CDFA Spotlight: Breaking Down the New $20 million IDB Capital Expenditure Limitation By Stan Provus

Preface

This article reviews the recent change in the capital expenditure limitation from $10 million to $20 million for qualified small issue bonds (IDBs) for manufacturers. The article examines what the change means and how it works with the $10 million small issue bond limitation and provides case study examples. CDFA would like to thank Bernard S. Davis, Esq., Wolff & Samson, Bob Labes, Squire, Sanders & Dempsey L.L.P., Meegan Lally Spicer, Squire, Sanders & Dempsey L.L.P. and Scott Lilienthal, Hogan & Hartson L.L.P for their assistance in compiling information used in this article, although Stan Provus is solely responsible for its content.

In May of 2006, CDFA’s capital expenditure limitation amendment passed Congress, and was signed by the President. This was a major legislative victory for the organization after nearly two years effort to pass the amendment. Effective December 31, 2006, the capital expenditure limitation is increased from $10 million to $20 million.

The $10 Million Bond Dollar Amount Limitation

The $10 million dollar amount limitation is a separate test from the $20 million capital expenditure limitation. At the election of the issuer (conduit borrower), the principal amount of small issue bonds that may be issued cannot exceed $10 million. For purposes of the $10 million bond limitation, the face amount of the proposed bond issue in question and the face amount of all issued and outstanding prior small issues in the same jurisdiction must be counted. It doesn’t matter when these prior issues were closed so long as there are still bonds outstanding. For the $10M small issue limit, you count any issues that are still outstanding on the date the new bonds are issued, except for bonds being refunded by the new bonds. There is no six-year window like the one explained below for the capital expenditure limitation.

Example

The City of Hot Springs issued a $5 million small issue in 1995 for the Spa Furniture Company, a manufacturer of quality spa furniture. In 1998, Hot Springs also issued a $2 million small issue for the Relax Furniture Company, which is also located in Hot Springs and is a wholly owned subsidiary of the Spa Furniture Company. It is now Jan. 1, 2007, and Spa furniture wishes to issue another $4 million small issue. $3 million and $1 million of the prior issues for Spa Furniture and Relax Furniture, respectively, are still outstanding.

Will Spa Furniture be able to meet the $10 million small issue bond dollar amount limitation? Yes. This is because the prior (outstanding amounts not the original issue amount) and current (proposed $4 million issue) issues are located in the same jurisdiction and total less than $10 million ($3M + $1M + $4M=$8M)

This example also illustrates another Internal Revenue Code (IRC) rule applicable to both the $10 million bond dollar amount limitation and the $20 million capital expenditure limitation. In totaling bond amounts for the $10 million bond limit test and capital expenditures for the $20 million limitation, you must consider outstanding prior bonds ($10 million bond limit test) or capital expenditures (actual amounts during 6-year window explained below) not only by the project owner but all principal users and related parties as well in the same jurisdiction.

A “Principal User” is any person who owns or leases more than 10% of the project. The IRC is somewhat lengthy in defining who is a “Related Person to Principal Users but here are a few examples: a family member (brother, sister, parents, etc.) and a corporation that owns 50% of the stock of another corporation in the same jurisdiction. In our example, Relax Furniture was a wholly owned subsidiary of Spa Furniture so we had to count their outstanding prior issue.

The $20 Million Capital Expenditure Limitation

The $20 million Capital Expenditure limitation, which is effective December 31st of this year, is a separate test from the $10 million bond dollar amount limit as well as other tests like the $40 million nationwide limit. The $20 million capital expenditure limitation says that if the par amount of proposed bonds in the same jurisdiction as well as other capital expenditures (also in the same jurisdiction) may not exceed a $20M capital expenditure limitation. These include capital expenditures that were paid or incurred during a six year period, beginning three years before the date of the proposed new bond issue and ending three years after the date of such proposed new bond issue—the 6-year window.

The capital expenditure limitation applies literally, so you measure capital expenditures only within the six-year period in the same jurisdiction, rather than looking at when prior bonds were issued or if bonds were issued. You do not count prior small issues if they fall outside of the six-year window; however, the actual amount of a prior or future small issue, unlike the outstanding amount that applies to the $10 million bond limit test, that does fall within the six-year window must be counted along with the original amount of all other capital expenditures.

The $20 million capital expenditure limit will be determined by inclusion of not just the proposed issue in the same jurisdiction but also certain other capital expenditures. The following capital expenditures paid or incurred must be tallied, regardless of how they were financed (equity, bank loans, etc.) over the 6-year window:

• All capitalized or capitalizable costs; generally includes improvements or property that can be depreciated.

• Small issues or even Exempt Facility issues that were sold within the 6-year window.

• All borrowings from bank loans for capital expenditures, including the amount of any equity injection.

• The value of property purchased elsewhere and then moved to the project area.

• Capitalized interest and other capitalized soft costs of the proposed or prior bond issues within the 6-year window, including issuance costs.

• A tax-free like-kind exchange of property under Section 1031 of the IRC is a capital expenditure to the extent of the fair market value of property received.

• Principal payments on capital leases.

• Research and development costs and expenses are examples of expenditures that may have to be treated as capital expenditures. For example, R&D costs, including equipment costs, related to the development of products that will be produced at a proposed facility, regardless of where such R&D was carried-out (anywhere, not just in the same jurisdiction) might be treated as a capital expenditure.

• Replacement of property damaged by casualty to the extent it is the fair market value replacement cost;

• Capital expenditures required by a change in federal, state or local law after the date bonds are issued for the proposed project;

• Capital expenditures required by circumstances which could not be reasonably foreseen on the date bonds are issued for the proposed project or arising out of a mistake of law or fact (the aggregate amount of exclusions can not exceed $1 million); and

• Leased personal property, if leased pursuant to a “true lease” and not a “financing lease.”