As you may remember, in the first episode, we discussed how the federal government’s primary goal in subsidizing tax-exempt bonds is to encourage investment by issuers in long-lived, tangible assets. We also discussed how the federal government has tried to keep issuers on the intended path by preventing them from exploiting the difference between the tax-exempt and taxable markets. Finally, we noted that bonds will generally be taxable arbitrage bonds if the issuer has successfully exploited the difference between tax-exempt and taxable interest rates and has also overburdened the tax-exempt bond market.

This episode will discuss the three rules intended to prevent the overburdening of the tax-exempt bond market – (1) You shall not issue too early; (2) You shall not issue too much; and (3) You shall not issue for too long. 

Why would you issue too early?   To take advantage of a low interest rate environment.  For example, an issuer might not have a capital project for Year 1 when interest rates are low, but anticipates having a capital project in Year 3 when interest rates might be higher.  The rule imposed by the federal government to prevent the issuer from issuing tax-exempt bonds too early is a requirement that the issuer reasonably expect on the issuance date of the tax-exempt bonds that it will spend at least 85% of the spendable proceeds within three years of the issuance date.  Even though the test involves “reasonable expectations,” remember that hindsight is always 20/20, and thus issuers should strive to actually meet this goal.  

Why would you issue too much?  To take advantage of a low interest rate environment. If an issuer reasonably expects that the proceeds of its tax-exempt bond issue will exceed the governmental purpose of the issue by more than $100,000, that constitutes evidence that the issuer overburdened the tax-exempt bond market by issuing too many tax-exempt bonds. Thus, it is best to avoid having over $100,000 of unspent proceeds upon completion of the bond-financed project. Unexpected excess sale and investment proceeds of the tax-exempt bond issue can be used to redeem or defease bonds of the issue to comply with this $100,000 limitation on unspent proceeds.

Why would you issue for too long?  To take advantage of a low interest rate environment, and possibly for cash flow reasons (i.e., to defer principal payments).  If the weighted average maturity (WAM) of the bond issue exceeds 120% of the weighted average economic life of the assets financed by the bond issue, that is evidence that the issuer overburdened the tax-exempt bond market by letting its bonds remain outstanding too long.  In other words, the federal government does not want issuers issuing 30-year tax-exempt bonds to finance computers with a 5-year useful life (unless, of course, the amortization of the bonds is front-loaded, such that the WAM of the bond issue does not exceed 6 years).

When overburdening isn’t actually overburdening.  Even if an issuer satisfies one or more factors discussed above, the issuer’s action will be excused (meaning that no overburdening will be deemed to occur) if the issuer can demonstrate that the action was necessitated by factors such as unexpected construction delays, bona fide cost underruns, a bona fide need to finance extraordinary working capital expenditures (e.g., a litigation settlement), or the issuer’s long-term financial distress.  Exceptions.  They are what keep tax lawyers employed. 

Preview of Episode 3 – What Happens to the Arbitrage Sinners and the Arbitrage Saints?

Next week’s Season Finale will discuss what happens to issuers that violate the arbitrage rules, along with some potential rewards for the rule-followers.

Stay tuned . . .