COVID-19 has rightfully dominated the news over the last several weeks, leaving municipalities, nonprofit organizations and businesses scrambling to determine the impact of this pandemic on, among other things, their finances. Many organizations have contacted their lenders in the past two weeks to seek out short-term deferrals of their payment obligations on loans. But what are the tax implications of such deferrals when an organization has a tax-exempt loan?
Under the Internal Revenue Code and applicable Treasury Regulations, a modification of a debt instrument, if “significant,” results in a reissuance of the obligation. Thus, the obligor is treated as having replaced the instrument with a new one for tax purposes. On the tax-exempt side, this results in the prior, unmodified obligation being deemed refunded by the modified obligation.
The obligation as modified must be retested for compliance with the tax-exempt bond rules under sections 103 and 141 to 150 of the Internal Revenue Code, and certain steps must be taken to ensure the obligation remains tax-exempt. Failure to do so results in the obligation losing its status as tax-exempt – a result that should be avoided at all costs!
A short-term deferral of payment obligations, even if not formally documented by the parties, is a modification. But in many cases, such a deferral won’t be considered “significant,” and therefore won’t cause a reissuance. The Treasury Regulations interpreting the reissuance requirement, at 26 C.F.R. Section 1.1001-3, contain a special safe harbor for which many obligors will qualify.
This safe harbor allows obligors to defer payments for up to the lesser of five years or 50% of the original term of the instrument. So long as the deferred payments remain unconditionally payable no later than at the end of this deferral period, the deferral meets the requirements of the safe harbor. Furthermore, if the deferral period is less than the full safe-harbor period available to be used, the unused portion of the period remains available for any subsequent payment deferrals.
Therefore, if after the initial deferral period, an organization’s finances remained in a precarious state, the organization could request a further deferral, so long as the combined deferral period remains in the safe harbor. But keep in mind – if the deferral is extended beyond the deferral period, or any amounts are forgiven, you are no longer eligible for the safe harbor.
Organizations with outstanding tax-exempt obligations considering making a request for a temporary deferral of payments should contact experienced bond or tax counsel to confirm that the deferral meets the requirements of the Code and Regulations. If the organization is considering requesting other changes to its loan in addition to the deferral request, all of the changes must be considered to determine the overall effect on the tax-exempt status of the loan.