The Assault on Tax-Exempt Bonds

1. American Public Power Association The Assault on Tax-Exempt Bonds November 15, 2005 Mitch Rapaport Nixon Peabody LLP 401 Ninth Street, N.W. Washington, D.C. 20004 (202) 585-8305 mrapaport@nixonpeabody.com

2. Overview Of CurrentLegislative Atmosphere • JCT proposals • Potential SFC proposals • Budget Picture – search for revenue raisers • Tax Reform Proposals and Process

3. JCT Proposals • Eliminate advance refundings of bonds issued after enactment • Not retroactive • 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

4. JCT Proposals – cont’d • 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

5. JCT Proposals – cont’d • Potential impact on issuers if enacted • Advance refunding • Demand side changes • Information reporting

6. Potential SFC Proposals • 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

7. Potential SFC Proposals – cont’d • 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

8. Potential SFC Proposals – cont’d • 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

9. Tax Reform Proposals • Tax reform status • Presidential Commission released its report on October 31, 2005 • Report to be followed by Treasury Department proposals and then White House proposals • Potential concerns prior to report release: • 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

10. Tax Reform • Two Different Proposals: • “Simplified Income Tax Plan” • “Growth and Investment Tax Plan” • Both eliminate the AMT • Both revenue neutral • Both eliminate deduction for State and local taxes

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

12. Tax Reform—Impact on Tax-Exempt Bonds • Simplified Plan: • 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 • Growth Plan would make all interest received by corporations (other than financial institutions) tax-exempt

13. Tax Reform—Impact on Tax-Exempt Bonds (cont’d) • 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

14. 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

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

16. Circular 230 - Future • Impact of Final Regulations for other transactions • What happens next? • Regulatory process • Are bond counsel already reacting?

17. IRS Audit Program – Status • Status of Audit Program • 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?

18. IRS Audit Program –Risks and Problems • 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 • Difficult to convince the auditors that they are wrong

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

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

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