VIII. Tax-exempt Bonds

• Library: Municipal Law Deskbook (ABA) (2015 Ed.)

VIII. TAX-EXEMPT BONDS

A. In General

Section 103 of the United States Internal Revenue Code of 1986, as amended (the Code), provides that interest paid on an obligation of a state or one of its political subdivisions is excludable from gross income for purposes of calculating federal income tax liability.

Local government borrowings paying interest that is excludable from gross income under the Code are commonly referred to as tax-exempt bonds.

Although it was once commonly believed that the federal government lacked the power to impose taxes on the obligations of sovereign states and their political subdivisions, recent United States Supreme Court decisions suggest that the federal government does have the power to impose taxes on the interest that states and local governments pay to nongovernmental entities.

Congress has enacted laws and the United States Internal Revenue Service has imposed regulations that substantially limit the availability of tax-exempt financing. These limitations are quite complex, and are generally found in Sections 141 to 149 of the Code and in the regulations issued under those sections.

In the absence of an exemption, interest paid to a lender or a bond owner would be ordinary income; the Code generally subjects ordinary income to the highest level of taxation. The interest rate that a local government pays on a tax-exempt borrowing is usually substantially less than the rate the local government would pay on an equivalent borrowing that is not tax-exempt. The rate is less because the lender does not have to pay federal income tax on the interest the lender receives, so the lender passes on a portion of that savings to the local government borrower in the form of a reduced interest rate. The amount of the rate reduction that results from tax-exemption depends on market conditions and a variety of other factors; however, the most common (and usually inaccurate) ballpark estimate is that tax-exemption results in a 2 percent savings on the interest rate. For example, if a taxable borrowing would bear interest at an annual rate of 6 percent, the ballpark estimate of the tax-exempt rate would be 4 percent.

Many states that impose income taxes also exempt interest on obligations issued by local governments in their states, further reducing the borrowing cost of those local governments.

B. The Arbitrage Restrictions

Because tax-exempt bonds bear interest at an unusually low interest rate, it is often theoretically possible for a local government to issue low-rate tax-exempt bonds and reinvest the proceeds in taxable obligations that pay a higher interest rate...