Tax Reform Threatens the Future of Direct Purchase Transactions
On December 22, 2017, the president signed into law the Tax Cuts and Jobs Act (the Act). Effective Jan. 1, 2018, the Act represents the first major overhaul of the Internal Revenue Code in over 30 years. While the Act contains provisions that will have a direct impact on the municipal bond market (such as the elimination of advance refundings and tax credit bonds), it also contains provisions that will have an indirect impact on both the municipal bond market and, more importantly, issuers of tax-exempt debt. One such provision is the lowering of the maximum corporate tax rate from 35 percent to 21 percent. As discussed below, a cut in the corporate tax rate will not only reduce future demand for tax-exempt direct purchase transactions, it may also increase the interest rate on existing tax-exempt debt.
Municipal issuers have increasingly turned to tax-exempt direct purchase transactions as an alternative to traditional public bond financings. With a corporate tax rate of 35 percent, purchasing tax-exempt debt generally provided a better after-tax benefit to lenders than purchasing taxable debt. In fact, according to SIFMA, lenders held approximately $376.9 billion in municipal debt and $180.3 billion in municipal bank loans as of the end of the third quarter of 2017. However, by reducing the corporate tax rate to 21 percent, lenders may decide to forego purchasing tax-exempt debt in favor of other, higher yield investment opportunities (including taxable debt). With a lower corporate tax rate, the after-tax return for lenders on purchasing tax-exempt is diminished. As a consequence, it will be necessary for interest rates on tax-exempt debt to increase in order to provide the same after-tax yield as taxable debt or other types of investments. Unfortunately, for municipal issuers, this means an increase in borrowing costs associated with direct purchase transactions.
A second consideration is the potential impact on existing tax-exempt debt. As a result of a lower corporate tax rate, some lenders may seek to enforce “gross-up” or “yield maintenance” clauses found in financing documents, causing interest rates on existing debt to increase. The purpose of a gross-up clause is to neutralize the effects of any change in the corporate tax rate, enabling a lender to adjust the interest rate on existing debt in order to maintain the same after-tax yield as if the corporate tax rate remained unchanged. Gross-up clauses shift the risk of tax rate changes to the municipal issuer. While not all gross-up clauses are alike, generally speaking, a gross-up clause includes a formula that produces a tax adjustment multiplier that is then applied to the current interest rate on the outstanding debt (whether fixed or variable). While some gross-up clauses are discretionary and leave the decision to raise the interest rate to a lender, others may be mandatory. In cases where the gross-up clause is mandatory, yet the lender decides to waive the interest rate increase, the waiver may cause a reissuance for federal tax purposes. As result of the decrease in the corporate tax rate, municipal issuers should be prepared to potentially see their interest rates on existing tax-exempt debt increase in the event that a gross-up clause is enforced by a lender.