Tax Webinar: Expenditure of Proceeds – Timing and Planning Winnie Tsien, Orrick, Herrington & Sutcliffe LLP Rosa H. Renaud, Financing and Treasury August 24, 2017 ***These materials have been prepared for this internal CSU presentation only. Do not distribute as the information largely incorporates current internal procedures, which procedures are periodically changed and updated.***
Agenda Introduction I. II. Tax Parameters and Considerations III. F&T Financing Review IV. Putting It All Together
Tax Parameters and Considerations
CSU and Tax-Exempt Bonds Tax-exempt bonds established to finance capital projects for state and local governments Borrowing cost of tax- exempt bonds “subsidized” by income tax forgone by U.S. Govt. CSU has $5 billion tax-exempt bonds currently outstanding Among currently available alternatives, tax-exempt bonds are the least-expensive and relatively simple to administer 1
Tax Rules Favor Quick and Clear Expenditure of Proceeds Proceeds are spent/expended to create Capital Assets Tax rules for Proceeds differ than for Capital Assets Proceeds require tracking, are subject to investment restrictions, and need to be properly spent IRS assumes the longer there are unspent proceeds, the greater likelihood of abuse Goal: Spend quickly! 2
CSU Tax Certificate CSU focuses on spending* Proceeds within a 2 year period: 10% by 6 months; 45% by 12 months; 75% by 18 months; 100% by 24 months. * Expenditures are based on a cash basis, as they are processed and paid through the State Controller’s Office. CSU’s goals: Timely, safe, orderly and consistently-applied expenditure plan Maximize earnings retention ability Project expectations and assumptions are reasonable based on a comprehensive review Project funding sources are prioritized throughout project timeline 3
Prioritization of Funding Sources During Project Timeline Financing #1 – Tax-Exempt CP Reserves #2 – Tax-Exempt Bonds #3 – Taxable Bonds #4 – Reserves/Donations 4 Generally: Early Stages of Project Construction Period Planning & Working Drawings
“Hedge Bonds” – Taxability Risk if Timing Not Met Do not let your tax- exempt bonds become “Hedge Bonds” – hedge bonds lose their tax exemption, and there is no available remedy As written, hedge bonds rule focuses on “reasonable expectations” of issuer But, as currently enforced in an audit, IRS position is: unexpended proceeds 3 years from issuance means issuer’s expectations are not reasonable Therefore, CSU task to ensure all projects in an issue, collectively, are on track to meet test, with sufficient time to accelerate spending 5
F&T Financing Review
All Timing Rules Measured Collectively Per Issue Tax-exemption on bonds is based on the sum of the parts: Each project impacts all projects and entire bond issue CSU is measured by its compliance record, which requires having a good process in place that is followed Tax Counsel advises CSU to follow 2-year period as reasonable completion period, for best practices and effective planning, in light of complexity of SRBs 6
Steps to Establish and Monitor Reasonable Expectations in Expenditure of Proceeds - I Are Due Diligence items complete and reasonable? Project Description and potential risks (ex. permits; site; litigation) Project Budget (CPDC 2-7) Campus Debt Service Coverage Ratio Analysis (only for Self-Support projects) Preliminary Allocation of Bonds Proceeds form Site Certification by Land Use Planning and Environmental Review (LUPER) with clearance and no outstanding issues with easements and liens Private Use Checklist Reimbursement Summary form Will the information stand up to future scrutiny by an outside party over time? 7
Steps to Establish and Monitor Reasonable Expectations in Expenditure of Proceeds - II F&T’s review of Cash Flow projections considers: How “reasonable” are the expectations? Will the project meet spenddown targets/requirements? Can the projects be grouped to meet the targets? What is the impact if the targets are not met? - Perform a sensitivity analysis Where is the project in its development? Do we have Commercial Paper capacity? When will the long term bond issuance be? 8
Cash Flow Projection Examples** Appears Unlikely Good representation 9 ** Goal is to reflect anticipated payments of expenditures processed through the State Controller’s Office
Cash Flow Review – 2017 SRBs 2017A, B, 84 Project Analysis* and C Cash Flow Bond Projections Issuances (a) Pay-Off Commercial Paper (b) New Construction: $1,196,360,000 12 Self Support & 72 Academic (c) Refunding of 3 Bond Series (w/7 projects) 10 * By F&T, CSU Financial Advisor, and Tax Counsel
Financial Planning Process with Cash Flows #1 CO CPDC Campus Analysis Projections Tax- Exempt F&T Bond Analysis Proceeds Financial Advisor & Tax 11 Analysis
Steps to Establish and Monitor Reasonable Expectations in Expenditure of Proceeds - III Bond Sale and Closing: Formal Due Diligence Review for overall bond issuance with Underwriters Extensive Tax Review for new projects and proposed refunding of bonds (and related prior projects) Posting Preliminary Official Statement (POS) locks in representations to investors Sale of bonds via (Bond Purchase Agreement/Contract) BPA locks in cost and terms of borrowing Bond Opinion and Tax Opinion delivered as CSU confirms representations and covenants Chancellor, CFO, and Management certify compliance on behalf of CSU Trustees 12
Steps to Establish and Monitor Reasonable Expectations in Expenditure of Proceeds - IV Post Bond Issuance: During Construction – periodic review of projects to see if on track Near Completion – review progress and identify potential problems Completion of Projects – accounting and allocation of proceeds documentation; final chance to try to fix any expenditure problem (but not everything can be fixed) Uniform process of cash flow and project reviews are necessary for systemwide bonds to meet tax compliance Ongoing F&T , CPDC, and Campus effort: time and resources to continue monitoring and adjusting Best Proof of Expectations is Actual Facts and Performance 13
Putting It All Together
Why have a uniform process? CSU’s representations are only as good as underlying information and compliance efforts by campuses Executives signing tax certificate, bond indenture and other documents certify as to representations and covenants for all campuses and underlying units Tax documents require that CSU has institutional knowledge of all matters represented, and has system for compliance Active tax compliance starts on campus level – complete and robust monitoring and reporting F&T level of compliance largely depends on active tax compliance by campus IRS expects issuers to have adequate procedures to comply with expenditure of proceeds rules 14
What can campuses do? Develop realistic cash flow projections given a project’s particular circumstances Consider how best to position a project to meet expectations Identify risks and bottlenecks Move towards being “shovel ready” prior to financing Document and retain information tracking financing proceeds, expenditures, and use of completed facility Monitor and advise CPDC and F&T as you identify potential problems 15
Lessons in Timing of Expenditures One project can affect all projects CP lesson learned: failure of 1 project in spenddown resulted in all projects not meeting spenddown Therefore payment owed on all projects due to positive earnings Future CP issuances then only allowed 1 project each, spaced out by 15 days, to assure separate spend- down requirements and “wall off” effects of one project from another Separating projects is not practical in SRBs. Taxable SRBs provide buffer on spend-down, but more expensive, so due diligence focuses on not issuing earlier or more than necessary Changes to a project, or a change in projects, requires additional due diligence, staff time and other costs 16
Rebate Payment and Costs CSU has paid the IRS approximately $2.4 million in rebate in recent years: SRBs: 27 projects paid out $1,952,364 Commercial Paper (CP): 17 projects paid out $422,570 Each issue not meeting rebate exception incurs costs for reports, legal fees, and staff and campus time As long as there are proceeds, ongoing costs for monitoring and reports will incur fees. Lost earnings not used for more projects 17
What happens if Non-Compliance? Certain self-correction rules available if internal system properly - and timely - identifies problem Voluntary Closing Agreement Program (VCAP) with IRS considers issuer’s system of compliance monitoring Ultimate fear – IRS audit Audited bond issue is completely re-analyzed, with hindsight but possible missing records or memory; incurs time and costs even if resolved favorably No issuer can challenge IRS finding in court; issuer may need to pay even if they are “right” Adverse effects include expansion of audit, other financings, increased costs and downgrades, negative publicity, costs and payment to IRS 18
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