More attacks likely against tax breaks for U.S. munis

SAN ANTONIO, Texas Fri Oct 14, 2011 10:51am EDT

SAN ANTONIO, Texas Oct 14 (Reuters) - Legislative strikes against the tax exemption associated with U.S. municipal bonds are not likely to end soon, but will probably come in a variety of forms, according to analysts and lawyers.

"Let me assure you that, very unfortunately, reports of the demise of the 28 percent cap are greatly exaggerated," said Victoria Rostow, director of governmental affairs for the National Association of Bond Lawyers at an association meeting on Thursday.

In the American Jobs Act proposed last month, President Barack Obama suggested capping the size of the tax breaks that high-earners can take for the interest payments they receive from the municipal bonds they buy.

Tax exemption is a key selling point for the debt that states, local governments and authorities sell, allowing them to pay lower interest rates.

Rostow, though, said that the defeat of Obama's plan in the Senate did not end the possibility of a cap, because Congress may take up parts of the plan in separate bills.

A bicameral, bipartisan committee created to cut the deficit could also suggest bringing in revenues through limiting the exemptions, she said. The so-called "SuperCommittee" has until Nov. 24 to make suggestions.

For Antonio Martini, an attorney at Edwards Angell Palmer & Dodge LLP in Boston, the tax exemption is in a "policy-making crucible," where different bills and proposals arose in the last year to change, limit or eliminate it.

"There's a broad spectrum," he said.

Alongside Obama's cap, an independent deficit reduction commission, known as Simpson-Bowles for its leaders, recently suggested wiping out the exemption entirely.

Senator Ron Wyden has introduced a bill to replace some infrastructure bonds with bonds that give credits against their tax charges instead of paying interest.

The popularity of last year's taxable Build America Bonds have "framed some of the discussions going on now about possible changes," said Scott Lillienthal, an attorney from Hogan Lovells US LLP in Washington at the conference.

The bonds pay issuers a rebate equal to 35 percent of interest, a subsidy so steep they caught on like wildfire. The federal government considered the bonds more "efficient" than tax-exempt debt, where issuers benefit from the subsidy indirectly and the investor base is narrow.

The federal government will likely rescind the tax exemption "step by step by step," said Charles Almond, an attorney at Vinson & Elkins LLP in Houston.

It will likely begin limiting the exclusion on private activity bonds sold for projects that fall outside the purview of typical public works or for those sold in conjunction with non-profits known 501c3s for their part of the tax code. Ultimately, he said the federal government could simply leave the tax exemption for debt related only to essential governmental functions.

"The threat is very real," said George Friedlander, Citi's senior muni bond strategist, agreeing that the federal government may simply chip away at the exemption, so that "we end up with half the existing market."

Friedlander, who suggested giving issuers the option of selling BAB-like debt at a lower subsidy rate or tax-exempt bonds, said that the threat to the exemption would persist.

"Once something is proposed it never dies. It will be brought up again and again and again."

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