EXPLAINED: Tax-Free Bonds for Economic Development
- Authored by Executive Director Andrew Hamilton
Tax-Free Bonds for Economic Development
Many of the seminars I have attended on bond financing are so technical that I walk away relatively confused. They are usually given by bond attorneys, investment bankers, or accounting professionals that concentrate on the accuracy of their statements to the point I can hardly understand what they are saying. I have tried to simplify the topic just so I can understand it better. For the professionals that are reading this, please bear with me in trying to simplify a very complex topic.
If a business needed to buy some equipment or construct an addition to their existing plant, they would typically go to the bank and ask them for a business or commercial loan. The bank would loan the company money at a rate above, at, or below their bank’s prime rate.
For example, if the prime rate was 4.00%, the company could borrow at prime plus one or 5.00%. If they are a strong customer, they could borrow at the prime rate or prime minus. However, certain manufacturing companies can qualify for a special type of financing that is called tax-free or tax-exempt financing.
They are described as Industrial Development Bonds or Industrial Revenue Bonds (IRB).
What is Meant by Tax-Free?
When I first think of tax-free financing, I think of donating money to a charitable cause and then deducting that donation from my income to reduce my income tax bill. That is NOT what we are talking about. In this case, it is a little different. The tax-free aspect of bond financing is related to the interest that is paid on the bond. This interest is received as income to the party that buys the bond (Bond Buyer), but that party does not have to pay federal income tax on that interest income.
Let’s take a simple example of an investor buying a taxable instrument, like a Certificate of Deposit (CD) that pays 6.0% interest. I would give the bank one dollar and then at the end of the first year they would pay me six cents in interest. This is the income on which I have to pay federal taxes. If I am in a tax bracket where I have to pay two cents in taxes, the net “after-tax” result to me is four cents or a four percent return.
If I buy a tax-exempt bond that pays a 4% rate, then it is essentially identical to buying a six percent taxable instrument. (Please bear with me simplifying the numbers for illustration). It is more complicated than this, but the concept is the same. So in this process, the “Bond Buyer” is hooked up directly with the “Borrower” and then passes this lower rate through to the Borrower.
What is Eligible for Tax-Free Bonds?
When Congress passed the Federal Tax Code, it felt that certain activities were so important to the welfare of the United States economy that they should be able to receive tax-free income, like airports, mass transit districts, etc. One of these square pegs in a square hole is a manufacturing company that spends less than $20 million.
This type of bond is referred to as an Industrial Revenue Bond or a Manufacturing Bond. Other activities include Not-For-Profit corporations [501(c)3] like hospitals, YMCAs, Boys Clubs, Senior Housing Projects, Senior Housing Projects, Multi-Family, Supportive living facilities, and Solid Waste Disposal Facilities, etc.
The eligibility is determined by the nature of the borrower’s activity. But no matter what the activity, the Federal Tax Code requires that a governmental body act as an “Issuer” on these types of bonds. The issuer is simply a conduit or middleman. They lend their governmental name to the project so it will qualify for financing.
A borrower has several choices of using a local issuer (city or county), a regional issuer (regional development authority like WIEDA), or a statewide issuer (state finance authority). Under the eyes of the Federal Tax Code, the product is identical.
The Issuer doesn’t have a bucket full of money that they loan out. They create an instrument, called a bond, and then this instrument is sold to the Bond Buyer. The bond has the issuer’s name on it, like the WIEDA Bond on behalf of Acme Manufacturing Company. The unit of government lends its name to the private company and this allows the project to qualify for low-interest financing.
What are the Maximums and Minimums?
Concerning maximums, some activities have no limits; others such as manufacturing deals have capital expenditure limits (CAPEX) the bond can not be larger than $1 million and all capital expenditures can not exceed $20 million. Not only do you have to spend less than $20 million in the current year, but you also have to keep it under $20 million for the next three years forward and three years back.
So for six years, you cannot spend more than $20 million on that parcel of soil. It doesn’t matter if you borrow money to spend or spend your equity. If you spend one penny more than $20 million, the entire transaction converts RETROACTIVELY to taxable. I don’t know exactly what happens, but they tell me bad things occur. (i.e., the tax-exempt income converts to taxable retroactive back to the beginning of the bond term).
Concerning the minimums, I have seen the minimum size settle around $1.5 million. It just costs more to do a bond than it does to go and borrow money on a conventional loan from a bank. The way I like to put it is whether you have a one million dollar deal or a ten million dollar deal, you still have to pay an attorney to draft three hundred pages of documents. Generally, up to 2% of these closing costs can be part of the bond.
Although it costs more upfront to do a bond, these costs are soon recaptured by the lower rate of interest. For example, if you take that lump sum of closing costs and divide it by 25-30 years, you get a smaller number. Then if you divide it by the size of the bond you get an even lower number. It adds a minuscule increase to the effective interest rate, which is generally two to three percent lower than a conventional taxable loan.
This is easy for me to say because I’m not the borrower paying those fees, but the reality is that those additional costs will likely be absorbed in the first year.
What is the “Hassle” Factor?
Unlike many governmental programs, this process is “timetable friendly”. The first step in the process is for the Issuer to pass preliminary approval or a Preliminary Inducement Resolution. The date of that resolution is in granite. All costs incurred after that date can be refunded with the bond proceeds and generally all costs before it cannot. There is, however, a sixty-day “look-back” provision. Any monies spent on the project before the sixty days of the preliminary Inducement Resolution can be folded into the bond. This allows the project to move forward on its timetable. As long as the early resolution is passed, the company can get interim or construction financing and close on the bonds two or three months later.
Once the bonds close, then the bond proceeds can “take out” the interim loan and reimburse the company for any of the eligible equity they spent on the project that the bank allows them to be reimbursed for.
What Exactly is Volume Cap?
Whenever you look at tax-free bond financing for a private company, you need to understand a mysterious, mystical, magical thing called VolumeCap (CAP). Volume Cap is measured in dollars but is not real money. It is an allocation of “tax exemptions” that is given to a governmental unit that can then allocate it to a private company.
When Congress passed the federal tax code, they felt it was appropriate for a governmental body to issue tax-exempt bonds for private (for profit) companies, but Congress set a limit on the total dollar amount of these types of bonds that can be issued in a calendar year. The amount in 2017 is equal to $100 per inhabitant of the state. The State of Illinois distributes this allocation to big cities, small cities, and state agencies. Allocation of the CAP is very competitive with generally more requests for CAP than what is available.
A state agency (regional or statewide) is eligible to request allotment of CAP from a $234 million separate state agency pool in January of each calendar year. There are two other allocation rounds available to an agency in June and July of each calendar year. If the Issuer is a smaller municipality (under 25,000 in population) like a city or village, they have a separate $234 million pool called the non-home rule pool. This pool is also competitive and historically has been oversubscribed. A small city requesting the non-home rule pool will receive a formula allocation pro-rata allotment.
For example, if $468 million is requested, then each city would get 50% of what they asked for and be required to close in 60 days. If they fail to close in 60 days, the allotment goes back to the State, which draws names out of a hat to fulfill the requests. You may have a good project but may not have the luck of the draw.
Larger cities (25,000 or over in population or voted home rule) receive a direct allotment available in January of $100 per their population as of the U. S. Census. For example, a home rule city with a population of 25,000 has an allocation of $2,500,000 in 2017. This means they can issue one bond for up to this amount. If the project they are helping is larger, (i.e., $3,000,000) the city needs to obtain $500,000 of CAP from somewhere else to close. They can ask for an allotment from the Governor’s Office in June of each calendar year or they can ask a neighboring home rule city to transfer or “cede” their allotment.
The larger cities must obligate their cap by May of each year or it is automatically transferred back to the State. Half of each dollar returned is available for State agencies and the other half is available to other larger cities.
In any case, whoever is the issuer (city, regional, or State) needs an allotment of volume cap for the project to qualify as tax-exempt.
More details on the authority’s services please contact Andrew Hamilton at 866-325-7525 or visit www.wieda.com.