The Tax Cut and Jobs Act (the “TCJA”) was signed into law by President Donald Trump on December 22, 2017. The TCJA is a sweeping piece of legislation that is designed to simplify the tax code and to reduce (1) itemized exemptions, (2) personal tax rates until 2025, and (3) corporate tax rates permanently. The Congressional Budget Office, Joint Committee for Taxation, and the Tax Policy Center expect that the legislation will increase the budget deficit by one trillion dollars over the next 10 years. (Tax Cut and Jobs Act, 2017).
The purpose of this article is to focus on how the TCJA will likely impact state and local governments, and other tax-exempt organizations (including 501(c)(3) nonprofit organizations), and their investors.
Generally, commercial entities develop for profit enterprises. In connection with such development, investors provide capital in the form of debt and equity to fund commercial entities’ operating and capital expenditures. The interest income due to the investor on these debt obligations is subject to federal taxation, which represents revenue to the federal government. Consequently, in order for the investor to lend money, the interest income from the loan must be high enough to pay the federal tax whilst providing enough after-tax yield to adequately compensate the investor for its risk.
Generally, tax-exempt borrowers (state and local governments and 501(c)(3) nonprofit organizations) provide a public benefit to society. As a result, Section 103 of the IRS Code (with respect to state and local governments) and Section 145 of the IRS Code (with respect to 501(c)(3) nonprofit organizations) authorized the interest income from obligations of these borrowers to be exempt from federal taxation. This results in a comparable risk-adjusted yield when compared to commercial transactions. As such, investors traditionally require lower interest rates on tax-exempt loans than commercial loans. The difference between commercial interest rates and tax-exempt interest rates represents a subsidy to the state and local government borrower.
The table below compares the interest income and savings for a commercial and tax-exempt borrower.
In the table above, both the commercial borrower and the tax-exempt borrower financed $10,000,000 over 15 years at 6.00% and 3.90%, respectively. The 2.10% reduction in interest rate and the corresponding $2,047,015 interest savings represent a subsidy to the tax-exempt borrower and foregone revenue to the federal government.
The TCJA lowered corporate tax rates from 35% to 21%, which effectively reduces the subsidy to the tax-exempt borrower and reduces the taxable equivalent yield on tax-exempt loans to the investor. As a result, tax-exempt financing rates to state and local governments and other tax-exempt organizations must rise to offset the decline in the investor’s taxable equivalent yield. Without such a change, it is less advantageous for an investor to invest in tax-exempt debt. Additionally, if investors do not change the tax-exempt rate, it will be more advantageous for an investor to invest in commercial debt rather than tax-exempt debt.
The formula below illustrates how to calculate a tax-exempt rate:
Tax Exempt Rate = Taxable Equivalent Yield * (1 – Marginal Tax Rate)
In the table below, assume the investor requires a taxable equivalent yield of 6.00%. The investor would require a 3.90% tax-exempt rate with a 35% marginal corporate tax rate. However, the investor would require a 4.74% tax-exempt rate with a 21% marginal corporate tax rate.
3.90% = 6.0% * (1 – 35%)
4.74% = 6.0% * (1 – 21%)
In summary, there is an inverse relationship between federal tax rates and tax-exempt rates. The tax-exempt borrower will see a rise in its tax-exempt interest rate with a decline in the federal corporate tax rates. Conversely, the tax-exempt borrower will see a decline in its tax-exempt interest rate with an increase in the federal corporate tax rates.
A refunding bond is any bond that is used to pay the principal and interest on an outstanding bond. An advance refunding occurs when proceeds of the refunding bond are used to retire the outstanding bond more than ninety (90) days after the issuance of the refunding bond. A current refunding occurs when the proceeds of the refunding bond are used to retire the outstanding bond within ninety (90) days of the issuance of the refunding bond. The interest income under both the advance and current refunding bonds were federally tax-exempt to the investor. Under the TCJA, the interest income on advance refunding bonds is taxable to the investor, which will make most advance refunding bond financings economically infeasible. With that said, however, the interest income for current refunding bonds remains exempt from federal taxation.
Prior to the passage of the TCJA, when an advance refunding bond was issued, the proceeds were used to purchase State and Local Government Series bonds from the US Treasury to defease (make scheduled principal and interest payments) the outstanding bonds. Once the outstanding bonds became callable, the State and Local Government Series bonds were then sold in the market and the proceeds were used to retire the outstanding debt. Meanwhile, the municipality immediately began paying the lower interest rate on the new bonds to reduce its borrowing cost for the term of the financing.
As a result, advance refunding bonds increase the federal government’s outstanding debt, interest expense, and provided two subsidies to the state and local government. The TCJA eliminated the second subsidy by making the interest income, on the refunding bonds, taxable to the investor, which translates into lost yield to the investor and additional revenue for the federal government.
Preceding the TCJA, state and local governments and other tax-exempt entities were allowed to issue tax credit bonds to lower their borrowing cost. The tax credit bonds were designed to incentivize investors to (1) direct capital to state and local governments and other tax-exempt entities and (2) support socially conscious goals, such as renewable energy or lower income schools.
In theory, while state and local government and other tax-exempt entities are required to pay the entire principal on the bond, the investor received a subsidy in the form of a federal tax credit to reduce the interest payments due on the bond. Said differently, the federal tax credit was a means that allowed the state and local government to “buy down” the interest rate on the financing. With that said, however, the tax credit represented forgone revenue to the federal government over the life of the bonds.
Examples of tax credit bonds include Clean Renewable Energy Bonds (CREBs) and Qualified Zone Academy Bonds (QZABs). Prior to the TCJA, CREBs were used to finance renewable energy production facilities that are owned by state and local governments, mutual and cooperative electric companies, or public power providers. QZABs were used to finance facility improvements, equipment acquisitions, curriculum development, and professional development for teachers and staff at schools in empowerment zones or enterprise zones.
It is important to reiterate that municipal borrowers continue to qualify for tax-exempt financing that provides financing rates lower than commercial transactions.
In conclusion, the Tax Cut and Jobs Act, reduced the maximum corporate tax rate from 35% to 21%, which caused tax-exempt interest rates to rise market wide. The TCJA repealed the use of advanced refunding bonds to eliminate double subsidies to state and local governments with the goal of reducing future federal debt issuance. Lastly, tax credit bonds for targeted socially conscious goals have also been repealed to recapture federal revenue.