Lawmakers in Washington, D.C. have created a present day difficult situation as a result of the budget process in 2010. That year they could not agree to increase the federal debt ceiling and Tea Party Republicans held the debt ceiling hostage with demands to make spending cuts. Fast forward to today and the time has come for Congress and the President to make a deal by December 31 or significant cuts will take effect that were first laid out in 2010 as a short-term compromise tactic.
You have likely heard that Democrats have taken cuts to “entitlements” off of the table and that the Republicans have taken tax increases off of the table. What’s left? One item is the tax exemption for municipal bonds. The chatter on this item appears to range from subsidy payments on Build America Bonds issued in 2009 and 2010 being reduced or eliminated to the tax exemption itself being capped for high income earners or eliminated altogether.
President Obama first proposed a 28 percent cap on the value of the tax exemption in his jobs bill in 2011 and reintroduced it earlier this year in his fiscal 2013 budget. It failed to gain momentum, but municipal market participants were unsettled and have said it would increase borrowing costs for state and local governments. Recently, Municipal Bonds for America (MBFA), a coalition of municipal market groups and participants, is fighting threats to tax exemption and has urged lawmakers to preserve tax-exemptions on state and local governmental bonds as they consider new forms of revenue for tax reform and proposals to avoid the now infamous “fiscal cliff.” Many years past, the market has reacted severely to threats to the municipal bond tax exemption, however, there may be momentum on both sides of the aisle to reduce the benefit to high income earners, which could ultimately raise borrowing costs of state and local government.
While it is likely that many proposals on reducing or eliminating the tax exemption on state and local governmental bonds will be introduced as the end of 2012 approaches, it is also possible that January arrives without a deal and Congress and the President act in 2013 to have a retroactive effect on taxpayers. It will be important for local agencies to consider the impacts of a diminished tax exemption when planning for construction of capital projects and finding the means to pay for such projects.
As we wait to see what our lawmakers have in store for us in terms of the fiscal cliff, other issues – such as post issuance compliance regarding your existing bonds – must continue to be dealt with.
Consider the following scenario: you and your finance team have spent months planning and negotiating the issuance of your bonds. The documents have been signed, the closing certificates and legal opinions delivered, and the closing date has come and gone. You and your staff can breathe a collective sigh of relief. You are free to move on to more pressing matters (like constructing the project, next year’s budget, and completing the annual audit). Eventually the bond transcript arrives in the mail. What do you do with it? What do you do with construction invoices and other receipts?
Maintaining the exclusion from gross income of interest on the bonds requires more than signing the tax certificate at closing. Governmental issuers are routinely required to covenant to comply with many complex provisions of the Tax Code and Regulations. These covenants continue for the life of the bonds, which can be 30 years or longer. Local governments need procedures that are understandable and that can be implemented over time, as the officials responsible for monitoring compliance with tax laws may change. Assigning responsibility for post issuance compliance with tax law and assurance that sufficient information is routinely identified and maintained to allow those who later inherit that responsibility to successfully continue the job is critical for local governments’ finance programs. Special care must be given to record retention policies for bond issues, as record retention requirements for bond issues may differ significantly from those required under state law or other governing rules for other governmental actions. Post issuance compliance has also been a target question for the Internal Revenue Service in their process of routine or targeted audits of bond issues.
Post issuance tax compliance is an integral part of an issuer’s debt management process. In some organizations, compliance may be adequately supported by ad hoc procedures or by the efforts of a single individual. However, consideration should be given to whether ongoing timely, reliable institutional compliance should be supported by practices integrated within the core policies and procedures of the institution. Local agencies should review existing policies on contract compliance, record retention, and investments coincide with managing tax-exempt debt and whether a comprehensive statement of policies and procedures should be adopted.
Kim Byrens is a partner in the Public Finance practice group of Best Best & Krieger LLP. Ms. Byrens has worked on a broad variety of transactions as bond counsel, underwriter’s and disclosure counsel. Such financings include Marks-Roos Joint Financing Authority lease or enterprise revenue bonds, Mello-Roos bonds, sales tax revenue bonds, tax allocation bonds, and certificates of participation. She has also worked as bond counsel in several complex bond restructures. Ms Byrens can be contacted at Kim.Byrens@bbklaw.com
John Rottschaefer is partner and a tax exemption specialist in the Public Finance Department of Best Best & Krieger LLP and has worked on many bond transactions as tax counsel. He has assisted many local agencies with tax compliance and has acted as special counsel for local agencies which are audited or investigated by the Internal Revenue Service. Mr. Rottschaefer can be contacted at John.Rottschaefer@bbklaw.com.