IRS Warns That Financial Restructurings Can Jeopardize Tax-Exemption of Bonds

by Mintz Levin - Public Finance Matters
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[author: Len Weiser-Varon and Jeremy A. Spector]

The IRS is planning on sending out letters (“Letters”) over the next few months to several hundred issuers who have experienced covenant or payment defaults from 2007 to the present. The Letters remind issuers of their tax compliance responsibilities in the context of a restructuring and encourage them to self-police compliance of their bond issues with federal tax rules. By sending these Letters, the IRS is signaling a new focus on the tax-exempt status of defaulted and restructured debt.

The Letters specifically focus on the types of debt modifications that can cause a “reissuance”. Generally, there is a reissuance for tax purposes when payment terms on bonds are significantly changed such that the original bonds are deemed exchanged for the restructured bonds. Issuers are directed in the Letters to an article on the IRS’s website describing the specific types of significant modifications to watch out for.

Generally, the “traps for the unwary” triggering a reissuance arise when there is (1) contractual forbearance beyond certain specified periods; (2) changes in yield greater than 25 basis points; (3) certain significant changes in timing of payments, such as extensions of maturity and deferral of payments; and (4) substitution of obligors, changes in security or credit enhancement, or changes in priority of the bonds that cause a change in payment expectations from adequate to primarily speculative or vice versa.

Whenever there is a reissuance an issuer typically must (i) “retest” the bonds for tax compliance as if they were newly issued under existing law; (ii) for certain types of bonds and under certain circumstances, obtain an additional volume cap allocation; (iii) under certain circumstances, obtain elected official approval; and (iv) file a new tax return. The inadvertent failure of an issuer to take any required action to preserve the tax status of the bonds upon a reissuance is referred to by the IRS as a “violation” and, if unaddressed, risks a future determination by the IRS that the reissued bonds are taxable from their reissuance date.

The IRS encourages any issuer who becomes aware of a tax rule violation to take advantage of its voluntary compliance program, which resolves non-compliance problems at a lesser cost than is the case if the IRS initiates an audit and determines that noncompliance exists.

For issuers, conduit obligors, bond trustees and bondholders, this IRS warning highlights the importance, in connection with any bond workout or restructuring, of consulting with qualified bond counsel to ensure that any agreements executed will not adversely impact the tax status of the bonds.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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