Build America Bonds: A New and Innovative Financing Tool for State and Local Governments

BY KATRINA C. GONZALES

The American Recovery and Reinvestment Act of 2009 contains a number of important financing tools that provide state and local governments with access to much-needed funding for capital projects. One such provision authorizes the creation of a new category of taxable governmental bonds known as Build America Bonds ("BABs"). BABs offer an innovative feature that allows issuers of state and local governmental bonds to receive direct subsidy payments from the United States Treasury Department in lieu of providing traditional tax-exempt interest or tax credits to bondholders. The Internal Revenue Service recently issued Notice 2009-26 and provides guidance on the types of eligible projects and financing, direct federal subsidy payment procedures, and election requirements for BABs.

WHAT ARE BABS?

BABs are any taxable state or local governmental bonds (but not private activity bonds) issued before January 1, 2011 that meets the requirements for traditional tax-exempt bonds and does not have an issue price with more than a de minimis amount of premium over the bond's stated principal amount. State and local governments must make an irrevocable election to issue bonds as BABs (including the type of BABs) on or before the issue date of the bonds. They may issue two general types of BABs: Direct Payment BABs, which allow issuers to receive a federal subsidy payment equal to 35% of the interest payment on the bonds; or Tax Credit BABs, which allow bondholders to receive a tax credit equal to 35% of the interest payment on the bonds.

DIRECT PAYMENT BABS

The direct payment option provides a federal subsidy of approximately 35% of the issuer's taxable borrowing cost. As a result, state and local governments would have lower net borrowing costs and would be able to reach more sources of borrowing than with traditional tax-exempt or tax credit bonds. To illustrate, a city that elects to issue Direct Payment BABs at a 10% taxable interest rate would receive a payment from the Treasury Department that would result in a net borrowing cost of only 6.5% on a bond that actually pays 10% interest.

Section 54AA(g) of the Internal Revenue Code (Code) limits the use of proceeds and types of financing available for Direct Payment BABs. While state and local governments may issue Tax Credit BABs (described below) for any governmental purpose for which tax-exempt governmental bonds could be issued, they may only issue Direct Payment BABs for:

1. Capital expenditures (which normally include costs to acquire, construct, or improve land, buildings, and equipment, but not working capital expenditures);
2. Issuance costs not exceeding 2% of the proceeds; and
3. A reasonably required reserve fund as provided by Section 150(a)(3) of the Code.

In addition, Direct Payment BABs may not be used for refundings except to reimburse capital expenditures and costs paid or incurred after February 17, 2009 that were originally financed with temporary short-term financing issued after that date.

Issuers of Direct Payment BABs must report the issuance on IRS Form 8038-G and request each direct payment on the new IRS Form 8038-CP. Notice 2009-26 outlines additional reporting requirements and payment procedures for both fixed rate and variable rate Direct Payment BABs. See IRS Notice 2009-26 (Apr. 3, 2009). The IRS currently began making direct payments to bond issuers in July 2009. Further, the IRS and Treasury Department are soliciting public comment on all aspects of direct payment procedures, including comments regarding efficient methods of making direct payments, the workability of proposed procedures for state and local governments, ongoing compliance standards, and the procedural tax framework for Direct Payment BABs.

TAX CREDIT BABS

If the state or local entity elects to issue Tax Credit BABs, bondholders would be entitled to a tax credit equal to 35% of each interest payment payable on each interest payment date. Although the credit is nonrefundable, the bondholder may carry forward the unused portion to succeeding taxable years if it exceeds the limitation imposed by Section 54AA(c) of the Code.

Unlike Direct Payment BABs, Tax Credit BABs are not subject to the 2% cost of issuance limitation and may be used to finance capital and working capital expenditures. Further, they may involve the same types of financings as traditional tax-exempt governmental bonds (for example, original new money financings, current refundings, and one advance refunding).

Issuers of Tax Credit BABs must report the issuance on IRS Form 8038-G. Additional reporting requirements are listed in Notice 2009- 26.

TRADITIONAL TAX-EXEMPT BOND RULES APPLY TO BABS

BABs are not federally guaranteed on the basis of the tax credit or direct payment provided by the Treasury Department. In addition, BABs are subject to arbitrage rules contained in Section 148 of the Code. For purposes of those rules, the yield on Tax Credit BABs is calculated without an adjustment for the tax credit provided to bondholders. In contrast, the yield on Direct Payment BABs is calculated by reducing the interest paid to bondholders by the amount of direct payments received from the Treasury Department.

Failure of a BAB to comply with underlying tax-exempt bond rules would result in a retroactive loss of BAB status. This presumably would expose holders of Tax Credit BABs to a retroactive loss of tax credits and expose issuers of Direct Payment BABs to an obligation to return the full amount of the subsidy payment previously received from the Treasury Department.

CONCLUSION

BABs offer an innovative way for state and local governments to finance necessary capital projects such as public buildings, schools, transportation infrastructure, public safety facilities and equipment, water and sewer project facilities, environmental and energy projects, and public utilities. They signal a shift in approach to subsidizing municipal obligations as the federal government seeks more creative ways to help revitalize local communities and address the current economic climate.

FOR ADVICE FROM RW&G CONCERNING BUILD AMERICA BONDS AND OTHER BOND PROGRAMS UNDER THE AMERICAN RECOVERY AND REINVESTMENT ACT OF 2009, PLEASE CONTACT KATRINA C. GONZALES, LOLLY A. ENRIQUEZ, OR ANY OF THE LAWYERS IN THE FIRM'S PUBLIC FINANCE DEPARTMENT.

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