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Turning the Page to 2016: Bank-Qualified Tax-Exempt Obligations

December 15, 2015

by Timothy J. Horstmann

Reprinted with permission from the December 15, 2015 issue of The Legal Intelligencer © 2015 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

As 2015 winds down and we prepare to welcome 2016, many smaller municipalities, municipal authorities, and other public entities may be putting the final touches on last-minute financings, or preparing for new financings in early 2016. In many of these issuances, the term “bank-qualified” will be used.

For such issuers, bank qualification is a means to enhance the attractiveness of the entity’s tax-exempt debt when placed with a bank or other financial institution, regardless of whether the debt is to be publicly offered or placed privately.

Tax-exempt debt is bank-qualified if it meets the requirements for such debt under Section 265 of the Internal Revenue Code. Because certain of the requirements under Section 265 reset each calendar year, there is often a rush to close transactions by Dec. 31, or as soon as possible after the first of the year.

Under Section 265, a tax-exempt obligation is bank-qualified if it: is issued by a “qualified small issuer”; is used for governmental or Code Section 501(c)(3) tax-exempt purposes; and is designated as bank-qualified by the issuer. A tax-exempt obligation that is bank-qualified carries lower interest costs, as this designation allows banks and other financial institutions to avoid certain adverse tax consequences that would otherwise be imposed on such holders for carrying tax-exempt debt.

The definition of a “qualified small issuer” is straightforward: a “qualified small issuer” is an issuer that reasonably expects to issue not more than $10 million in tax-exempt obligations during a calendar year. However, like many provisions in the Internal Revenue Code, there are a number of exceptions to this rule, and thus certain tax-exempt debt is not counted for purposes of determining the amount of tax-exempt debt issued in a calendar year. Obligations that do not count toward this $10 million cap include obligations issued to currently (within 90 days of closing) refund outstanding tax-exempt bonds, but only to the extent the amount of the refunding bonds does not exceed the outstanding amount of the refunded bonds. Private activity bonds (other than those used for Code Section 501(c)(3) tax-exempt purposes) are also not counted for purposes of this $10 million cap.

Consider the following example to see how the definition of a “qualified small issuer” is applied: a municipality plans to issue two obligations in 2016—one in the amount of $9.5 million to finance the construction of a new municipal building, and a second in the amount of $5 million to currently refund a prior tax-exempt obligation. The municipality does not contemplate issuing any other tax-exempt debt in 2016. In both cases, the municipality intends to use proceeds from the obligation to pay closing costs. In determining the amount of the obligations that apply toward the $10 million cap (and thus whether the municipality is a “qualified small issuer”), the municipality adds the two obligations together, then subtracts from that amount the prior obligation that is to be refunded. If the result is less than $10 million, the municipality is a “qualified small issuer.”

An issuer that meets the definition of a qualified small issuer in a calendar year may designate up to $10 million of tax-exempt obligations as bank-qualified during that calendar year. However, the issuer may deem designate certain tax-exempt obligations as bank-qualified; such obligations do not count against this second, $10 million cap.

In order for a tax-exempt obligation to be deemed designated by the issuer, it must meet three requirements: it is an obligation issued to currently refund an outstanding tax-exempt obligation, but only to the extent the amount of the obligation does not exceed the outstanding amount of the prior obligation; the weighted average maturity of the obligation is not greater than the remaining weighted average maturity of the prior obligation; and the final maturity date of the obligation is not later than 30 years from the date of issuance of the original obligation.

Consider the effect of the deemed designated exception on the above example. If the municipality’s proposed refunding issue in 2016 has a weighted average maturity in excess of the remaining weighted average maturity of the prior obligation, the refunding issue cannot be deemed designated, and therefore will count against the second $10 million cap. The refunding issue also cannot be designated as bank-qualified, as the combined amount of the two issues contemplated for 2016 exceeds $10 million. This illustrates an important point about Section 265: a particular issue may not count against the $10 million cap for purposes of the definition of qualified small issuer, but may count against the separate $10 million cap for purposes of the deemed designated rule.

Even if a particular obligation meets the requirements to be designated or deemed designated as bank-qualified, another provision in Section 265 may apply, and prevent the obligation from receiving bank-qualified status. Section 265 provides that if the obligation in question is part of an issue that had a total face amount in excess of $10 million, and any portion of that issue was used to refund another obligation, then the obligation may not be designated or deemed designated. This rule only applies if the obligations are all part of the same issue, (i.e., the obligations are sold less than 15 days of each other pursuant to a common plan of financing and are expected to be paid using substantially the same source of funds).

Returning to the example again, the two obligations the municipality plans to issue in 2016 exceed $10 million. Therefore, the municipality should take care to ensure that the obligations planned for 2016 are not deemed to be part of the same issue.

To further complicate matters, Section 265 also requires that in certain cases, two or more issuers must be aggregated for purposes of applying the two $10 million caps. Aggregation is intended to prevent issuers from circumventing the rules of Section 265 by creating related, subordinate entities for the purpose of issuing additional obligations beyond the “parent” issuer’s permitted amount. When an entity acts on behalf of another entity in issuing obligations, the aggregation rules may require that the two entities may be considered as a single entity. Additionally, the obligations of an entity that is subordinate to another entity may be included when testing whether the other entity meets the rules.

The issue of aggregation may arise in connection with obligations issued by small municipalities or their related municipal authorities; the issue of aggregation is usually not present when dealing with larger, regional or joint authorities. Whether a municipality and its related authority must be aggregated for purposes of Section 265 will depend on all of the facts and circumstances.

Returning to the example one last time, let’s assume that the municipality has a related municipal authority. The municipality will have to carefully review all of the facts and circumstances of its relationship with the municipal authority to determine whether aggregation is required. Generally, facts showing the independence of the municipal authority (e.g., separate facilities, staff, revenue stream, etc.) will support a finding that aggregation is not required, while the reverse is true where the facts indicate control by the municipality.

There are other provisions in Section 265 that may affect the determination of whether a particular tax-exempt obligation is “bank-qualified.” A municipality, municipal authority or other public entity that is contemplating issuing a bank-qualified tax-exempt obligation should seek professional advice as early in the process as possible to ensure that their plan meets all of the requirements of Section 265. Municipal officers will take comfort in knowing their plans won’t go awry as we look forward to the holiday season and 2016.

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