4.13 Tax Risk
As described above, for bonds to be and remain tax exempt, some complex issues must be addressed. If the IRS determines and successfully demonstrates that an issue of bonds is “taxable” the issuer would likely be subjected to a suit for damages by unhappy investors unless the issuer enters into a “settlement agreement” with the IRS in which the IRS agrees to allow the bonds to continue to be tax exempt in exchange for a substantial payment by the issuer. If taxability results from an act or omission of the issuer it generally constitutes an event of default on the debt.
Even if a bond issue is not declared taxable, if an issue becomes subject to a “tax cloud,” either because of something relating directly to the issue or because similar transactions unrelated to the issue or the issuer are called into question, the issuer may experience trouble marketing future debt. If a “tax cloud” appears on variable rate tender debt, the debt may all be tendered, and remarketing of the debt may not be possible or may require very high interest rates.
Because of the potential losses involved, it is incumbent upon public agencies issuing tax exempt debt to assure that the debt in fact is and remains tax exempt. Public agencies can minimize tax risk by selecting highly competent and careful bond counsel and other financing professionals and by exercising prudence in deciding how to structure each transaction.
Bond counsel oversees all aspects of the transaction relating to tax exemption, advises the issuer and other financing participants of the impact of various structural alternatives on tax exemption, and renders an opinion that interest on the debt is tax exempt (generally stated, “excluded from gross income for federal income tax purposes”).