Profit from differences in markets. All tax-advantaged bonds are subject in one way or another to the arbitrage requirements, which are contained in Section 148 of the Code and the Treasury Regulations that go along with it.
This section is intended to provide a basic summary of federal income tax law relating to municipal Tax-Advantaged Bonds, including Tax-Exempt Bonds, Tax Credit Bonds and Direct Pay Bonds. The discussion herein will help the reader understand certain requirements for issuing such Bonds. Many of these requirements will be incorporated into the Arbitrage Certificate executed at the issuance of the Bonds. The discussion that follows is not intended to provide all the complex tax rules related to each type of Tax-Advantaged Bond, and the reader should consult other references, including those prepared by the National Association of Bond Lawyers, for a more in-depth analysis of any particular concept.
Note: As of the date of publication, new issuances of Tax Credit Bonds and Direct Pay Bonds are no longer authorized under the Code (as set forth in the 2017 Tax Act). However, many Tax Credit Bonds and Direct Pay Bonds that were issued when their issuance was permitted remain outstanding, and Congress may reauthorize them in one form or another in the future.
Source of Income Tax Exemption
Section 103 of the Code excludes Interest on any “state or local bond” from gross income for federal income tax purposes. A state or local bond is defined as an obligation issued by or on behalf of a state or Political Subdivision thereof. An “obligation” is a debt incurred by the Issuer pursuant to the exercise of its borrowing power and is not limited in form to Bonds or other Securities. There are many categories of state or local governmental or quasi-governmental Issuers whose obligations may qualify as Tax-Exempt Bonds, including the 50 states, Indian tribal governments, U.S. possessions, the District of Columbia, cities and towns, Political Subdivisions (including Special Assessment districts) and “on behalf of” Issuers, including constituted authorities and 63-20 Corporations. Generally, counsel look to the presence or absence of the Shamberg Powers (i.e., tax, eminent domain and police powers) to determine whether an entity is a Political Subdivision.
Whether, and under what circumstances, Interest on a Bond is exempt from state and local income tax in any particular state is determined by the law of that state. Many states have enacted provisions that piggyback on the federal income tax exemption and provide that the Interest on Bonds that are exempt under federal law is also exempt from state and local income tax in those states. Other states provide that Interest on all obligations issued by state and local Issuers is exempt from state and local income tax in that state, even if the Interest is federally taxable. The relevant state legal authority for the Issuer should be examined to determine the extent of state income tax exemption.
There are certain basic federal tax rules that apply to all Tax-Advantaged Bonds. These rules are generally found in Sections 103, 141, 148, 149 and 150 of the Code. Below are some, but not all, of these basic rules.
A requirement imposed under the Code to pay to the Internal Revenue Service an amount equal to the arbitrage earned on tax-exempt bonds.
As computed under the Code provisions applicable to bonds, the internal rate of return that causes the present value of the payments of principal and interest (and, in certain cases, certain other payments) on an issue of bonds to equal the issue price of the bonds.
A term defined in the Code and generally meaning, depending on the context, the dollar price at which a maturity of a bond issue or all of the bond issue was offered to the public by the underwriter.
Use of bond proceeds to pay project costs prior to the issuance of bonds. Reimbursement raises questions related to whether the reimbursement qualifies as an expenditure of tax-exempt bond proceeds for federal income tax purposes.
Section 149(e) of the Code provides that an Issuer must timely file an information return for Interest on the Bonds to be exempt from federal income tax. IRS Form 8038 (for qualified Private Activity Bonds), IRS Form 8038-G (for Governmental Bonds) or IRS Form 8038-GC (for small Bond Issues) must be filed not later than the 15th day of the second calendar month following the end of the calendar quarter in which the Bonds are issued (i.e., February 15, May 15, August 15 and November 15).
Compare and Contrast
Private Activity Bonds v. General Obligation Bonds
Private Activity Bonds (PABs) generally benefit private entities and require the private entities to repay the principal and interest of the bonds. In contrast, Governmental Bonds are municipal bonds that do not meet certain criteria of PABs. Learn more about the two below.
The term used in the Code to describe any bond issued as part of a bond issue that meets both of the private business tests or meets the private loan financing test.
Bonds issued by an issuer to finance all or a portion of its own project and that do not satisfy both the Private Business Tests and the Private Loan Financing Test.
What Makes a PAB?
Explore the concept of private business use (PBU), the private business tests, and the private loan financing test to better understand what makes a bond a PAB.
Other Tax Topics to Explore
A taxable bond that provides a tax credit to the holder in lieu of tax-exempt interest.
A taxable bond that offers a federal Interest subsidy to the Issuer in lieu of the interest being excludable from federal income tax.
A transaction in which refunding bonds are issued and their proceeds are used to pay off outstanding bonds.
The deemed new issuance of outstanding tax-exempt bonds for federal tax purposes under Section 1001 of the Code and Treasury Regulations Section 1.1001-3 as a result of certain changes to the terms of the tax-exempt bonds after original issuance of such tax-exempt bonds.
Action taken by the issuer to address events that occur after closing that could impair the tax status of tax-exempt bonds.