Corporate Tax Change Could Make Schools' Tax-Exempt Bonds Taxable

Article by Charles E. Procknow, George K. Baum & Company

This information is provided for general educational purposes only. It should not be relied upon as, or in place of, legal, financial or other professional advice. Readers are encouraged to work with their legal and financial advisors when addressing specific issues.

Over the past 10 years, most independent school tax-exempt financings were structured as “direct purchases,” which typically have a clause that allows the bank to increase the interest rate (variable or fixed) in the event the bank’s tax rate decreases. Since the recent tax law changes decreased the corporate tax rate for banks from 35 percent to 21 percent, many schools are seeing their interest rates adjusted upward. The average increase appears to be about 0.60 percent (60 basis points), or $60,000 per year for a $10 million issue.

Some schools have not had to deal with this increase in their interest rate. This may be because the clause was not in their loan documents, or because the bank declined to change the interest rate. But all schools should clearly understand their loan documents to know whether the tax law change triggers a “reissuance.” Reissuance, an Internal Revenue Code term, requires certain regulatory steps to be taken to ensure tax-exempt financing remains tax-exempt. If your school’s bonds are subject to reissuance, not taking the proper regulatory steps may cause your financing to be declared taxable by the Internal Revenue Service, costing your school thousands of dollars in additional interest expense and potentially additional penalties. 

If your school has a tax-exempt direct purchase with its bank, here are five possible scenarios:

1. No tax law change clause. The school’s loan agreement does not have a tax law change clause. No need for the school to do anything. 
2. Automatic rate increase due to tax law change. The school’s loan agreement requires the interest rate to increase upon a decline in the corporate tax rate. 
1. If the rate has been increased as directed by the loan agreement this does not trigger a reissuance; no need for the school to take action (although you may want to contact your bank and push back).
2. If the bank agrees to waive this clause and not increase the interest rate, this triggers a reissuance and certain steps will need to be taken.
3. Optional rate increase at the bank's discretion. The bank has the option to increase the rate or not.
1. If the rate is increased, most tax counsel will consider this a reissuance – especially if the rate rises more than 0.25 percent. Certain steps will need to be taken.
2. If the rate remains unchanged, this is not considered a reissuance. 

From talking to counsel at Kutak Rock and Butler Snow, we at George K. Baum understand you'll need to take the following steps to properly document a reissuance and to preserve the tax-exempt treatment of your school’s debt: 

1. For situations (2.2 and 3.1 above), modify the loan documents with an amendment. (This will require the school’s signature, the issuing authority’s signature and the bank’s signature).
2. File a new IRS Form 8038;
3. Obtain either a new tax opinion or at least the shorter “no adverse” change opinion from bond counsel. This step is critical for ensuring your bond remains tax exempt.
4. Be aware that the reissuance resets the clock for arbitrage rebate purposes. A new arbitrage rebate calculation may be required (unlikely if there is no project fund or debt service reserve fund).

Because the whole concept of reissuance can be daunting, we think it is important for schools to reach out to their counsel to walk through their specific situation to obtain clarity. 

Charles E. Procknow is executive vice president in George K. Baum & Company's higher education & nonprofit finance group. His national practice focuses on the tax-exempt financing needs of independent primary and secondary schools.