iIn Part 1, we introduced the cash flow relief technique/staple of your morning commute known as “Scoop and Chuck.” In particular, we discussed an issuer that will issue new bonds and use the proceeds to pay interest and no principal on a prior issue of bonds. The new bonds will have a debt service schedule that is pushed out later in time compared to the debt service schedule on the prior bonds. This enables the issuer to keep some of the revenues that it otherwise would have used to pay debt service on the prior bonds. In Part 2, below, we’ll add more facts and try to provide some answers.
We left our last post with you heading to the local mattress store to check in with a radio sidekick. More to the point, we left you with Reg. 1.150-1(d)(2)(i), which provides a way for us to avoid treating our scoop and chuck issue as a refunding issue, meaning that it can’t be an advance refunding issue, meaning that we could use proceeds of our scoop and chuck issue to pay interest that accrues more than 90 days (but within 1 year) of the issue date of our scoop and chuck bonds.
While this rule seems to provide a great benefit (enabling the issuer to ignore, to a limited extent, the prohibition on tax-exempt advance refundings), the benefit comes in most cases with a great cost that sharply reduces its effectiveness in providing cash flow relief to an issuer.
Let’s add more facts. Assume that our prior bonds are fixed rate new money governmental bonds issued in 2013 to build a courthouse. The issuer placed the courthouse in service in 2015. The bonds have an interest payment that is due on February 1. The issuer wants to scoop that sucker and chuck it far into the future. Because the bond-financed project has been placed in service, that interest is not a capital expenditure. Our scoop and chuck issue won’t pay any other principal nor any other interest. Accordingly, our scoop and chuck issue isn’t a refunding issue, because the only principal or interest that the scoop and chuck issue will be paying is interest on another issue that accrues on the other issue during a one-year period including the issue date of the scoop and chuck issue.
So, if our scoop and chuck issue isn’t a refunding issue, what is it? It is a new money issue of a sort, and, because it’s a new money issue, we have to ask what sort of new money expenditures it is financing. Here, because the “new money expenditures” are working capital expenditures, we have jumped out of the frying pan of the advance refunding issue prohibition and into the fire of the working capital rules. Uh oh.
The two critical questions in any working capital financing are: (1) Can we treat the bond proceeds as allocated to the working capital expenditures we want to finance? (2) How long can we leave the bonds outstanding?
Question (1) is actually not the pain in the neck that it usually is. We won’t have to navigate the veritable mattress-store-parking-lot-dunk-tank that is the “proceeds-spent-last” rule to ensure that our scoop and chuck proceeds can be treated as spent on the interest payment to be scooped and chucked. Bond proceeds that are used to pay principal or interest on a prior issue aren’t subject to the proceeds-spent-last rule.[1] In other words, even if the issuer has other “available amounts” that it could have used to pay the February 1, 2021 interest payment, the issuer can still spend the scoop and chuck proceeds on that payment and also treat the proceeds as allocable to that payment (rather than being forced to allocate the proceeds to the issuer’s other available amounts).
Question (2) ruins our party, however. In general, it is difficult for an issuer to leave working capital bonds outstanding for longer than 13 months unless the issuer has no “available amounts” to pay working capital expenditures beyond that point. The existence of available amounts while a working capital financing is outstanding can lead to an “overissuance” under the arbitrage anti-abuse regulations[2] if the working capital bonds are outstanding longer than 13 months. While this wouldn’t necessarily make the scoop and chuck bonds taxable, it is flirting with disaster, because the overissuance triggers many draconian revisions to the normal tax-exempt bond rules,[3] making it more likely that the issuer will trip over them. It should be noted that the arbitrage anti-abuse rule says that the overissuance concern “can” (not “will be,” but “can”) be outweighed by the issuer’s bona fide need to finance extraordinary working capital items or an issuer’s long-term financial distress.
Even so, if the scoop and chuck bonds under our facts are outstanding longer than 13 months, the issuer will probably want to deal with the potential overissuance concern by complying with the safe harbor rules for long-term working capital financings.[4] This safe harbor requires the issuer to test annually for available amounts, and then to use any available amounts that arise during the term of the bonds to redeem its tax-exempt bonds or continuously invest those amounts in non-AMT tax-exempt securities (or mutual funds that invest almost exclusively in non-AMT tax-exempt securities) or demand deposit SLGS. The financial burden and the complicated annual testing involved in this is enough to prompt most issuers to use taxable bonds if they want to do the “interest-only” scoop and chuck.
There are many more variations on this theme. In some cases, seemingly minor distinctions can produce major changes to the tax analysis.
[1] Reg. 1.148-6(d)(3)(ii)(C).
[2] Reg. 1.148-10(a)(4). Specifically, if the issuer leaves the scoop and chuck bonds outstanding beyond 13 months, it can lead to an “overburdening” of the tax-exempt market. The overburdening rules are a subsidiary of the arbitrage anti-abuse rule, which can be summarized as “overburdening + exploitation of tax-exempt vs. taxable interest rates = taxable arbitrage bonds.” No one really knows what the hell “exploitation” means, especially since it can occur even if “in the aggregate, the gross proceeds of the issue are not invested in higher yielding investments over the term of the issue.” Reg. 1.148-10(a)(3). There is one example of exploitation in the regulate-
[3] See Reg. 1.148-10(b).
[4] Reg. 1.148-1(c)(4)(i)(B).
