The American Recovery and Reinvestment Act of 2009: Impact on Tax-Exempts

The American Recovery and Reinvestment Act of 2009 (the “Act”) was signed into law by President Obama on February 17, 2009, and components of the Act should prove to create a much needed beneficial impact, namely lower borrowing costs, on a tax-exempt bond landscape plagued by the ongoing credit and liquidity crises. Borrower costs on tax-exempt bonds are lower because the interest on such bonds are exempt from federal income tax, and in many cases state and local taxes. Tax-exempt bonds have traditionally been utilized by both governmental and non-governmental entities to finance various public and quasi-public projects including economic development, education, housing, infrastructure, renewable energy, and transportation. While the Act should have a profound impact on strained state and local government operations, the focus of this article will be its effect on the tax-exempt financings of non-governmental or conduit borrowers.

Financial Institutions – Deductibility of Interest on Tax-Exempt Bonds

Section 265(b) of the Internal Revenue Code of 1986, as amended (the “Code”) currently disallows financial institutions a deduction for interest expense incurred to purchase or carry an inventory of tax-exempt bonds. The Code excepts from this general rule “qualified tax-exempt obligations” or “bank-qualified bonds” which are designated tax-exempt bonds and issued by a “qualified small issuer.” “Bank-qualified bonds” are more attractive to purchasers because of a financial institution’s ability to deduct such bond’s interest expense, and they are thus willing to offer a lower rate of interest on such bonds, ultimately resulting in lower borrowing costs to issuers and conduit borrowers of “bank-qualified bonds.” A “qualified small issuer” until recently has been defined, with respect to tax-exempt bonds issued during any calendar year, as an issuer who issues no more than $10 million of tax-exempt bonds during the calendar year. For the years 2009 and 2010, the Act redefines a “qualified small issuer” as an issuer issuing no more than $30 million of tax-exempt bonds. Consequently, larger sized projects can be undertaken and benefit from this expansion. Any interest savings realized by issuers as a result of this expanded ability to issue bank-qualified debt will necessarily pass through to benefit their conduit borrowers.

Additionally, the Act creates a temporary 2% safe harbor (up to 2% of a financial institution’s assets) permitting financial institutions to purchase tax-exempt bonds in 2009 and 2010 without the corresponding interest expense disallowance under Section 265(b) of the Code. Previously this safe harbor applied solely to corporations. This safe harbor is in addition to the exception from the interest expense disallowance under the “qualified small issuer” provision described above. Thus, the 2% safe harbor will also likely result in lower borrowing costs to issuers and their respective conduit borrowers since the financial institutions will likely offer a lower interest rate.

The Act also treats 501(c)(3) entities and governmental conduit borrowers as separate issuers for purposes of the bank-qualification requirements, and therefore if they are participating in a pooled, composite or conduit borrowing they are not aggregated with other conduit borrowers. Based upon the foregoing, the Act would now enable a non-profit school conduit borrower participating in a pool of non-profit school borrowers, to lower its borrowing costs since it will not be aggregated with other non-profit conduit borrowers in a pooled context, as such transactions will more likely qualify for the “qualified small issuer” exception described earlier.

Temporary Repeal of AMT for Private Activity Bonds

Currently, individuals and corporations must account for the interest from private activity bonds which is excluded from gross income for federal income tax purposes when computing their alternative minimum tax (the “AMT”). A bond is a private activity bond if, with certain exceptions, more than 10% of the proceeds of the issue are used for any private business use and the payment of the principal of or interest on more than 10% of the proceeds of such issue is secured by or payable from property used for a private business use. A bond also is a private activity bond if, with certain exceptions, the amount of proceeds of the issue used to make loans to non-governmental borrowers exceeds the lesser of 5% of the proceeds or $5 million. Typically, interest on private activity bonds is not excluded from gross income for federal income tax purposes unless the bonds fall within certain defined categories under the Code. The Act temporarily repeals the AMT for private activity bonds, the interest on which is excluded from gross income for federal income tax purposes, issued in 2009 and 2010, thus interest on such bonds are no longer treated as a preference item for purposes of the AMT, and is also not included in the current earnings adjustment under the corporate AMT. The effect of this measure will be that borrowing costs associated with these types of private activity bonds will reduced for issuers of such bonds, and such savings will necessarily be realized by their conduit borrowers.

High Speed Rail Bonds

The Act also provides a modification of the current law as it relates to high speed intercity rail facility tax-exempt bonds. Previously such tax-exempt private activity bonds could only be issued for such facilities where the vehicles utilizing such facilities operated at speeds in excess of 150 miles per hour between scheduled stops. The Act modifies this definition to permit bonds to be issued for facilities involving vehicles merely capable of attaining a maximum speed in excess of 150 miles per hour. This less stringent standard should promote the undertaking and financing of a greater number of rail transportation projects by non-governmental entities.

Clean Renewable Energy Bonds and Qualified Energy Conservation Bonds

Another provision of the Act expands the ability of governmental and non-governmental entities to undertake certain clean renewable energy projects through the issuance of clean renewable energy bonds (“CREBs”) to finance facilities that generate electricity from wind, closed-loop biomass, open-loop biomass, geothermal, small irrigation, hydropower, landfill gas, marine renewable, and trash combustion facilities. A clean renewable energy bond is a tax credit bond whereby governmental and non-governmental entities can borrow funds at a 0% interest rate and the holder of the bond receives a federal tax credit in lieu of an exemption from taxation for interest paid by the issuer. The Act authorizes the issuance of an additional $1.6 billion of CREBs. Additionally, the Act authorizes the issuance of an additional $2.4 billion of qualified energy conservation bonds in order to further incentivize the undertaking of projects directed at reducing greenhouse gas emissions. Similarly to CREBs, bondholders receive a federal tax credit and the issuer receives interest-free financing. Both measures should further promote the undertaking alternative or green technology initiatives by governmental and non-governmental entities.

Qualified Small Issue Bonds – “Manufacturing Facilities”

Prior to the enactment of the Act, non-governmental entities could have tax-exempt private activity bonds issued on their behalf to finance “manufacturing facilities” which are facilities used in the manufacturing or production of tangible personal property. Additionally, facilities that were ancillary to a manufacturing facility could be eligible for tax-exempt financing, but only if not more than 25% of the net proceeds of a bond issue were used to construct such ancillary facilities. The Act, for bonds issued in 2009 and 2010, expands the definition of “manufacturing facility” to include any facility used in the manufacturing, creation, or production of tangible or intangible property, such as patent, copyright, formula, process, design, know-how, format, or other similar items. Furthermore, the Act, for bonds issued in 2009 and 2010, expands the scope of a “manufacturing facility” to include, on an unlimited basis (eliminating the 25% of net proceeds standard), those facilities which are functionally related and subordinate to the manufacturing facility. The Act’s expansion of the types of qualifying structures should encourage the construction and tax-exempt financing of such facilities by non-governmental borrowers.

School Construction Bonds

A new category of tax credit bonds in an amount not to exceed $22 billion in 2009 and 2010 ($11 billion each year) is created under the Act to finance the construction, rehabilitation and repair of public school facilities, or the acquisition of land on which a school facility would be constructed. The Act specifies an allocation formula for availability of funds to the states, but generally the largest share of funds will be available to the largest school districts in the country. The same beneficial tax attributes of tax credit bonds (bondholders receive a federal tax credit in lieu of an exemption from taxation for interest received) are applicable to this new category of school construction bonds and should stimulate further construction, rehabilitation and repair of the nation’s public school infrastructure.

Qualified Zone Academy Bonds and Recovery Zone Bonds

Currently, qualified zone academy bonds can be issued by eligible schools located in empowerment or enterprise zones to rehabilitate or repair public school buildings, provide equipment for public school use, develop course materials, and train teachers and other school personnel. The Act authorizes an additional $1.4 billion of qualified zone academy bonds for state and local governments in 2009 and 2010 to finance renovations and repairs at existing school facilities.

The Act also creates a new category of tax credit bonds in 2009 and 2010 called recovery zone economic development bonds which may be issued in the amount of $10 billion to finance the redevelopment of designated recovery zones plagued by significant poverty, unemployment, or home-foreclosure rates. The Act also creates a new related category of tax-exempt private activity bonds in 2009 and 2010 called recovery zone facility bonds, authorized to be issued in the amount of $15 billion, to finance depreciable property to be utilized in designated recovery zones in the active conduct of a trade or business.