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CDFA Spotlight:
State Income Tax Exemption/Bank Qualification
By Stan Provus |
Preview
In this article Kurt Froehlich writes about “state income tax exemption and bank qualified bonds” and the related interest rate savings to banks. Banks sometimes purchase qualified small issue bonds even though they are not bank qualified. In direct purchase, private-placement transactions, Kurt’s analysis suggests, in one example, that a bank should generally charge about 1% (i.e. 100 basis points) more for bonds that are not bank qualified in contrast to those that are. However, bank qualification is worth only about 15-20 basis points when bonds are underwritten and sold in the public markets. This difference makes sense because most non-bank public buyers could not take advantage of the carrying charge deduction. Kurt is a long time CDFA member and partner in the law firm of Evans, Froehlich, Beth & Chamley, Champaign, Illinois. He is a member of the Tax-Exempt Financing Committee of the American Bar Association and of the National Association of Bond Lawyers. He concentrates in the area of public and municipal finance, generally as bond counsel and underwriter’s counsel.
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Introduction
Not all issuers can issue so-called “bank qualified bonds.” Subject to certain exceptions, those issuers would be those which in the applicable calendar year would not reasonably anticipate issuing more than $10,000,000 of tax-exempt obligations (including only non-private activity bonds (i.e. governmental bonds) and qualified 501(c)(3) bonds, but excluding all other types of private activity bonds). The common reference to this is that such bonds would be “bank qualified”, since banks and other financial institutions derive a larger deduction for interest purchase and carrying costs than would otherwise apply. (Because of the odd term, bank qualified, some banks even mistakenly believe that they cannot purchase and hold non-bank qualified bonds. It is just an interest rate question).
In structuring transactions circumstances may arise where the $10,000,000 limit is or may be exceeded such that bonds may not constitute “qualified tax-exempt obligations” under Section 265(b)(3) of the Internal Revenue Code of 1986, as amended (the “Code”). Because larger issuing finance agencies typically issue significant amounts of qualified 501(c)(3) bonds for, among other purposes, health care and educational facilities, such agencies usually do not issue bank qualified bonds, but often can offer, in addition to the federal exclusion from gross income of the interest on the bonds, a State income tax exemption, as a particular State’s law may allow. And in cases where a local issuer may be unable to issue bank qualified obligations (perhaps late in a year when it is at or near its own $10,000,000 limit or otherwise is not qualified), that local issuer might consider issuing tax-exempt or taxable obligations purchased by a State issuing agency and derive a pass-through State tax exemption benefit for the interest on the issue where, because State law would not otherwise allow a State exemption, it otherwise might not have this benefit. And in the rare case where such a State agency might have bank qualification capacity (i.e., late in a year when it has issued no governmental or qualified 501(c)(3) bonds), the local issuer might have bank qualified and State exemption benefits together for an issue. The term “double exempt” often is used in this connection. Of course this is in addition to the federal exclusion from gross income of the interest on the bonds.
Concern. The concern with State exempt v. bank qualified bonds is: Which is or may be actually better? [Of course, the double exempt is often best of both worlds and the decision in most cases is then easy.]
State Exemption. Since the value of the State tax exemption depends on the interest rate and the applicable State income tax rate, which varies from State to State, this can be perhaps more easily illustrated by an example:
$5,000 bond at 6%.
The annual interest on a $5,000 bond at 6% is $300.00. Using Illinois as an example, the individual income tax rate is 3%. Then, 3% of $300.00 is $9.00. The value of the State tax exemption on this $5,000 / 6% bond is:
$9.00 / $5,000.00 = 0.0018.
This decimal is sometimes referred to as 18 “basis points.”*
* Each one percent of a rate is 100 basis points. This term is used to avoid confusion in using rates. For example, if someone said a 6% bond has increased one percent due to market conditions, that could mean it is now (i) a 7% equivalent (a 100-basis point increase) or (ii) 6.06% (1.01 x 6 = 6.06, a 6-basis point increase) or (iii) is worth $5,050.
Bank Qualification. Bank qualification means that a bank (or other financial institution) can deduct almost all of its interest costs in the purchase and carry of the particular tax-exempt bond. Under present law such a financial institution is denied a deduction for 20% of such purchase and carry costs in any event. In many cases that bank could lose the other 80% as well. For bonds to be so-called “bank qualified” the general rule is that:
- The bonds must be governmental bonds or qualified 501(c)(3) bonds and must be specifically designated by the issuer for purposes of this exception.
- During the calendar year of the issue of the bonds, the issuer must not reasonably anticipate issuing governmental and qualified 501(c)(3) bonds in excess of $10 million. Not more than $10 million of obligations may be designated by an issuer for purposes of this special exception during any calendar year. For purposes of this $10 million exception, an issuer and all subordinate entities are treated as one issuer.
Since the value of bank qualification depends on the deduction related to a bank’s interest costs, this can be perhaps more easily illustrated by an example:
$5,000 bond at 6% with bank average purchase and carrying costs of 4%.
A $5,000 bond with a 4% purchase and carrying costs has $200.00 (.04 x $5,000) of such costs. Since in all cases 20% is disallowed, look at the consequences of the remaining 80%:
80% x $200.00 = $160.00.
The bank would be denied a deduction in its federal income taxes for that $160.00. A bank in a 34% tax bracket (typical for a bank that would generally consider a tax-exempt bond purchase) would lose:
34% x $160.00 = $54.40. For such a bank, the value of bank qualification is:
$54.40 / $5,000.00 = 0.01088.
This decimal is 108.8 basis points. [This is the reason local banks seldom purchase industrial development revenue bonds for manufacturing facilities and other non-501(c)(3) private activity bonds. A bank or other financial institution expecting a 6% bond would have to have 7.088% to have the same yield after allowing for the initial deduction disallowance. Notwithstanding non-bank qualification some banks do in fact purchase these types of bonds, either totally or partially absorbing the cost of the loss of the purchase and/or carry deduction.]
This is a general summary of the bank qualification effects of a bond sold to a bank or other financial institution. The above effects can be pro-rata adjusted based on a bank’s actual costs of purchase and carry. The general experience with underwritten transactions involving non-bank qualified publicly sold issues is a little different and cannot be mathematically determined as clearly as in the above example. Experiences observing transactions and conversations with underwriters and placement agents and the review of generally available municipal offering summaries suggests that the real open market effect of underwritten and placed transactions is that bank qualification generally appears to be in a 10-20 basis point range (15 basis points would be typical).
Comparison. The raw numbers in the above examples show that: (i) the State income tax exemption is worth about 18 basis points where the State income tax rate is 3% (36 basis points if a 6% tax rate, etc.); (ii) the raw calculation for bank qualification is 108.8 basis points with 4% purchase/carry costs; and (iii) the general public sale effect of bank qualification is 15 basis points.
Also note that non-bank qualification might limit marketing opportunities generally to taxpayers who or which are not financial institutions, perhaps substantially reducing marketing and remarketing opportunities. The general value in the realistic and general application of bank qualification is about 15 basis points.
CONCLUSION. A local issuer should examine very critically any proposed transaction in which it would not use its available bank qualification capability in favor of an applicable State income tax exemption. Where a State-level issue and a local issue would be required for the State income tax deduction advantage, there would be in most cases the additional transaction costs of multiple issues and the loss of at least 15 basis points that otherwise would be available from a local issuer taking advantage of its own bank qualification capacity. Of course, the double exempt is the best of both worlds. Even this still needs a hard look (especially with a smaller local issue and a low State income tax rate) to make sure double issuance costs don’t offset the State tax exemption. As in so many public finance matters, nothing is categoric or absolutely clear, until examination of the real numbers.
This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.