Potential Impacts of the Federal Stimulus Legislation on Municipal Bond Issuers

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1 February 2009 Practice Group(s): Public Finance Portland Jennifer B. Córdova Carol Juang McCoog Gülgün Ugur Mersereau Harvey W. Rogers Ann L. Sherman Seattle Scott A. McJannet Robert D. Starin David O. Thompson Cynthia M. Weed Spokane/Coeur d Alene Kevin R. Connelly Laura D. McAloon Brian M. Werst Potential Impacts of the Federal Stimulus Legislation on Municipal Bond Issuers On February 17, 2009, President Obama signed into law the American Recovery and Reinvestment Tax Act of 2009 ( ARRA ). ARRA includes economic incentives for almost everyone, and issuers of tax-exempt bonds are among the intended beneficiaries. Among the many provisions of this stimulus legislation are several provisions that may affect municipal issuers of tax-exempt bonds and tax credit bonds. Provisions Affecting Tax-Exempt Bonds Increase in Limit for Bank Qualified Bonds ARRA increases the limit on the amount of Bank Qualified ( BQ ) bonds that can be designated by a small issuer during calendar years 2009 and 2010 from $10 million per year to $30 million per year. In general, financial institutions can only take a deduction for the portion of their interest expense that is allocable to such institution s investments in tax-exempt municipal bonds with respect to certain tax-exempt bonds that are designated BQ by small issuers. This change will allow an issuer to be treated as a small issuer for BQ purposes if it issues no more than $30 million in tax-exempt bonds (excluding most private activity bonds) during the year and should allow more issuers to access the lower interest rates historically available for BQ bonds. Conduit Borrowers may be Treated as Small Issuers for BQ Purposes Currently, the small issuer exception described above is applied at the issuer level. For bonds issued during 2009 and 2010, ARRA allows the small issuer exception to also be applied to qualified 501(c)(3) bonds if the 501(c)(3) borrower would qualify as a small issuer for the year. This provision could permit smaller 501(c)(3) borrowers to borrow at BQ rates even if the bonds are issued through a large conduit issuer, such as the Washington State Housing Finance Commission or the Oregon Facilities Authority. In the case of a pooled financing in which proceeds are loaned to one or more state or local governments and/or 501(c)(3) borrowers, this rule can also be applied only if all of the ultimate borrowers in such issue would separately qualify for the small issuer exception. Again, this change should allow more issuers and 501(c)(3) borrowers to access the lower interest rates typically available for BQ bonds. De Minimis 2% Safe Harbor for Financial Institutions Investing in Tax-Exempt Bonds ARRA creates a de minimis exception from the general rule discussed above that prohibits a financial institution from deducting the portion of the interest expense that is allocable to such institution s investments in tax-exempt bonds other than BQ bonds issued by small issuers. This general rule will not apply with respect to investments in new money tax-exempt municipal bonds (both governmental and private activity bonds) issued during 2009 and 2010 to the extent that these investments constitute less than 2% of the average adjusted bases of all the assets of the financial

2 institution. As with BQ bonds, financial institutions will be able to deduct 80% of its interest expense allocable to such investments. For purposes of this de minimis exception, refunding bonds are treated as issued on the date of issue of the refunded bond (or in the case of a series of refundings, the original bond). This provision should make investments in new money tax-exempt municipal bonds more attractive to financial institutions. Relief from the Alternative Minimum Tax Prior to ARRA, private activity bonds, other than qualified 501(c)(3) bonds and tax-exempt housing bonds, were subject to the alternative minimum tax ( AMT ). This generally increased the interest rates paid on those private activity bonds. In addition, interest on all tax-exempt bonds, with the exception of tax-exempt housing bonds, was treated as an adjustment to current earnings for certain corporations which could impact the calculation of such corporations AMT liabilities. ARRA changes the law regarding private activity bonds subject to the AMT by providing that private activity bonds are not subject to the AMT. In addition, ARRA provides that no interest on tax-exempt bonds is to be treated as an adjustment to current earnings for the affected corporations. These provisions apply to all new money tax-exempt bonds issued during 2009 and In addition, refunding bonds issued during 2009 and 2010 to refund bonds issued after 2003 but before 2009 qualify for relief from the AMT as well. These provisions should remove the AMT penalty rate paid on qualifying bonds. These provisions providing relief from the AMT do not change any of the other tax rules applicable to private activity bonds. e.g., most private activity bonds are not eligible to be designated as bank qualified and private activity bonds, other than qualified 501(c)(3) bonds, may not be advance refunded. Expansion of Use of Small Issue Bonds to Finance Manufacturing Facilities This legislation makes tax-exempt financing available for a broader range of private manufacturing facilities. The legislation expands the definition of manufacturing facility to include facilities for manufacturing intangible property, used in the manufacturing, creation, or production of tangible or intangible property described in section 197(d)(1)(c)(iii) of the Internal Revenue Code of 1986, as amended. Intangible property is any patent, copyright, formula, process, design, pattern, knowhow, format, or other similar item. Formerly, only facilities used for manufacturing tangible personal property were eligible for tax-exempt financing. The legislation also expands the availability of tax-exempt financing for facilities related to qualifying private manufacturing facilities. The legislation provides that the 25% limitation on financing directly related and ancillary facilities will not apply. Instead, tax-exempt financing can be used for facilities that are functionally related and subordinate to the manufacturing facility as long as those facilities are located on the same site as the manufacturing facility. These changes are effective for bonds issued after the date of enactment of the legislation and through December 31, Tribal Economic Development Bonds to Spur Economic Development ARRA creates a new form of tax-exempt bonds called Tribal Economic Development Bonds ( TEDB ), which can be issued by tribal governments for any purpose that a state or local government could issue tax-exempt bonds without regard to the requirements that the project involve an essential 2

3 governmental function. TEDBs cannot be issued for facilities that house or are used in the conduct of gaming or for facilities that are located outside a reservation. There is a national limit of $2 billion on these TEDBs and this limit will be allocated among tribal governments by the Secretary of the Treasury. Expansion of Exempt Facility High-Speed Rail Bonds Currently, tax-exempt bonds can be issued for high-speed intercity rail facilities. ARRA modifies the requirement that high-speed intercity rail transportation facilities use vehicles that are reasonably expected to operate at speeds in excess of 150 mph to read attain a top speed in excess of 150 mph. This provision is effective for bonds issued after the date of enactment of the legislation. Provisions Affecting Tax Credit Bonds Additional Allocation of New Clean Renewable Energy Bonds This legislation authorizes an additional $1.6 billion of New Clean Renewable Energy Bonds ( CREB ) to finance facilities that generate electricity from the following sources: wind, closed-loop biomass, open-loop biomass, geothermal, small irrigation, hydropower, landfill gas, marine renewables and trash combustion facilities. One third of the CREBs allocation will be available for qualifying projects of state, local, and tribal governments; one-third for qualifying projects of public power providers; and one-third for qualifying projects of electric cooperatives. Additional Allocation of Qualified Energy Conservation Bonds An additional $2.4 billion of Qualified Energy Conservation Bonds ( QECB ) is authorized under ARRA. QECBs are tax credit bonds the proceeds of which are used to finance state, municipal and tribal government programs and initiatives designed to reduce greenhouse gas emissions. ARRA also clarifies that an issuer can use bond proceeds for loans and grants for green community programs. In addition, QECBs that are used to provide loans, grants, or other repayment mechanisms for capital expenditures to implement green community programs will not be treated as private activity bonds. Increase in Limits on Qualified Zone Academy Bonds Qualified Zone Academy Bonds ( QZAB ) are a form of tax credit bond that can be used to finance renovations, repair, and equipment purchases for certain schools in connection with a required private contribution. ARRA increases the QZAB limit to $1.4 billion in each of 2009 and New Qualified School Construction Bonds ARRA creates Qualified School Construction Bonds ( QSCB ), a new category of tax credit bonds for the construction, rehabilitation, or repair of public school facilities or for the acquisition of land on which a public school facility will be constructed. There is a national limitation on the amount of QSCBs that may be issued by state and local governments of $11 billion in each of 2009 and This national limit will be allocated among the states and certain large school districts. Unused allocation can be carried forward to subsequent years. There is an additional national limitation on the amount of qualified school construction bonds that may be issued by tribal governments of $400 million ($200 million allocated initially in 2009 and the remainder allocated in 2010). 3

4 Recovery Zone Economic Development Bonds ARRA authorizes $10 billion in Recovery Zone Economic Development Bonds ( RZEDB ), a new category of tax credit bond, for investment in economic recovery zones. RZEDBs are taxable but include a tax credit, equal to 45% of interest paid on the RZEDBs, that is payable to the issuer. Proceeds of the bonds may be used to invest in infrastructure, job training, education, and economic development in recovery zones. Recovery zones are (i) areas designated by the issuer as being areas within the boundaries of the issuer that have significant poverty, unemployment, rate of home foreclosures, or general distress; (ii) empowerment zones or renewal communities; or (iii) areas designated by the issuer as distressed by reason of the closure or realignment of certain military installations. Each state is guaranteed a 0.9% allocation of the national recovery zone economic development bond limitations; the balance will be allocated based on states job losses in 2008 as a percentage of national job losses in That allocation will be sub-allocated to local municipalities. RZEBDs can be issued during 2009 and Recovery Zone Facility Bonds Recovery Zone Facility Bonds ( RZFB ) are a new form of exempt facility private activity bonds, the proceeds of which must be used for recovery zone property, including depreciable property that (i) was constructed, reconstructed, renovated, or acquired by purchase after the date of designation of the recovery zone; (ii) the original use of which commences with the taxpayer; and (iii) substantially all of the use of which is in a recovery zone and in the active conduct of a trade or qualified business of the taxpayer. There is a national limitation of $15 billion of RZFBs to be issued in 2009 and This limitation will be allocated among the states and municipalities on the same basis as for the RZEBDs described above. New Taxable Bond Financing Option Build America Bonds Issuers that could issue otherwise tax-exempt governmental bonds (not private activity bonds) during 2009 and 2010 may elect to issue such bonds as taxable bonds and permit bondholders to receive a tax credit equal to 35% of the interest paid on the bonds. These bonds are called Build America Bonds. For capital project bonds issued during 2009 or 2010 (as opposed to bonds issued to finance working capital needs), issuers may, in lieu of the tax credit to bondholders, instead elect to receive a direct payment from the Federal government equal to the subsidy that would have otherwise been delivered to the bondholders through the Federal tax credit for these bonds. There are several additional requirements to issue Build America Bonds to be taken into account in considering whether to proceed with this structure. Grants to State Housing Agencies in Lieu of Low-Income Housing Tax Credits The legislation provides a grant to state housing finance agencies of up to 85% of 40% of the 2009 low-income housing tax credit they would otherwise receive and 100% of unused and returned credit. Sub-recipients of the grants would be subject to the normal requirements attached to the low-income housing tax credit, including rent and income restrictions. The grant applies to the 2009 low-income housing tax credit allocation. 4

5 Other Provisions Affecting Municipal Issuers Delay of Contractor Withholding Tax Previous law required federal, state, and many local governments to begin remitting a withholding tax of 3% on payments made by the governmental unit to contractors beginning January 1, This legislation delays the effective date of that requirement by one year, until January 1, Increase in New Markets Tax Credits (NMTCs) The legislation increases the total amount of new market tax credits available in 2008 and 2009 to $5 billion for each year. The additional credits for 2008 will be allocated to community development entities that submitted an allocation application with respect to the 2008 calendar year and either did not receive an allocation, or received an amount less than the amount applied for. Authors: Jennifer B. Córdova Jennifer.cordova@klgates.com