As we have noted in previous client advisories, under current law, direct pay bond subsidy payments are subject to federal budgetary sequestration through fiscal year 2024.  On February 2, 2015, the Office of Management and Budget released the nondefense mandatory sequester percentage for fiscal year 2016.  The percentage reduction that will be applied to payments to issuers of direct pay bonds for fiscal year 2016, beginning October 1, 2015, will be 6.8 percent. The percentage reduction for the current fiscal year is 7.3 percent.  The sequestration rate for federal fiscal years 2017 through 2024 will be set from time to time in the future, unless Congress takes action to change or eliminate the sequestration percentage.

The office of Tax Exempt Bonds within the Internal Revenue Service (IRS-TEB) has previously advised that issuers of direct pay bonds should complete IRS Form 8038-CP as directed in the instructions for the form, claiming the full amount of the direct pay subsidy to which they would be entitled absent sequestration, and has noted that issuers will receive correspondence concerning the subsidy payment reduction after they file the form.

The types of direct pay bonds affected by federal budgetary sequestration include build America bonds, recovery zone economic development bonds, qualified zone academy bonds, qualified school construction bonds, qualified energy conservation bonds and clean renewable energy bonds.

As we have noted before, in light of the sequestration process, issuers of direct pay bonds may wish to consider whether and to what extent they are currently in a position to exercise a special, extraordinary or other optional call right (if any) under the terms governing their direct pay bonds.  The answer to this question will turn in part on the specific language creating the call right (if any) in the relevant bond document or statutory authorization, and on the economics of refinancing the direct pay bonds from other sources, including the cost of any redemption premium associated with calls of those bonds.

The Public Finance Practice Group of Locke Lord LLP continues to actively monitor developments relating to sequestration and, more broadly, the proposals being made from time to time to limit or repeal the exclusion of interest on state and local bonds for purposes of federal tax law.