Tax-exempt financing in the President's budget.

AuthorSpain, Cathy
PositionImplications of the provision on corporations

During the budget reconciliation negotiations on the FY1996 budget in December 1995, the Clinton administration offered to eliminate a corporate tax deduction that it described as a corporate welfare provision and, in the process, set off a battle with supporters of tax-exempt financing. The proposal would have a profoundly negative effect on state and local government financing costs and would not harm the targeted corporations. It was offered again as part of a larger package in January, and on February 5, 1996, the administration included the provision in the President's FY1997 budget request submitted to Congress.

Under current law, the general rule is that no income tax deduction is allowed for interest on debt used directly or indirectly to acquire or hold tax-exempt securities. For example, in the case of a bank, an interest-expense deduction is not allowed for the portion of a bank's interest expense equal to the portion of its total assets that is comprised of tax-exempt securities. Special rules applied to banks for many years but have been whittled away as a result of various tax acts. A well-known exception that remains in the tax code is the interest deduction banks are permitted to take for 85 percent of the interest costs incurred to hold or purchase bank-qualified tax-exempt securities, which are governmental or 501 (c)(3) bonds issued by small issuers of $10 million or less annually. Prior to 1982, banks were free to take an interest deduction for all interest costs incurred for all tax-exempt bond investments.

Nonfinancial corporations and certain other taxpayers are permitted to apply a tracing rule to determine if their interest expenses are permitted deductions. If a corporation can demonstrate that it did not finance its purchases of tax-exempt bonds through borrowing, no portion of its interest expense deduction is disallowed. Furthermore, the Internal Revenue Service (IRS) established in Revenue Procedure 7218 two other "bright line" tests to assist taxpayers in complying with the law. The first of these is the 2 percent de minimis rule. The rule provides that so long as the investor's holdings of municipal securities constitute less than 2 percent of it total assets, the IRS generally will not inquire whether any of the borrowings of the investor were incurred for the purpose of purchasing or carrying tax-exempt securities. The second test is a vendor financing exception, which allows a corporation to take nonnegotiable obligations as payment for goods or services rendered to a state or local government. A tax-exempt lease payment is an example of such a payment, and a portion of that payment is tax-exempt income to the lessor.

The Clinton Administration Proposal

Under the Clinton administration proposal, all corporations would be treated...

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