Public Finance Alert | January.25.2018
The recently enacted reduction of the maximum federal corporate tax rate may trigger contractual provisions that provide for a significant increase in the interest rate on tax-exempt debt privately placed with a bank lender or require issuers or conduit borrowers to pay a significant fee. In each case, this adjustment is meant to compensate a bank lender for the reduction in after-tax return relative to a comparable taxable investment. We advise you to consult bond counsel before amending or allowing the waiver of any contractual provisions providing for interest rate increases or fees resulting from the change in the maximum federal corporate tax rate.
The recently enacted tax bill reduces the maximum federal corporate tax rate from 35% to 21%. This reduction increases the after-tax return on taxable investments currently held by bank lenders but does not affect the after-tax return on their tax-exempt investments. As a result, the change in law reduces the after-tax return on tax-exempt investments relative to the return on comparable taxable investments.
Most tax-exempt bank loans include “gross up” adjustment provisions crafted to deal with the adverse effect of corporate tax rate reductions on the relative return on such loans. The adjustments can take various forms, including a permanent, automatic, formula-based rate increase or a one-time fee determined by the bank lender to be adequate to compensate it for the reduction in the relative value of its tax-exempt investment. See the chart below for examples of two common “gross up” rate adjustment formulas.
Issuers, conduit borrowers and bank lenders may agree to limit the adverse effect of the “gross up” adjustment provisions on issuers and borrowers by amending such provisions to reduce the interest rate increase or fee. In some cases, a bank lender, with an issuer’s or conduit borrower’s consent, may simply waive the interest rate adjustment or fee. Amending or waiving the “gross up” adjustment provisions effectively changes the terms of the loan for federal tax purposes, and may cause a federal tax reissuance of the loan. At a minimum, a reissuance of the loan requires a new information return (Form 8038) to be filed in order to preserve the tax exemption.
In conduit transactions, when these “gross up” adjustment provisions are specifically placed in a document between the bank and the conduit borrower (e.g. the continuing covenant agreement) instead of a document between the bank and the conduit governmental issuer (e.g. the indenture), the conduit borrower and the bank lender may be tempted to change the terms of their document without involving the conduit governmental issuer. This raises the same federal tax reissuance concern but, in this context, bond counsel should be consulted to determine whether the conduit governmental issuer must be a party to or otherwise participate in the modifications in order to preserve the tax-exempt status of the loan.
Issuers and borrowers who may be affected by a tax-driven rate or fee increase should consult with bond counsel before taking any actions to amend or waive “gross up” adjustment provisions regardless of the document in which such provisions are located.
Examples of Common “Gross Up” Rate Adjustment Formulas
For bonds bearing interest at a fixed rate:
Adjusted interest rate = (Interest rate at original issuance) (1 - x)
Where x= maximum federal corporate tax rate in effect on date of adjustment
So, if the interest rate on the date of original issuance was 4.0% when the maximum federal corporate tax rate was 35%, the adjusted interest rate now when the maximum federal corporate tax rate is 21% would be:
= (4.0) (1 – 0.21)
This results in an increase of 86 basis points.
For bonds bearing interest at a variable rate and in an index-based mode:
Adjusted interest rate
Where Margin Rate Factor is defined as the greater of:
When Maximum Federal Corporate Tax Rate was 35%:
Margin Rate Factor = (1 - 0.35) x 1.53846 = 1.00
Now that the Maximum Federal Corporate Tax Rate is 21%:
Margin Rate Factor = (1 – 0.21) x 1.53846 = 1.22 (rounded upwards to two decimal places)
Assuming that the bonds bear interest based on a LIBOR index, and the interest rate would have been 1.0996% when the Maximum Federal Corporate Tax Rate was 35%, the adjusted interest rate as a result of the Maximum Federal Corporate Tax Rate at 21% would be as follows:
= 1.0996 x 1.22
This results in an increase of approximately 24 basis points.