n November 2, 2017, the “Tax Cuts and Jobs Act” was introduced in the House of Representatives. This act has immediate and far-reaching implications for tax-exempt finance.

Among other things, the Tax Cuts and Jobs Act would:

• Repeal the authority to issue “qualified private activity bonds” after December 31, 2017. These bonds generally include all tax-exempt bonds that are not “governmental bonds,” and include tax-exempt bonds issued for the benefit of 501(c)(3) organizations and many other types of tax-exempt bonds.
• Repeal the authority to issue advance refunding bonds after December 31, 2017. The repeal applies to advance refundings of governmental bonds as well as bonds issued for the benefit of 501(c)(3) organizations.
• Repeal the authority to issue tax-exempt bonds for professional sports stadiums after November 2, 2017.
• Repeal the authority to issue “tax credit bonds” after December 31, 2017. This repeal concerns a much more limited type of special tax-advantaged bonds.

Summary of Key Points

• The legislation would not adversely affect “governmental” bonds issued for the benefit of state and local governments, except for advance refunding bonds and bonds issued for the professional sports stadiums.
• Certain categories of tax-exempt bonds are at more risk for repeal or restriction than others. The proposed legislation indicates that categories at most risk for repeal or restriction are: all categories of tax-exempt bonds issued for the benefit of borrowers other than state or local governments (that is, “qualified private activity bonds”); advance refunding bonds; and tax-exempt bonds for professional sports stadiums. It is important to note, however, that qualified private activity bonds include a wide range of different types of tax-exempt bonds for different purposes, and that the authority to issue certain types of tax-exempt qualified private activity bonds might be at greater risk than others.
• A “rush to market” is a distinct possibility. The proposed repeal of the authority to issue tax-exempt qualified private activity bonds and advance refunding bonds may result in a much increased volume of tax-exempt bonds for those purposes before the end of 2017.
• “Grandfathering” of bonds issued before tax law change. The tax-exempt status of bonds issued before the relevant effective dates would not be adversely affected by the proposed legislation.
• Transition rules for current refundings of bonds issued before the effective dates will be critically important and are much less certain than in the past. The Tax Cuts and Jobs Act as proposed contains no “transition rules” that permit tax-exempt bond current refundings of qualified private activity bonds issued before the effective date. Whether enacted legislation contains any such transition rules will be of critical importance to many borrowers. In the past, Congress has in many, but not all, instances of enactment of new restrictions on tax-exempt bonds permitted tax-exempt refundings of “grandfathered” bonds issued before the effective date. For a number of reasons, transition rules permitting future tax-exempt bond current refundings are much less certain than in the past.
• Certain types of outstanding tax-exempt financing structures are exposed to risks of tax law changes that are not readily apparent. Examples of types of financing structures that may have “hidden” change of law tax risks include particularly “direct purchases” by banks, tax-exempt commercial paper, and tax-exempt draw-down loans.
• Issuers and borrowers should separately consider the risks for outstanding bonds and the risks for future financing plans. The risks for outstanding bonds are not the same as the risks for future financing plans. Assessing these risks separately can help to focus an action plan.
• It may be prudent for issuers to evaluate future financing plans and to consider an action plan to accelerate the timing of some financings.
• It may be prudent for issuers and borrowers to evaluate, and take steps to manage, the tax risk of their outstanding bonds.
• It may be prudent for issuers and borrowers to start to evaluate the capital raising tools that would replace tax-exempt financing. A variety of capital raising structures in addition to the issuance of taxable bonds is likely to emerge to replace tax-exempt financing if certain types of tax-exempt financing are repealed or further restricted.

A Description of Relevant Provisions of the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act was introduced on November 2, 2017, in the U.S. House of Representatives by House Ways and Means Committee Chair Brady. Although the enactment of significant tax reform legislation is of course uncertain, this proposed legislation has very large implications for tax-exempt finance. Developments over the next several weeks, including particularly the expected introduction of tax reform legislation in the U.S. Senate, will further inform the risks presented by the introduction of the Tax Cuts and Jobs Act.

Repeal of authority to issue “qualified private activity bonds.” The proposed legislation would repeal the authority to issue all “qualified private activity bonds” after December 31, 2017. ”Qualified private activity bonds” include a large number of different types of tax-exempt bonds that are issued for the benefit of borrowers other than state and local governments. The tax-exempt bonds subject to repeal include all “exempt facility bonds” under Section 142 of the Internal Revenue Code (the “Code”) (such as bonds for airports and docks and wharves and multifamily housing when financed projects are treated as privately used), “single family housing” bonds issued under Section 143 of the Code, qualified small issue bonds for manufacturing issued under Section 144 of the Code, and “qualified 501(c)(3) bonds” issued under Section 145 of the Code (such as bonds issued for the benefit of nonprofit hospitals and universities). The repeal does not apply to traditional “governmental” bonds, which generally do not finance projects treated as privately used, except for advance refunding bonds and bonds for professional sports stadiums. Some types of tax-exempt “governmental” bonds are issued for the benefit of private persons, but are not technically treated as “private activity bonds” (for example, some general obligation bonds used to make grants to private persons); the authority to issue those types of bonds would not be repealed.

The proposed legislation would make a number of revisions to the Code which appear to be intended to purge references and provisions relating to “qualified private activity bonds.”

Repeal of authority to issue “advance refunding bonds.” The proposed legislation would repeal the authority to issue all tax-exempt “advance refunding” bonds after December 31, 2017. Advance refunding bonds are bonds issued more than 90 days before refunded bonds are actually retired. This repeal would apply to advance refunding “governmental” bonds as well as advance refunding “qualified 501(c)(3) bonds.” This is the provision in the Tax Cuts and Jobs Act that would most significantly adversely affect issuers of tax-exempt governmental bonds.

Repeal of authority to issue bonds for professional sports stadiums. The proposed legislation would repeal the authority to issue tax-exempt bonds to finance or refinance capital expenditures for a facility which, during at least five days during any calendar year, is used as a stadium or arena for professional sports exhibitions, games, or training. The repeal would apply immediately, to any bonds issued after November 2, 2017. Although this repeal would apply only to bonds financing professional sports stadiums, the prohibition is written in a manner that is strict.  For example, the prohibition contains no “de minimis” relief, so that it appears that a bond issue would fail to be tax-exempt if even $1 is spent on a professional sports stadium.  Also, because of the proposed immediate effective date, this proposed prohibition may immediately require special review of tax-exempt bonds that have not yet been issued.  Bonds issued after November 2, 2017 for professional sports stadiums may require, at a minimum, special disclosures to investors.

Repeal of authority to issue tax credit bonds. The proposed legislation would repeal the authority to issue tax credit bonds after December 31, 2017. Although many types of tax credit bonds were authorized to be issued under prior legislation, the Code currently permits only a relatively small volume of tax credit bonds to be issued. For example, the authority to issue Qualified Zone Academy Bonds would be repealed. Accordingly, this provision has much less important and far-reaching effects than the provisions concerning tax-exempt bonds.

The Tax-Exempt Bond Markets Could Be Significantly Disrupted Well in Advance of the Actual Enactment of Tax Legislation

In assessing the risks presented by federal tax reform, one particularly important point is that issuers and borrowers could be significantly adversely affected by merely by the credible possibility of specific tax legislation well in advance of enactment. Over the years, members of Congress have on many occasions introduced legislation containing immediate effective dates that would restrict the authority to issue different types of tax-exempt bonds. For example, in June 1996, Senator Moynihan introduced the Stop Tax-Exempt Arena Debt Issuance Act with an immediate effective date, which would have prohibited issuance of tax-exempt bonds for sports stadiums. Because investors generally require a high degree of certainty in tax position, introduction of this type of legislation could have the immediate practical effect of restricting issuance of certain types of tax-exempt bonds, particularly if the legislation is introduced by a prominent member of Congress, or if legislation is introduced with bipartisan support.

Similarly, the mere introduction of credible legislation restricting the issuance of tax-exempt bonds, such as the Tax Cuts and Jobs Act, could result in a “rush to market,” even if the legislation is never in fact enacted.

For these reasons, there is a substantial risk that issuers and borrowers will be immediately affected by the Tax Cuts and Jobs Act and the prospect of enactment of tax reform.

Prior Legislation May Inform an Assessment of the Likelihood of Tax Law Changes Adverse to Tax-Exempt Financing

It is of course not possible to predict with confidence the exact form that enacted tax legislation may take, or even whether fundamental tax reform legislation will be enacted in the near future. An assessment of the risks presented by the Tax Cuts and Jobs Act, however, can be informed by the prior history of legislation and prior legislative proposals. At a minimum, it is reasonable to expect that drafters of any final legislation will at least consider the effectiveness of past legislation.

In broad sweep, the history of federal tax legislation concerning tax-exempt bonds since 1968 has been to place increasing limitations on issuance of tax-exempt bonds, including in particular the permitted uses of tax-exempt bond proceeds.

A general historical trend has been the imposition of increasing limits on the issuance of tax-exempt bonds for the benefit persons other than state and local governments. Most notably in 1968, 1982, 1984 and 1986, by placing restrictions on the issuance of these bonds (now called “qualified private activity bonds”) by, among other things, limiting the types of projects that qualify and, in most instances, by imposing limits on the volume of such bonds and in 1986 Congress placed restrictions on advance refunding bonds.

Accordingly, the provisions adverse to qualified private activity bonds and advance refunding bonds are consistent with a long history of actual tax law changes and proposed legislation.  As one example, at a House Ways and Means Committee hearing on tax-exempt bonds on March 19, 2013, both Republican and Democratic members of the Committee raised particular questions about the policy justifications for the authority to issue tax-exempt qualified private activity bonds. Thus, the history of actual tax law changes and prior proposed legislation leads to an objective assessment that the authority to issue tax-exempt qualified private activity bonds and advance refunding bonds faces significant risk of repeal.

Assessing the Risks for Different Categories of Tax-Exempt Bonds

Based on proposed provisions of the Tax Cuts and Jobs Act and the history of past legislation, it is evident that some types of tax-exempt bonds are more at risk for repeal or restriction than others, although all types of tax-exempt bonds may be at some risk.

As is discussed above, the Tax Cuts and Jobs Act would repeal the authority to issue qualified private activity bonds, advance refunding bonds and professional sports stadium bonds; accordingly, the authority to issue those types of tax-exempt bonds is clearly at risk.

It is important to note, however, that “qualified private activity bonds” include a large number of different types of tax-exempt bonds that can be issued for different purposes. It is entirely possible that enacted legislation would repeal the authority to issue some types, but not all types, of qualified private activity bonds.

For example, a reasonable guess may be that qualified private activity bonds issued to finance for government-owned public infrastructure may be at lower risk for repeal than other types of qualified private activity bonds. For example, many tax-exempt bonds issued for government-owned airports and docks and wharves are issued as qualified private activity bonds. The policy arguments that it is appropriate to subsidize borrowing for this type of public infrastructure may be particularly compelling.

On the other hand, a number of provisions in the Tax Cuts and Jobs Act suggest that the authority to issue qualified 501(c)(3) bonds may be at greater risk. One theme in this proposed legislation appears to be a willingness to enact stricter rules for 501(c)(3) organizations to raise federal revenue. For example, the Tax Cuts and Jobs Act would impose a new excise tax on certain investment income of private colleges and universities. In that light, there appears to be no reason to assume that 501(c)(3) organizations will necessarily be afforded favorable treatment in enacted legislation.

Grandfathering of Outstanding Tax-Exempt Bonds

The provisions in the Tax Cuts and Jobs Act would not adversely affect the tax-exempt status of tax-exempt bonds issued before the relevant effective date of repeal. This approach is consistent with prior legislation.

In most prior legislation, Congress has taken care to avoid retroactive imposition of limitations on tax-exempt bonds, in large part to avoid disruption of the financial markets. The model for “grandfathering” outstanding bonds generally has been to provide that new restrictions apply only to bonds issued after an effective date. For example, this model was followed in the effective date provisions to the Tax Reform Act of 1986.

This “grandfathering” approach has the weight of history and fairness to the financial markets, but it must be acknowledged that it has a considerable cost to the United States Treasury. Under this approach, the tax expenditure of tax-exempt bonds has a long “tail.” Indeed, many tax-exempt bonds the financed purposes that were prohibited decades ago continue to remain outstanding. Even if repeal of the authority to issue certain types of tax-exempt bonds is enacted in new legislation, tax-exempt bonds issued before the relevant effective date may similarly continue to be outstanding for decades.

This large “tail” on the tax-exempt bond expenditure likely means that effective date provisions will receive close scrutiny in an environment where tax expenditure reduction is of paramount concern. In light of the historical approach of Congress, retroactive legislative repeal appears to continue to be unlikely, but that favorable approach is not absolutely certain.

Grandfathering of Current Refundings of Outstanding Tax-Exempt Bonds?

The Tax Cuts and Jobs Act contains no “transition rules” that would permit tax-exempt current refunding of tax-exempt bonds issued prior to the effective date. We expect that such transition rules will be a particularly important question for the public finance industry as legislation proceeds.

A question that is related to, but different from, the “grandfathering” of bonds issued before new legislation is whether, or how, refinancings of such “grandfathered” bonds may continue to be “grandfathered.” A review of the Tax Cuts and Jobs Act and prior legislation leads to the conclusion that there is considerable risk that final legislation will not necessary “grandfather” refinancings issued after the effective date of the new legislation.

Because of the tax expenditure relating to the tax-exempt bond “tail,” the approach to “grandfathering” of refundings can be expected to have a large revenue effect, and will likely attract the scrutiny of writers of legislation.

Prior legislation restricting tax-exempt bonds has often provided favorable grandfathering to subsequent refinancings, but the approach of Congress has been inconsistent and checkered. Perhaps most notably, the Tax Reform Act of 1986 contained detailed transition rules that permitted favorable grandfathering of refundings. Indeed, such transition rules remain relevant in the municipal market, even 31 years later, as many types of tax-exempt bonds prohibited in 1986 (for example, for privately-owned pollution control facilities and sports facilities) continue to be refunded with new tax-exempt bonds.

Not all new legislation, however, has included favorable transition rules. Most notably, the American Recovery and Reinvestment Act of 2009 permitted the issuance of Build America Bonds in 2009 and 2010, but does not permit the issuance of refunding Build America Bonds.

In the past, many tax-exempt bond issuers and borrowers have drawn comfort from the argument that Congress is likely to be favorably disposed to permitting tax-exempt bond refundings of “grandfathered” bonds, because such treatment has been viewed as a “win/win” situation. That is, if a current refunding reduces interest costs to the borrower, the amount of revenue to the federal government in foregone income tax may also be reduced.

A closer consideration of this “win/win” argument, however, casts doubt on whether it will continue to carry the day for tax-exempt bond issuers. A more refined analysis of the revenue effects to the federal government of “grandfathering” current refundings could be quite complex; the important point, however, is that it is entirely possible that Congress could take the view that such favorable grandfathering for refundings will entail a significant additional federal expenditure.

Accordingly, the risk of losing the ability to refund outstanding tax-exempt bonds on a tax-exempt basis in the future should be viewed as one of the most important considerations for issuers and borrowers.

Although transition rules for tax-exempt refinancings have great practical importance for issuers and borrowers (and to the tax expenditure of the federal government), transition rules have commonly been treated as an afterthought in prior tax legislation. Accordingly, assessing this risk will require a particularly close review of legislation as it is developed.

Assessing Refunding and “Reissuance” Risk

The real possibility that Congress will prospectively repeal the authority to issue certain types of tax-exempt bonds and not provide transition rules for tax-exempt refinancings of outstanding bonds makes an assessment of effective date risk particularly important.

Some of these risks are more obvious than others. For example, if enacted legislation contains no transition rules for refundings, “reissuance” questions will have vastly heightened importance. Reissuance questions commonly are raised for “multi-modal” tax-exempt bonds that permit conversions to different interest rates. In certain situations, the conversion of tax-exempt bonds to a new interest rate after the effective date of repeal might result in loss of tax-exempt status. Particular reissuance questions have been raised with respect to “direct purchase” bonds. Accordingly, one reasonable approach may be to consider whether any tax-exempt bonds held by “direct purchasers” raise particular reissuance risks.

Particular Risks for “Draw-Down” Bonds, Commercial Paper and Similar Tax-Exempt Financing Structures

The relevant effective dates of the Tax Cuts and Jobs Act are based on when “bonds” are issued. This is consistent with prior legislation affecting tax-exempt bonds, but presents particular risks for draw-down bonds, commercial paper, and similar tax-exempt financing structures.

The IRS has issued guidance that generally treats a “bond” as issued when money is actually paid for the bond. This guidance also makes a distinction between the date of issuance of a “bond” and the date of issuance of an “issue” of bonds. For example, consider a “draw-down” tax-exempt financing that permits an issuer to draw down $100 million of tax-exempt bonds over a two-year period; the issuer actually draws down the first $10 million on December 1, 2017, and expects to draw down the remaining $190 million after December 31, 2017. Under existing guidance, only the $10 million actually drawn down in 2017 would be treated as “issued” in 2017. The remaining portion would be subject to any change of law that occurred after 2017.

This means that draw-down bonds, commercial paper, and similar tax-exempt bond structures are subject to particular change of law risks that may not be immediately obvious.

“Rush to Market” Strategies and Limitations

The last enactment of fundamental reform (that is, the enactment of the Tax Reform Act of 1986) was immediately preceded by an enormous “rush to market” issuance of tax-exempt bonds. This “rush to market” included the issuance of a high volume of pooled financing bonds and bonds issued earlier than customary before the effective date of new restrictive rules. The IRS challenged a limited number of these “rush to market” bonds as abusive, which underscores the need for careful structuring and review in such circumstances. For example, in a landmark court decision, the IRS successfully asserted that multifamily housing bonds issued by the Housing Authority of Riverside County were not properly treated as issued before the relevant effective date. The overwhelming majority of such bond issues, however, were not challenged.

The imposition of new restrictive rules in the Tax Cuts and Jobs Act could result in a similar rush to market.

Because of tax law changes since 1986, many of the strategies and approaches used in 1985 will no longer be available. To the extent that an issuer or borrower may seek to issue bonds earlier than is customary before an effective date of new legislation, the “hedge bond” limitations of section 149(g) of the Code will be an important consideration. Although a number of provisions of the tax regulations restrict early issuance of tax-exempt bonds, the most important restriction is set forth in the hedge bond rules. These rules require that, in all instances, an issuer must reasonably expect that it will spend the “spendable proceeds” of the bond issue within certain time periods. One way to meet the “hedge bond” rules is if the issuer reasonably expects that it will spend at least 85% of the spendable proceeds within three years of the date of issuance and the issuer does not invest more than 50% of the proceeds in an investment having a substantially guaranteed yield for four years or more. The other way for an issuer to meet the “hedge bond” rules is for the issuer to reasonably expect that it will spend the proceeds no later than the following schedule:

“Hedge Bond” Requirements

For issuers seeking to maximize the issuance of bonds before a restrictive date, the foregoing schedule sets forth the outside limits, and can be expected to be an important consideration in any “rush to market” situation. For planning purposes, it may be prudent for issuers to assess the amount of financeable projects that could fit within these time periods.

Pooled financing bonds may also be an important strategy to issue bonds before the effective date of restrictive new rules. This strategy will be constrained by the restrictions on “pooled financing bonds” set forth in section 149(f) of the Code, but could still be viable in some circumstances.

“Pooled Financing Bond” Requirements

The Risks for Outstanding Bonds and Future Bonds are Not Necessarily the Same and Need to Be Separately Considered

Just as the tax risks to issuers are different than the tax risks to holders, the risks for outstanding tax-exempt bonds are different than the risks for future tax-exempt financings. For example, as is discussed above, if Congress repeals the authority to issue tax-exempt bonds after the date of enactment of new legislation, an issuer possibly would gain a benefit with respect to its outstanding bond issues, particularly if the outstanding bond issues have variable interest rates. If the volume of tax-exempt bonds were so restricted going forward, it is reasonable to assume that the pricing of the remaining tax-exempt bonds on the market would benefit. Such legislation, however, would plainly disadvantage issuers for future financings.

For these reasons, the best approach to assessing the possible effects of tax reform is to separately consider possible effects on outstanding bond issues and future financing plans.

The Current Market Pricing of Tax-Exempt Bonds is Not Necessarily a Good Indicator of the Risks to Issuers

Will the risk of tax reform adverse to tax-exempt bond issuers and borrowers be reflected in the bond markets? A large part of the answer to that question is that the risks to holders of outstanding tax-exempt bonds are not the same as the risks to issuers and borrowers of tax-exempt bonds. Also, the analysis of how different proposed changes to the Code would affect holders of outstanding tax-exempt bonds is complex, because some changes might be favorable, and some unfavorable, to holders of outstanding tax-exempt bonds.

In the most straightforward example, suppose that Congress repeals the authority to issue certain types of tax-exempt bonds after the date of enactment of new legislation, but “grandfathers” the tax-exempt status of interest on bonds issued before the date of enactment. That change would plainly be unfavorable to issuers and borrowers of tax-exempt bonds, but would likely be favorable to holders of outstanding tax-exempt bonds, at least with respect to that change considered in isolation.

The analysis of how tax law changes may affect holders of tax-exempt bonds is necessarily complex, and requires a consideration of the effects of changes in tax rates, the effects on the permitted supply of tax-exempt bonds going forward, the extent to which other tax-advantaged investments are permitted, and other factors. The important point is that many of these factors are not directly relevant to assessing the risks that an issuer’s authority to issue tax-exempt bonds will be repealed or restricted. Because of these complex factors, market interest rates may provide no meaningful information about the risks of prospective repeal.

Effect on Tax-Exempt Financing of Other Tax Law Changes

The Tax Cuts and Jobs Act would make a number of other changes to the Code that would not expressly refer to tax-exempt bonds, but which could have a fundamental effect on certain types of tax-exempt financing. For example, the Tax Cuts and Jobs Act would reduce the maximum federal corporate income tax rate from 35% to 20%. Among other things, this reduction might have the effect of significantly reducing the role of banks and other financial institutions and direct purchasers of tax-exempt bonds, because such purchasers would receive a lesser tax benefit.

Such a rate reduction would also trigger interest rate increases for many issuers and borrowers of “direct purchase” bonds, because many “direct purchase” bonds include provisions providing for an increase in interest rate if the tax benefit to the holder is reduced.

Anticipating Capital Raising Structures that May Replace Tax-Exempt Financing – Not Just Taxable Bonds

A final point is that, if the authority to issue certain types of tax-exempt bonds is repealed, taxable bonds may not be the only replacement financing vehicle. Particularly for 501(c)(3) organizations, the future unavailability of tax-exempt financing likely will lead to a reconsideration of a number of different types of possible financing structures, including possible greater use of joint ventures and similar structures. One view is that the use of such structures may have been impeded in the past because of the relative benefits of tax-exempt financing.