The Federal tax-exemption subsidy is available under stringent rules administered by the Internal Revenue Service (IRS). A primary abuse that the IRS monitors concerns so-called tax arbitrage. Tax arbitrage occurs when a borrower issues tax-exempt bonds at low, subsidized interest rates and then, taking advantage of the fact that State of Oregon bonds are not subject to taxes, opportunistically invests the tax-exempt bond proceeds in investments which offer higher rates of return because most investors are subject to tax.
The arena bonds and their connection to the Legacy Fund gifts tread into tax law territory where compliance with these arbitrage rules is delicate and must be examined carefully with bond counsel and the IRS. To better understand these issues our subcommittee had two discussions with Scott Schickli, a specialist in tax law who is of Counsel to Orrick, LLC. Mr. Schickli expressed the opinion that the financing plan is legal under the following three conditions.
First, the UO cannot issue more bonds that it needs to issue. The arena will cost $200 million to build. The Legacy Fund is not intended to pay for the arena, and in any case, it will reach its full level of $100 million over the next 5 years, with $20 million contributions expected each year. So as a practical matter beginning the arena in the summer of 2008 requires funds sufficient to build the arena.
Second, the donors to the Legacy Fund cannot impose a quid pro quo that directly links the Legacy Fund and the arena bond financing. We are concerned, and have explicitly inquired about the connection between the arena project, its proposed bond financing, and the conditions in the Legacy Fund gifts. Direct and public statements by Athletics Department officials have made it clear to us that if the arena is not financed by the $200 million dollar debt obligation, there will be no Legacy Fund gift. Mr. Schickli has offered his assurances that the conditions in the gift agreements do not violate the tax law.
Third, the UO cannot expect to pay debt service with the Legacy Fund gift nor can they secure the debt with the Legacy Fund gift. Revenue projections are critical to the financing plan. As long as ex ante revenue projections reasonably suggest that the arena will be self-supporting, then if in the future the Legacy Fund must be drawn upon there are limited sanctions imposed – namely some of the excess investment earnings must be rebated to the federal government. Because the conservative CSL revenue estimates are below the debt service requirements for the arena, a critical opinion on this point is that pledging DAF donations connected to football to pay the arena bond debt service and then replenishing those DAF funds with Legacy Funds to balance the Athletics Department budget, does not invalidate the Federal tax-exemption subsidy. According to Mr. Schickli the pledge of preexisting DAF monies to support the arena, and the backfilling of required DAF monies with draws from the Legacy Fund, is allowed by the IRS. The condition that the Legacy Fund secures the debt is not at issue given that the debt are GO bonds issued by and secured by the state of Oregon.
A final concern expressed by Orrick was that even if the financing plan is clearly legal, there is always the risk that the IRS may interpret the law differently than the issuer and may bring an action against the issuer. Mr. Schickli used the term “optics” to describe how it is important that the financing and the statements surrounding it do not taunt the IRS. The IRS may take umbrage if the financing appears to exploit clever and legalistic interpretations that violate the spirit, but not the letter of the law. Thus, bond counsel urges great caution in how the arena financing plan is described. The subcommittee members have been present at meetings in which UO administrators described the financing plan in a manner which suggests that the Legacy Fund is a pledge securing the debt payments. These statements should be made with greater care, according to Mr. Schickli.
Potential Penalties for Arbitrage Violations
In the event that the IRS brings action against an issuer the following penalties are possible, according to Mr. Schickli:
“if the IRS concluded that certain amounts in the Legacy Fund should have been treated as replacement proceeds of the bonds, it would most likely demand that the Department [of Athletics] rebate to the IRS the amount by which the average investment yield on such Legacy Fund amounts exceeded the average bond yield, plus interest. Unlike arbitrage abuse situations, the IRS could only declare the bonds taxable as a result of failure to pay rebate if the failure to pay was due to willful neglect, and there is no argument that such would be the case here. It would be less likely that the IRS (assuming it found fault with the transaction) would conclude that the bonds failed to comply with the basic conditions for tax-exempt status, either from the start (by issuing bonds in excess of those necessary or later on, by leaving bonds outstanding when they should have been retired); if it did so, in order to avoid the IRS imposing tax on prior bond interest, the issuer/department would have to agree to make a payment to the IRS approximately equal to 50% of the tax that would have been imposed on the bonds in the current and past 3 tax years, assuming tax at a rate of 29%. Under no circumstances would criminal penalties be applicable unless there were bid rigging or kickbacks involved in the sale of the bonds or the investment of bond proceeds.” (quoted from email of Dec. 21, 2007)
Avenues for Obtaining Assurances that the financing complies with IRS RegulationsAn issuer can ask for a private letter ruling from the IRS which implicitly gives the IRS’ tacit approval that the financing complies with the law. Obtaining a private letter ruling may take 4-6 months time and cost approximately $100,000 in legal costs. An alternative avenue is referred to as a pre-submission conference. This provides less formal assurance but is more expeditious and less expensive.
B) Limitations on use Debt at the UO-Subsidy from the State of Oregon
By agreement with the OUS , bond debt service for f-bonds cannot exceed 7% of the university budget. In 2007-08, projections by the administration show that there are approximately $193 million in outstanding F bonds with associated debt service of $17.8 million. As a result, current debt service represents 3.4% (= 17.8/524.3) of the projected expense base. In 2008-09, after amortization of some existing debt, the $200 million arena debt, and additional debt issues are expected to increase outstanding f-bond debt to $399 million with associated debt service projected to be $29.7 million. As a result, debt service is projected to represent 5.2% (=29.7/567) of the projected expense base. Thus, the new arena will utilize approximately 26% (=1.8/7) of the 7% guideline. When combined with proposed housing projects, anticipated over the next decade, forecasts suggest that between 2010-2018 available debt capacity will be below $100 million falling to a low of $27 million in 2016-17 a year where the debt service to budget ratio is projected to hit 6.7%. The constraints on the use of bonded debts mean that bonds must be used judiciously and in a manner consistent with the University’s mission because debt is a scarce resource.
The state treasurer determined this week that all of the $200 million bonds approved by the state legislature for the University to build the basketball arena will be taxable – possibly adding up to $2 million per year to the debt payments.
The bonds’ taxable status could raise the total annual debt payments for the athletic department to as much as $16.5 million, which the athletic department plans to pay back over 30 years using arena revenue. That number includes debt from the land purchase, which could be paid off quicker, however.
Nevertheless, revenue projections for the arena have varied from as low as $4 million in the 2004 ECONorthwest report, to as high as $15.5 million in a feasibility study from CSL International.
“I think we really need to go back to the revenue estimates and run it out over the next 30 years to see if this will be manageable,” said University Senate President Gordon Sayre, who has scrutinized the arena project while working for the senate’s arena subcommittee. “An extra $2 million is not a small amount.”
University General Counsel Melinda Grier said the University has done so and determined it can still make the debt payments with help from Phil Knight’s $100 million donation, which is expected to accumulate $50 million in additional donations.
The Oregon State Board of Higher Education will decide June 6 if it wants to proceed with the funding model and sell the bonds to national investors.
But University and state officials say the taxable status might actually help the arena earn more revenue because unlike tax-free bonds, the taxable bonds come with no restrictions as to the kinds of revenue that can be used to make debt payments.
For example, interest revenue from Knight’s donation couldn’t be used to pay back the bond debt on a non-taxable bond because it violates arbitrage, an IRS tax law.
Under the new taxable model, that money can be used to directly pay back the bond debt, as can other more rigorous profit strategies such as alternative vendors and advertising.
“The University is gaining maximum flexibility here so it can generate the maximum amount of revenue for the building,” said Kate Cooper Richardson, chief of staff in the State Treasurer’s Office. “It’s not so unusual for us to do a fully taxable deal.”
Originally, only 20 percent of the $200 million of state bonds were assumed to be taxable, said Legislative Fiscal Office analyst Steve Bender. “As we do more public-private partnerships, and do other things with the private sector, that sort of changes the flexibility that we need because the IRS is fairly strict about that,” Grier said.
The University also used fully taxable bonds when it purchased the Williams’ Bakery lot and during construction of the Lorry Lokey underground science complex.
The bond interest rate could be somewhere around 5.5 percent, which is only a few percentage points more than a tax-free bond, Grier said.
New concerns
Since September, University administrators have assured skeptical faculty that the arena funding model wouldn’t violate arbitrage tax law.
Arbitrage prevents public institutions from using revenues – such as high-interest investments – to pay back debts on low interest rate bonds.
Now that all of the bonds are taxable, it shows there was at least some merit to faculty concerns.
“I feel vindicated to some degree,” Sayre said. “But I’m also more terrified than ever.”
But Richardson noted that the taxable status will raise money for the state.
“Over time, those benefits outweigh the additional interest rate cost,” she said.
But that doesn’t change the extra burden it puts on the athletic department, which has already agreed to accept 70 percent of the debt payments on a $10.9 million bond that will be used to pay for the $18 million parking structure.
Sayre said the reason the funding model looked good before was because the Legacy Fund, which was established by Knight’s donation, was leveraged against the state bonds at the lowest possible interest rate.
“So now the advantages of that leverage are greatly diminished,” he said.
Grier said she couldn’t be sure the athletic department will be able to earn more revenue.
“I can tell you that the financial models still work with this interest rate and it gives us enough flexibility that it isn’t a concern,” she said.
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