Noted public finance tax lawyer Clubber Lang remains correct in his prediction about Direct-Pay bonds.

For those issuers that haven’t yet redeemed their direct-pay bonds with tax-exempt bonds, sequestration cuts to interest subsidies for direct pay bonds will continue for federal fiscal year 2016 (October 1, 2015 through September 30, 2016), according to a report that the IRS has posted on its website. The sequestration rate is a bit lower this year. The IRS will now keep 6.8% of each subsidy payment, down from 7.3% in fiscal 2015, which was a slight increase from 7.2% in fiscal 2014, the first full year of sequestration (in the portion of fiscal 2013 during which sequestration was in effect, the rate was 8.7%).

All direct pay subsidies paid between Oct. 1, 2015, and Sept. 30, 2016 will be reduced by 6.8%, regardless of when the direct pay bond issue was issued. 

Sequestration applies to all outstanding direct pay bonds. Direct pay bonds include Build America Bonds, their close cousin Recovery Zone Economic Development Bonds, and all of the other types of qualified tax credit bonds (Qualified School Construction Bonds, etc.) that were issued on a direct payment, rather than tax credit, basis. The sequestration rate for fiscal 2016 applies to all subsidy payments for direct pay bonds, regardless of when those bonds were issued. As an example, subsidy payments that an issuer requests in fiscal 2016 both on a Recovery Zone Economic Development Bond issued in 2009 and on a Qualified Energy Conservation Bond issued in 2015 will all be reduced by 6.8%. Unlike the rate of the interest subsidy that the issuer receives, which is locked in for the life of an issue of direct pay bonds on the sale date, the sequestration rate can (and likely will) change from year to year during the term of the bonds. Naomi Jagoda has reported in The Bond Buyer ($) that the sequestration rate for direct pay bond subsidy payments will likely continue to dip slightly if Medicare costs continue to increase and soak up more and more of the required reduction in nondefense spending.

Currently, the sequestration order is scheduled to last through fiscal 2025, but Congress can always act to reduce or repeal sequestration.

As a reminder, the IRS will do the math for you (if that’s any consolation). 

As a reminder, issuers should remember to timely file IRS Form 8038-CP to request their interest subsidy payment for any direct pay bonds, showing the full amount of interest paid, just as they did in those blissful years before we learned of sequestration.

Also as a reminder, for fixed rate bonds, issuers should file Form 8038-CP between 90 and 45 days prior to an interest payment date if they want to receive the interest payment subsidy on the interest payment date. This timing also applies for variable rate bonds where the issuer knows the amount of interest that will be due at least 45 days prior to the interest payment date. For variable rate bonds where the issuer doesn’t know the amount of interest that will be due within 45 days of the interest payment date, the issuer should aggregate all of the interest payments in a particular quarter and file a Form 8038-CP in arrears no later than 45 days after the last interest payment date in the quarter. In each of these cases, the IRS will automatically apply the reduction and send a check for the direct pay subsidy amount net of the sequestration reduction.

On the back end, the IRS Chief Counsel’s Office has advised in PMTA-2014-04 that an issuer will, essentially, have 3 years from an interest payment date to file an initial Form 8038-CP to request a subsidy payment for that interest payment (beyond three years, an issuer could potentially begin to lose the ability to claim subsidy payments). The IRS recently announced that it considers itself to have three years from the date that the issuer files Form 8038-CP to challenge the amount of the subsidy or the status of the bonds as direct pay bonds entitled to a subsidy.

If there’s any further consolation in all of this, recall that the subsidy payments are governed by the very same Internal Revenue Code sections that govern your personal federal income tax refund. (See IRS Notice 2009-26, Section 3.3, for discussion.) So, if the powers that be determined that they were on solid legal footing to use sequestration to reduce subsidy payments on direct pay bonds, I guess we should be thankful that they haven’t applied the same logic to our personal income tax refunds? (Right? Hey, where are you going?!?)