonds, however, the tax credit rate is 35 percent of the interest actually payable on each bond.

Possible Complete Separation of Credit Risk and Tax Risk
The Build America Bond provisions are written in a manner that suggests that eligibility to receive the tax credit may not necessarily depend on the actual payment of interest by a state or local government issuer. That is, the legislation refers to a tax credit based on interest that is payable, as opposed to interest that is actually paid. Whether the tax credit can, in fact, be so severed from credit risk may be clarified by IRS guidance.

No Application of Federal Prevailing Wage-Labor Standards
Under the ARRA, federal prevailing wage-labor standards apparently do not apply to Build America Bonds, even though they apply to other types of tax credit bonds, including new clean renewable energy bonds, qualified energy conservation bonds, qualified zone academy bonds, qualified school construction bonds, and qualified recovery zone economic development bonds. This point may need IRS clarification.

Special Rules for Direct Payments
The ARRA provides that direct payments from the Treasury will be made on interest payment dates and may be made either directly to the state or local government issuer or to a person acting on behalf of the issuer such as a bond trustee. The IRS and the Treasury will need to put into place specific procedures for making the direct payments. It is unclear, for example, whether the direct payments will be administered by the IRS, the Bureau of Public Debt, or some other function within Treasury.

For purposes of the arbitrage restrictions on investments, the direct payments are required to be taken into account to reduce bond yield.

Assessing the New Options
In the case of any new issue of governmental bonds, the issuer will now be presented with an opportunity to choose among the options described above. Experience with existing tax credit bonds suggests that the market for tax credit bonds may currently be somewhat limited if the holder is required to use the tax credit. The new rules, however, provide for two additional options to address this market limitation: an issuer can strip the tax credit and sell it to other investors or, in the case of Qualified Build America Bonds, the issuer can receive a direct payment in an amount equal to the credit (35 percent of each interest payment).

Financial Benefit
For any particular financing, an issuer will have the opportunity to assess the financial benefit of the different options. Based on the historical relationships between taxable and tax-exempt interest rates, it is possible that the optimal approach could be to select one option for some maturities and another option for other maturities in the same financing. For example, traditional tax-exempt bonds might be the best option for short maturities, and direct-payment taxable bonds could be the best option for longer maturities.

Combining the Financing Tools
Under the new legislation, the taxable bond election is framed as a bond-by-bond election rather than an issue-by-issue election, so that an issuer should be able to combine different approaches in a single financing. Certain technical issues may arise regarding whether tax-exempt bonds and taxable bonds are treated as the same “issue” for purposes of the private use, arbitrage, and other requirements that apply for eligibility as a tax-exempt bond issue, but we anticipate that it will be possible to resolve those technical issues.

Federal Government Payment Risk
Some industry observers have expressed concern that the direct payments from the Treasury may be subject to payment risk. In our view, this risk would mostly concern possible delays in implementation or glitches of payment procedures adopted by the United States. We speculate that an issuer that is concerned about this payment risk might issue direct-payment tax credit bonds in a short-term mode that could be refinanced with traditional tax-exempt bonds if necessary. We note that state and local government issuers of traditional tax-exempt bonds are exposed to the risk that Congress could remove or make less valuable to investors the interest exemption on state and local government bonds, although this risk is most directly borne by issuers of bonds that do not have a fixed-interest rate.

Disclosure Considerations
Traditionally, the corporate bond market has required a more rigorous level of initial disclosure, and continuing disclosure, than the market for tax-exempt governmental bonds. It is possible that certain state and local government issuers (particularly smaller issuers) would need to adopt more rigorous initial disclosure and continuing disclosure practices in order to access effectively the market for taxable bonds. The costs of such enhanced disclosure could be a factor in determining whether to use the Build America Bonds option.

State Tax Treatment
The legislation provides that, except as otherwise provided by a state after the date of enactment, the interest on any Build America Bonds and the credit allowed will be treated as tax-exempt for federal income tax purposes under state law. That is, to the extent that state tax law “piggybacks” on whether interest on a bond is tax-exempt for federal tax purposes, the ARRA provides that Build America Bonds will be treated in the same manner as traditional tax-exempt bonds. This limited federal preemption of state tax law will likely require some special disclosure and special consideration of possible enactment of new state legislation.

Other Consequences for State and Local Government Financing Practice
We believe that the Qualified Build America Bond option will have other less obvious but important consequences.

Dramatic Change in Administrative Relationship to the IRS
In the case of bonds for which the direct-payment election is made, the administrative relationship between the IRS and the state or local government issuer may be fundamentally changed. The ARRA indicates that the direct payments made by the Treasury to an issuer of Qualified Build America Bonds will be treated as a “negative tax” for procedural purposes, and will be subject to certain rules that ordinarily apply to tax deficiencies. Although this provision appears to have been included to resolve the procedural treatment of direct payments made by the Treasury, we believe that many procedural questions will arise. In the case of a direct-payment bond, it is not clear what procedural approach the IRS would take in the event of asserted noncompliance. Possibly the IRS could cause the Treasury to cease making payments to the state or local government issuer after determining that a bond issue failed to meet the applicable requirements. The IRS might seek to recover a refund of prior payments, plus interest, from the state or local government issuer, but it is not clear whether a refund demand would be limited in exactly the same manner by the three-year statute of limitations that applies in most cases to taxpayers. Also, it is not clear that the IRS would seek to employ the same collection procedures against a state or local government issuer that it would employ against an ordinary taxpayer.

In addition, it is possible that the mechanisms for taking a remedial action in the case of a “change in use” of bond-financed property could be affected. For example, it is possible that the IRS would accept an agreement with the issuer to treat reduced subsidy payments from the Treasury as an acceptable remedial action.

The IRS will likely need to publish some guidance setting forth the administrative procedures for this new relationship. In any event, administrative procedures under the Qualified Build America Bonds provision will need to take into account the special and sensitive relationship between the federal government and state and local governments.

Finally, a few important special rules are set forth in federal tax law that provide favorable treatment to state and local issuers of tax-exempt bonds. These special rules include the ability of a state or local government to seek a declaratory judgment from the United States Tax Court if the IRS declines to issue a favorable private letter ruling on a proposed bond issue. It is not clear whether Qualified Build America Bonds will be eligible for these special rules.

Tax Opinion Considerations
In the case of bonds for which the direct-payment election is made, it is not clear that the “unqualified opinion” standard that the market ordinarily requires of traditional tax-exempt bonds will apply. That is, it is not clear that the IRS will require any particular opinion of bond counsel, or any high level of certainty of tax position, in connection with submissions for direct payments from the Treasury. Presumably, most state and local government issuers of Qualified Build America Bonds will require a “filing position” that would be at least comparable to the standards that ordinarily apply to taxpayers for the avoidance of penalties (for example, a tax position with “substantial authority” or a “reasonable basis”), but such standards are less rigorous than the unqualified opinion standard. Possibly, state and local government issuers could choose to take somewhat less-certain tax positions for some Qualified Build America Bonds, particularly if no formal tax opinions from bond counsel are required by the IRS.

On the other hand, many issuers may choose to require an unqualified tax opinion from bond counsel, even in the case of bonds for which the direct-payment election is made, as a matter of policy or best practice. In this regard, we note that the issuer may benefit from leaving open the option to refinance Qualified Build America Bonds in the future with traditional tax-exempt bonds. Preserving a refinancing option may be easier if an unqualified opinion standard is adhered to in connection with the issuance of Qualified Build America Bonds.

Application to Financial Covenants
Some bonds for state and local government enterprises and other types of revenue bonds contain financial covenants based on annual debt service, including in particular debt service coverage ratio tests. The treatment of Qualified Build America Bonds under these types of covenants can be expected to raise a number of interpretive questions. For example, if an issuer elects the direct-payment option, can the periodic payments from the federal government be included as revenue under such financial covenants? We anticipate that analysis of such questions will require a careful review of the specific wording of different financial covenants. We also speculate that, in many cases, the bond documents will need to provide specifically that the direct payments made by the Treasury will need to be included in pledged revenues.

Recovery Zone Economic Development Bonds
The direct-payment option is also available for another type of tax credit bond under the ARRA: “Recovery Zone Economic Development Bonds”. Recovery Zone Economic Development Bonds must meet the eligibility requirements for Build America Bonds. In addition, all of the available project proceeds (other than amounts in a reasonable required reserve fund) must be used for qualified economic development purposes. The ARRA provides that these purposes are promoting development or other economic activity in a recovery zone, including (1) capital expenditures paid or incurred with respect to property located in a zone, (2) expenditures for public infrastructure and construction of public facilities, and (3) expenditures for job training and educational programs.

The tax credit for Recovery Zone Economic Development Bonds is 45 percent rather than 35 percent. One of the advantages of Recovery Zone Economic Development Bonds is that the proceeds can be used for working capital purposes.

Recovery Zone Economic Development Bonds are subject to a national volume limitation of $10 billion. The volume limitation is to be allocated among the states and political subdivisions within a state based on 2008 employment decline, subject to a rule that each state receive not less than 0.9 percent of the national limitation. Thus, this type of tax credit bond will be more readily available to state and local government issuers in states that had significant 2008 employment decline.

Build America Bonds — Decision Grid

 

Traditional Tax-Exempt Bond

Build America Bonds — Tax Credit to Holder

Build America Bonds — Stripped Tax Credit

Qualified Build America Bonds — Direct Payment to Issuer

Financial Benefit

Spread between taxable and tax-exempt interest rates

35 percent of interest tax credit to holder (estimated 74.1 percent of comparable taxable bond)

35 percent of interest tax credit to holder (estimated 74.1 percent of comparable taxable bond)

35 percent of interest payment to issuer (estimated 65 percent of comparable taxable bond)

Market for Investors

Investors interested in tax-exempt interest

Investors interested in tax credit

Expanded market for taxable bonds to include investors not interested in tax benefits (e.g., pension funds and foreign investors)

Expanded market for taxable bonds to include investors not interested in tax benefits (e.g., pension funds and foreign investors)

Disclosure

Traditional tax-exempt bond disclosure

More rigorous disclosure may be required for taxable obligations

More rigorous disclosure may be required for taxable obligations; special disclosure for stripped tax credit

More rigorous disclosure may be required for taxable obligations

Opinion/Filing Standards

Unqualified tax opinion generally required

Unqualified tax opinion generally required

Unqualified tax opinion likely to be required

Unqualified opinion not necessarily required

Federal Payment or Tax Risk

Change of tax law risk; issuer generally exposed only as provided in bond documents or if bonds are not fixed-rate

Change of tax law risk; issuer generally exposed only as provided in bond documents

Change of tax law risk; issuer generally exposed only as provided in bond documents

Risk of federal government delay or failure to make direct payments

Financial Covenants

Existing treatment applies

In general, existing treatment should apply

In general, existing treatment should apply, although some questions may need to be resolved if the issuer strips the tax credit

Treatment of direct payments needs to be resolved; express addition to pledged revenues may be required

IRS Administration

IRS remedy for noncompliance to tax bondholders; three-year statute of limitations generally presumed to apply

IRS remedy for noncompliance to tax bondholders; three-year statute of limitations generally presumed to apply

IRS remedy for noncompliance to tax stripped tax credit holder; three-year statute of limitations generally presumed to apply

Act references negative tax deficiency procedures, but IRS enforcement procedures have not yet been developed and are uncertain; likely cessation and recovery of direct federal payments

State Tax Treatment

Existing state tax treatment applies

Applicability of the limited federal preemption of state tax law needs to be considered and may need to be disclosed; state tax treatment of tax credit needs to be considered and may need to be disclosed

Applicability of the limited federal preemption of state tax law needs to be considered and may need to be disclosed; state tax treatment of tax credit needs to be considered and may need to be disclosed

Applicability of the limited federal preemption of state tax law needs to be considered and may need to be disclosed; state tax treatment of tax credit not an issue


Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:

Michael G. Bailey
Chicago, Illinois
312.832.4504
mbailey@foley.com

David Y. Bannard
Boston, Massachusetts
617.342.4033
dbannard@foley.com

Henry A. Gempeler
Madison, Wisconsin
608.258.4294
hgempeler@foley.com

Reed Groethe
Milwaukee, Wisconsin
414.297.5764
reed.groethe@foley.com

Dana M. Lach
San Francisco, California
415.984.9898
dlach@foley.com

Chauncey W. Lever, Jr.
Jacksonville, Florida
904.359.8774
clever@foley.com

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