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Post Issuance Compliance

Annual Meeting

July 16, 2012

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Post Issuance Compliance – AgendaRoom X, 16th Floor, MSB, Monday, July 16th, 2-4 PM

I. Welcome and Introductions – Nancy Winkler, City Treasurer

II. Post-Issuance Compliance Team

III. Bond Arbitrage 101 – Joan DiMarco, PFM Asset Management

IV. Private Use 101 – Valarie Allen, Ballard Spahr

V. IRS Audit and Compliance Initiatives – Kim Betterton, Ballard Spahr

VI. Policies and Procedures – Charlie Jones, Sinking Fund

VII.Investments – Nancy Winkler

VIII.Adjournment

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Post Issuance Compliance Team Members

Not only does Uncle Sam want you, but the City of Philadelphia needs you to be an active member of the team. Because of the wide-ranging nature of bond proceeds, including issuance, spending, investing and tracking, no one person or department can handle all the tasks that are necessary to adequately and successfully perform post issuance compliance. The Treasurers Office takes the lead in this activity but will recruit, enlist and, if necessary, draft individuals to assist in this process. We appreciate the time and effort that you will contribute to this process.

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“Dear IRS”

Maybe it works for Snoopy, but it doesn’t work for the rest of us. Even though we are a tax-exempt bond issuer, the City of Philadelphia is still subject to many IRS rules and regulations. No matter how many times we tell them not to, they still keep sending us audits and examinations.

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Timeline

Before, During and Immediately After Issuance

Capital Programming

• Team:• Budget• Depart

ment/• Authori

ty• Considerat

ions:• Useful

life of projects

• Tax status of projects

• Availability of prior proceeds/other capital

Bond Issuance/DS Payment

• Team:• CTO/

Sinking Fund

• Department/ Authority

• Law Dept• Bond

Counsel• Financial

Advisor• Underwri

ter• Key

Outcomes:• Proceeds

(and their purpose)

• Yield• Tax

Status

Investment of Proceeds

• Team:• CTO• Money

Manager

• Goals:• Protect

principal

• Liquidity

• Yield (below Arb Restriction)

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Timeline (continued)

Change in Use

• Projects funded with bond proceeds are changed from original stated purpose

• Potential Impact: tax status of bonds may change

• Potential to have to call bonds

Arbitrage Rebate

• Capital monies from bonds may not be invested at a rate above the “arbitrage yield” of the bonds

• Sinking Fund Commissioner and Arb Rebate consultant monitor each outstanding City issue

• If non-compliant, City would have to rebate some investment earnings

Closing Accounts

• Once bond proceeds of certain issue are spent, accounts should be closed

• Includes both capital monies and costs of issuance

Post Issuance Compliance – Potential Issues

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Arbitrage Rebate 101

Joan DiMarco

PFM Asset Management

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Background – Why we have Arbitrage Rebate

To prevent abuses, the tax code limits the permitted uses of tax-exempt bonds

Prevents issuance of more bonds than are necessary

Prevents issuance of bonds earlier than is necessary

Prevents bonds from remaining outstanding longer than is necessary

Limitations on advance refunding

In other words, borrow what you need, when you need it, for an appropriate duration based on what is being financed.

Tax law and Regulations create financial disincentives (i.e., arbitrage rebate) to prevent issuance of tax-exempt debt for profit-driven reasons

Yield restriction – IRC Section 148(b)

Arbitrage rebate – IRC Section 148(f)

Overlapping requirements – “Belt & Suspenders”

Applies to every tax-exempt borrowing

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How is Arbitrage Measured?

Arbitrage % = Actual investment earnings yield (–) average borrowing rate (aka, the Arbitrage Yield)

Arbitrage rebate liability =

Earnings of bond proceeds invested in taxable securities less (-)

Earnings of bond proceeds invested at the Arbitrage Yield “Positive Arbitrage” = Actual Earnings > Earnings @ arbitrage yield (positive

earnings yield spread) “Negative Arbitrage” = Actual Earnings < Earnings @ arbitrage yield (negative

earnings yield spread)

Future value methodology

Measured on an issue-by-issue basis

Within an issue, aggregated among funds

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Funds Subject to Rebate

Proceeds Category

Sale Proceeds / Investment Proceeds

(“Proceeds”)

Transferred Proceeds (“Proceeds”)

Cash / Revenue Funded (“Replacement Proceeds”)

Proceeds + Replacement Proceeds = Gross Proceeds

Proceeds Category Funds

Funds

Project / Construction FundsCapitalized Interest Funds

Debt Service Reserve FundsEscrow Funds

Costs of Issuance Funds

Any of the above

Debt Service FundsDebt Service Reserve Funds

Any “Pledged” Fund

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Arbitrage Rebate – An Example

($150)

($100)

($50)

$0

$50

$100

$150

$200

($100)

($25)($5)

($25)

$150

($5)

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Exceptions to Arbitrage Rebate

The Small Issuer Exception

The Spending Exceptions

6-month spending exception

18-month spending exception

2-year spending exception

“Bona Fide” Debt Service Fund exception

Electing to pay the 1.5% penalty in lieu of rebate

Investing in tax-exempt obligations

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Spending Exceptions

6-Months 12-Months 18-Months 24-Months0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%1

15%

60%

100%

10%

45%

75%

100%

6-Month Exception 18-Month Exception2-Year Exception

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“Bona Fide” Debt Service Fund Exception

Depleted at least annually except for greater of:

Previous year’s earnings in the fund, or

1/12th of previous year’s principal and interest payments

Private Activity Bonds, Variable rate governmental bonds, < 5 years governmental bonds

Fund has annual earnings of less than $100,000, or

Average annual debt service does not exceed $2.5 million

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What is Yield Restriction?

Like rebate, restriction against investing above the arbitrage yield

Only applies to proceeds that are subject to yield restriction

Exceptions apply

Temporary periods

Exception for “Reasonably Required” Reserve Fund

Minor Portion

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Temporary Periods

Fund Type

Construction fund

Bona fide Debt Service Funds

Advance Refunding Proceeds

Current Refunding Proceeds

Investment Proceeds

Temporary Period

Typically 3 years, with 5 year cert.

13 months

30 days

90 days

1 year from date of receipt

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Yield Restriction Impact - Unspent Proceeds

Yield restriction liability calculation• cannot blend negative arbitrage on unrestricted proceeds with positive arbitrage on

restricted proceeds (can blend for rebate liability calculation)

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Yield Restriction Compliance Methods

Active Yield Restriction

Investments must be purchased at fair market value

Yield Reduction Payments

Rebate like payments

Limited availability for advance refunding issues

Other Options

Longer construction fund temporary period (5-years vs. 3-years)

Waiver of temporary period at issuance

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Accounting for Bond Proceeds

Significant factor in determining arbitrage rebate and yield restriction liabilities

Permitted to use any reasonable, consistently applied accounting method to account for gross proceeds, investments, and expenditures of an issue

Examples: FIFO, direct tracing, ratable allocation, gross proceeds spent first

Proceeds are allocated to an issue until they are spent (actual cash outlay)

Expenditure reallocations are permitted, however there are time limits

Expenditure allocations must be made no later than 18-months after the later of the expenditure date or the date the project is placed in service

Must be made no later than 60 days after five-year anniversary/final maturity date

Proceeds of working capital financings (e.g., TANS, TRANs) subject to “proceeds-spent-last” requirement

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Private Use 101

Valarie Allen

Ballard Spahr

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Tax Exemption = Subsidy

Congress promoting public purposes of, and investment by, state and local governments by lowering cost of capital

Issuers must ensure that uses of bond financed facilities are for the public good for federal tax purposes

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The Holy Grail: Governmental Bonds

Federal tax code allows for tax-exempt interest on:

Governmental Bonds

“Qualified” Private Activity Bonds

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The Holy Grail: Governmental Bonds

Governmental Bonds means

Bonds that are not Private Activity Bonds

Governmental issuer is not enough

For federal tax purposes “governmental” refers to the ownership and use of the facilities being financed

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PAB Tests: Don’t Want No Satisfaction

A Bond is a Private Activity Bond (PAB) if it meets either:

BOTH the Private Business Use andPrivate Security and Payment Tests

OR

Private Loan Financing Test

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PAB Tests: Don’t Want No Satisfaction

Private Business Use Test: No more than 10% of the proceeds of the issue can be used in private business

Private Security or Payment Test: No more than 10% of the debt service on the bonds may be secured by private security or payment (capped at $15,000,000)

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PAB Tests: Don’t Want No Satisfaction

Private Loan Financing Test: No more than the lesser of 5% and $5,000,000 of the proceeds of the bonds can be used to finance private loans

Grants, unlike loans, are not private use

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Hypotheticals

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IRS Initiatives and Audit Compliance

Kim Betterton

Ballard Spahr

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Time Line

Early 1990s – IRS basically has no tax-exempt bond audit program. Issuers are operating under the assumption that if they had reasonable expectations of compliance at the time of issuance, everything will be fine.

Mid 1990s – IRS begins targeted audits. Audit program is still very small and very few agents are dedicated to tax-exempt bonds.

Early 2000s – Audit program begins to ramp up.

Mid 2000s - IRS publishes an FAQ stating that issuers have responsibility to PROVE that their bonds are tax-exempt by keeping records for the life of the bonds (including any refunding bonds) plus three years.

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Time Line (cont’d)

Late 2000s – IRS has as many as 60 field agents dedicated to auditing tax-exempt bonds in both targeted and random audits.

Additionally, IRS begins sending out post-issuance compliance questionnaires requesting “voluntary” disclosure of information concerning bonds. So far these questionnaires have covered:

– 501(c)(3) Bonds– Governmental Bonds– Build America Bonds– Advance Refundings– Tax Anticipation Notes– Small Issuers

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Time Line (cont’d)

Current – IRS is increasingly adding questions about WRITTEN post-issuance compliance procedures to its Forms 8038-G, 8038, post-issuance compliance questionnaires, audit information requests, and, for 501(c)(3) organizations, Schedule K to the Form 990 (the annual tax filing).

IRS is considering requiring a filing similar to the Schedule K from governmental entities (which would include the City of Philadelphia).

IRS has added provisions to its Voluntary Closing Agreement Program (“VCAP”) that give special benefits to issuers who have written procedures in place.

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WHY?

Tax-exempt (and tax-favored financing, such as build America bonds or tax credit bonds) are a form of federal subsidy. Just as there are strings attached to most federal grants, similar strings are attached to the ability to borrow at a low rate of interest.

Issuers have control over whether their bonds are in compliance with the tax rules.

IRS believes that if the proper procedures are put in place that issuers will be able to keep their bond issues in compliance.

If you put procedures in place that you can actually follow, the IRS is probably correct in that belief.

Cost of audit, regardless of outcome, is most likely far greater than a good faith effort toward compliance.

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Policies and Procedures

Charlie Jones

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Scope

The policies and procedures apply to all tax-exempt governmental and qualified private activity bonds issued by the following entities:

City of Philadelphia General Fund (including TRANs)

Philadelphia Gas Works

Philadelphia Water Department

Philadelphia Airport

Philadelphia Authority for Industrial Development (PAID)

Philadelphia Municipal Authority (PMA)

Philadelphia Redevelopment Authority

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Expenditure of Proceeds for Qualified Costs

Records must be kept of date, amount and purpose of each capital expenditure

Requisitions must identify the property in conformity with the Tax Certificate

Reimbursements of previously expended costs must be for expenditures made subsequent to or within 60 days prior to the declaration to reimburse such costs

Initial funding of debt service reserve funds must be made according to certain limitations

Timing of expenditures will be according to documentation at the time of issuance. If the expected schedule is not met, reasons will be documented and retained

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Use of Bond-Financed Property (after completion and in

service)

After a property that has been financed with bond proceeds is put into use, the use of that property must be monitored

If the property is leased or sold to a for-profit entity (private use), the status of the tax-exempt bonds may change

If the private use of property exceeds 10% of the proceeds the status of the tax-exempt bonds may change

Prior to the switch of a bond-financed property to private use, a remedial action must be determined per Treasury regulations

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Refunding Bonds

Refunding (new) bonds are treated as if they were the refunded (old) bonds

Use of the property financed by old bonds is continued to monitored in the same manner during the life of the new bonds

Advance refunding bonds, proceeds of which are used to refund bonds more than 90 days after the new bonds are issued, have additional compliance requirements regarding the investments and escrows

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Record Keeping

Requirements are burdensome and may not be consistent with document destruction policies

Life of the Bonds + 3 years

If the Bonds are refunded, life of refunding bonds + 3 years

Consider separate document collection, storage and destruction policies for bond related records

Consider electronic storage systems

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Examples of Records to Maintain

Board minutes, resolutions

Appraisals

Bond transcripts

Newspaper ads, misc. correspondence

Investment records

Expenditure histories

Invoices

IRS Filings

Records related to acquisition of investment agreements and interest rate swaps

Payments for credit facilities

Arbitrage rebate and yield restriction compliance reports

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Certifications

Private use

Change in use/Dispositions

Final allocation of new money

Secondary market pricing

Cost of issuance (2% limit on PABs and BABs)

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Investments

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Resources

DAC

https://www.dacbond.com/

IRS

http://www.irs.gov/taxexemptbond/article/0,,id=243503,00.html

http://www.irs.gov/taxexemptbond/issuers/index.html

See IRS Publication 4079 Tax-Exempt Governmental Bonds Compliance Guide

and IRS Publication 4078 Tax-Exempt Private Activity Bonds

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Questions

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Benjamin Franklin

“We must all hang together,

or assuredly we’ll all hang separately.”