Debt is commonly issued by governments around the world to finance capital projects. State and local governments in the U.S. have traditionally issued tax-exempt debt as governments receive benefits that lower borrowing costs. Since tax-exempt interest paid to government bondholders is excludable from gross income for federal tax purposes, investors agree to lower interest rates. Globalization of capital markets, elimination of tax-exempt advance refunding in the Tax Cuts and Jobs Act of 2017, and complicated U.S. tax rules relating to tax-exempt financing have increased the use of taxable debt by governments seeking to gain operating flexibility or expand their financing options.
GFOA recommends that state and local governments consider whether issuing taxable debt is the best financing option for their proposed project and develop a thorough understanding of the differences between the tax-exempt and taxable markets before proceeding with a planned sale. Each issuer in consultation with appropriate counsel and advisors should conduct an analysis of how these differences will affect their overall financial plan and ability to manage its debt program.
Reasons to Issue Taxable Debt. In most instances, tax-exempt debt offers lower cost financing; however, there are reasons an issuer might contemplate use of taxable debt in its financing structure. Often the issuer and their Municipal Advisor and other members or their financing team will need to analyze both economic and non-economic consideration prior to making a determination.
Relief from Legal Covenants
A bond covenant is a legally binding term or condition of an agreement between a bond issuer and a bondholder. Bond covenants are designed to protect the interests of both parties. A bond's indenture describes the covenants and is enforceable throughout the entire life of the bond until maturity or refunding.
Use of bond proceeds or bond-financed property by a nongovernmental party (individual or entity) in furtherance of a trade or business activity is considered a private business use for tax-exempt bond purposes. If private use of a bond-financed property is likely, governments may consider issuing taxable bonds to avoid violating Internal Revenue Code (IRC) Section 103.
The Tax Cuts and Jobs Act of 2017 prohibited the issuance of tax-exempt advance refunding bonds; thus, taxable bonds must be issued for advance refundings. Current refundings are still allowable on a tax-exempt basis. A refunding bond issued within 90 days or less of redemption of the “refunded” bond is a “current” refunding. A refunding bond issued more than 90 days prior to redemption is an “advance refunding.” Proceeds of the advanced refuding bond are deposited into an escrow fund, invested in US Treasury securities, and applied to pay debt service and the redemption price of the refinanced bonds through the call date. Upon financial close of the refinancing, the original or “refunded” bonds may be considered to be legally defeased and the state or local government issuer is left servicing only the debt associated with the new refunding bonds.
In evaluating whether to issue taxable debt, each issuer should consider the following:
- Evaluate applicable federal and state constitutional and statutory debt legal provisions. Various state and federal securities law requirements apply to both taxable and tax-exempt debt. Taxable offerings often must meet the same state law requirements as tax-exempt debt and issuers should not assume that the absence of some federal tax code restrictions on "private activity bonds" (tax-exempt bonds used for projects that primarily benefit private entities but have some public benefit and the municipal entity does not pledge its credit) allows for these bonds to be issued without restrictions. In some cases, taxable debt may be subject to various federal, state, and local laws, including state laws restricting the lending of the issuer’s credit to private entities (“lending of credit”). Issuers should consult with counsel about the various tax issues that arise with taxable bonds.
- Some jurisdictions may have additional restrictions on the issuance of taxable debt and the jurisdiction’s debt policy should be reviewed to determine if it specifies when taxable debt may be issued.
- Subject to bond counsel review, the IRS generally permits up to 10% of a tax-exempt issuance can be used for non-tax-exempt purposes. Any amount of use of proceeds above this 10% threshold would need to be issued on a taxable basis.
- Evaluate the total cost of issuing taxable debt, including legal, marketing, and other up-front costs and the interest cost over the life of the bonds, in relation to the financing objectives to be achieved. The cost of taxable debt will generally be higher because investors are not able to deduct interest earnings from taxable income. Consideration also should be given as to how proceeds will be invested to minimize possible negative arbitrage. Additional earnings may be possible as taxable bonds are not subjected to the same IRS arbitrage requirements as tax-exempt bonds.
- Consider structural features that can provide long-term benefits, such as amortizing debt as quickly as possible or embedding early call provisions to have the ability to call debt if the project being financed generates excess cash flows. In some instances, issuers may wish to use a hybrid structure - a combination tax-exempt and taxable issue to satisfy certain IRS sizing, cost of issuance, and private use restrictions. An “interim” taxable issue may also make sense when there is uncertainty regarding a project’s ability to comply with IRS requirements. If an issuer and their bond counsel are uncertain as to the amount of “private use” of a project, it may make sense to issue all or a portion of a financing on a taxable basis, since taxable bonds can be reissued on a tax-exempt basis later, if a tax counsel has determined the reissuance qualifies for tax-exemption.
- Following the passage of the Tax Cuts and Jobs Act in December 2017, municipal issuers are no longer allowed to advance refund prior debt on a tax-exempt basis. Assuming favorable market conditions, issuers may consider the issuance of taxable bonds to refinance prior debt when the refunding escrow exceeds 90 days to the call date. Consideration should be given as to the potential foregone savings from a taxable refunding versus waiting to current refund the bonds on a tax-exempt basis under similar market conditions.
Issuers should recognize that some features that enhance flexibility, such as an early call provision, may be more costly to exercise for taxable debt than for tax-exempt debt. While “Make-whole call provisions” are commonly expected call features in the taxable debt market, generally preclude the opportunity to refinance the bonds in the future to realize debt service savings. The increase in municipal taxable issuance over the past decade has made traditional municipal tax-exempt par call redemption features more prevalent and accepted in the taxable market.
Issuers and their Municipal Advisor should evaluate the relative cost between a make-whole call and a conventional 10-year par call, or shorter optional call provision, prior to pricing of the bonds.
Investors of taxable debt can be different from those of tax-exempt debt and may require additional information about state and local government credits to understand the underlying credit of the bonds.
- Develop an understanding of the market in advance of the planned sale, including types of investors, structural features, and size requirements needed to attract investor interest. For instance, a low-interest rate environment may minimize the long-term costs associated with issuing taxable debt relative to tax-exempt debt.
- Evaluate whether there are advantages to selling bonds outside of the U.S. domestic market and the costs associated with this approach, such as the costs of registering with a foreign exchange. Legal counsel familiar with international capital markets should be involved in order to review specific regulatory and disclosure requirements that may differ from U.S. markets. Also, governments must be sure they have sufficient staff time and expertise to manage taxable debt offered in the international marketplace.
- Allow sufficient time to educate investors who may be less familiar with state and local credit, about the offering and the issuer.
- Evaluate the market for taxable state and local government bonds prior to the pricing process, including identification of comparable issues and interest rates, including the use of variable rate debt.
- Issuers and their Municipal Advisor should discuss that less frequent issuance of taxable state and local government bonds increases the risk that a government may pay an interest rate penalty when its bonds are priced.
- Prior to any potential taxable bond sale, Issuers and their Municipal Advisor should discuss the material differences in the pricing process for taxable bonds, when compared to a tax-exempt issuance. The taxable process includes several additional steps taken by the underwriter to lock in the final interest rates.
- Fees for professionals (e.g., bond counsel, Municipal Advisors, and disclosure counsel) should not be materially higher in a taxable transaction than for tax-exempt bonds absent unusual circumstances.
- GFOA Best Practice, Managing Build America and Other Direct Subsidy Bonds
- GFOA Best Practice, Refunding Municipal Bonds
- GFOA Advisory: Other Postemployment Benefit Bonds
- GFOA Advisory: Pension Obligation Bonds
- Board approval date: Friday, March 4, 2022