April 23, 2019

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Interest rate changes may cause loss of tax exemption for tax-exempt obligations

Issuers, borrowers and banks should be cautious when making, waiving or delaying interest rate increases to tax-exempt obligations (bonds) resulting from the reduction in corporate marginal tax rates following the December 2017 Tax Act (the Tax Act) because the tax exemption on the interest could be jeopardized unless certain steps are taken.  Issuers and borrowers may be contacted by banks that have purchased their bonds to discuss an increase in the interest rate on those bonds.  Many bonds owned by banks provide for an increase to the interest rate on the bonds in the event corporate marginal tax rates decrease, like the reduction in corporate tax rates from 35 percent to 21 percent January 1, 2018, as a result of the Tax Act.  Issuers, borrowers and banks should be cautious and contact bond counsel when implementing, waiving and/or delaying any increase to the interest rate on bonds to ensure the bonds remain tax-exempt.  Depending on the specific terms of the bond documents, an increase, waiver or delay of that increase may result in a “reissuance.”  If a reissuance occurs, the bonds that are considered reissued do not automatically continue to be tax-exempt and the parties will need bond counsel to assist them in taking the necessary steps to maintain the tax-exempt status of the bonds.  Some bonds may require action by May 15, 2018, to remain tax-exempt.

Many tax-exempt obligations (bonds) purchased by banks feature interest rate adjustment provisions in the event that the maximum corporate marginal tax rate decreases, to ensure that the after-tax yield on tax-exempt bonds remains the same.  What issuers and borrowers may not realize is that some rate adjustment provisions may cause some bonds to become taxable unless the issuer takes certain affirmative steps by May 15, 2018.

On January 1, 2018, the maximum corporate marginal tax rate decreased from 35 percent to 21 percent as a result of tax law changes made in December 2017.  This reduction in tax rate may cause automatic interest rate increases for the bonds or give the bondholder the option to increase the interest rate on the bonds which, in certain circumstances, may cause a “reissuance” of the bonds for tax purposes.  Automatic interest rate increases or the exercise of an option to increase the interest rate may trigger a reissuance of the bonds, which may result in their taxability unless appropriate steps are taken, such as filing a Form 8038 or 8038-G with the Internal Revenue Service in a timely manner, and obtaining a new tax-exempt opinion with related due diligence and tax certifications.

An automatic interest rate increase typically will not cause a reissuance of the bonds unless the bondholder delays, eliminates or modifies the automatic interest rate increase provided for in the bond documents.  The bondholder’s exercise of an option to increase the interest rate on the bonds typically will not cause a reissuance of the bonds, unless the issuer or borrower has the right to redeem the bonds at the time the option is exercised or as a result of the exercise of the option.  However, failure of a bondholder to exercise an option typically will not result in a reissuance.

The preceding is a brief summary of the potential tax consequences that may result from certain interest rate adjustment provisions present in bond documents. The facts and circumstances relating to interest rate increases are varied and often subtle and require the guidance of bond counsel to determine whether any action must be taken to preserve the tax exemption of the bonds.  You should contact bond counsel as soon as possible to ensure that your bonds remain tax-exempt if their interest rate has increased, was scheduled to increase but the increase was delayed, or has the potential to increase pursuant to an option.    

© 2019 Dinsmore & Shohl LLP. All rights reserved.


About this Author

Clifford A. Pastel, Dinsmore Shohl, Tax Compliance Lawer, Bonds Attorney
Of Counsel

Clif’s extensive experience in public finance gives his clients reassurance when they’re seeking legal help. Whether it is on tax-exempt financing, including arbitrage rebate calculation and compliance, or low-income housing tax credit transactions, he provides a professional and personalized experience. 

Clif works on a variety of tax-exempt bond issues, bank loans and interest rate swap transactions for school districts, sewer and water authorities, hospitals, industrial development authorities, redevelopment authorities,...

(412) 261-4250
Dinsmroe Shohl, Lona J. Valentine, Federal Tax Lawyer, Arbitrage Attorney

Lona Valentine concentrates her practice in the area of tax and financial analysis, handling arbitrage rebates and providing guidance on federal tax topics related to tax-favored bond financings for governmental and conduit financings.

Ms. Valentine has worked on a wide variety of municipal financing transactions including projects for traditional governmental infrastructure, hospital expansion, continuing care retirement communities, cultural facilities, small issue manufacturing and exempt facilities. Ms. Valentine works with issuers and conduit borrowers to address all of the  federal tax issues from the inception of a financing throughout the entire term of the financing and has a wide array of experience in refundings, derivative products, multipurpose allocations and private use analyses.

513) 639-9238
Steve M. Sparks, Dinsmore Shohl, Government Finance Attorney, Capital Growth

Steve Sparks is an associate in the firm's Finance Department, working with local governments to finance their capital needs, Mr. Sparks has also worked with state universities and healthcare providers. He uses his advanced tax degree to structure financings in ways that can lower costs to borrowers.

(513) 639-9206