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Is Tax Exempt Debt Going the Way of the Dinosaur Presented by: Jim Ginty Senior Managing Consultant

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Title: Is Tax Exempt Debt Going the Way of the Dinosaur Presented by: Jim Ginty Senior Managing Consultant


1
Is Tax Exempt DebtGoing the Way of the Dinosaur
?Presented byJim GintySenior Managing
ConsultantPublic Financial Management215-557-146
0
Public Financial ManagementTwo Logan Square,
Suite 160018th Arch StreetsPhiladelphia, PA
19103-2770215 567-6100215 567-4180 fax
2
Table of Contents
  • Overview of Joint Committee on Taxation Proposal
  • Summary of Proposals that affect Municipal
    Issuers
  • What you can do

3
Overview
  • On January 27, 2005, the Staff of the Joint
    Committee on Taxation (JTC) released a report
    entitled "Options to Improve Tax Compliance and
    Reform Tax Expenditures."
  • The report contains approximately 170 proposals
    to raise revenues by changes in federal tax laws
  • This includes 6 proposed changes to Section 103
    governing tax-exempt bonds
  • Central arguments made by the staff to justify
    these changes are
  • Issuance of tax-exempt bonds is a Federal subsidy
  • Proposed changes halt Feds perception of misuse
    of subsidy
  • Decreased volume of tax-exempt debt will lead to
    lower costs

Source Bond Buyer February 8, 2005
4
Overview
  • Proposals would have serious negative effects on
    the issuers of tax-exempt bonds
  • Reduce incentive of corporations and insurance
    companies to buy municipal bonds
  • Increase borrowing cost to State and Local
    Governments in issuing tax-exempt bonds
  • Decrease demand for tax-exempt bonds
  • Eliminate advance refunding
  • Increase administrative burden on State Local
    Government
  • Reporting requirements
  • Proposals submitted by the JCT affecting
    Tax-Exempt Issuers Include
  • Disallow Deduction for Interest on Indebtedness
    Allocable to Tax-Exempt Obligations
  • Disallow Deduction for Interest on Indebtedness
    Allocable to Tax-Exempt Income of Insurance
    Companies
  • Impose Loan and Redemption Requirements on Pooled
    Loan Financing Bonds
  • Amend Information Requirements to Include
    Interest on Tax-Exempt Bonds
  • Clarify Limitations on Indian Tribes Use of
    Tax-Exempt Bond Proceeds
  • Eliminate Private Payment Test for Stadium Bonds
  • Allocation of Volume Cap to Mortgage Credit
    Certificates
  • Eliminate Advance Refunding of Governmental Bonds
    and 501( c ) (3) Bonds

5
Disallow Deduction for Interest on Indebtedness
Allocable to Tax-Exempt Obligations
Reduce Corporate demand for municipal securities
by changing allowable deduction formula
  • Currently, interest deduction allowance rules
    vary among different types of buyers of
    tax-exempt bonds
  • Banks and Securities Firms
  • Lose a portion of their interest expense
    deduction for every dollar of tax-exempt interest
    earned
  • Small Issuer Exception (under 10 million issued
    per year)
  • Banks may purchase bonds issued by entities who
    borrow less than 10 million per year in
    tax-exempt municipal bonds without penalty (Bank
    Qualified)
  • Corporations
  • Subjected to Tracing Rule or 2 de minimis Rule
    (Safe Harbor to Tracing Rule)
  • Must demonstrate tax-exempt holdings are not
    tied to borrowing in order to claim the interest
    tax free (difficult to enforce, easy to avoid)
  • As long as a corporations tax-exempt bond
    portfolio does not exceed 2 percent of its total
    assets, in general the IRS will not inquire if
    borrowings were incurred to purchase municipals

6
Disallow Deduction for Interest on Indebtedness
Allocable to Tax-Exempt Obligations
  • Financial corporations and dealers
  • Subject to Pro-rata Rule
  • Generally denied a deduction for that portion of
    its interest expense that equals the ratio of the
    average adjusted basis of tax exempt obligations
    acquired after August 7, 1986 to the average
    adjusted basis of all the taxpayers assets
  • debt/capitalization ratio
  • Small Issuer Exception does not apply
  • Instead only 20 of the interest allocable to the
    tax-exempt obligations of a small issuer is
    disallowed
  • Rule does not apply to dealers
  • JCT Proposal
  • Repeal Both the 2- percent de minimus Rule and
    Tracing rule
  • Apply the pro-rata interest expense disallowance
    applicable to broker- dealers and financial
    institutions to ALL corporations (would not
    affect Banks and Securities Firms)
  • Small issuer exemption for disallowance would NOT
    be available to other corporations
  • JCT Argument
  • Tracing Rule difficult to administer and easy to
    avoid
  • 2 percent de minimus rule provides opportunities
    for tax arbitrage
  • NO burden of proof that corporations are engaging
    in abusive arbitrage transactions

7
Disallow Deduction for Interest on Indebtedness
Allocable to Tax-Exempt Obligations
  • Effects on Corporate Investment Decisions
  • Increase compliance burden
  • Force corporations to engage in annual
    calculations of the proportion of their assets
    represented by exempt obligations
  • Discourage some corporations to buy municipal
    bonds (hassle factor, increased costs)
  • Would change allowable deduction percentage
    formula
  • Effectively change the breakeven
    tax-exempt/taxable yield ratio
  • currently 65 (1-tax rate) assuming tax rate of
    35
  • New break-even ratio a function of corporations
    debt to total capitalization
  • The higher the debt/capitalization ratio, the
    higher the break-even yield ratio
  • If 10 debt/capitalization break-even yield at
    68.5 1-(.35(1-.10))
  • If 30 debt/capitalization break-even yield at
    75.5 1-(.35(1-.30))

8
Disallow Deduction for Interest on Indebtedness
Allocable to Tax-Exempt Income of Insurance
Companies
Could further limit the demand for tax-exempt
bonds thereby increasing costs to issuers
  • Property and Casualty insurance companies
  • Large Institutional Investors of municipal bonds
  • 246 billion in municipal holdings (12
    outstanding municipal securities )
  • Tend to buy long term fixed rate municipal bonds
    (20-year range)
  • Currently PCs are permitted a deduction for
    contributions to loss reserves
  • However, this reduction is reduced by 15 of
    proration income
  • 15 deduction reduction is effectively a tax on
    tax-exempt interest earnings
  • JCT proposal seeks to eliminate 15 reduction and
    apply pro-rata rule to PCs
  • Changes could create a disincentive for PCs to
    invest in municipal bonds

9
Impose Loan and Redemption Requirements on Pooled
Financing Bonds
This proposal could increase cost of pooled loan
programs for pooled loan program borrowers and
issuers
  • Current Qualifications for Tax- Exempt Status
  • 95 of net proceeds must be lent to ultimate
    borrowers within 3-years of issue
  • Proposed New Requirements
  • Written loan commitment requirement to restrict
    the  issuance of pooled bonds where potential
    borrowers have not been identified ('blind
    pools')."
  • Prior  to the issuance of tax-exempt bonds, the
    issuer must have written loan commitments for a
    minimum of 50 of the net bond proceeds
    (commitments would be binding)
  • In order for a loan commitment to qualify, all
    three requirements must be met
  • (i) the issuer must commit to lend proceeds to
    the identified borrower
  • (ii) the borrower must apply for and agree to
    execute a loan for a specific amount to finance a
    specifically identified project and
  • (iii) the borrower must pay a "nonrefundable
    commitment fee in an amount commensurate with
    fees customarily paid for similar loan
    commitments." 

10
Impose Loan and Redemption Requirements on Pooled
Financing Bonds
  • Additional requirement that at least 50 will be
    lent within one year
  • Redemption Provision
  • Effectively create spend down test on bond
    proceeds
  • If after 1 year less than 50 of proceeds issued,
    difference used to redeem bonds (i.e., 45
    issued to borrowers, 5 must be used to redeem
    bonds)
  • If after 3 years less than 95 of proceeds
    issued, difference used to redeem bonds (i.e.,
    85 issued to borrowers, 10 used to redeem)
  • New Requirements could most likely
  • Preclude smaller issuers from participating due
    to binding loan agreement
  • Increase cost of borrowing through establishment
    of non-refundable commitment fee
  • Force issuers to limit size of pools through
    compliance of Spend Down Test
  • Lead to an increase in frequency of pooled
    borrowings
  • Lead to increased transaction costs
  • Increase in borrowing costs as flexibility of
    programs is decreased

11
Require Reporting of Payment of Tax Exempt
Interest
Increase administrative cost to issuer,
effectively increasing cost of issuing tax-exempt
debt 
  • Except for the issuers of tax-exempt bonds, all
    payers and payees of interest must report the 
    payment of such interest to the Internal Revenue
    Service on an annual basis.
  • This proposal would require the issuers of
    tax-exempt bonds to report the name, address and
    taxpayer identification number of the person(s)
    to whom interest is paid. The staff included two
    options 
  • Option 1
  • issuers would be required to report information
    on an annual basis.
  • Option 2
  • the issuer would be required to produce payee
    information upon request.
  • Issuers would be allowed to satisfy the
    requirement by contracting through a third party
    to maintain and produce the information. 
  • Produces no revenue to Federal Government, while
    driving up costs to issuers

12
Clarify Limitations on Indian Tribes' Use of Tax
Exempt Bond Proceeds
Proposal seeks to limit amount of tax-exempt
bonds available to Indian Tribes for
non-essential purposes
  • Currently, Indian tribes can only issue
    tax-exempt bonds for "essential governmental
    functions or certain manufacturing facilities."
  • Fewer limitations exist upon financings in which
    the Indian tribe is a conduit borrower
  • Allows Indian tribes to finance casinos with
    tax-exempt bond proceeds
  • The report suggests broadening the restrictions
    that apply to Indian Tribes as a conduit borrower
    not just the direct issuer
  • Limit further use of tax-exempt proceeds in the
    financing of casinos 

13
Eliminate Private Payment Test for Stadium Bonds
Reduce Issuances of tax-exempt debt used to
finance professional sport facilities
  • Under existing regulations, for a bond to be
    deemed a private activity bond, the bond must
    pass a two prong test
  • (i) more than 10 percent of the proceeds "are to
    be used in the trade or business of any person
    other than a governmental unit ('private business
    use test')" and
  • (ii) more than 10 of the debt service is,
    "directly or indirectly, secured by
  • (a) property used or to be used for a private
    business use or
  • (b) to be derived from payments in respect of
    property, or borrowed money, used or to be used
    for a private business use ('private payment
    test').
  • Creative financing structures have allowed
    tax-exempt bonds to fail these tests
  • qualified private activity bonds
  • The proposal would eliminate the private payment
    test for determination of private activity bond
    status for any bond issued to finance a
    "professional sports facility."
  • Ensure that all bonds would be classified as
    Private Activity Bonds

14
Allocation of Volume Cap to Mortgage Credit
Certificates
Reduce Issuances of Mortgage Revenue Bonds, by
including Mortgage Credit Certificates against
States volume Cap
  • Currently "qualified mortgage bonds" are included
    as "qualified private activity bonds" under a
    state's volume cap restriction
  • Qualified Mortgage Revenue Bonds (MRBs) offer
    below market mortgages to qualified homebuyers
  • Mortgage Credit Certificates (MCCs) offer
    qualified buyers an annual income tax credit
  • Subsidize cost of conventional mortgages
  • The proposal would require states to allocate a
    specific portion of its private activity volume
    cap to mortgage credit certificates MCCs based
    upon a prescribed ratio to the allocation of
    private activity volume cap to qualified mortgage
    bonds.
  • Reduce Housing Financing Authority (HFA)
    flexibility to apply MCC program most efficiently
  • Would reduce funds available to help defray cost
    of providing housing assistance
  • MRBs provide funds to HFAs through spread
    between borrowing cost and mortgage rate

15
Eliminate Advance Refunding of Governmental and
501(c)(3) Bonds
This proposal would effectively eliminate the
issuance of tax-exempt bonds for any advance
refunding purposes and reduce amount of
tax-exempt bonds outstanding
  • Prohibit Issuers from maximizing refinancing
    opportunities in favorable rate environments
  • Prohibit Issuers from eliminating burdensome
    Indentures in most efficient manner
  • Would eliminate a powerful management tool used
    to minimize borrowing costs
  • Reduce subsidy of Call features, or early
    redemption provision, built into borrowing rate
  • Typically a 10year call feature plus a
    redemption premium of 0-2
  • In a typical 30-year amortization, maturities
    10-30 may be called after 10 years
  • Advance Refunding Bonds
  • Issued to refund bonds GREATER than 90 days in
    advance of refunded bonds call date
  • Allow issuers ability to get to, or refinance a
    larger portion of outstanding debt
  • Current law allows callable bonds ONE Advance
    Refunding
  • Limits number of bonds outstanding per project to
    two (until call date)
  • Current Refunding Bonds
  • Issued to refund bonds that have call dates of 90
    days or LESS
  • Fed imposes NO limit on amount of current
    refundings

16
Eliminate Advance Refunding of Governmental and
501(c)(3) Bonds
  • Advance Refunding Bonds
  • Issued to refund bonds GREATER than 90 days in
    advance of refunded bonds call date
  • Allow issuers ability to get to, or refinance a
    larger portion of outstanding debt
  • Current law allows callable bonds ONE Advance
    Refunding
  • Limits number of bonds outstanding per project to
    two (until call date)
  • Current Refunding Bonds
  • Issued to refund bonds that have call dates of 90
    days or LESS
  • Fed imposes NO limit on amount of current
    refundings
  • Effectively only one series of bond outstanding
    per project

17
Options/Alternatives to Advance Refundings
IF Advance Refundings are eliminated, Issuers Do
Have Options (although limited)
  • Issue Bonds with shorter call features (5-7 year
    call features versus 10-year)
  • Allow issuers to current refund bonds earlier
    versus standard 10-year call option
  • Increase cost of borrowing by 5 -10 basis points
  • Dramatically increase yield to maturity kicker
    on premium callable bonds
  • Alternative Refunding Strategies
  • Effectively lock in current market rates for
    future refunding opportunities (within 90 days of
    call date),
  • Forward Delivery Bonds
  • Forward Starting Swaps
  • Forward Starting Swaptions

18
What Can you Do About the JCT Proposals
Act NowThese proposals have legs
  • Identify proposals that affect your business and
    assess financial impact of these proposals
  • Full report available online at
  • www.house.gov/jct/s-2-05 pdf
  • Submit your thoughts formally through MDGFOA
  • Formal responses to Report have been submitted to
    Senate Finance Committee by
  • GFOA (as part of coalition of 14 other public
    finance associations)-available on GFOA website
  • The Bond Market Association (TBMA)-available on
    TBMA website
  • Write to the Senate Finance Committee
  • The Honorable Charles Grassley The Honorable Max
    Baucus
  • Chairman Ranking Member
  • Committee on Finance Committee on Finance
  • United States Senate United States Senate
  • Washington, DC 20510 Washington, DC 20510
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