The Assault on Tax-Exempt BondsThe Assault on Tax-Exempt Bonds

November 15, 2005November 15, 2005

Mitch RapaportMitch Rapaport

Nixon Peabody LLPNixon Peabody LLP401 Ninth Street, N.W.401 Ninth Street, N.W.

Washington, D.C. 20004Washington, D.C. 20004

(202) 585-8305(202) 585-8305

mrapaport@nixonpeabody.commrapaport@nixonpeabody.com

American Public Power AssociationAmerican Public Power AssociationAmerican Public Power AssociationAmerican Public Power Association

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Overview Of CurrentOverview Of CurrentLegislative AtmosphereLegislative Atmosphere

JCT proposalsJCT proposals

Potential SFC proposalsPotential SFC proposals

Budget Picture – search for revenue raisersBudget Picture – search for revenue raisers

Tax Reform Proposals and ProcessTax Reform Proposals and Process

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JCT ProposalsJCT Proposals

Eliminate advance refundings of bonds Eliminate advance refundings of bonds issued after enactmentissued after enactment Not retroactiveNot retroactive

Information reportingInformation reporting Require issuers to provide 1099 type information to Require issuers to provide 1099 type information to

bondholders and IRS. Alternatively, require issuers bondholders and IRS. Alternatively, require issuers to maintain bondholders lists to be provided to the IRS to maintain bondholders lists to be provided to the IRS if requestedif requested

Designed to improve the IRS’ ability to tax Designed to improve the IRS’ ability to tax bondholders on “bad” dealsbondholders on “bad” deals

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JCT Proposals – cont’dJCT Proposals – cont’d

Changes that will reduce investor demand for Changes that will reduce investor demand for tax-exempt bonds:tax-exempt bonds: Eliminate de minimis rule for corporate investors in Eliminate de minimis rule for corporate investors in

tax-exempt bondstax-exempt bonds Eliminate special rules for insurance companies that Eliminate special rules for insurance companies that

invest in tax-exempt bondsinvest in tax-exempt bonds Proposals would eliminate tax deductions for Proposals would eliminate tax deductions for

corporate and insurance company investments in corporate and insurance company investments in tax-exempt bonds – reduces after tax returntax-exempt bonds – reduces after tax return

P&Cs hold almost 15% of outstanding bondsP&Cs hold almost 15% of outstanding bonds

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JCT Proposals – cont’dJCT Proposals – cont’d

Potential impact on issuers if enactedPotential impact on issuers if enacted Advance refundingAdvance refunding Demand side changesDemand side changes Information reportingInformation reporting

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Potential SFC ProposalsPotential SFC Proposals

SFC staff investigation of tax-exempt bondsSFC staff investigation of tax-exempt bonds Follows from investigation of nonprofit Follows from investigation of nonprofit

organizationsorganizations Goes beyond JCT proposalsGoes beyond JCT proposals Involves research, interviews with market Involves research, interviews with market

participants, and extensive discussions with participants, and extensive discussions with IRS audit groupIRS audit group

Staff call for industry to develop its own reform Staff call for industry to develop its own reform proposalsproposals

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Potential SFC Proposals Potential SFC Proposals – cont’d– cont’d Interest of Senator Grassley, SFC ChairInterest of Senator Grassley, SFC Chair

Grassley focus on nonprofits and tax-exempt bonds Grassley focus on nonprofits and tax-exempt bonds in complimenting JCT on its report proposalsin complimenting JCT on its report proposals

Need for revenueNeed for revenue Sen. Grassley led the charge against “abusive” Sen. Grassley led the charge against “abusive”

leasing transactions involving state and local leasing transactions involving state and local governmentsgovernments

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Potential SFC Proposals Potential SFC Proposals – cont’d– cont’d Areas of concern and possible proposalsAreas of concern and possible proposals

Very supportive of JCT proposals and JCT Very supportive of JCT proposals and JCT in generalin general

Belief that IRS lacks resources to effectively police Belief that IRS lacks resources to effectively police the industrythe industry

Concern with issuer/borrower failures to spend bond Concern with issuer/borrower failures to spend bond proceeds – led to mandatory redemption proceeds – led to mandatory redemption requirement for unspent CREB proceedsrequirement for unspent CREB proceeds

SFC staff belief that there are lots of problems with SFC staff belief that there are lots of problems with tax-exempt bonds and QZABstax-exempt bonds and QZABs

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Tax Reform ProposalsTax Reform Proposals

Tax reform statusTax reform status Presidential Commission released its report on October Presidential Commission released its report on October

31, 200531, 2005 Report to be followed by Treasury Department Report to be followed by Treasury Department

proposals and then White House proposalsproposals and then White House proposals Potential concerns prior to report release:Potential concerns prior to report release:

Eliminate tax on all investment earningsEliminate tax on all investment earnings Subject tax-exempt entities to income taxSubject tax-exempt entities to income tax Eliminate deductibility of state and local taxesEliminate deductibility of state and local taxes Potential impact on tax-exempt bondsPotential impact on tax-exempt bonds

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Tax ReformTax Reform

Two Different Proposals:Two Different Proposals: ““Simplified Income Tax Plan”Simplified Income Tax Plan” ““Growth and Investment Tax Plan”Growth and Investment Tax Plan” Both eliminate the AMTBoth eliminate the AMT Both revenue neutralBoth revenue neutral Both eliminate deduction for State and local taxesBoth eliminate deduction for State and local taxes

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Tax Reform Proposal--OverviewTax Reform Proposal--Overview

Overview of Simplified Income TaxOverview of Simplified Income Tax Converts many deductions to creditsConverts many deductions to credits New tax brackets: 15%, 25%, 30% and 33% and New tax brackets: 15%, 25%, 30% and 33% and

31.5% for businesses31.5% for businesses Overview of Growth and Investment Tax Overview of Growth and Investment Tax

Similar to Simplified Plan for individuals but with Similar to Simplified Plan for individuals but with 15%, 25% and 30% tax brackets and 30% for 15%, 25% and 30% tax brackets and 30% for businessesbusinesses

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Tax Reform—Impact on Tax-Tax Reform—Impact on Tax-Exempt BondsExempt Bonds

Simplified Plan:Simplified Plan: interest on “tax-exempt bonds” held by corporations interest on “tax-exempt bonds” held by corporations

would be taxable, potentially eliminating 30% of the would be taxable, potentially eliminating 30% of the investorsinvestors

Corporate dividends to individuals would be tax Corporate dividends to individuals would be tax exempt and 75% exclusion for corporate capital exempt and 75% exclusion for corporate capital gains gains

Growth Plan would make Growth Plan would make all interestall interest received by received by corporations (other than financial institutions) corporations (other than financial institutions) tax-exempttax-exempt

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Tax Reform—Impact on Tax-Tax Reform—Impact on Tax-Exempt Bonds (cont’d)Exempt Bonds (cont’d)

Both plans would create new tax-favored Both plans would create new tax-favored savings vehicles for individualssavings vehicles for individuals

SummarySummary: Both plans would substantially : Both plans would substantially reduce demand for tax-exempt bonds by either reduce demand for tax-exempt bonds by either eliminating the benefit of tax-exempt bonds eliminating the benefit of tax-exempt bonds for certain investors or by providing tax-for certain investors or by providing tax-exempt status for other investments that would exempt status for other investments that would compete with tax-exempt bondscompete with tax-exempt bonds

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Circular 230Circular 230

What is Circular 230?What is Circular 230? Proposed rules for tax-exempt bond opinionsProposed rules for tax-exempt bond opinions Why is this being done?Why is this being done? The rules govern how bond counsel renders their The rules govern how bond counsel renders their

opinionsopinions Requires a written description by bond counsel of Requires a written description by bond counsel of

facts, law and analysis of tax issuesfacts, law and analysis of tax issues

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Circular 230 – Potential Circular 230 – Potential Consequences for IssuersConsequences for Issuers

Additional transaction costsAdditional transaction costs Potential disclosure issue and higher Potential disclosure issue and higher

interest ratesinterest rates Provides audit roadmap for IRSProvides audit roadmap for IRS Opinion “disclaimer”?Opinion “disclaimer”? Immediate problem for “long” forward transactionsImmediate problem for “long” forward transactions Bond counsel become more conservative? Bond counsel become more conservative?

More aggressive?More aggressive?

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Circular 230 - FutureCircular 230 - Future

Impact of Final Regulations for other transactionsImpact of Final Regulations for other transactions What happens next?What happens next? Regulatory processRegulatory process Are bond counsel already reacting?Are bond counsel already reacting?

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IRS Audit Program – StatusIRS Audit Program – Status

Status of Audit ProgramStatus of Audit Program Areas of IRS focus:Areas of IRS focus:

Largely aimed at “abuses” blind pools, escrow Largely aimed at “abuses” blind pools, escrow puts, yield burningputs, yield burning

Selected other areas (solid waste)Selected other areas (solid waste) Development of IRS “expertise”Development of IRS “expertise” Possible expansion of audit topicsPossible expansion of audit topics Are swaps the next big problem area?Are swaps the next big problem area?

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IRS Audit Program IRS Audit Program –– Risks and Problems Risks and Problems

Impact on outstanding bondsImpact on outstanding bonds Whether to disclose auditWhether to disclose audit Impact of disclosure – Variable rate bondsImpact of disclosure – Variable rate bonds Impact of disclosure – Fixed rate bondsImpact of disclosure – Fixed rate bonds Impact of disclosure – New IssuesImpact of disclosure – New Issues

The audit process is stacked against issuersThe audit process is stacked against issuers Difficult to convince the auditors that they Difficult to convince the auditors that they

are wrongare wrong

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IRS Audit Program – IRS Audit Program – Risks and Problems (cont.)Risks and Problems (cont.)

No real ability to obtain an independent review No real ability to obtain an independent review of the matterof the matter

IRS doesn’t like to go away empty handedIRS doesn’t like to go away empty handed 6700 penalty threat to issuers, underwriters, 6700 penalty threat to issuers, underwriters,

bond counsel, etcbond counsel, etc

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IRS Audit Program – IRS Audit Program – Risks and Problems (cont.)Risks and Problems (cont.)

Is there any hope for improvement?Is there any hope for improvement? NABL ADR proposalNABL ADR proposal Treasury/IRS interestTreasury/IRS interest

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IRS Audits – Avoiding AuditsIRS Audits – Avoiding Audits

Analyzing tax risks to avoid auditsAnalyzing tax risks to avoid audits How do issuers protect themselves?How do issuers protect themselves? Avoiding “abusive” transactionsAvoiding “abusive” transactions Reliance on counsel – is it enough?Reliance on counsel – is it enough? What if you find a problem? VCAP programWhat if you find a problem? VCAP program