Bloomberg Bonds: Municipal Bonds May Get Swept Into Fiscal Changes, Deficit Reduction, Practitioners Say

Bloomberg Bonds: Municipal Bonds May Get Swept Into Fiscal Changes, Deficit Reduction, Practitioners Say

Bloomberg Bonds

Municipal Bonds May Get Swept Into Fiscal Changes, Deficit Reduction, Practitioners Say

Fiscal Cliff Law Impact on Municipal Securities

Key Development: Legislation extended certain tax advantages for municipal bonds; perhaps as importantly it did not eliminate or restrict tax deductibility of bond income.

What’s Next: Debate over municipal-bond tax exemption still in play on Capitol Hill; could be component of any major tax reform plan. Municipal bond market could also be impaired by expiring legislation providing ongoing funding for the federal government.

NEW YORK—Legislation enacted Jan. 2 to avoid or delay approximately $606 billion in automatic spending cuts and tax increases shielded—perhaps only temporarily—tax and other federal policy changes that could materially impair municipal securities markets, practitioners told BNA Jan. 3-4.

The legislation, the American Tax Relief Act (H.R. 8), extended several types of bond-related activities, such as funding school renovations or paying for construction projects in New York City near the area of Sept. 11, 2001, terrorist attacks. The law also permanently revised the alternative minimum tax; without the legislation the purchase of certain types of municipal bonds could have been unattractive for tax purposes to tens of millions of taxpayers.

Perhaps as important to municipal bond markets, the law did not include language to limit or eliminate the tax exemption on municipal bond income, an idea contemplated by both the White House and some lawmakers on Capitol Hill.

Now that H.R. 8 prevented or delayed the automatic tax hikes and spending cuts comprising the fiscal cliff, a chief fiscal objective in Washington shifts to searching for new revenues in part to resolve the country’s longer term deficits. And that has placed the favorable tax treatment associated with municipal bonds—enjoyed by taxpayers since the enactment of the Revenue Act of 1913 (Pub. L. No. 63-16)—in jeopardy, the practitioners said.

Capitol Hill Discussions

While presidential candidates in the 2012 elections representing both major political parties discussed concepts that would limit tax deductions, exemptions, and exclusions—the idea of capping the amount of income not counted in taxpayers’ gross income was mentioned—those ideas were absent from H.R. 8.

Nevertheless, changing the tax treatment of municipal bonds is still a topic of discussion on Capitol Hill and may catch the attention of lawmakers during anticipated debates over the pending sequestration order scheduled to be issued March 1. The topic too could be part of the discussion on how to fund the government following the expiration of the current continuing resolution paying federal government bills. The CR expires March 27.

A key feature of those discussions is how to devise a longer term strategy to reduce the federal deficit by utilizing spending cuts and targeting methods of raising additional taxes. Many policymakers have identified the exemption of municipal bond income from tax as a possible revenue raiser, the practitioners said.

“I think the concern is that although there will presumably be spending reductions, they will also be looking for revenue raisers. And I think the municipal market is concerned about their involvement with being a raiser,” Orrick Herrington & Sutcliffe LLP partner Edwin G. Oswald told BNA Jan. 4.

Involvement With Possible Tax Reform

More generally, the 113th Congress may attempt to address comprehensive tax reform, which could also impair municipal issuance, many sources said.

“There is serious talk on Capitol Hill of undertaking tax reform. It’s not exactly clear what that means … it’s not clear what the schedule for that might be, what the process for undertaking that debate would be on the Hill,” Securities Industry and Financial Markets Association Managing Director Michael Decker told BNA Jan. 4.

“But if and when there is a serious attempt to make substantial reforms to the tax code, I think that there’s a risk that the tax exemption could be curtailed or eliminated,” said Decker, the co-head of SIFMA’s municipal securities activities.

Indeed, the possibility of municipal-bond income losing its exemption from tax is as great as any time since 1986, when major tax reform was ushered into law during the Reagan administration, George Friedlander, Citigroup Inc. senior municipal strategist, told BNA Jan. 4.

Municipal bonds losing their tax-favored treatment “is a very real threat,” Bond Dealers of America Chief Executive Officer Michael Nicholas told BNA Jan. 4.

H.R. 8 Provisions

The law’s alternative minimum tax permanent revision means bonds subject to the AMT will now likely be, on a permanent basis, attractive to tens of millions of investors. Without the revision, those investors could suffer adverse tax consequences. Many qualified private activity bonds are subject to the alternative minimum tax.

Other parts of the law may be seen as benefitting municipal and other tax-favored bonds as well. Section 303 of H.R. 8 extends a housing allowance exclusion for determining area median gross income for qualified residential rental project exempt facility bonds.

Section 310 of the law extends the use of qualified zone academy bonds, instruments that may be used to raise money to renovate school buildings, purchase equipment, develop curricula, and train school personnel. Those bond proceeds cannot be used to fund new construction.

And Section 328 of H.R. 8 extends the eligibility to issue New York Liberty Zone bonds, tax-exempt facility bonds. No new issuance was allowed after Jan. 1, 2005, under the program, created by the Job Creation and Worker Assistance Act of 2002 (Pub. L. No. 107-147), but legislators have continually extended the program’s expiration date.

“The upshot is that this particular bill is not harmful [to municipal bonds] and I definitely think it has the potential for being beneficial in the short term,” Ballard Spahr LLP partner Kimberly C. Betterton told BNA Jan. 3.

Direct Payment Bonds

The longer term is another story. The law delayed until March 1 a list of spending cuts that includes the elimination of a federal subsidy to state and local government issuers of taxable bonds, commonly known as direct payment bonds, in exchange for the subsidy, the amount of which is a percentage of interest payments on the issued bonds.

Any action by Congress to eliminate the subsidy could materially disrupt municipal markets and increase tax risks associated with issuing or investing in the bonds, the practitioners said.

First, reducing or eliminating the federal government payment would disrupt investors’ tax strategies. Further, the reductions could trigger redemption options for issuers, which could be advantageous for issuers but hurt outcomes for investors.

As is the case with possible changes to deduction, exclusion, and exemption rules regarding municipal bond income, the practitioners said just how Congress will deal with direct payment bond subsidies is currently unknown.

Already, municipal issuers and their advocates have enhanced their congressional lobbying efforts. A group known as Municipal Bonds for America, formed Oct. 10, 2012, is currently contacting federal legislators in an effort to preserve the tax-favored status of municipal bonds.

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