United States

Advance refundings face repeal in tax reform proposals

TAX ALERT  | 

The race to tax reform has begun. Both the House and the Senate have their respective proposals documented and ready for markup ahead of an ultimate vote before both chambers of Congress. As mentioned in a previous article, Private activity bond provisions face changes in the House tax reform proposals, an area that caught many by surprise is a provision related to tax-exempt bond refundings not continuing to receive favorable tax exempt interest treatment. The House version of the tax reform package repeals private activity bond interest income from favorable tax-exempt treatment going forward for new issues. This provision is not present in the Senate Committee’s plan. However, refundings of bond issues also appears in the cross-hairs of the proposed plans from both the House and the Senate. The following are the provisions that will be stricken from tax law if passed.

Section 103 generally provides that gross income does not include interest received on state or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental facilities or the debt is repaid with governmental funds. Private activity bonds are bonds in which the state or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals). Bonds issued to finance the activities of charitable organizations described in section 501(c)(3) (qualified 501(c)(3) bonds) are one type of private activity bond. The exclusion from income for interest on state and local bonds only applies if certain Internal Revenue Code requirements are met.

The exclusion for income for interest on state and local bonds applies to refunding bonds but there are limits on advance refunding bonds. A refunding bond is defined as any bond used to pay principal, interest, or redemption price on a prior bond issue (the refunded bond). Different rules apply to current as opposed to advance refunding bonds. A current refunding occurs when the refunded bond is redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified as an advance refunding if it is issued more than 90 days before the redemption of the refunded bond. Proceeds of advance refunding bonds are generally invested in an escrow account and held until a future date when the refunded bond may be redeemed.

Although there is no statutory limitation on the number of times that tax-exempt bonds may be currently refunded, the Internal Revenue Code limits advance refundings. Generally, governmental bonds and qualified 501(c)(3) bonds may be advance refunded one time. Private activity bonds, other than qualified 501(c)(3) bonds, may not be advance refunded at all. Furthermore, in the case of an advance refunding bond that results in interest savings (e.g., a high interest rate to low interest rate refunding), the refunded bond must be redeemed on the first call date 90 days after the issuance of the refunding bond that results in debt service savings.

The House provision repeals the exclusion from gross income for interest on a bond issued to advance refund another bond. This provision is also present in the proposed Senate plan. In the area of advance refund of another bond, both Chambers see a need for reform and limitation.

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