Tax-Exempt Bonds: IRS and Congressional Initiatives September 26, 2005 Mitch RapaportNoreen Roche-Carter Nixon Peabody LLPSacramento Municipal Utility District 401 Ninth Street, N.W.P.O. Box Washington, D.C Sacramento, CA (202) (916) American Public Power Association

2 Tax Credit Bonds: Background For some time IOU’s have had a tax incentive for development of renewable energy resources For some time IOU’s have had a tax incentive for development of renewable energy resources 2005 Energy Policy Act provides additional tax credits 2005 Energy Policy Act provides additional tax credits Public Power and Coops have made tremendous effort to obtain legislation to provide similar incentives for public power Public Power and Coops have made tremendous effort to obtain legislation to provide similar incentives for public power 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” 2005 Energy Policy Act permits Clean Renewable Energy Bonds to be issued as tax credit bonds 2005 Energy Policy Act permits Clean Renewable Energy Bonds to be issued as tax credit bonds 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 Reimbursement and refinancing permitted for post-8/8/05

5 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 Treasury is responsible for allocating this volume cap among projects but no guidance on how this is to be done Treasury is responsible for allocating this volume cap among projects but no guidance on how this is to be done

6 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 Limited final maturity: number of years such that final maturity has a PV equal to 50% of its face amount 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

7 Marketing Challenges – Lessons From QZABs Pricing Prices set by Treasury once a day Prices set by Treasury once a day  2005 rates ranged from 4.90% to 5.64%  ‘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

8 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 tax credits will be valid for life of the bond  Impact on pricing Any OID reduces the benefit of the “interest free” borrowing Any OID reduces the benefit of the “interest free” borrowing

9 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

10 The Allocation Process The application process to Treasury has not yet been developed The application process to Treasury has not yet been developed Not yet determined what criteria Treasury will use to allocate bonds among competing applicants Not yet determined what criteria Treasury will use to allocate bonds among competing applicants Opportunity for input to Treasury/IRS Opportunity for input to Treasury/IRS

11 Overview Of Current Legislative Atmosphere JCT proposals JCT proposals Potential SFC proposals Potential SFC proposals Budget Picture – search for revenue raisers Budget Picture – search for revenue raisers Tax reform Tax reform

12 JCT Proposals Eliminate advance refundings of bonds issued after enactment Eliminate advance refundings of bonds issued after enactment  Not retroactive Information reporting Information reporting  Require issuers to provide 1099 type information to bondholders and IRS. Alternatively, require issuers to maintain bondholders lists to be provided to the IRS if requested  Designed to improve the IRS’ ability to tax bondholders on “bad” deals

13 JCT Proposals – cont’d 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 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  P&Cs hold almost 15% of outstanding bonds

14 JCT Proposals – cont’d Potential impact on issuers if enacted Potential impact on issuers if enacted  Advance refunding  Demand side changes  Information reporting

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

16 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  Need for revenue  Sen. Grassley led the charge against “abusive” leasing transactions involving state and local governments

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

18 Longer Term Risks – Tax Reform Tax reform status Tax reform status  Presidential Commission report due September 30, 2005  Report to be followed by Administration proposals Potential changes Potential changes  Eliminate tax on all investment earnings  Subject tax-exempt entities to income tax  Eliminate deductibility of state and local taxes  Potential impact on tax-exempt bonds

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

20 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?

21 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 Are bond counsel already reacting? Are bond counsel already reacting?

22 SLGS - Overview Flexibility of prior SLGS regulations provided significant advantages: Flexibility of prior SLGS regulations provided significant advantages:  Ability to lock in rates even if transaction is not a sure thing  Ability to use the “free option” in SLGS to restructure escrows to eliminate negative arbitrage  Interest rate setting process provides opportunities to eliminate negative arbitrage

23 SLGS – New Rules Changes to SLGS regulations: Changes to SLGS regulations:  Mandatory use of SLGS-Safe  New interest rate setting procedure  Elimination of ability to change delivery date  Elimination of penalty free cancellation  Requirement that subscriptions be filed by 10 p.m. Eastern time  Eliminate ability to increase yield in purchase or redemption of SLGS  Why did this happen?

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

25 IRS Audit Program – Risks and Problems Impact on outstanding bonds Impact on outstanding bonds  Whether to disclose audit  Impact of disclosure – Variable rate bonds  Impact of disclosure – Fixed rate bonds  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

26 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

27 IRS Audit Program – Risks and Problems (cont.) Is there any hope for improvement? Is there any hope for improvement?  NABL ADR proposal  Treasury/IRS interest

28 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

29 Transmission and Private Use RTOs: private use rules are very favorable for transmission in an RTO RTOs: private use rules are very favorable for transmission in an RTO Other open access: Transmission is subject to the private use rules if used in open access but not as part of an RTO Other open access: Transmission is subject to the private use rules if used in open access but not as part of an RTO Private use regulatory relief not as generous as relief provided to IOUs and Coops in recent legislation Private use regulatory relief not as generous as relief provided to IOUs and Coops in recent legislation

30 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.  “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.  The private use and equity must be “allocable” to the same facility for the equity first rule to apply.

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

32 Equity First – Status of Allocation and Accounting Regulations and Next Steps Timing Timing Scope Scope Opportunity for input Opportunity for input