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Bond Dealers Urge Revision to Proposed Exempt Bond Regs

MAR. 1, 2019

Bond Dealers Urge Revision to Proposed Exempt Bond Regs

DATED MAR. 1, 2019
DOCUMENT ATTRIBUTES
  • Institutional Authors
    Bond Dealers of America
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Tax Analysts Document Number
    2019-13883
  • Tax Analysts Electronic Citation
    2019 TNT 69-34
    2019 EOR 5-52
  • Magazine Citation
    The Exempt Organization Tax Review, May. 2019, p. 395
    83 Exempt Org. Tax Rev. 395 (2019)

March 1, 2019

Internal Revenue Service
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

RE: Notice of Proposed Rulemaking [REG-141739-08] Regarding Reissuance of State or Local Bonds

Dear Sirs or Madams,

On behalf of the Bond Dealers of America (“BDA”), I am pleased to submit this letter in response to the Internal Revenue Service notice of proposed rulemaking [REG-141739-08] concerning reissuance of state or local bonds (the “Proposed Regulations”). The BDA is the only DC-based group representing the interests of securities dealers and banks exclusively focused on the U.S. fixed income markets. We welcome this opportunity to present our comments.

On December 31, 2018 the Internal Revenue Service issued a notice of proposed rulemaking concerning reissuance of state or local bonds (the “Proposed Regulations”). Although the Bond Dealers of America believes that, for the most part, the Proposed Regulations are consistent with the prior rules related to “qualified tender bonds,” we are concerned with one provision that would not permit bonds being converted to fixed interest rates to maturity to be remarketed at a premium (or discount). This is a change from the rules that were issued in 2008 as part of Notice 2008-41 (the “Notice”) and which we believe, as further described below, would negatively impact the interest rates at which these fixed rate bonds would be sold. This, in turn, would raise costs for state and local governments. As further described below, we suggest that the Proposed Regulations be conformed to the provision on this issue in the Notice.

The Proposed Regulations

The general rule of the Proposed Regulations is that, in the case of a qualified tender bond, the existence or exercise of a qualified tender right is ignored in determining whether the bond has been reissued for purposes of the tax-exempt bond provisions of the Internal Revenue Code and regulations. In defining “qualified tender right” section 1.150-3(e)(3) of the Proposed Regulations provides, in part, the following requirement:

Following each such tender, the issuer or its remarketing agent either redeems the bond or uses reasonable best efforts to resell the bond within the 90-day period beginning on the date of the tender. Upon any such resale, the purchase price of the bond is equal to par (plus any accrued interest).

We note that although not specifically phrased as a requirement for qualified tender bonds, this appears to be the intent of the quoted provision.

Although the Notice takes a slightly different technical approach to the determination of whether changes in interest rate mode result in a reissuance of a qualified tender bonds, the results are generally the same as under the Proposed Regulations. Specifically, the Notice generally provides that a “qualified interest rate mode change” does not result in a reissuance. The Notice provides, in part, that:

In order to be a qualified interest rate mode change, the terms of the bond must require that the bond be purchased and resold at a price equal to par upon conversion to a new interest rate mode, except only that, upon a conversion to an interest rate mode that is a fixed interest rate for the remaining term of the bond to maturity, the bond may be resold at a market premium or a market discount from the stated principal amount of that bond.

We believe that the approach of the Notice on conversions to fixed interest rates to maturity is significantly preferable to the approach taken in the Proposed Regulations. Most importantly, the Proposed Regulations would prohibit qualified tender bonds from being remarketed at a premium when converted to fixed interest rates. As further described below, the standard pricing structure in the municipal bond industry for fixed rate bonds for many years is to price those bonds at a premium in order for those bonds to be most attractive to institutional investors. If qualified tender bonds cannot be remarketed at fixed interest rates to maturity at a premium to their face amounts, there will be a resulting reduced demand for those bonds, forcing issuers to offer those bonds at higher interest rates than comparable newly issued fixed rate bonds. We see no reason to change the rule on this from the guidance in the Notice. If the IRS and Treasury are concerned that the rule provides issuers with a means of generating additional proceeds, that concern could be dealt with by limiting the amount of proceeds generated in a remarketing or by treating any additional amounts as proceeds that are subject to the requirements of sections 141-150. If there are other technical issues that arise, we would be happy to work with you to develop solutions to those issues.

Why premium bonds

The primary reason that fixed rate municipal bonds are sold at premiums above their face amounts is to help ensure that those bonds do not result in market discount that is taxed as ordinary income. Under the rules for market discount on tax-exempt bonds, if the amount of market discount exceeds the permitted de minimis amount (0.25% for each full year from the purchase date until final maturity), the full amount of that discount will be taxed as ordinary income. If the amount of market discount is less than the de minimis amount, the appreciation will be taxed as capital gain. Finally, if a bond is purchased at a price above its face amount, there will be no taxable income produced at all.

As noted in a recent publication from Pimco, Understanding the De Minimis Tax Rule,1 as higher interest rates push bond prices lower, tax-exempt bonds issued at or near par may become exposed to adverse tax and liquidity consequences related to the de minimis rule. The adverse tax consequence relates to the fact that, because of the higher tax rate on bonds purchased at a price reflecting a discount in excess of the permitted de minimis amount, bonds that would trade near that price or below it, will trade at an even lower price to compensate investors for the additional tax (or risk of the additional tax). In other words, the trading price of the bonds will reflect something like a “gross up” of its interest rate to compensate investors for the additional tax (or potential tax) lability. The potential for additional taxes could also result in a reduction in demand for these bonds as municipal bond investors who are tax sensitive (for example, tax-exempt mutual funds) avoid the purchase of bonds with any tax consequences or potential tax consequences even if the yield on those bonds would provide compensation for the income tax liability. This reduction in demand could further drive down the prices for these bonds in the market.

As a method of avoiding the consequences described above, most fixed rate municipal bonds issued [since the financial crisis] have been and continue to be issued at premiums above their par amounts. These original issue premiums provide a substantial cushion so that even if prices drop as interest rates increase, the bonds should continue to trade at a premium above par so as to avoid the concerns with market discount. As a result, the [vast majority] of fixed rate municipal bonds are initially sold at a premium.

Impact of the Proposed Regulations

Based on the tax impact on tax-exempt bonds that trade at prices near the permitted de minimis price, we are concerned that a requirement that qualified tender bonds remarketed at fixed interest rates be sold at par would cause those bonds to be remarketed at higher yields than comparable newly issued fixed rate bonds. Fixed rate qualified tender bonds subject to a requirement to be sold at par would face reduced demand from investors who seek to avoid any ordinary income and would have to be sold at higher interest rates to compensate investors for the potential tax liability related to the risk that the price of the bonds would cause the market discount to exceed the permitted de minimis limit. By one estimate, the increase in interest rate required to remarket these bonds at par could equal or exceed 30-35 basis points.

Generally speaking, issuers of qualified tender bonds could avoid the restriction contained in the Proposed Regulations by issuing new fixed rate bonds at a premium rather than converting their existing qualified tender bonds to fixed rates and selling them at par. Absent an intervening change in law that makes a new issuance problematic, the issuance of new fixed rate bonds would be permitted although it would typically result in additional transaction costs to the issuer. Similarly, an issuer could remarket the qualified tender bonds at a premium and then treat the remarketed bonds as reissued for tax purposes, with the same consequences and risks of tax law changes as if it had issued new bonds. We do not believe that it should be necessary for State and local governments to take these steps to avoid the seemingly unnecessary limitation contained in the Proposed Regulations.

Conclusion

For the reasons set forth above, we believe that the Proposed Regulations should be revised to permit qualified tender bonds that are converted to fixed rates to maturity to be remarketed at prices in excess of their face amounts as was the case under the Notice. We are not aware of any abuses that occurred under the rule provide in the Notice. In addition, we believe that it is possible to address any technical issues that arise, such as the treatment of the proceeds generated from bonds being sold at a premium. State and local governments should not be forced to pay the higher interest rates that would result from the adoption of the Proposed Regulations.

The BDA would be happy to meet with IRS and Treasury staff to discuss this issue or to respond to any questions.

Thank you for the opportunity to provide these comments.

Sincerely,

Mike Nicholas
Chief Executive Officer
Bond Dealers of America
Washington, DC

FOOTNOTES

1 https://www.pimco.com/en-us/resources/education/understanding-the-de-minimis-tax-rule/

END FOOTNOTES

DOCUMENT ATTRIBUTES
  • Institutional Authors
    Bond Dealers of America
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Tax Analysts Document Number
    2019-13883
  • Tax Analysts Electronic Citation
    2019 TNT 69-34
    2019 EOR 5-52
  • Magazine Citation
    The Exempt Organization Tax Review, May. 2019, p. 395
    83 Exempt Org. Tax Rev. 395 (2019)
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