Presentation on theme: "2009 DELAWARE COUNTY BUSINESS FUNDING FORUM May 5, 2009 The Anatomy of a Tax Exempt Financing Valentino F. DiGiorgio III, Esq. Stradley Ronon Stevens &"— Presentation transcript:
2009 DELAWARE COUNTY BUSINESS FUNDING FORUM May 5, 2009 The Anatomy of a Tax Exempt Financing Valentino F. DiGiorgio III, Esq. Stradley Ronon Stevens & Young, LLP Adam Matlawski, Esq. McNichol, Byrne & Matlawski, P.C
The Anatomy of a Tax Exempt Financing The purpose of this presentation is to provide some basics relating to the tax-exempt financing. This outline is not an exhaustive outline of the legal and tax issues relating to a tax-exempt financing, but attempts to highlight some of the more basic and important concepts of which a potential borrower, lender and their respective counsel should be aware. Tax-exempt financings can take place in the form of a bonds or notes. The basic premise, however, is the same: interest paid on the obligation is not subject to federal income tax and (depending on the state) state income tax. U.S. Treasury Circular 230 Notice: We inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication, including attachments, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service. In addition, if any such tax advice is used or referred to by other parties to promote, market, or recommend any transaction or investment, then (i) the advice should be construed as written in connection with the promotion or marketing by others of the transaction(s) or matter(s) addressed in this communication and (ii) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.
I. Description of Process A.Interest Income Exemption 1.The holder of a tax exempt bond or note (collectively herein, a “bond”) is entitled, subject to certain requirements, to exclude the interest income received thereon from its gross income for Federal income tax purposes. Section 103 of the Internal Revenue Code of 1986, as amended (the “Code”), serves as the source of the exemption. In enacting Section 103, Congress chose to exclude interest on any “state or local bond.” Such a bond is defined as “an obligation of any state or political subdivision thereof.”
I. Description of Process (continued) 2.As such, a “bond” need not be a bond as common nomenclature would indicate but merely be an obligation of a political subdivision under a written contract whereby the governmental entity borrows money that is available for its use and that entity must repay the obligation and interest thereon pursuant to such contract. 3.In Pennsylvania, state law has enabled the creation of certain “constituted authorities” which have been established for the purpose of issuing bonds on behalf of a borrower engaging in a qualified transaction. These are: a)Industrial development authorities; b)Health authorities; and c)Educational authorities
I. Description of Process (continued) B.Eligibility. Extensive tax analysis must be performed to determine whether the proposed borrower and its anticipated use of the proceeds meet the requirements of the Code pertaining to tax exempt transactions. The threshold factor is whether the borrowing entity operates for a purpose that qualifies for exempt treatment. The two most popular forms of issue are for: 1.Manufacturing; 2.501(c)(3) charitable entities. - All property being financed must be owned by the 501(c)(3) entity; and 3.Exempt Facility Bonds (e.g. water, sewer airports, solid waster, high speed rail).
I. Description of Process (continued) C.Selection of an Authority. Although 501(c)(3) organizations are non-profit and are generally exempt from paying taxes, they cannot issue tax-exempt bonds on their own. In order to secure the federal and state tax exemption, the bonds must be issued through a "conduit" authority (e.g. state agency, county or city) (“Authority”), with individual state law determining which of these entities are permitted by statute to serve in this capacity. The issuing Authority, in turn, enters into a “loan agreement” with the 501(c)(3) borrower setting out the terms for debt repayment. The Authority will also ensure that the financing is consistent with their policies, pass appropriate resolutions, hold the necessary public hearings, and generally oversee the “pricing” (i.e. sale) of the bonds. In order for a bank to be able to deduct interest allocable to a private placement financing, the note or bond being issued must be a “qualified tax-exempt obligation” as defined in Section 265(b)(3) of the Code. In order to meet this requirement, the Authority can issue not more than $10,000,000 of such debt in any given calendar year.
I. Description of Process (continued) D.Sizing - Use of Proceeds. Proceeds must be used for limited purposes and only a limited percentage of the proceeds may be used for soft costs associated with the financing. Soft costs such as Authority, bank and bond counsel fees may be paid from the proceeds so long as such costs do not exceed 2% of the total proceeds. In charitable entity financings, all of the proceeds must be used for nonsectarian purposes. E.Declaration of Official Intent. In order for a Borrower to reimburse itself for costs that it incurs in advance of the date of the debt offering, it must enact a Declaration of Official Intent that complies with the requirements of the Code. Typically, a Declaration of Official Intent is adopted in the same manner as a board resolution. In general, a Declaration of Official Intent must have the following attributes:
I. Description of Process (continued) i.it must be in reasonable form; ii.it must contain a declaration of intent to reimburse costs incurred with regard to certain expenditures, as well as a general functional description of the property to which the reimbursement relates; iii.it must indicate the reasonably necessary maximum principal amount of debt to be issued for reimbursement; and iv.as of the date of declaration, the borrower must reasonably expect to reimburse the expenditures with the proceeds of a tax-exempt borrowing. The Declaration of Official Intent must be adopted not later than 60 days after the date of payment of the original expenditure. There is a special exception set forth in the Code for certain preliminary expenditures. Such expenditures can include architectural, engineering, surveying, soil testing, and similar costs that are incurred prior to the commencement of construction or rehabilitation of a project. While such expenditures can be incurred without regard to when the Declaration of Official Intent is adopted, they cannot exceed 20% of the ultimate debt issuance.
I. Description of Process (continued) F.Public Bond Issues versus Private Placement. The borrowing must elect between either a publicly offered bond or a privately placed note. Publicly offered bonds involve a larger financing team and increased costs but often yield significant interest rate advantages. Privately placed notes usually take the form of a typical bank financing. While privately placed note transactions typically involve a lower cost of issuance, the interest rates are generally higher than those obtained in publicly offered bond transactions. Public bond issues may also require a rating from a rating agency, such as Moody’s or Standard & Poors. Also, depending on its creditworthiness, the borrower may have to obtain credit enhancement such as a letter of credit or bond insurance backing up the repayment of the bonds.
I. Description of Process (continued) Public Bond IssuePrivate Placement Advantages Potential to borrow significant amounts at a very low interest rate Flexibility of financing options Less complex Shorter time period to close Less disclosure Disadvantages Higher cost of issuance Complexity Disclosure Official statement Longer time period to recover costs Higher interest rate than public bond issue Lower amount of finance
I. Description of Process (continued) G.Single Application for Assistance. Once the financing team and the authority have been identified then a Pennsylvania Department of Community and Economic Development (“DCED”) Single Application for Assistance must be prepared by the borrower for submission to the Authority. The Authority’s counsel and borrower’s counsel will provide the borrower with assistance in completing the application. H.TEFRA Hearing. The Authority then conducts what is known as a TEFRA hearing. This is a public hearing in which the financing is discussed and pursuant to which the public has an opportunity to comment. This hearing, held before the Authority officers, must be held not more than 14 days after notice is given in a newspaper of general publication for the jurisdiction ion which the project is located and in which the authority is located. At this hearing the Authority officially authorizes its sponsorship of the financing project and its role as the conduit borrower.
I. Description of Process (continued) I.Bond/Note Counsel. 1.The role of bond counsel is to ensure that the bonds or note being issued and the use of the proceeds thereof comply with the requirements of the Code. 2.Bond counsel will deliver an opinion to the bondholders or purchasers of the note to the effect that interest on the bonds or note is exempt from state and federal income taxes. 3.In order to be able to give this opinion, bond counsel needs to perform due diligence on the borrower to ensure its status as a 501(c)(3) entity and that the facility being financed complies with the restrictions and limitations of the Code. 4.Bond counsel is also the “quarterback” of the deal and is responsible for filing the IRS Form 8038 relating to the issuance of the bonds or note. 5.Bond counsel also frequently serves as borrower’s counsel as well.
I. Description of Process (continued) J.Submission to DCED. Counsel for the Authority then completes the Single Application for Assistance by attaching the minutes from the TEFRA hearing and various other approvals that are required, including approval from the top elected official of the jurisdictions in which the project is located and the Authority is located. Counsel for the Authority then forwards the completed bond application to the DCED for approval. K.Due Diligence. Qualified bond counsel will then perform due diligence to ensure that the requirements of the Code as they relate to the use of the proceeds of the issue, the borrower’s 501(c)(3) status, arbitrage limitations and other limitations and requirements. Bond counsel will typically send the borrower a tax questionnaire and ask for various documents to be reviewed. L.Closing. Once approval from the DCED is obtained, the transaction can close. The way a privately placed note financing technically works is that the Authority issues a note which is then purchased by the bank. Publicly offered bonds are sold directly to investors, usually large institutional investment companies. The Authority then uses the proceeds of bonds or the note to loan funds to the actual borrowing entity. As such, an obligation of the Authority has been created that qualifies for the interest exemption.
II. IRS Code Limitation and Requirements A.Ownership Requirement. All property to be financed must be owned by Section 501(c)(3) organization. B.Use Requirement. 1.At least 95% of the net proceeds must be use only by 501(c)(3) organizations engaged in exempt activities. a)Use of property equals use of proceeds. Multiple uses of the same property must be allocated. To the extent there is use of the property that is “an unrelated trade or business” such use must be quantified and cannot exceed the 5% “bad money” limit discussed below. b)Cost of issuance count against the five percent (5%) “bad money” limitation.
II. IRS Code Limitation and Requirements (continued) 2.Use by Section 501(c)(3) organization engaged in a unrelated trade or business is not a “good” use, so it counts toward the 5% “bad money” limitation together with other private use. a)An activity will be characterized as an unrelated trade or business if it is: (i) a trade or business; (ii) regularly carried on; (iii) there is no substantial cause or relationship to further in the organization’s exempt purposes. b)Activities that are excluded from the definition of “unrelated trade or business” include: (i) activities conducted primarily for the convenience of the organization’s members, students, patients, officers or employees (e.g., hospital gift shop, cafeteria, campus bookstore); (ii) activities in which substantially all of the work is performed for the organization without compensation; (iii) the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions.
II. IRS Code Limitation and Requirements (continued) c) Common unrelated trade or business activities: (i) hospital lab work or pharmacy sales to persons who are not patients or employees of a hospitals; (ii) Section 501(c)(3) organization provides administrative or other support services to unrelated Section 501(c)(3) organizations; (iii) rental of museum or school facilities after hours for private events; (iv) certain gift shop activities that are not related to exempt purposes and do not qualify for the convenience exception set forth by the IRS. (v) operation of a parking lot open to the public or open during the hours in which the exempt organization is closed.
II. IRS Code Limitation and Requirements (continued) 3.Joint ventures may also raise private use issues. 4.Common types of “use” include leases (both lessee and lessor are users) management contracts, other service agreements and cooperative research agreements. 5.IRS regulations provide various safe harbors for service and other management contracts and research agreements.
II. IRS Code Limitation and Requirements (continued) C.Financings by Religious Organizations. The issuance of tax exempt bonds or notes for the benefit of a school or community center sponsored by or affiliated with the religious organization raises issues under the Establishment Clause of the United States Constitution and similar provisions in state constitutions. Recent decisions of the United States Supreme Court have given bond counsel an increasing level of comfort in connect with the issuance of tax exempt obligations to finance religious affiliated schools and other projects. As a result, in recent years, an increasing number of secondary and primary schools with religious affiliations have looked at tax exempt bonds to finance their capital projects. D.Limitation on Maturity of Obligation. The note or bond will not qualify for tax exemption if the average maturity of the obligation exceeds 120% of the average reasonably expected economic useful life of the facility’s financed with bond proceeds. Economic useful life based upon IRS depreciations schedules.
II. IRS Code Limitation and Requirements (continued) E.Prohibition on Use of Proceeds. The proceeds of the note portion of the proceeds of the bond or note may be used to provide an airplane, sky box, other private luxury box, health club facility, gambling facility or liquor store. F.Arbitrage Concerns - Spending Requirements. Basically, arbitrage occurs when the interest earned by the borrower upon the bond proceeds prior to project use exceeds the interest rate paid by the borrower upon such debt. The Code sets forth several safe harbors that allow the bond proceeds to be spent over time without becoming subject to arbitrage rebate. Any such excess earnings must be paid over to the Internal Revenue Service unless a safe harbor exists. There are three rebate exceptions set forth in the Code, a 6 month exception, an 18 month exception and a 2 year exception
II. IRS Code Limitation and Requirements (continued) 1.6 Month Rebate Exception. Under the 6 month rebate exception, if all of the gross proceeds of the issue have been properly expended within 6 months of the issue date, the rebate rules are inapplicable. In qualified 501(c)(3) bond issuances, the 6 month spending period can be extended for an additional 6 months if the unspent gross proceeds at the end of the initial term do not exceed 5% of the issue price Month Rebate Exception. Under the 18 month rebate exception, at least 15% of the gross proceeds must be spent within 6 months of the date of issuance, at least 60% within 12 months and 100% within 18 months. Under the 18 month rule a reasonable retainage, an amount not to exceed 5% of available construction proceeds, may be retained for up to another year on account of construction disputes and the completion of outstanding items.
II. IRS Code Limitation and Requirements (continued) 3.Two Year Rebate Exception. If a Borrower anticipates using a majority of the bond proceeds for construction projects, it may also elect to apply the Code’s 2 year rebate exception. This exception is only available to bond issuances at least 75% of the available construction proceeds of which will be used for construction expenditures. Construction expenditures are those expenditures that may be capitalized as part of the basis of real property and can include items such as rehabilitation costs, wiring, parking areas, plumbing and HVAC systems. Under the 2 year rule: 10% of the bond proceeds must be spent within the first 6 months; 45% within one year; 75% within 18 months; and 100% within 2 years.
II. IRS Code Limitation and Requirements (continued) Once again, a reasonable retainage provision, for a sum not to exceed 5% of the available construction proceeds, is available for an additional 12 month period. If the Borrower does not anticipate meeting the deadlines of the 2 year rule it can elect, prior to the date of issuance, to pay a penalty equal to 1 ½% times the amount of available construction proceeds that were required to be spent, but were not, at the close of each 6 month period. If the Borrower elects this penalty prior to the date of issuance, it will not be required to pay rebate as required by the Code. If the spending requirements at each 6 month period are met, the penalty is not imposed. There are also exceptions for bona fide debts service reserve funds created pursuant to the indenture or other loan document. Failure to comply with one of the rebate limitations above will result in the borrower having to rebate to the IRS any “excess earnings” earned on the proceeds of the bonds. If the borrower fails to do so at the times set forth in the Code, the bonds could be declared taxable.
II. IRS Code Limitation and Requirements (continued) G.Reimbursement Period Requirements. The Code sets forth limitations on the period of time in which costs must be reimbursed. Under these requirements, the bonds must be issued not later than 18 months after the later of: (i) the date on which the original expenditure is paid; or (ii) the date on which the property is placed in service or abandoned (not to exceed 3 years after the date on which the original expenditure is paid). Note, however, that in order to be eligible for reimbursement, the expenditure must be capital in nature. Also, as with the Declaration of Official Intent requirements above, the reimbursement period requirements are not triggered by the aforementioned preliminary expenditures.
II. IRS Code Limitation and Requirements (continued) H.Capital Campaigns and Replacement Proceeds. 1.Generally - Charitable or educational organizations described in section 501(c)(3) of the Code frequently conduct capital giving programs for projects that the organization ultimately determines to finance with tax- exempt bonds. 2.Treatment as Replacement Proceeds – Borrower must make sure that the funds raised through the capital giving program are not treated as “replacement proceeds” of the bonds. Treatment as replacement proceeds is undesirable because of the arbitrage rules of the Code, which provide that replacement proceeds cannot be invested at a yield higher than the bond yield without jeopardizing the tax-exemption of the bond interest.
II. IRS Code Limitation and Requirements (continued) 3.Definition - The definition of replacement proceeds states that: “Amounts are replacement proceeds of an issue if the amounts have sufficiently direct nexus to the issue or to the governmental purpose of the issue to conclude that the amounts would have been used for that governmental purpose if the proceeds of the issue were not used or to be used for that governmental purpose. For this purpose, governmental purposes include the expected use of amounts for the payment of debt service on a particular date. The mere availability or preliminary earmarking of amounts for a governmental purpose, however, does not in itself establish a sufficient nexus to cause those amounts to be replacement proceeds.” (Treas. Reg. Section (c)).
II. IRS Code Limitation and Requirements (continued) 4.Preliminary earmarking - This regulation means that a borrower may solicit gifts for a project and then use bond financing for the project and use the gift funds for other purposes, provided the solicitation was not more than a “preliminary earmarking.” 5.Pledged funds - As noted in the regulation, in addition to preliminary earmarking, replacement proceeds can be treated as present in a situation if funds are used or expected to be used to pay or secure debt service on bonds. This aspect of the regulation would prevent a borrower from pledging its endowment to secure a bond issue, regardless of whether or not the endowment was preliminarily earmarked for the bond project. Additionally, if a borrower has an endowment or construction fund specifically segregated and earmarked for the purposes of the bond project, such funds could be considered replacement proceeds subject to yield restricted investments.
II. IRS Code Limitation and Requirements (continued) 6.Avoiding arbitrage violation – Earmarked capital campaign funds and pledged funds must either be: (i) deposited into debt service fund to pay principal and interest or to redeem bonds within a 12 month period, or (ii) subject to the investment earnings being “yield restricted” to the interest rate on the bonds. To achieve the greatest flexibility, organizations are encouraged to solicit contributions that support general capital improvements, rather than specifically for the projects being financed with tax-exempt debt.
II. IRS Code Limitation and Requirements (continued) I.Build American Bonds American Recovery and Reinvestment Act of 2009 provides for 2 types of taxable bonds that provide an alternative to traditional tax-exempt bonds with lower net borrowing costs: 1.Tax Credit Build America Bonds a)must be issued before January 1, 2011 b)must comply with requirements applicable to tax- exempt bonds and can finance “any governmental purpose for which tax-exempt governmental bonds (excluding private activity bonds under § 141) could be issued under § 103” c)interest is includible in gross income d)tax credits provided to holders of bonds holding bonds on one or more interest payment dates during taxable year – 35% of coupon interest payable by issuer – and may be carried over to future tax years e)issuer must submit Form 8038-G
II. IRS Code Limitation and Requirements (continued) II.Direct Payment Build America Bonds a.must be issued before January 1, 2011 b.use is more limited than for Tax Credit BABs – generally can be used for “governmental purposes for which tax- exempt governmental bonds (excluding private activity bonds under § 141) could be issued under § 103” but excess of proceeds (after paying up to 2% costs of issuance) over amounts in reasonably required reserve fund must go to capital expenditures” c.refundable tax credit paid to issuer – 35% of coupon interest payable to bondholders d.issuer must submit Form 8038-G – 30 days before filing new Form 8038-CP – Return for Credit Payments to Issuers of Qualified Bonds; Form 8038-CP must be submitted in timely fashion
III. Costs, Interest Rates and Flow of Funds A.Cost of Issuance. Fees and expenses are greater than those customarily associated with a typical two party loan transaction, however, depending on the size of the loan, the borrower can often recoup these excess fees in interest savings over the first few years of the loan. Costs will vary based on the complexity and size of the transactions and will be more for public bond issues than the private placements. Costs range as follows: 1.IDA fee: Application fee plus ¼ to ½ of one percent of the loan amount plus annual monitoring fees; 2.IDA Counsel fee: $4,000 to $10,000; 3.Bond Counsel fee: $7,500 to $15,000 for (note issue) and $25,000 to $75,000 for bond issue; 4.Bank Counsel fee (private placements): $7,000 to $15,000; 5.Underwriter counsel fees (public offerings): $15,000 to $35,000; 6.Borrower counsel fees: 10,000 to 30,000; 7.Underwriter fees (public offering); 8.Credit enhancement costs (public offerings); 9.Other normal costs such as title insurance, appraisals, environmental, etc.
III. Costs, Interest Rates and Flow of Funds A.Interest Rates. Interest rates in tax exempt financing transactions can vary depending upon whether borrower elects to make a public bond offering or proceeds with a private placement of a note, typically with a bank. In either of such transactions, borrowers are normally able to elect between a variable or floating interest rate or a fixed rate. If a borrower elects a floating rate, it may have the option, subject to certain limitations, to enter into a swap agreement in order to hedge its interest rate risk.
III. Costs, Interest Rates and Flow of Funds As with any borrowing, the interest rate available to a borrower is largely dependent upon its credit worthiness. In privately placed transactions, the borrower’s credit worthiness is underwritten directly by a bank which, in addition to being desirous of increasing its loan portfolio, may also have customer relationship considerations when it makes its determination to extend credit to a borrower and the interest rate that such debt will bear. In publicly offered bond transactions, in order to achieve a sale of the bonds, a borrower must obtain a credit rating from either Standard & Poors, Fitch or Moody’s. Typically, this credit analysis must yield an investment grade rating in order to achieve a successful sale of the bonds. This credit rating will also have a direct correlation to the interest rate that investors will be willing to accept for the corresponding credit risk. Many borrowers find it advantageous in publicly offered bond transactions to obtain credit enhancement in the form of bond insurance or a irrevocable standby letter of credit issued by a banking institution. Each of these financial products allow the ultimate investors to look beyond the credit worthiness of the actual borrower (a credit rating of the borrower is often not even obtained) but rather base its investing decision upon the credit rating of the credit enhancement provider. Most borrowers find that the reduction in interest rates achieved through the purchase of credit enhancement financial products justify the related cost.
IV. Advantages The primary advantage of tax exempt financing transactions is the reduced interest rates that a borrower can enjoy. As noted above, this advantage does, however, come at a fairly significant cost in terms of the cost of issuance. Privately placed transactions are typically less expensive than the publicly offered bond transactions. As such, it has been our experience that borrowers typically will not enter into a tax exempt financing transaction unless they are borrowing more than $1,000,000. At level, they will prefer a private placement transaction over a public bond offering. Typically, a publicly offered bond transaction involves an issuance of more than $5,000,000 of debt.