WASHINGTON -- Treasury and Internal Revenue Service officials this week warned issuers unable to do legitimate tax-exempt bond reimbursements against trying to avoid requirements by selling taxable reimbursement debt and then refunding it with tax-exempts.
Bond firms and issuers promoting such deals claim they would be refunding rather than reimbursements and that reimbursement rules would not apply, several lawyers said.
The Treasury and IRS officials disagree.
"We think Treasury's rules prohibit that," a Treasury official said. "But to the extent we feel it is necessary, we may clarify that this type of transaction will not get you out from under the reimbursement rules. And whatever clarification we make will be retroactive," he added.
An IRS official agreed. "A taxable reimbursement bond, followed by a tax-exempt refunding will not be permitted unless that taxable bond was used for a good reimbursement," the IRS official said.
During the next six weeks, it is not completely clear what standards, if any, a good governmental bond reimbursement would have to meet, agency officials conceded. But good deals clearly could not be abusive or arbitrage-driven, such as the proposed Macomb County, Mich., jail deal that the IRS said, in a 1989 private letter ruling, would not be tax-exempt.
After Sept. 7, a good governmental bond reimbursement would be one that meets the new reimbursement rules, the agency officials said. Those rules, which were proposed last April to discourage issuers from doing bond reimbursements to avoid arbitrage restrictions, take effect for most governmental and 501(c)(3) bonds issued after Sept. 7.
Industry and agency officials this week said they do not think any such deals have come to market yet. But more issuers have been considering doing them as the effective date of the reimbursement rules looms closer. State and local issuers and bond lawyers have complained the pending rules will severely restrict their ability to do bond reimbursements.
"I don't think these deals are being done yet. but a lot of folks are actively considering them," said one bond lawyer in the South who did not want to be identified.
A lawyer from the Midwest who also did not want to be named agreed, saying, "I don't think we've seen these yet because if an issuer can get a tax-exempt bond issued, he'll try to do that. But unfortunately, some of the underwriters have really jumped on this. They're suggesting it's a way to get around the reimbursement rules. It's become a stone that's gathering a lot of moss."
Promoters of these deals say the reimbursement rules do not address tax-exempt refundings of taxable reimbursements.
"The reimbursement rules tell you when proceeds are deemed as spent. In a legitimate deal, they are spent as soon as the bonds are issued and can be invested without restriction," one New York lawyer said. "But in a refunding, the proceeds are not deemed to be spent, they are actually spent to pay down existing debt. And the reimbursement rules do not address this," he said.
But the Treasury official pointed out that existing Treasury rules -- Section 1.103-7(d) -- say refunding bonds are to be considered used for the same purpose as the refunded bonds. Under these rules, he said, the Treasury could argue that the purpose of both issues is reimbursement and that neither meets the reimbursement rules.
The proceeds of the taxable deal would not be considered spent and, in a refunding, would have to transfer to the tax-exempt refunding issue. Any investment of the proceeds would either have to be restricted to the tax-exempt rate or would be subject to arbitrage rebate requirements, depending on whether the temporary period had expired. If the temporary period had expired and the issuer failed to meet yield-restriction requirements, the refunding bonds would not be tax-exempt.
But some bond lawyers said these existing Treasury rules were meant to apply to private-activity bonds and not to this kind of transaction.
In any case, many bond lawyers are concerned such deals with lead the Treasury to come out with new rules restricting all tax-exempt refundings of taxable issues, even those that are legitimate.
"I'm concerned that this may lead to a recurrence of the cycle that we have seen many times before, in which arguably abusive transactions designed to avoid tax rules result in overly strict and broad regulations which unfairly restrict traditional and legitimate financing techniques," the New York lawyer said.
The reimbursement rules are an example of that cycle, he said. Many bond lawyers believe the rules were prompted by the Macomb County, Mich., jail deal.
Some lawyers also are concerned that these deals will lead Treasury to regret setting a prospective effective date for the reimbursement rules. "We're playing right into their hands," said the Midwest lawyer, "Treasury will say, 'See what happened. We gave you guys a little break and you turned it into a big loophole.'"