United States: Sequestration To Reduce Government Payments To Issuers Of Certain Qualifying Bonds

On March 1, 2013, $85 Billion in automatic reductions in federal spending occurred as mandated by federal law. The automatic budget cuts are known in the parlance of the Beltway as "sequestration." For issuers of certain types of tax-favored bonds, sequestration now will result in a reduction of the direct-payment subsidy payment.

A Brief History of Sequestration

The history of how sequestration became possible dates back to the Budget Control Act of 2011. The Budget Control Act introduced sequestration as an inducement for the Supercommittee to reach an agreement to reduce the federal deficit by $1.5 Trillion over a 10 year period. Under the Budget Control Act, absent reaching a deal on deficit reduction, sequestration was scheduled to take effect beginning in 2013, which coincided with the expiration of tax cuts. The confluence of sequestration and the expiration of tax cuts became known as the "fiscal cliff."

Sequestration is the product of the inability of Congress and the White House to reach a long-term solution to ease increasing federal deficits. Congress temporarily avoided sequestration by enacting the American Taxpayer Relief Act, H.R. 8 in the early morning hours of January 1, 2013. The American Taxpayer Relief Act avoided drastic tax increases by largely extending the tax rates in effect as of 2012. The American Taxpayer Relief Act did not, however, produce a long-term federal budget solution. Rather, the American Taxpayer Relief Act only temporarily addressed spending cuts by establishing March 1, 2013 as the new date for sequestration to occur, absent a long-term deal.

March 1 has now come and gone, without an agreement between the White House and Congress to reduce the federal budget deficit. As a result, sequestration became reality on March 1 and $85 Billion in federal spending was automatically cut. A point that is often overlooked is that the American Taxpayer Relief Act, by delaying sequestration by 90 days to March 1, resulted in the automatic spending cuts being imposed over a 7-month period rather than a normal 12-month fiscal year.

Impact of Sequestration on the Municipal Bond Community

The sequestration order effective on March 1, 2013, has a direct impact on issuers of certain types of tax-advantaged bonds which the issuer elected to receive a direct credit subsidy under Section 6431 of the Internal Revenue Code of 1986, as amended ("IRC"). Specifically, sequestration will operate to reduce the direct-pay subsidy for issuers, making an election under IRC Section 6431, of Build America Bonds, Recovery Zone Economic Development Bonds, Qualified School Construction Bonds, Qualified Zone Academy Bonds, New Clean Renewable Energy Bonds, and Qualified Energy Conservation Bonds.

An issuer claims the direct-credit subsidy by filing Internal Revenue Service ("IRS") Form 8038-CP. The Form 8038-CP typically must be submitted at least 45-days prior to the interest payment date on the bonds in order for the IRS to timely process the payment. According to IRS officials, subsidies for Forms 8038-CP filed before March 1 were paid without reduction. The sequestration order will apply to direct-pay amounts claimed by issuers to be paid after March 1, 2013.

The exact amount of the reduction in the direct-pay subsidy still remains to be determined. The Office of Management and Budget ("OMB") publicly stated that the direct-pay subsidy under IRC Section 6431 will be cut by 8.7%. However, IRS officials have recently publicly stated that OMB statement is only a helpful generalization and that issuers should not read too much into the OMB statement. Rather, the IRS officials stated the actual reduction in subsidy payments for individual bond issues is not quite as simple as an 8.7% across-the-the-board cut. The IRS has spent considerable time on determining how the reduction in subsidy will be determined. Accordingly, the IRS has instructed issuers to file the Form 8038-CP requesting the full subsidy payment and the IRS will then provide written notice to issuers of the exact amount of the cut in the direct-pay subsidy.

Several open questions remain with respect to the effect of sequestration on direct-pay subsidy bonds. For example, U.S. Department of the Treasury officials have acknowledged that there are open questions whether subsequent subsidies would be reduced to those issuers that received March subsidy payments prior to sequestration taking effect.

Furthermore, whether sequestration could serve as a basis for an issuer to exercise extraordinary call provisions will depend on the terms of the bond documents. Some Build America Bonds ("BAB") contain make-whole provisions that would need to be examined on a case-by-case basis to determine the costs to an issuer of refunding a BAB through the exercise of an extraordinary call provision.

Finally, several questions have been raised with respect to the consequences if the subsidy payments are fully restored in the future. For instance, an open question exists whether bond issuers will be able to recover the lost portion of subsidy payments. Additionally, some bond issuers have raised the question whether the effects of sequestration can be avoided by filing the request for payment of the direct-pay subsidy late. The IRC generally imposes a two-year statute of limitations for a taxpayer to claim a refund. Certain provisions of the federal tax law characterize the subsidy payment for direct-pay bond as "refunds."

Long-Term Effects of Sequestration

The reduction in the direct-pay subsidy arising from sequestration will be in effect until at least the end of the 2013 fiscal year, September 30, 2013, unless Congress moves to reinstate the automatic budget cuts earlier. In the current political environment, it appears unlikely Congress will act before September 30. Whether the White House and Congress can reach a long-term budget solution still remains anybody's guess.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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