By Jodie Zesbaugh, Senior Municipal Advisor
and Nick Anhut, Senior Municipal Advisor

Evaluating Taxable & Tax-Exempt Borrowing Options

Perhaps it is no secret to our readers, but the federal government provides state and local governments the privilege of issuing tax-exempt debt to finance the projects that deliver generational benefits to their communities.  As an added bonus, some states and municipalities follow suit for tax-exempt debt of resident issuers (so-called “double” and “triple” tax-exempt).   Tax-exempt status for any debt issue can be attractive for issuers and investors alike. Here’s why: The purchasers of the debt enjoy tax-free income.  And since investors are typically most interested in their after-tax rate of return, the borrowing costs for tax-exempt debt are justifiably lower than comparable taxable obligations.

When you see the words “tax-exempt,” think of it as a tacit subsidy from the U.S. government, which ultimately reduces tax revenue flowing into federal coffers.  As you might imagine, the Internal Revenue Service has a keen interest in limiting the amount of tax-exempt debt outstanding, so has established rules to make sure the privilege is only enjoyed when the proceeds of tax-exempt bonds are generally used for a public purpose and not for private benefit.

When issuers develop financing plans, they most often collaborate with their bond counsel to undertake diligence that supports a legal opinion as to whether the proposed issue meets federal tax code rules to be deemed a tax-exempt obligation. The basis of that opinion stems from analysis of the proposed issue’s facts and circumstances against a two-pronged test under the tax code.  The two prongs of the test focus on  “private use” and “private pay.”  While the test is nuanced relative to tax code language, it generally examines whether the proceeds of the bonds benefit a private party or if they are directly or indirectly secured by payment from a private entity.  Ironically, this is a test the issuer wants to fail!  Pass both prongs and the bonds will be considered taxable obligations.  In some cases, passing just one prong may preserve the tax-exempt status of the bonds, while in others, the issuer can still enjoy tax-exempt status if there is a “de minimis” (10% or less) amount of private use and/or private payment. It’s complex and just one of the many reasons engaging  your municipal advisor and bond counsel early in the process is so important.

So, we know that issuing tax-exempt debt is less expensive than its taxable counterpart, but we also know doing so comes with specific restrictions that may disqualify a borrower from doing so.  Are there compelling reasons to issue taxable obligations? The short answer is yes; there are several examples we frequently encounter with our clients.

First, local units of government finance various facilities that may lend themselves to private entanglements.  For example, a school district may construct or acquire a facility and lease a portion of the space to a tenant or make certain spaces available for rent.  Or a district acquires a facility with existing tenants whose lease terms extend beyond the acquisition date.  Depending on the proportion of private use of the property, the debt used to finance construction or acquisition may be declared taxable.  In some cases, these private payments may reduce or eliminate the need to levy taxes to support debt repayment.  It’s important to note that the latter situation may only be temporary if a larger proportion of the facility becomes occupied by the district for public use over time, potentially creating an opportunity to transition to tax-exempt debt (more on this later).

Issuers may also enter into management agreements or offer naming rights for their facilities.  While a management agreement can be crafted in a way to allow for tax-exempt financing, it could also be structured to transfer certain risks from the owner (the public entity) to the manager, which can result in any debt associated with that facility to be deemed taxable.  The higher cost of the taxable debt is the cost of risk transfer, which an issuer may be willing to bear for economic reasons.  A similar concept can apply to naming rights for spaces like athletic fields.  The payment(s) associated with naming rights might equal or even overcome the higher costs related to taxable financing, delivering a net benefit to the issuer.

Second, economic development is a primary focus for many local units of government.  Participation in (re)development projects takes many forms and often includes contractual agreements with private parties.  These contracts may include provisions to protect and secure the position of the public entity that may issue debt as a means of funding certain parts of a project.  How the bond proceeds are spent, and any guarantees made by the private party in the form of minimum assessed value or property tax payments may constitute private payment.  Private use and private payment would likely result in the issuer’s debt being taxable.  However, the security of the minimum taxable value or tax payment can be an important risk mitigation tool for the issuer, reducing or even eliminating concerns about issuing taxable bonds.

Property (primarily real estate) acquisition is another example where taxable debt may be an issuer’s best bet.  Much like the IRS’ interest in avoiding subsidizing private use and private payment with tax-exempt debt, it also wants to eliminate situations where state and local governments issue tax-exempt obligations to purchase property and subsequently sell it for a profit.  If an issuer wants the ability to dispose of real estate it acquired with bond proceeds at a price higher than it paid, it can preserve that option by issuing taxable debt.  However, in this scenario, issuers may want to consider using interim or short-term financing to minimize the cost of taxable debt.

Finally, when an issuer is considering a multi-series financing plan over several years, taxable debt may prove to be key component.  For example, many borrowers sell tax-exempt bonds over more than a single calendar year so each issue can achieve “bank qualified” status, typically benefiting from slightly lower interest cost than non-bank qualified debt.  An issuer might sell a taxable obligation among two other series of bank qualified bonds issued closely over consecutive years to lock in a lower cost of capital and avoid undue interest rate risk by waiting another calendar year to complete a subsequent tranche of financing.

It’s important to note that even when taxable debt is issued, governmental entities can include certain provisions in their original bond documents to transition to tax-exempt financing should circumstances change.  For example, an issuer may include language that adjusts the rate on the debt if the factors that lead to the taxable nature of the bonds are abated.  Similarly, an issuer could draft favorable pre-payment language that allows for a tax-exempt refinancing, thereby reducing the cost of capital.  It’s common for municipalities to acquire property that has current tenants with leases that expire after the acquisition of the property.  Once those leases term out, the issuer should pivot to tax-exempt financing as quickly as possible.

Despite benefits of lower repayment costs for tax-exempt debt, governmental entities should know there are situations where taxable debt may be the more preferable option.  It’s important to carefully weigh the benefits and costs, both quantitative and qualitative, associated with both before you move forward with any financing plan. And it’s imperative to seek advice from bond counsel and municipal advisors early in the process to achieve the outcomes you desire.

Important Disclosures:

Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an SEC registered investment adviser; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.

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