In 2009 and 2010, Congress authorized or expanded several tax-advantaged alternatives for financing governmental infrastructure under the American Recovery and Reinvestment Act of 2009 (ARRA). The most popular ARRA financing program, Build America Bonds, was used as an alternative to traditional tax-exempt bonds for new money financings of governmental capital projects. BABs were taxable direct subsidy bonds and entitled the issuer to receive a payment from the federal government equal to thirty-five percent (35%) of the interest paid on the bonds (the “subsidy payment”) for the lifetime of the bond. In many cases, BABs provided the issuer with a lower net interest cost on the financing (65% of the taxable rate on the bonds) compared with conventional tax-exempt interest rates. The authority to issue new BABs expired at the end of 2010.
Another direct subsidy bond program created in ARRA, that is no longer available, was Recovery Zone Economic Development Bonds (RZEDBs), which provided a 45% subsidy rate for qualifying governmental purpose projects. Additionally, traditional tax credit bond programs - Qualified Zone Academy Bonds (QZABs), Qualified School Construction Bonds (QSCBs), Clean Renewable Energy Bonds (CREBs) and Qualified Energy Construction Bonds (QECBs) – were given federal allocation amounts (administered through each state) in 2009 and 2010, allowing these bonds to be issued as direct subsidy bonds, and receive various subsidy payments. States that have unused allocations may continue to issue these bonds as direct subsidy bonds until the allocation is used.
Governments that issued direct subsidy bonds during 2009 and 2010 need to be aware of post-sale considerations and responsibilities while the bonds remain outstanding.
GFOA recommends that governments that issued BABs or other direct subsidy bonds, be acutely aware of their ongoing responsibilities associated with these bonds and be cognizant of Internal Revenue Service (IRS) actions related thereto. Additionally, if Congress reinstates direct subsidy bond programs, the GFOA advises governments to exercise caution and have a full understanding of the differences between tax-exempt bonds and direct subsidy taxable bonds.
Post Sale and Ongoing Responsibilities
- Governments should ensure that they have procedures and internal controls in place for the timely filing of IRS Form 8038-CP required for each interest payment date as a condition to receiving the subsidy payment due and to confirm receipt of the subsidy payments from the federal government.
- Governments should develop appropriate internal controls to ensure that the issuer calculated subsidy payment amount is the same amount as what is received from the U.S. Department of the Treasury. In the event that the subsidy payment is not the same amount, governments should contact the IRS and Department of the Treasury Department to learn why the payment changed.
- Issuers also should consider requesting that subsidy payments be made by electronic funds transfer (EFT) rather than paper checks via U.S. mail.
- A reduction in subsidy payments or “offset” can occur for tax liabilities or any other amount that may be owed the federal government by the issuer (e.g., non-compliance with terms or grants or any federally funded program). The federal law authorizing “offsets” is the “Debt Collection Improvement Act of 1996” and the Treasury Offset Program (“TOP”) describes the procedures for reducing subsidy payments which is currently linked to the issuer’s employer identification number (EIN).
- In the event that the issuer’s subsidy payment is offset, issuers should develop a system within their government to recoup the amount lost from the department where the federal liability exists. In order to effectively manage federal subsidy payments, governments may wish to consider the use of separate EIN or multiple EINs
- The IRS has been sending direct subsidy bond issuers a tax compliance questionnaire. An issuer’s failure to complete the questionnaire could trigger an IRS audit. Governments are encouraged to discuss the questionnaire with their bond counsel, and respond accordingly.
- Governments should develop written tax compliance procedures. The IRS has stated consistently that issuers should have written tax compliance policies and procedures, and IRS Form 8038 asks governments if such policies and procedures are in place. Additionally, the IRS’s Voluntary Closing Agreement Program (VCAP), may have more beneficial terms for issuers that have written qualifying post issuance compliance procedures.
- The percentage of IRS audits on direct subsidy bonds could be greater than those for tax-exempt bonds, as the IRS has focused its attention on the issue price of the bonds. The IRS is calling into question the true issue price of bonds due to reports that soon after the bonds were priced, they traded higher in the secondary market. Governments may be audited about the initial pricing of bonds issued in previous years, including those for direct subsidy bonds. While issuers should review the issue price of their bonds at the time the bonds are issued as part of their ongoing debt management practices, they are encouraged to maintain this information in case of an IRS audit.
- Throughout the term of the bonds, issuers must be compliant with all tax laws related to direct subsidy bonds to ensure that they will continue to receive federal subsidy payments. Issuers are encouraged to consult with their bond counsel if any questions arise about tax compliance, for instance if there is a change in the purpose of the project to one that does not qualify as a direct subsidy bond.
- Governments should look for alerts from GFOA and other organizations in the event that Congress acts to reduce or eliminate the subsidy payments at any time during the years that the federal government will be making direct subsidy bond payments.
Future Considerations if Direct Subsidy Bonds Are Reauthorized by Congress
In the event that direct subsidy bond programs once again become a financing option for state and local governments, GFOA advises governments to exercise caution and, prior to issuing direct subsidy bonds in the future, have a full understanding of the differences between tax-exempt bonds and these taxable bond instruments. If your government determines that issuing direct subsidy bonds is appropriate, the following items should be taking into consideration.
Change in subsidy payments. Consider the risk that the federal government (through an act of Congress) could reduce or eliminate the subsidy payments at any time during the years that the direct subsidy bonds are outstanding and evaluate strategies or techniques to mitigate this risk (i.e., ten year par call option or extraordinary call option).
Direct Subsidy Bond Sale Planning Considerations
- Consult with an independent financial advisor and analyze whether tax-exempt interest rates or taxable interest rates (net of the subsidy payment) results in a lower borrowing cost.
- An optimal bond structure may involve the issuance of both tax-exempt bonds (in the shorter maturities) and taxable direct subsidy bonds for longer maturities. When employing a competitive sale process, consider allowing bidders to determine which maturities will be tax-exempt and which will be taxable direct subsidy bonds.
- Evaluate permitted use of subsidy payments under the bond documents and determine what to do with those payments:
- deposit into sinking fund and use to pay debt service - effectively reduces borrowing cost to net interest rate;
- pledge subsidy payment as security for bonds – normally requires amendment of bond resolution or indenture; consult bond counsel;
- use subsidy payment for some other purpose - however, diverting subsidy payment is effectively borrowing for the other purpose;
- other direct subsidy bond planning considerations include:
- create a process for filing IRS Form 8038-CP to request the subsidy payment and for verifying that the subsidy payments are received;
- evaluate/quantify potential reductions in bonding capacity from issuing debt at higher interest rate (i.e., taxable rates);
- evaluate the impact that the bonds’ gross debt service may have on funding requirements of reserves;
- analyze/amend bond indentures/resolutions to incorporate bond subsidy payments;
- quantify the total subsidy payments to be received over the term of the bonds to measure the monetary amount at risk of potential changes in the subsidy rate if retroactive changes are enacted;
- if subsidy payment is to be used to pay debt service, consider modifying debt structure to achieve desired debt payments structure (i.e. level, ascending, descending) after applying subsidy payment;
- Taxable bond market conventions are different than tax-exempt municipal market conventions in several respects, including the terms of the bonds and the sale process.
- For direct subsidy bonds sold through a negotiated sale, issuers should give attention to the coordination of the taxable and tax-exempt underwriting desks of the book-running senior manager.
- Issuers should familiarize themselves with terminology used in the taxable market (e.g., price indications, launch print and set the coupon), and the process for marketing taxable bonds in order to effectively manage a negotiated bond sale.
- Competitive sales of direct subsidy bonds are a viable option. Issuers should evaluate the most effective method of sale to get the lowest interest rate on the bonds.
- Direct subsidy bonds structured with the standard municipal 10-year par calls have become more viable as direct subsidy bonds have become more common to the market.
- Call provisions for taxable bonds (including direct subsidy bonds) can be very different than call provisions for tax-exempt bonds. Make-whole calls, typical of taxable bonds, can effectively make bonds prohibitively expensive and preclude the ability to refinance such bonds in the future in order to realize potential debt service savings. Issuers should seriously consider the propriety of selling non-callable bonds or using a make-whole call.
- General obligation bonds and other bonds for essential public services or with high-grade ratings (AA or better) are well received by the taxable market; lower rated credits or unconventional structures are more challenging in the taxable market and may require extra education of analysts/potential investors.
- Taxable investors are less familiar with municipal market credits. Special consideration, therefore, should be given to educating analysts/potential investors on the structure and credit (e.g., using web site to educate investors about your entity, investor “road show”).
- Issuers typically will use a combination of tax-exempt bonds and direct subsidy bonds to achieve the lowest possible borrowing cost. Tax-exempt bonds may be more cost effective for some maturities, (particularly shorter maturities), and direct subsidy bonds may be more cost effective for other maturities (historically about ten years and longer).
- Direct subsidy bonds may be structured as serial bonds, term bonds or some combination of serials and terms. Issuers should evaluate the cost effectiveness of alternative issue structures.
- Analysis for determining the most cost effective alternative, tax-exempt versus taxable direct subsidy bonds, should be updated immediately prior to sale to enable a modification, if market conditions warrant.
- The underwriting spread on direct subsidy bonds should not be materially higher than the underwriting spread on tax-exempt bonds absent extenuating circumstances or substantially different issue structures.
- In the taxable market, underwriting compensation for negotiated sales is typically determined on a “group net basis in which compensation is set and determined ahead of the bond sale and is unrelated to actual underwriting/sales performance. As the direct subsidy bond programs have matured, more issuers are providing underwriting compensation on a “net designated” basis for negotiated sales.
- Modifications to the preliminary official statement and official statement will need to be made to accurately describe the direct subsidy bonds, the gross debt service schedule, and the tax treatment of interest.
- Fees for professionals (e.g., bond counsel, financial advisors and disclosure counsel) should not be materially higher in a direct subsidy bond transaction than for tax-exempt bonds absent unusual circumstances.
- Following the bond sale, issuers should prepare a post-sale analysis to evaluate the estimated savings from using the direct subsidy bond alternative and compare results to pre-sale estimates for future reference in evaluating the potential use of direct subsidy bonds for other financings.