April 22, 2009
Previously published on February 14, 2009
On Friday, Feb. 13, 2009, Congress pass and sent to the president the American Recovery and Reinvestment Act of 2009 (the Act). The Act contains a wide range of provisions intended to expand the role of tax-exempt bonds in an effort to stimulate the U.S. economy.
Manufacturing
Under current law, tax-exempt financing is available for qualifying manufacturing facilities. Section 144 limits the qualifying facilities to ones that are used in the manufacturing or production of “tangible personal property.” The Act amends the definition of manufacturing facility to include any facility used in the manufacturing, creation or production of tangible or intangible property. Under Section 197(d)(1)(c)(iii) of the Internal Revenue Code of 1986, as amended, intangible property includes any patent, copyright, formula, process, design, pattern know-how, format or other similar item. Under the Act, firms producing software and similar intellectual property and biotech firms that engineer health-related products and movie production facilities will fall within the expanded definition of manufacturing facility. Under the right circumstances, other manufacturing companies that package or design materials also may qualify if the product relates to intangible property. Additionally, under the Act, ancillary facilities that are located on the same site as a qualifying facility are permitted to be financed with bond proceeds if financing takes place prior to Jan. 1, 2011.
Increased Capacity of Financial Institutions to Acquire 2009 and 2010 Bonds
Of significance to many financial institutions, the Act expands the exceptions to the rules imposed on financial institutions which limit their ability to deduct the interest expense attributable to holding tax-exempt bonds. Under Section 265(b) of the Internal Revenue Code, as amended, financial institutions are generally not allowed to take a deduction for the portion of their overall interest expense that is allocable to the institutions’ ownership of tax-exempt municipal bonds. The amount of interest that is disallowed is an amount which bears the same ratio to such overall interest expense as the taxpayer’s average adjusted bases of tax-exempt obligations acquired after Aug. 7, 1986, bears to the average adjusted basis for all assets of the taxpayer. This is referred to herein as the pro rata interest disallowance rule. As discussed hereafter, the pro rata disallowance rule does not apply to “qualified tax-exempt obligations” also known as bank qualified obligations. Instead only 20 percent of the interest expense allocable to “qualified tax-exempt obligations” is disallowed.
The Act softens the applicability of the pro rata interest disallowance rule on financial institutions holding tax-exempt bonds in two ways. First, it excludes from the operation of Section 265(b) a financial institution’s investment in any tax-exempt bond (whether or not the obligation is bank qualified) as long as the obligation is issued in 2009 and 2010, to the extent that these investments constitute less than 2 percent of the average adjusted basis of all of the assets of the financial institution. Consequently, under the Act, financial institutions holding a de minimis amount of municipal bonds issued in 2009 and 2010 will only be required to treat such obligations as financial preference items subject to the 20 percent allocable interest expense disallowance. If the financial institution holds tax-exempt obligations with a basis in excess of 2 percent of its total assets, the amount in excess will be subject to the pro rata interest disallowance rule.
Secondly, the Act expands the definition of “qualified small issuers.” As stated above, financial institutions are generally not allowed to deduct interest expense attributable to such institution’s ownership of tax-exempt bonds. Notwithstanding this general limitation, bank qualified obligations have been excluded from the operation of the general rule. Under Section 291(e) of the Internal Revenue Code, as amended, however, bank qualified obligations are treated as a financial institution preference item, which results in only 20 percent of the interest expense allocable to owning such to bank qualified obligations being subject to disallowance.
A bank qualified issue consists of public purpose and 501(c)(3) tax-exempt obligations from “qualified small issuers,” which by definition was limited to those governmental issuers (and subordinated entities aggregated with them) that reasonably expected to issue not more than $10 million of qualifying bonds in any given calendar year. Under the Act, the definition of qualified small issuer is expanded to raise the limit to $30 million of qualifying tax-exempt bonds that an issuer can reasonably expect to issue during any calendar year. In order to be within the new definition of “qualified small issuer,” the obligation in question must be a qualifying obligation designated by the issuer in question and be issued during 2009 or 2010. Consequently, the Act substantially expands the universe of issuers that can qualify as a “qualified small issuer” and thereby increases the availability of bonds that can be owned by a financial institution without suffering the effect of the pro rata disallowance rule. Instead, bank qualified obligations issued during 2009 and 2010 are treated as financial institution preference items and thereby are subject only to the 20 percent of the allocable interest expense disallowance.
Finally, the Act softens the impact of the Alternative Minimum Tax (AMT) on private activity bonds. These bonds historically have been subject to AMT which often raised the cost of ownership of such bonds. Interest paid on all private activity bonds issued in 2009 and 2010 is excluded from the AMT, thereby making private activity bonds a potentially more attractive investment.
Tax Credit Bonds
The Act provides evidence House Ways and Means Chairman Rangel’s desire to shift federal governmental support away from the traditional municipal bond structure to one that favors tax credit bonds. Tax credit bonds are a different form of a municipal bond with respect to which a state or local government is responsible for the repayment of the principal of the indebtedness, but the federal government subsidizes the project by providing tax credits at a rate that, theoretically, allows the bonds to be sold without a discount or an interest coupon. The tax credit is included in the federal taxable income of the holders of the bonds as if the tax credit was interest income. The local government is responsible for the repayment of principal and thus benefits from this type of obligation by avoiding the obligation to pay the interest on the debt or at least by greatly reducing its responsibility if an interest component is added to the tax credit obligation to make the obligation saleable.
While tax credit bonds were introduced more than 10 years ago, their acceptance in the marketplace has been limited. Nevertheless, their prominence in the Act gives reason to believe that there is likely to be a gradual shift in the municipal marketplace to reflect greater market acceptance.
Listed below are the various types of state and local projects that are provided subsidies through issuances of federal tax credit bonds under the Act. The amount of the bonds authorized under the Act is indicated below and reflects the growing emergence of tax credit bonds.
School Construction Bonds
$22 billion for school construction
Qualified Zone Academy Bonds
$2.8 billion for school rehabilitation
Clean Renewable Energy Bonds
$1.6 billion for facilities that generate electricity through renewable resources
Recovery Zone Economic Development Bonds
$10 billion for infrastructure, job training education and economic development in federally designated areas
Build America Bonds (Taxable Option)
Unlimited for capital expenditures
Build America Bonds – Tax Credit Equal to 35 Percent of Stated Interest
As reflected above, the Act authorizes an unlimited amount of “Build America Bonds.” These are taxable governmental bonds (private activity bonds will not qualify) for which the federal government agrees to provide a tax credit to the holder in the amount of 35 percent of the interest payable by the issuer with respect to the bond. Essentially, an issuer can elect to have any bond (other than a private activity bond) that would qualify for tax exemption under Section 103 of the Internal Revenue Code be issued as a taxable bond. To qualify for Build America Bond treatment, the issuer must issue the bonds before Jan. 1, 2011, make an irrevocable election at the time of the bond issuance for the debt to be treated as a taxable Build America Bond, and, after providing a reasonably required reserve fund, if any, for such issue, use 100 percent of the available project proceeds for capital expenditures. Basically, the provision requires that all bond proceeds plus investment earnings, less any reserve funded from bond proceeds, are to be used for capital costs net of an amount not to exceed 2 percent of the sale proceeds which may be used to pay issuance costs.
For Build America Bonds issued before Jan. 1, 2011, the local governmental issuer can elect to receive a cash payment equal to the credit the federal government would have otherwise been obligated to allow to the holders of the bonds. In other words, the issuer can elect to receive from the federal government a cash payment of 35 percent of the interest payable with respect to the bonds in lieu of the tax credit. The payment from the federal government is not a lump sum payment to the governmental issuer, but is to be paid when interest payments on the bonds are due. Whether or not the cash payment is elected, the interest paid on the bonds (and the tax credit if allowed to the holder) is taxable for federal income tax purposes.
Private Activity Bonds – Energy Conservation Bonds and Recovery Zone Facility Bonds
The Act further authorizes $2.4 billion of qualified energy conservation bonds and another $15 billion of recovery zone facility bonds. These are bonds authorized to be issued in as traditional private activity exempt facility bonds. The energy conservation bonds are tax-exempt bonds that are designed to reduce greenhouse gas emissions, and the recovery zone facility bonds are tax-exempt bonds that are designed to promote investment in designated economic recovery zones.
Conclusion
The federal government’s support for tax credit bonds is made clear by the amount of tax credit bonds authorized by the Act. Since the Act provides for authorization of tax credit bonds in an amount that exceeds the amount of new exempt facility bonds authorized under the Act (without giving effect to the unlimited amount of Build America Bonds authorized by the Act), it appears that tax credit bonds will receive greater opportunity for acceptance in the marketplace. For a state or local government to access the full subsidy provided by the Act, it will need to be ready and willing to take advantage of tax credit bonds. Notwithstanding the high costs generally attributed to the Act, the bond provisions do not offer great incentives to state and local governments or private entities to start new projects. An educated guess is that the projects most likely to be financed under the Act are public purpose projects in which the federal government ends up absorbing 100 percent of the interest component through tax credit subsidy. Finding buyers for such obligations will be of paramount importance to the state or local government and suggests that bringing financial institutions back to the marketplace for state and local obligations will be particularly meaningful during the next few years.
For more specific information about any of the above types of bonds, simply click on the links provided below to access excerpts from the Joint Committee on Taxation “Description of the America Recovery and Reinvestment Act of 2009,” Jan. 23, 2009 (JCX-10-09) prepared by the staff of the Joint Committee on Taxation which provides a description of the Chairman’s Mark prior to the Senate bill being adopted by Congress. The Chairman’s Mark does not purport to be a description of the Act as adopted.
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