Public Finance Alert | March.23.2020
Many clients have been asking questions relating to the current market challenges with VRDOs and CP (high interest rates and lack of demand). The discussion below was drafted to provide some basic information and analysis with respect to the federal tax issues that arise in this context. All of the members of the Orrick Public Finance Tax Group are happy to talk about this topic with clients or other market participants if that would at all be helpful. We also plan to report new developments as they arise. The dynamics here are a bit like the 2008-2009 time period, so we have experience with it, but it is important to realize that the tax law and the debt documentation have changed since that time period as well.
Issuers are experiencing high interest rate resets on VRDOs and the looming possibility of remarketing failures. For issuers with substantial cash resources, one thought is to use cash to buy in bonds, wait out the market disruption, and put the bonds back out when the market has settled. There likely are document and/or securities law limitations relating to the different potential strategies in that regard, but there are also tax limitations. In general, if an issuer acquires its own debt, whether in a secondary market trade or pursuant to a tender right, and the bonds are not immediately resold/remarketed, the bonds are extinguished for tax purposes. Extinguishment is bad, because when the issuer later sells the bonds to investors, that sale is treated as a new debt issuance for tax purposes (a new money transaction) and not as a continuation of the original deal or even a refunding of the original deal. The tax exemption on the original bonds is essentially lost.
The one exception to this bad result that is found in the current law is a rule that says if the issuer acquires its own bonds pursuant to a tender right in the bond documents, the issuer can hold the bonds for up to 90 days without the bonds being extinguished, so long as the issuer is consistently making a good faith effort to remarket the bonds. The problem with this rule is that if there are investors willing to buy the bonds, even at a very high interest rate, the issuer has to sell to those investors. Thus, this rule is not a solution unless there really are no investors interested in the bonds.
During the financial crisis, there was a rule that allowed for the holding period to be up to 180 days with no good faith remarketing requirement. That rule has expired. The industry, through NABL (and the NABL President and Orrick tax partner, Rich Moore), is pushing the IRS to release some new guidance along the lines of the financial crisis guidance. It is very likely that the IRS will accommodate, and soon, but the timing and scope of their action is not yet clear. It also is very likely that the guidance will be retroactive. Thus, we expect we will have some new tools to deal with this problem soon.
Also during the financial crisis, there was a voluntary closing agreement program (VCAP) procedure that allowed issuers to acquire their own bonds and hold them without triggering an extinguishment, so long as the issuer made a formal VCAP request and paid a fairly small fine (.029% of the related principal amount of bonds per month). The industry/NABL are also requesting reinstatement of this procedure. While voluntarily approaching the IRS, filing a VCAP request and paying a fine is not optimal, and the flexibility of this procedure could be helpful.
Commercial paper presents special challenges because individual notes mature, and a failed roll is a failed issuance, as opposed to a failed remarketing. In a failed remarketing, the bonds typically continue to be outstanding for state law purposes, and the IRS seems to have thought that feature to be important. With a failed CP roll, there is no debt outstanding even for state law purposes. The emergency guidance being requested of the IRS should cover CP programs as well as VRDOs.
One concept we are considering with some clients in order to avoid VRDOs becoming bank bonds is for the issuer to obtain a bank loan or line of credit that would be drawn on to acquire bonds/notes. In the bank loan scenario, the bonds/notes could even be pledged to the bank lender. The bank loan/line would be paid down as the acquired bonds/notes are resold into the market at a later date. The bonds/notes would still be extinguished at the time they are acquired by the issuer, but the bank loan/line would be a refunding transaction, and the later sale into the market of the bonds/notes (and repayment of the bank loan/line) would also be a refunding. This would require some specialized tax documentation (new tax certificate) and filing (new Form 8038-G), and other complications may arise, such as dealing with any related hedging transactions, but the issuer should be able to preserve the tax-exemption. The important point is that there would be a third-party debt outstanding at all times,
The discussion above focuses on bonds/notes that are not conduit transactions. For conduit transactions in which a government agency issues bonds and loans the proceeds to a non-government agency borrower, the tax rules apply in a different manner. Importantly, the tax rules use a form-over-substance approach, so that if a conduit borrower acquires its own bonds, there is no extinguishment of the bonds because the conduit borrower is not the issuer. Therefore, the extinguishment concerns discussed above simply do not apply.
There are other tax limitations that apply to conduit borrower acquisitions. For example, if a conduit borrower that is a for-profit entity acquires its own bonds, the tax rules cause the interest accruing to the conduit borrower to be taxable income to the conduit borrower. Under yet another rule, the acquisition of by the borrower of its bonds could violate an arbitrage restriction relating to the spread between the yield on the bonds and the yield on the conduit loan.
For VRDOs, we anticipate that any purchases of bonds by issuers and conduit borrowers and any sale of bonds back into the market will be at par. That will be required under the bond documentation and the tax law if the resale into the market is through a remarketing. Issuers and conduit borrowers that hope to purchase bonds or sell bonds back into the market at other than par should clear that plan with tax counsel.