Tax-Exempt Bonds: Regulatory Update September 18, 2006 Mitch RapaportNoreen Roche-Carter Nixon Peabody LLPSacramento Municipal 401 Ninth Street, N.W. Utility District Washington, D.C P.O. Box (202) Sacramento, CA American Public Power Association

2 Tax Credit Bonds: Background Public Power and Coops have sought tax incentives for development of renewable energy resources, comparable to those provided to IOU’s through tax credits Public Power and Coops have sought tax incentives for development of renewable energy resources, comparable to those provided to IOU’s through tax credits 2005 Energy Policy Act authorized Clean Renewable Energy Bonds (CREBs) to be issued as Tax Credit Bonds 2005 Energy Policy Act authorized Clean Renewable Energy Bonds (CREBs) to be issued as Tax Credit Bonds Tax Credit Bonds are an alternative to the politically unpopular tradable tax credits Tax Credit Bonds are an alternative to the politically unpopular tradable tax credits

3 Tax Credit Bonds: “CREBs” Designed to provide an interest free loan to munis and coops for qualified projects Designed to provide an interest free loan to munis and coops for qualified projects CREBs may be issued in 2006 and 2007 CREBs may be issued in 2006 and 2007 Based on “QZAB” program Based on “QZAB” program

4 CREBs: Qualified Projects CREBs: Qualified Projects Wind, closed and open-loop biomass (including agricultural livestock waste nutrients), geothermal, solar, small irrigation power, landfill gas, hydropower, and trash combustion Wind, closed and open-loop biomass (including agricultural livestock waste nutrients), geothermal, solar, small irrigation power, landfill gas, hydropower, and trash combustion Applies to expenditures made after August 8, 2005 Applies to expenditures made after August 8, 2005 Reimbursement and refinancing permitted for post-8/8/05 expenditures Reimbursement and refinancing permitted for post-8/8/05 expenditures

5 CREBs: Maturity and Yields Must pay principal in level annual installments Must pay principal in level annual installments Limited final maturity: number of years such that final maturity has a PV equal to 50% of its face amount. Currently a 15 year limit Limited final maturity: number of years such that final maturity has a PV equal to 50% of its face amount. Currently a 15 year limit Intended to be issued at par with a tax credit equivalent to a taxable coupon Intended to be issued at par with a tax credit equivalent to a taxable coupon On September 13, 2006 QZAB rates ranged from 5.43% for a one year maturity to 5.75% for a 15 year maturity On September 13, 2006 QZAB rates ranged from 5.43% for a one year maturity to 5.75% for a 15 year maturity

6 Marketing Challenges – Lessons From QZABs Pricing Prices set by Treasury once a day Prices set by Treasury once a day “One size fits all” pricing does not address differing credit quality of issuers “One size fits all” pricing does not address differing credit quality of issuers Issued at prices as low as 80% Issued at prices as low as 80% Levelized principal payments present additional pricing complexity over bullet maturities Levelized principal payments present additional pricing complexity over bullet maturities Market’s appetite for such bonds could be limited, especially if other tax credit bond programs are authorized. New GO Bonds are the latest tax credit bond Market’s appetite for such bonds could be limited, especially if other tax credit bond programs are authorized. New GO Bonds are the latest tax credit bond

7 Marketing Challenges – cont’d Tax credits cannot be stripped from underlying bond Tax credits cannot be stripped from underlying bond Assumes investor will continue to have tax liability for the life of the bond Assumes investor will continue to have tax liability for the life of the bond Assumes tax credits will be valid for life of the bond Assumes tax credits will be valid for life of the bond Impact on pricing Impact on pricing Any OID reduces the benefit of the “interest free” borrowing Any OID reduces the benefit of the “interest free” borrowing Coops may well have marketing advantage in pooling of issuance through CFC and CoBank Coops may well have marketing advantage in pooling of issuance through CFC and CoBank

8 CREBs: Expenditure and Other Requirements 95% of the proceeds must be spent within 5 years of the issuance of the CREBs unless extended by the IRS 95% of the proceeds must be spent within 5 years of the issuance of the CREBs unless extended by the IRS If this requirement is not satisfied, a portion of the CREBs must be redeemed within 90 days If this requirement is not satisfied, a portion of the CREBs must be redeemed within 90 days CREBs are subject to arbitrage and rebate rules CREBs are subject to arbitrage and rebate rules

9 CREBs Volume Cap In total, $800 million of CREBs may be issued but at least $300 million is reserved for cooperatives In total, $800 million of CREBs may be issued but at least $300 million is reserved for cooperatives Congress directed Treasury to determine an allocation methodology for the volume cap, but provided no guidance on how it should be done Congress directed Treasury to determine an allocation methodology for the volume cap, but provided no guidance on how it should be done IRS opted to make allocations using a smallest-to largest method IRS opted to make allocations using a smallest-to largest method Does this lead to inaccurate pricing signals to Treasury? Does this lead to inaccurate pricing signals to Treasury?

10 Allocations -- Process and Status Applications were due April 26, 2006 Applications were due April 26, 2006 IRS indicated 700 applications received totaling over $2 billion IRS indicated 700 applications received totaling over $2 billion IRS estimates allocations to be made by early October IRS estimates allocations to be made by early October The Bureau of Public Debt sets rates and maturities on a daily basis The Bureau of Public Debt sets rates and maturities on a daily basis

11 CREBs: Future Questions Could the delay in awarding of allocations, lead to unused allocations? Could the delay in awarding of allocations, lead to unused allocations? Can deadline for issuance be extended? Can deadline for issuance be extended? No set process for reallocating volume cap No set process for reallocating volume cap Several bills were introduced in the Senate that would extended CREBs program and increased the cap Several bills were introduced in the Senate that would extended CREBs program and increased the cap If this occurs, will Congress or Treasury be open to reassessing the basis for allocation? If this occurs, will Congress or Treasury be open to reassessing the basis for allocation? Will Tax Credit Bonds eventually replace traditional tax exempt financing? Will Tax Credit Bonds eventually replace traditional tax exempt financing?

12 PREPAYMENTS: Background on Final Regulations Number of gas prepayments done in the 1990s under old regulations (“substantial business purpose” test) Number of gas prepayments done in the 1990s under old regulations (“substantial business purpose” test) IRS audits of several deals in the late 1990s IRS audits of several deals in the late 1990s IRS issued proposed regulations to stop new deals IRS issued proposed regulations to stop new deals Ultimately closed all the audits with no changes Ultimately closed all the audits with no changes Final Regulations on prepayments issued in 2003 Final Regulations on prepayments issued in 2003 Legislation subsequently enacted – 2005 EPACT Legislation subsequently enacted – 2005 EPACT Provides an additional safe harbor to permit gas prepayments using tests which differ from the IRS regulations Provides an additional safe harbor to permit gas prepayments using tests which differ from the IRS regulations

13 Final Regulations— General Rules Prepayments made with bond proceeds ordinarily result in prohibited investment-type property and taxable bonds Prepayments made with bond proceeds ordinarily result in prohibited investment-type property and taxable bonds Final Regulations eliminate substantial business purpose exception Final Regulations eliminate substantial business purpose exception Exception for “customary prepayments” but this has limited applicability Exception for “customary prepayments” but this has limited applicability Exception for prepayments approved by the IRS Exception for prepayments approved by the IRS Exception for 90 day prepayments Exception for 90 day prepayments

14 Final Regulations—Special Rule for Prepayments for Gas Final Regulations permit prepayments for natural gas Final Regulations permit prepayments for natural gas At least 90% of the gas must be used for a qualifying use At least 90% of the gas must be used for a qualifying use “Qualifying use” means: “Qualifying use” means: Used by retail customers in the historic service area of a municipal utility Used by retail customers in the historic service area of a municipal utility Used by a municipal utility to produce electricity sold to retail customers in its historic service area Used by a municipal utility to produce electricity sold to retail customers in its historic service area Used to fuel the pipeline transportation of the qualifying gas supply Used to fuel the pipeline transportation of the qualifying gas supply

15 Final Regulations—Special Rule for Prepayments for Gas Qualifying service area: Area throughout which service was continuously provided for 5 years, or service area as defined under state law Qualifying service area: Area throughout which service was continuously provided for 5 years, or service area as defined under state law Nonqualifying Uses limited to 10 percent and are defined as sales to: Nonqualifying Uses limited to 10 percent and are defined as sales to: Governmental entities outside the service area that are not utilities Governmental entities outside the service area that are not utilities Nongovernmental entities outside service area Nongovernmental entities outside service area Retail customers of another municipal utility Retail customers of another municipal utility Comparable rules for electricity Comparable rules for electricity

16 90% Test and Remedial Actions Regulations provide that the 90% test is based on actual facts, not expectations Regulations provide that the 90% test is based on actual facts, not expectations Compliance with 90% test is measured over life of prepayment Compliance with 90% test is measured over life of prepayment Requires issuers to develop an effective tracking system Requires issuers to develop an effective tracking system How do swap and exchange agreements fit in? How do swap and exchange agreements fit in? Remedial action to cure noncompliance: Remedial action to cure noncompliance: Bond redemption or defeasance Bond redemption or defeasance Taxable refunding Taxable refunding 2 year rule for sales and repurchases 2 year rule for sales and repurchases

17 New Statutory Safe Harbor Enacted by Congress – 2005 EPACT Enacted by Congress – 2005 EPACT Qualified use test based on historic sales or consumption (rather than actual) Qualified use test based on historic sales or consumption (rather than actual) Volume of gas cannot exceed 100% of the utility’s average annual consumption over the past 5 years Volume of gas cannot exceed 100% of the utility’s average annual consumption over the past 5 years A one time test, therefore no continuing compliance aspects A one time test, therefore no continuing compliance aspects Issuers can choose to use Final Regulations or statutory safe harbor Issuers can choose to use Final Regulations or statutory safe harbor

18 Commodity Swaps Many transactions use commodity swaps to convert fixed price gas to indexed priced. Final Regulations limit the use of commodity swaps in prepayment transactions Many transactions use commodity swaps to convert fixed price gas to indexed priced. Final Regulations limit the use of commodity swaps in prepayment transactions Swaps are permitted between: Swaps are permitted between: Issuer of the bonds and an unrelated third party (but not the gas supplier) Issuer of the bonds and an unrelated third party (but not the gas supplier) The gas supplier and an unrelated third party (but not the issuer) The gas supplier and an unrelated third party (but not the issuer)

19 Commodity Swaps: “Independence” The commodity swap must be independent The commodity swap must be independent Matched swaps involving supplier, issuer, and third party are permitted Matched swaps involving supplier, issuer, and third party are permitted BUT each party’s obligation under the swap cannot depend on performance of another entity BUT each party’s obligation under the swap cannot depend on performance of another entity EXCEPT THAT, issuer’s swap contract may provide for termination for gas delivery failure EXCEPT THAT, issuer’s swap contract may provide for termination for gas delivery failure The application of the swap independence rule is a key aspect of many of the current gas prepayment structures The application of the swap independence rule is a key aspect of many of the current gas prepayment structures

20 Other Issues Practical problems that arise for tax counsel under the prepayment rules Practical problems that arise for tax counsel under the prepayment rules Circumstances under which the transaction can collapse raise tax and business issues Circumstances under which the transaction can collapse raise tax and business issues Continuing “business purpose” concern? Continuing “business purpose” concern? These structures are complex and will affect the documentation, negotiations, and the tax and business analysis These structures are complex and will affect the documentation, negotiations, and the tax and business analysis

21 New Excise Tax on Tax Shelters New Tax Act enacted Section 4965—imposes an excise tax on governmental entities and other nonprofits New Tax Act enacted Section 4965—imposes an excise tax on governmental entities and other nonprofits Tax applies to “prohibited tax shelter transactions” defined as “listed transactions” and reportable transactions. Listed transactions are transactions that Treasury identifies as abusive in a public notice Tax applies to “prohibited tax shelter transactions” defined as “listed transactions” and reportable transactions. Listed transactions are transactions that Treasury identifies as abusive in a public notice Tax imposed at 35% on greater of net income or proceeds from the transaction Tax imposed at 35% on greater of net income or proceeds from the transaction

22 New Excise Tax on Tax Shelters The excise tax applies retroactively to pre-enactment SILOs and LILOs, as well as a number of other transactions that governmental entities did not typically participate in The excise tax applies retroactively to pre-enactment SILOs and LILOs, as well as a number of other transactions that governmental entities did not typically participate in The excise tax will apply retroactively to transactions “listed” in the future. There is no reason that the tax could not be applied to tax-exempt bonds The excise tax will apply retroactively to transactions “listed” in the future. There is no reason that the tax could not be applied to tax-exempt bonds New rules also impose a $20,000 tax on “entity managers” who approve prohibited transactions New rules also impose a $20,000 tax on “entity managers” who approve prohibited transactions Treasury requested comments and will be issuing guidance shortly Treasury requested comments and will be issuing guidance shortly

23 Overview Of Current Legislative Atmosphere JCT proposals JCT proposals Legislative Action—information reporting Legislative Action—information reporting Other Legislative Issues Other Legislative Issues Potential SFC proposals Potential SFC proposals Budget Picture – search for revenue raisers Budget Picture – search for revenue raisers Tax reform Tax reform

24 JCT Proposals Eliminate advance refundings of bonds issued after enactment Eliminate advance refundings of bonds issued after enactment Not retroactive Not retroactive Changes that will reduce investor demand for tax-exempt bonds: Changes that will reduce investor demand for tax-exempt bonds: Eliminate de minimis rule for corporate investors in tax- exempt bonds Eliminate de minimis rule for corporate investors in tax- exempt bonds Eliminate special rules for insurance companies that invest in tax-exempt bonds Eliminate special rules for insurance companies that invest in tax-exempt bonds Proposals would eliminate tax deductions for corporate and insurance company investments in tax-exempt bonds – reduces after tax return Proposals would eliminate tax deductions for corporate and insurance company investments in tax-exempt bonds – reduces after tax return P&Cs hold almost 15% of outstanding bonds P&Cs hold almost 15% of outstanding bonds

25 JCT Proposals – cont’d Potential impact on issuers if enacted Potential impact on issuers if enacted Advance refunding Advance refunding Demand side changes Demand side changes

26 Information Reporting Information Reporting Information reporting requirement Information reporting requirement Requires that bondholders and IRS receive 1099 type. Requires that bondholders and IRS receive 1099 type. Lots of details still to be decided—implementation date, who provides the information, who bears the cost, what information to be provided Lots of details still to be decided—implementation date, who provides the information, who bears the cost, what information to be provided

27 Equity First Equity first – the problem Equity first – the problem IRS Proposal – advance notice of proposed rulemaking IRS Proposal – advance notice of proposed rulemaking For output facilities, private use may be allocated to equity first. For output facilities, private use may be allocated to equity first. “Equity” only includes taxable bond proceeds and issuer funds at closing. “Equity” only includes taxable bond proceeds and issuer funds at closing. For the equity first rule to apply, bond proceeds and equity must have been spent contemporaneously. For the equity first rule to apply, bond proceeds and equity must have been spent contemporaneously. The private use and equity must be “allocable” to the same facility for the equity first rule to apply. The private use and equity must be “allocable” to the same facility for the equity first rule to apply.

28 Equity First – Comments Comments: Comments: The contemporaneous expenditure requirement should be eliminated (especially for older transactions) The contemporaneous expenditure requirement should be eliminated (especially for older transactions) “Equity” should be defined to include retired tax-exempt bonds “Equity” should be defined to include retired tax-exempt bonds More flexible allocation rules are needed for this purpose More flexible allocation rules are needed for this purpose

Equity First – Status of Allocation and Accounting Regulations and Next Steps Timing—Soon! Timing—Soon! Scope—Broad! Scope—Broad! Opportunity for input—Expected request for comments Opportunity for input—Expected request for comments

30 IRS Audit Program – Status Status of Audit Program Status of Audit Program Areas of IRS focus: Areas of IRS focus: Largely aimed at “abuses” blind pools, escrow puts, yield burning Largely aimed at “abuses” blind pools, escrow puts, yield burning Selected other areas (solid waste) Selected other areas (solid waste) Development of IRS “expertise” Development of IRS “expertise” Possible expansion of audit topics Possible expansion of audit topics Swaps Swaps Issue Price/Flippers Issue Price/Flippers

31 IRS Audit Program – Risks and Problems Impact on outstanding bonds Impact on outstanding bonds Whether to disclose audit Whether to disclose audit Impact of disclosure – Variable rate bonds Impact of disclosure – Variable rate bonds Impact of disclosure – Fixed rate bonds Impact of disclosure – Fixed rate bonds Impact of disclosure – New Issues Impact of disclosure – New Issues The audit process is stacked against issuers The audit process is stacked against issuers Difficult to convince the auditors that they are wrong Difficult to convince the auditors that they are wrong

32 IRS Audit Program – Risks and Problems (cont.) No real ability to obtain an independent review of the matter No real ability to obtain an independent review of the matter IRS doesn’t like to go away empty handed IRS doesn’t like to go away empty handed 6700 penalty threat to issuers, underwriters, bond counsel, etc 6700 penalty threat to issuers, underwriters, bond counsel, etc

33 IRS Audit Program – Risks and Problems (cont.) Is there any hope for improvement? Is there any hope for improvement? NABL ADR proposal NABL ADR proposal Treasury/IRS interest Treasury/IRS interest Impact of new excise tax? Impact of new excise tax?

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

35 Circular UPDATE What is Circular 230? What is Circular 230? Proposed rules for tax-exempt bond opinions Proposed rules for tax-exempt bond opinions Why is this being done? Why is this being done? The rules govern how bond counsel renders their opinions The rules govern how bond counsel renders their opinions Requires a written description by bond counsel of facts, law and analysis of tax issues Requires a written description by bond counsel of facts, law and analysis of tax issues

36 Circular 230 – Potential Consequences for Issuers Additional transaction costs Additional transaction costs Potential disclosure issue and higher interest rates Potential disclosure issue and higher interest rates Provides audit roadmap for IRS Provides audit roadmap for IRS Opinion “disclaimer”? Opinion “disclaimer”? Immediate problem for “long” forward transactions Immediate problem for “long” forward transactions Bond counsel become more conservative? More aggressive? Bond counsel become more conservative? More aggressive?

37 Circular Future Impact of Final Regulations for other transactions Impact of Final Regulations for other transactions What happens next? What happens next? Regulatory process Regulatory process

38 Additional Materials

39 Potential SFC Proposals SFC staff investigation of tax-exempt bonds SFC staff investigation of tax-exempt bonds Follows from investigation of nonprofit organizations Follows from investigation of nonprofit organizations Goes beyond JCT proposals Goes beyond JCT proposals Involves research, interviews with market participants, and extensive discussions with IRS audit group Involves research, interviews with market participants, and extensive discussions with IRS audit group Staff call for industry to develop its own reform proposals Staff call for industry to develop its own reform proposals

40 Potential SFC Proposals – cont’d Interest of Senator Grassley, SFC Chair Interest of Senator Grassley, SFC Chair Grassley focus on nonprofits and tax-exempt bonds in complimenting JCT on its report proposals Grassley focus on nonprofits and tax-exempt bonds in complimenting JCT on its report proposals Need for revenue Need for revenue Sen. Grassley led the charge against “abusive” leasing transactions involving state and local governments Sen. Grassley led the charge against “abusive” leasing transactions involving state and local governments

41 Potential SFC Proposals – cont’d Areas of concern and possible proposals Areas of concern and possible proposals Very supportive of JCT proposals and JCT in general Very supportive of JCT proposals and JCT in general Belief that IRS lacks resources to effectively police the industry Belief that IRS lacks resources to effectively police the industry Concern with issuer/borrower failures to spend bond proceeds – led to mandatory redemption requirement for unspent CREB proceeds Concern with issuer/borrower failures to spend bond proceeds – led to mandatory redemption requirement for unspent CREB proceeds SFC staff belief that there are lots of problems with tax- exempt bonds and QZABs SFC staff belief that there are lots of problems with tax- exempt bonds and QZABs

42 Longer Term Risks – Tax Reform Tax reform status Tax reform status Presidential Commission released its report on October 31, 2005 Presidential Commission released its report on October 31, 2005 Report to be followed by Treasury Department proposals and then White House proposals Report to be followed by Treasury Department proposals and then White House proposals Potential concerns prior to report release: Potential concerns prior to report release: Eliminate tax on all investment earnings Eliminate tax on all investment earnings Subject tax-exempt entities to income tax Subject tax-exempt entities to income tax Eliminate deductibility of state and local taxes Eliminate deductibility of state and local taxes Potential impact on tax-exempt bonds Potential impact on tax-exempt bonds

43 Tax Reform Proposal 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 AMT Both eliminate the AMT Both revenue neutral Both revenue neutral Both eliminate deduction for State and local taxes Both eliminate deduction for State and local taxes

44 Tax Reform Proposal--Overview Overview of Simplified Income Tax Overview of Simplified Income Tax Converts many deductions to credits Converts many deductions to credits New tax brackets: 15%, 25%, 30% and 33% and 31.5% for businesses New tax brackets: 15%, 25%, 30% and 33% and 31.5% for businesses Overview of Growth and Investment Tax Overview of Growth and Investment Tax Similar to Simplified Plan for individuals but with 15%, 25% and 30% tax brackets and 30% for businesses Similar to Simplified Plan for individuals but with 15%, 25% and 30% tax brackets and 30% for businesses

45 Tax Reform—Impact on Tax- Exempt Bonds Simplified Plan: Simplified Plan: interest on “tax-exempt bonds” held by corporations would be taxable, potentially eliminating 30% of the investors interest on “tax-exempt bonds” held by corporations would be taxable, potentially eliminating 30% of the investors Corporate dividends to individuals would be tax exempt and 75% exclusion for corporate capital gains Corporate dividends to individuals would be tax exempt and 75% exclusion for corporate capital gains Growth Plan would make all interest received by corporations (other than financial institutions) tax-exempt Growth Plan would make all interest received by corporations (other than financial institutions) tax-exempt

46 Tax Reform—Impact on Tax- Exempt Bonds (cont’d) Both plans would create new tax-favored savings vehicles for individuals Both plans would create new tax-favored savings vehicles for individuals Summary: Both plans would substantially reduce demand for tax-exempt bonds by either eliminating the benefit of tax-exempt bonds for certain investors or by providing tax-exempt status for other investments that would compete with tax-exempt bonds Summary: Both plans would substantially reduce demand for tax-exempt bonds by either eliminating the benefit of tax-exempt bonds for certain investors or by providing tax-exempt status for other investments that would compete with tax-exempt bonds