Tax Exempt Financing

• Small Issue Bonds for Manufacturing Firms
• Small Issue Bonds for First-time Farmers
• Redevelopment Bonds
• Exempt Facility Bonds
• State Law Requirements

 (The following outline is from a presentation given by Timothy M. Anstine to the Pennsylvania Economic Development Association on March 7, 2000)

Rules Governing Tax-exempt Bonds

Revenue bond: a bond in which revenue from a specific project is used to pay the principal and interest on the bond. Bonds can be taxable, meaning that the interest on them is subject to federal and state income taxes, or tax-exempt. Taxable bonds have relatively few restrictions. Tax-exempt bonds have many restrictions.

Tax-Exempt bonds must be issued by a state or local government. If the proceeds are used for traditional governmental purposes they are considered "governmental bonds." If more than ten percent of the bond proceeds are used for any private business use and if repayment of more than 10 percent of the principal or interest of the bond issue is secured by or derived from private business property the bonds are "private activity bonds" and are generally taxable. However, Congress allows certain private activity bonds to qualify for the tax exemption; these are known as "qualified private activity bonds".

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There are eight categories of qualified private activity bonds. The significant ones for our purposes are small issue bonds for manufacturing facilities and first-time farmers, redevelopment bonds and exempt facility bonds.

1. Small Issue Bonds-manufacturing. Up to $1 million of bonds can be issued to finance land or depreciable property for any manufacturing facility within any incorporated municipality. The size of the bond issue may be up to $10 million provided certain capital expenditure limitations are met: Capital Expenditure Limitation. Up to $10 million of bonds can be issued for a manufacturing project if the sum of the following items does not exceed $10 million: a) the face amount of the bond issue plus b) capital expenditures made with respect to the facility financed with the bond issue or any other facility having the same principal user and located in the same incorporated municipality, and made within the six year period beginning 3 years before the bonds are issued and ending 3 years after the issue date.
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2. Small Issue Bonds-first-time farmers. Up to $250,000 can be used to provide depreciable farm property with respect to which the principal user is or will be the same person or 2 or more related persons. Depreciable farm property is property for which depreciation can be taken used in a trade or business of farming (i.e., buildings, equipment).No more than $62,500 of financing can be used for used farm equipment. Acquisitions of used equipment from related persons permitted if fair market value paid and seller will have no ongoing interest. Land must be used for farming purposes. Land is to be acquired by an individual who is a first-time farmer who will be principal user of land and who will materially and substantially participate in the operation of the farm on that land. A first-time farmer is any individual who never had direct or indirect ownership in substantial farmland in the operation of which he materially participated, and who has not received first-time-farmer financing which, added to current loan, would exceed $250,000. Any farmland previously owned by individual and disposed of during insolvency is disregarded if individual received income from discharge of indebtedness under section 108. "Substantial farmland" is any parcel unless smaller than 30% of the median farm size in the county and value never exceeded $125,000. Farms includes stock, dairy, poultry, fruit, fur bearing animal, truck farms, plantations, ranches, nurseries, ranges, greenhouses or other similar structures used for raising of agricultural or horticultural commodities and orchards.
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3. Redevelopment Bonds. Must be used for redevelopment purposes in a blighted area, the debt service on the bonds must be paid for through the use of tax increment financing, and there must be a redevelopment plan adopted. Eligible purposes include acquisition and rehabilitation of property, clearing and preparation of land, relocation of occupants of property acquired.
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4. Exempt Facility Bonds. Can be used to provide land, buildings or other functionally-related property for one of 12 types of facilities: Airports (must be government-owned); Docks and Wharves (must be government-owned); Mass Commuting Facilities (must be government-owned); Facilities for Furnishing of Water; Sewage Facilities; Solid Waste Disposal Facilities; Qualified Residential Rental Projects; Facilities for Local Furnishing of Electric Energy or Gas; Local District Heating or Cooling Facilities; Qualified Hazardous Waste Facilities; High Speed Inter City Rail Facilities ; Environmental Enhancements of Hydro-electric Generating Facilities; and Enterprise Zone Facilities.
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5. Volume Ceiling on Private Activity Bonds. The Internal Revenue Code imposes state by state ceilings on the amount of private activity bonds, including most industrial development bonds, issued during a calendar year. Generally, each stateâs ceiling equals $50 per person. The Internal Revenue Code allows the ceiling to be allocated within a state pursuant to legislation. In Pennsylvania this function is performed by the Department of Community and Economic Development under the Job Enhancement Act. There is a move in Congress to increase the volume cap.
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6. Limitation on Deduction of Expenses and Bank Qualified Bonds. Ordinarily a taxpayer is allowed to deduct on its tax return expenses incurred in earning taxable income. However, since interest earned on tax-exempt bonds is, obviously, exempt from tax, there is no logical reason for allowing a taxpayer to deduct the expenses incurred in earning tax-exempt income. The Internal Revenue Code specifically prohibits the deduction of most expenses allocable to tax-exempt income, and specifically interest incurred in purchasing or carrying tax-exempt bonds. Prior to 1987 this rule did not apply to banks. A bank could deduct the interest paid on deposits even if the bank owned tax-exempt bonds, thus making the bankâs effective tax rate very low. The Tax Reform Act of 1986 eliminated this loophole for the banks, and now the banks lose a proportionate share of the deduction for interest e expense if tax-exempt bonds are owned. The amount lost is based on the ratio of the basis of tax exempt bonds acquired by the bank after August 7, 1986 to the basis of all assets of the bank. However, there is an important exception to this general rule which allows small municipalities to issue "bank-qualified" tax exempt bonds. This exception allows small municipalities to borrow from local banks at favorable "bank qualified" rates. The following rules apply to this exception:
   
   
   1. The issuer must not expect to issue more than $10 million in qualified tax exempt bonds in any one year, and in fact not more than $10 million of qualified tax-exempt obligations per issuer per year may be issued. Private activity bonds (other than those issued for a 501(c)(3) entity) are not included. Thus, private activity bonds cannot be "bank qualified" and do not count towards the $10 million limit.
   2. Separate issues for certain issuers must be aggregated for purposes of the limits. The outstanding bonds of any issuer subordinate to the issuer are aggregated with those of the issuer for determining if the $10 million limit is met. However, the reverse is not true: the outstanding bonds of a superior entity are not aggregated with those of a subordinate unit. For example, the bonds of a township municipal authority are added to those of the township to see if the townshipâs limit is met, but the bonds of the township are not added to those of the municipal authority to see if the authorityâs limit is met.
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State Law Governing Project Eligibility.

Pennsylvania Economic Development Financing Law. --previously known as the Industrial and Commercial Development Authority Law - - is the statute which creates both the local Industrial and Commercial Development Authorities and the Pennsylvania Economic Development Financing Authority and authorizes them to issue bonds. The name is somewhat misleading. This Act authorizes the issuance of bonds not just for economic development projects but revenue bonds which advance any public purpose. The logic of the law is that conduit financing does not involve any expenditure of Commonwealth funds or the extension of Commonwealth credit and, therefore, there is no reason to husband its uses only for a limited category of public purpose projects. It permits all projects which advance a public good. The market determines whether the specific project is creditworthy and the federal government determines whether the project qualifies for tax exempt financing.

The Act authorizes the ICDAs "to enter into agreements providing for (i) the acquisition of projects by either the authority, the project applicant or the project user; (ii) the financing of projects where acquisition is by a project applicant or a project user; (iii) the financing of improvements to existing projects; and (iv) the leasing or sale of projects to or the loan financing of projects for the project users or project applicants as provided in this act."

A "Project" "means industrial facilities, commercial facilities, pollution control facilities, energy conversion facilities, energy-producing facilities, disaster relief project facilities, public facilities and other facilities or activities which promote any of the public purposes set forth in section 2 or 2.1 of this act, including any land, interests in land, easements, appurtenances, improvements, buildings, structures, equipment, furnishings or other real or personal property, whether tangible or intangible, or interest therein or any combination thereof. In addition, the project may include working capital and other capital needs for industrial, commercial and other economic or cost savings activities and may consist solely of the financing of operating expenses. The financing of projects may be with tax-exempt bonds or taxable bonds issued pursuant to this act and may be direct through application of bond proceeds or other funds to pay project costs or indirect through stock purchases or such other means as an authority or the financing authority may approve."

A "Project" moreover is not limited to the costs associated with capital assets for any of these purposes. It may also include "working capital" and may even consist "solely of the financing of operating expenses."

The Act expressly provides that an ICDA may not:

1. Acquire or finance the acquisition of a project which shall cause the removal of a plant, facility or other business from one area of this Commonwealth to another area of this Commonwealth, unless the secretary has found that relocation of the plant, facility or other business is necessary in order for the plant, facility or other business to remain competitive or to prevent the plant, facility or other business from leaving this Commonwealth.
2. Enter into any agreement to finance the acquisition of a project in excess of the cost of the project.
3. Engage in business, trade or commerce for a profit as an owner or lessee of a project, or otherwise.
4. Finance any project which will be used in whole or in part for illegal activities.
5. Finance any project which is not located within this Commonwealth.

Conduit financing carries with it other obligations as well. The most significant is the requirement that the "construction reconstruction, repairs or work of any nature made directly by any authority where the entire cost, value or amount of such construction, reconstruction, repairs or work, including labor and materials, shall exceed ten thousand dollars ($10,000) such projects be publicly bid" and the authority must enter into the contract with the lowest responsible bidder.

An important exception to this requirement is that when the authority is simply the legal title holder but a private company can acquire legal title to the project under terms and conditions, contracts for construction, reconstruction, repair, or work of any nature, or purchase of machinery and equipment, may be awarded by the project user or project applicant without regard to these limitations.

PEDFL now permits (it did not prior to the 1993 Amendments), PIDA certified IDCs as well as ICDAs to refer projects to PEDFA.

PEDFL has few technical requirements. The Act does require that the Secretary of DCED approve a bond issue before bonds may be sold or issued, but not, as under the previous law, prior to commencement of construction of a project. The law also authorizes the Secretary to issue rulings interpreting the Act should a question arise that needs to be addressed prior to issuance of the bonds.

The Act also provides broad powers to PEDFA to engage in other types of financing. Indeed, if funded, there is little that PEDFA cannot do in the way of financing projects that further the broad goals of the Act.

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