Alert July 29, 2011

IRS Scrutinizes Conduit Bonds

Conduit bonds provide private developers and nonprofit entities with low-cost, tax-exempt financing for projects that satisfy a public purpose or promote economic development, such as housing, hospitals, and industrial facilities. In a conduit bond financing, a governmental entity issues tax-exempt bonds on behalf of a private entity or nonprofit corporation, usually for a fee. Unlike general obligation bonds, which are secured by the governmental entity’s general fund, conduit bonds are generally payable solely from revenues generated by the project being financed.

According to Thomson Reuters, the conduit bond market grew four times faster than the overall municipal bond market during the past five years. According to the research firm Income Securities Advisors, however, while conduit bonds represent only one-fifth of the municipal bond market, they have accounted for two-thirds of all municipal bond defaults in recent years.

In light of the growth and turmoil in this market, the Internal Revenue Service (“IRS”) recently appointed an advisory panel to explore possible safeguards. The panel released a report last month, which concluded that local governments frequently misunderstand the tax rules applicable to conduit bond financings and are given insufficient instruction by the IRS. Consequently, the standards for approval and costs vary widely throughout the conduit bond market.

For example, conduit bonds were recently used to finance a casino resort and a private airport. Some local agencies have even begun issuing these bonds for projects in other cities or states, which raises issues of federal regulation under the Commerce Clause of the U.S. Constitution. The report recommended greater oversight of the conduit bond market by the IRS, as well as clearer rules and more guidance for conduit bond issuers.

Goodwin Procter will monitor the IRS’s efforts to increase its oversight and regulation of conduit bonds and report any developments in subsequent Public Finance Updates.