Chapter 22 - § 22.1 • INTRODUCTION

• Jurisdiction: Colorado

§ 22.1 • INTRODUCTION

Organizations exempt from federal income tax under Internal Revenue Code (I.R.C. or Code) § 501(c)(3) often borrow money to finance or refinance (refund) their projects. Financing for these purposes can come from a variety of sources, including conventional bank loans, governmental loans, and loans from individuals and corporations. One form of financing available to § 501(c)(3) organizations that provides a potential cost-of-funds savings benefit is borrowing proceeds of tax-exempt debt obligations and, more particularly, proceeds of qualified § 501(c)(3) bonds. See generally I.R.C. § 145 (allowing § 501(c)(3) organizations to benefit from the issuance of obligations the interest on which is excluded from gross income for federal income tax purposes).

The Code allows taxpayers to exclude from gross income for federal income tax purposes interest on certain debt obligations issued by certain state and local governmental units. I.R.C. § 103. "Interest" on an obligation generally includes stated interest (coupon) payments and original issue discount on such obligations. I.R.C. § 103. The ability to exclude such interest from gross income for federal income tax purposes is viewed as a subsidy by the federal government because, assuming two different investments with similar credit quality and other characteristics, an investor should require a lower return on an investment where the interest paid on such investment is not subject to federal income taxation. See, e.g., 113 Cong. Rec. 31611, 31612 (1967) (statement of Sen. Ribicoff); Robert S. Amdursky & Clayton P. Gillette, Municipal Debt Finance Law: Theory and Practice 428-29 (Little, Brown & Co. (Canada) Ltd., 1992). Accordingly, one commentator notes that the difference in interest rates between taxable and tax-exempt obligations can be as much as one to two full percentage points. Frederic L. Ballard, Jr., ABCs of Arbitrage: Tax Rules for Investment of Bond Proceeds by Municipalities 1 (2011 ed., American Bar Association, 2011).

Substantial restrictions and limitations apply to tax-exempt bonds both at issuance and over the life of the bonds to ensure that the federal subsidy provided through borrowing on a tax-exempt basis furthers the legislative purposes of the subsidy. Such restrictions and limitations are primarily found in I.R.C. §§ 103 and 141 through 150 and the Treasury Regulations promulgated thereunder. This chapter discusses several of the most important restrictions and...