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Section 4. Tax-Exempt Bonds
The Internal Revenue Code generally excludes interest on obligations ("bonds") of States and local governments from Federal income tax. Qualified governmental units may issue tax-exempt bonds to finance general governmental operations and facilities, including facilities such as schools, roads, and water and sewer facilities. They may also issue notes in anticipation of taxes or other revenues (so-called tax anticipation or revenue anticipation notes (TRANS)).
Additionally, subject to certain restrictions, qualified governmental units may issue tax-exempt private activity bonds for use by religious, charitable, scientific, or educational organizations (section 501(c)(3) organizations), and for certain activities of other nongovernmental persons (e.g., exempt facility bonds, qualified redevelopment bonds, qualified small issue bonds, qualified student loan bonds, and mortgage revenue bonds).
The Internal Revenue Code of 1986 (the "Code") does not define a governmental bond directly. Rather, a bond is generally deemed governmental if the amount of private business use made of its proceeds does not exceed certain prescribed percentages or no more than a certain amount of the proceeds is loaned to nongovernmental persons. Specifically, an issue is an issue of private activity bonds if (1) an amount exceeding 10 percent of the proceeds is to be used for any private business use, and (2) more than 10 percent of the payment of principal of, or interest on, the issue is to be made with respect to such private business use of the bond proceeds, or is otherwise secured by payments or property used for private business use. The private business use limit for output facility financing (e.g., public power facilities) is the lesser of 10 percent or $15 million.
The limit on the amount of proceeds that may be loaned to private persons without creating a private activity bond is the lesser of 5 percent or $5 million. The Code also includes a limitation on disproportionate and unrelated private business use of bond proceeds.
The use of bond-financed property is treated as use of bond proceeds. A person may be a user of bond proceeds and bond-financed property as a result of ownership, actual or beneficial use of property pursuant to a lease, a management or incentive payment contract, or any other arrangement such as a take-or-pay or other output-type contract. Use (including use as an industrial customer) on the same basis as the general public is not taken into account.
All activities of section 501(c)(3) organizations, the Federal Government, and other persons (other than States and local governments) who are not natural persons are treated as private business
activities. The determination of who uses bond proceeds or bondfinanced property generally is made by reference to the ultimate user of the proceeds or property.
The volume of outstanding tax-exempt debt has increased dramatically since 1977. The volume of long-term, tax-exempt debt increased from approximately $45 billion in 1977 to over $151 billion in 1986. A dramatic 35 percent decline in bond issuance occurred from 1985 to 1986. This decline reflected the impact of Federal tax reform in at least two respects. First, the enormous volume of taxexempt debt issued in 1985 to beat the expected effective date of the Tax Reform Act of 1986 (the “1986 Act”) made the issuance of additional debt unnecessary in the immediate future in many instances. Second, the 1986 Act imposed significant restrictions on both the types of tax-exempt bonds which could be issued and the volume of that debt. The decline in volume generally was with respect to private activity bonds, rather than governmental bonds.
A number of provisions in the 1986 Act influenced the volume of tax-exempt debt by affecting the demand for such debt. Most importantly, the reductions in marginal tax rates for both individuals and corporations reduced the advantage of holding tax-exempt securities. Another provision subjected the interest on certain private activity bonds, otherwise tax-exempt, to the alternative minimum tax, currently imposed at a 24 percent tax rate (21 percent until enactment of the Omnibus Budget Reconciliation Act of 1990) for individuals and a 20-percent rate for corporations. This minimum tax is imposed if the interest on these bonds plus other forms of "tax preferences" subject to this tax amounts to a significant percentage of total taxable income. The interest on all tax-exempt debt also is subject to the corporate minimum tax because of its inclusion in the corporate adjusted current earnings ("ACE") preference. (Before 1990, a book unreported profits preference achieved the same result.)
Finally, banks are no longer able to deduct the interest they pay when they borrow to finance the purchase of most tax-exempt bonds.
Conversely, the elimination of most ways of sheltering income from tax under the 1986 Act caused some investors to increase their purchases of tax-exempt bonds.
PRIVATE ACTIVITY BONDS
In general, the interest on private activity bonds is taxable. The interest on qualified bonds, however, is tax-exempt if the State volume limitation and certain other requirements are met. Qualified bonds are exempt facility bonds, qualified mortgage bonds, qualified veterans' mortgage bonds, qualified small issue bonds, qualified student loan bonds, qualified redevelopment bonds, and qualified 501(c)(3) bonds. Table 1 illustrates the differing volumes of private activity bonds by type of activity.
Exempt facility bonds are bonds at least 95 percent of the proceeds of which is to be used to finance airports, docks and wharves, mass commuting facilities, sewage facilities, solid waste disposal
facilities, qualified residential rental projects, facilities for the local furnishing of electric energy or gas, local district heating or cooling facilities, qualified hazardous waste facilities, high-speed rail facilities, or environmental enhancements of governmentally owned and operated hydroelectric generation facilities (for bonds issued after October 24, 1992).
Qualified mortgage bonds are bonds at least 95 percent of the proceeds of which is to be used to finance the purchase, or qualifying rehabilitation or improvement, of single-family homes for firsttime owners within the jurisdiction of the issuer of the bonds.1 The acquisition cost of a residence financed with qualified mortgage bonds generally may not exceed 90 percent of the average area purchase price. Additionally, qualified mortgage bond financing is available only to mortgagors whose family incomes do not exceed 115 percent of the higher of the median family income for the area in which the residence is located or the statewide median family income. Qualified governmental units may elect to exchange qualified mortgage bond authority (on a 4:1 basis) for authority to issue mortgage credit certificates which entitle homebuyers to nonrefundable income tax credits for a specified percentage of interest (between 10 and 50 percent) on mortgage loans on their principal residences. Certain States also may issue qualified veterans' mortgage bonds, at least 95 percent of the proceeds of which is to be used to make mortgage loans to qualified veterans for the purchase of owner-occupied residences.
Qualified small issue bonds are bonds at least 95 percent of the proceeds of which is to be used for manufacturing facilities or certain property for first-time farmers.2 Small issue bonds are issues having an aggregate authorized face amount (including certain outstanding prior issues) of $1 million or less. Alternatively, the aggregate face amount of the issue, together with the aggregate amount of certain related capital expenditures during the 6-year period beginning 3 years before the date of issue and ending 3 years thereafter, may not exceed $10 million. Interest on qualified small issue bonds is taxable if the aggregate face amount of all outstanding tax-exempt bonds that may be allocated to any beneficiary of the qualified small issue bonds exceeds $40 million.
Qualified student loan bonds are bonds issued by qualified governmental units or qualified scholarship funding corporations in connection with the Guaranteed Student Loans and Parent Loans for Undergraduate Students programs of the United States Department of Education. These bonds must be both guaranteed by the United States Department of Education and eligible for special assistance payments (unless such payments are precluded solely by virtue of the tax-exempt status of the bonds). Additionally, the interest charged student borrowers must be restricted as provided in the Higher Education Act of 1965. Qualified student loan bonds also include obligations used to make or finance loans under certain State supplemental student loan programs.
1The qualified mortgage bond program expired after June 30, 1992. H.R. 11, as passed by the House and Senate and vetoed by President Bush, would have extended the program permanently.
The qualified small issue bond program expired after June 30, 1992. H.R. 11, as passed by the House and Senate and vetoed by President Bush, would have extended the expiration date to allow issuance of such bonds through September 30, 1993.
Qualified 501(c)(3) bonds are bonds at least 95 percent of the proceeds of which is to be used by a section 501(c)(3) organization or a governmental unit and the facilities financed with which are owned by a 501(c)(3) organization or a governmental unit. With the exception of qualified hospital bonds, the maximum outstanding amount of qualified 501(c)(3) bonds of which a 501(c)(3) organization may be the beneficiary is $150 million.
Qualified redevelopment bonds must be part of an issue at least 95 percent of the proceeds of which is to be used for redevelopment purposes in a locally designated blighted area and the payment of debt service on which is primarily secured either by taxes of general applicability imposed by a general purpose governmental unit or by a pledge of incremental property tax revenues reserved exclusively for debt service on the issue and similar issues to the extent necessary to cover debt service. Incremental tax revenues are increased real property tax revenues attributable to increases in assessed value by reason of the redevelopment.
A variety of restrictions apply to private activity bonds: a 2-percent-of-proceeds limit on costs of issuance which may be paid from bond proceeds, a weighted average maturity limit of 120 percent of the weighted average economic life of the assets financed with the bonds, a 25-percent-of-proceeds limit on the financing of most land, a prohibition on the financing of most nonrehabilitated existing property, the requirement of a public hearing and approval process prior to issuance, and certain sanctions for changes in use of bondfinanced property.
Each State has an annual volume limitation on the amount of private activity bonds which it may issue, equal to the greater of $150 million or $50 per capita. Qualified 501(c)(3) bonds and bonds for airports, docks and wharves, governmentally owned solid waste disposal facilities and environmental enhancement of governmentally owned and operated hydroelectric generating facilities, and a portion of bonds for high speed rail facilities are not subject to the volume limitation. Bond volume authority not used by yearend may be carried forward for specific purposes for a period not to exceed 3 years.
Interest on any otherwise tax-exempt bond is taxable if the obligation is an arbitrage bond. An arbitrage bond is an obligation any portion of the proceeds of which is reasonably expected (at the time of issuance of the bond) to be used, or subsequently is intentionally used, to acquire higher yielding investments or to replace funds which were used directly or indirectly to acquire higher yielding investments. Exceptions to this general restriction are provided for materially higher yielding obligations held for certain temporary periods (principally 3 years for construction funds) and for reasonably required reserve or replacement funds (generally not exceeding 10 percent of proceeds).
Permissible arbitrage earnings generally must be rebated to the Federal Government. Exceptions are provided for: (1) governmental
issues the issuer of which issues no more than $5 million during the calendar year, (2) governmental and 501(c)(3) and certain private activity bond issues used primarily for construction projects if the proceeds are expended in accordance with a percentage schedule within 2 years of issuance, and (3) issues the proceeds of which (with the exception of a debt service reserve fund) are expended within 6 months of issuance.
Limits are placed on the number of times a bond issue may be advance refunded. An advance refunding issue is one issued to pay debt service on another issue more than 90 days before the prior issue is to be retired. Bonds issued prior to 1986 may be advance refunded twice. Bonds issued after 1985 may be advance refunded once. Bonds issued before 1986, which were advance refunded two or more times before March 15, 1986, may be advance refunded one additional time after March 14, 1986. Private activity bonds may not be advance refunded.
Certain requirements and limitations apply to all tax-exempt bonds (e.g., a prohibition on any Federal guarantee, limitations on bonds issued to hedge against increases in interest rates, a requirement that the bonds be issued in registered form, and a requirement that certain information be reported to the Internal Revenue Service).