Basic Terminology

November 29, 2009

Some of the matters discussed herein are excerpted from

Time Value of Money:  A dollar today is worth more than a dollar tomorrow.

Revenue Bond Index: Index computed by the Bond Buyer every Thursday and published every Friday. Index is based on the average rates of 25 selected revenue bonds with 30 year maturities.

Standard Measure of Risk Premium:  The different between interest rates on tax-exempt debt and those on short-term Treasury bonds is a standard measure of the risk premium that investors require in order to hold bonds.

Current Yield: Annual interest payment ÷ current market price of the bond.

Day Count Basis: The method of counting the number of days between two dates.  See the Wikipedia entry for additional information.

  • Banker’s Year/US: 30/360 convention (Excel = 0);
  • Actual/360: Counts actual number of days but assumes a year of 360 days (Excel = 2);
  • Actual/365: Counts actual number of days but assumes a year of 365 days (i.e., it ignores leap years) (Excel = 3);
  • Actual/Actual: Counts actual number of days and uses actual number of days in the year (Excel = 1); and
  • European 30/360: (Excel = 4).

Settlement Date:  This is the date the bond formally changes hands, and is usually several days after the trade date.  In the U.S., the settlement date is usually three days after the trade date.  Interest begins to accrue on the settlement date.

Discount Rate: This is the rate that is used to convert between future values and present values. The process of calculating present values is often referred to as “discounting” because present values are generally less than future values.

Internal Rate of Return:  This is the compound average annual rate of return that is expected to be earned on an investment held to maturity in which all cash flows are reinvested at the same rate as the IRR.  Investments that have an IRR of greater than the weighted average cost of capital should be accepted.  The Modified IRR is the same as the IRR, except that it is assumed that the reinvestment occurs at some other rate – usually at the cost of capital rate.

Municipal Market Advisors and Municipal Market Data:  Municipal Market Advisors and Municipal Market Data (a Thompson service) each provide a service that in the afternoon of each trading day makes available generic pricing scales for different bond maturities and different credit ratings.

Net Present Value:  This is the present value of a cash flow less the cost of the investment.  It is a measure of cost versus benefit.  If an investment has a negative net present value, this means the cost of the investment is greater than the present value of the expected cash flow. Think twice before investing in a net present value investment.

Rule of 72:  Rule of thumb for determining how long it takes for an amount to double at a given interest rate.  Of course, it can also be used to determine the interest rate required in order to double the amount during a given time period.  To determine how long it will take to double the amount for a given rate, simply divide 72 by the rate.  E.g., it will take 7.2 years to double the amount if the rate is 10%.  To determine the required rate to double an amount, simply rearrange the formula.  E.g., to double the amount within 5 years, divide 72 by 5, which equals 14.4%.

New Market Tax Credits (I.R.C. § 45D)

November 16, 2009

The Players:

  • CDE: Community Development Entity.
  • CDFI Fund: Authorized by Treasury to allocate to CDEs the authority to issue to their investors up to the aggregate amount of equity as to which NMTCs may be claimed.
  • NMTCs: Credits the CDE may allow to investors of qualified equity investments.
  • Treasury: Manages the CDFI Fund.

The Basics:

An investor who makes an investment to acquire stock or equity in a CDE may take certain tax credits (the “NMTCs”) so long as the investment constitutes a “qualified equity investment” (“QEI”). The credit provided to the investor total 39% of the cost of the investment and is claimed over a seven year period. In the first three years, the investor may claim 5% per year. In the remaining four years, the investor may claim 6% per year.  The NMTCs can be subject to RECAPTURE!

For the investment to remain a QEI, the (1) CDE must use (2) substantially all of the proceeds from the (3) QEI to make (4) QLICIs in (5) QALICBs located in (6) LICs:

  1. CDEs: (a) Must have a primary mission of community development, (b) Maintain accountability to LIC representatives through at least 20% representation on the CDE governing or advisory board, (c) Must be certified by the CDFI Fund, (d) Must be a domestic corporation or partnership including a multiple member LLC.
  2. Substantially All: (a) 85% of QEI must be invested in QLICIs (tested annually), (b) 12 months to invest QEI or to reinvest nonscheduled QLICI repayment, (c) Issuance costs and CDE overhead are not included in the “substantially all” requirement, (d) Up to 5% loan loss reserves do count toward QLICIs.
  3. QEI: (a) Must be investment in CDE, (b) Either stock or capital interest, (c) Acquired at original issue solely in exchange for cash, (d) Substantially all of such cash must be used to make QLICIs, (e) CDE must designate the investment as a QEI and provide notification of designation to investor and CDFI Fund.
  4. QLICIs (Qualified Low Income Community Investment): (a) Any capital or equity investment in, or loan to, any QALICB, (b) The purchase of qualifying loans from another CDE, (c) Financial counseling and other services to businesses located in, and residents of, LICs, (d) Any equity investment in, or loan to, another CDE to the extent the second CDE uses the proceeds as described in paragraphs (a) through (c).
  5. QALICBs: Any corporation or partnership (and LLCs including nonprofits) engaged in the active conduct of a qualified business that meets the following requirements:
    1. Gross Income Test: At least 50% of the total gross income is derived from the active conduct of a qualified business within an LIC. This test is met if the entity can meet the tangible property or services test using 50%;
    2. Tangible Property Test: At least 40% of the use of the tangible property (owned or leased and on a cost basis) of the business is within any LIC;
    3. Services Test: At least 40% of the services performed for the business by its employees is performed in any LIC. If business does not have any employees, it can meet the Gross Income and Services Tests if it meets the Tangible Property Test at 85%;
    4. Collectibles Test: Less than 5% of the average of the aggregate unadjusted bases of the assets of the entity is attributable to collectibles (antiques, stamps, alcoholic beverages, art, etc.)
    5. Nonqualified Financial Property Test: Less than 5% of the average of the aggregate unadjusted bases of the property of the entity is attributable to nonqualified financial property (includes debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities and other similar property). There are certain safe harbors to this test.
    6. Rental Real Estate Rules: (a) Cannot be Section 168(e)(2)(A) “residential rental property” (building which derives 80% or more of gross rental income from dwelling units), (b) Substantial improvements must be located on property, (c) Any lessee of the property must not be an excluded business, (d) No country club, golf course, massage parlor, hot tub facility, suntan facility, racetrack or other gambling facility or liquor store.
  6. LICs:
    (a) Any population census tract if: (1) the poverty rate for that tract is at least 20%; or (2) in the case of a tract not located within a metropolitan area, the median family income for the tract does not exceed 80% of the statewide median family income, or in the case of a tract located within a metropolitan area, the median family income for the tract does not exceed 80% of the greater of statewide median family income or the metropolitan area median family income; or
    (b) High out-migration rural county census tracts, which are population census tracts within a county which, during the 20-year period ending with the year in which the most recent census was conducted (2010), has a net out-migration of inhabitants from the county of at least 10% of the population of the county at the beginning of such period, if the median family income for the census tract does not exceed 85% of statewide median family income [The CDFI Fund has a list of census tracts that qualify under this provision. See the CDFI Fund Web site.]; or
    (c) Low-population/empowerment zone census tracts, which are population census tracts with a population less than 2,000 if the tract is within an empowerment zone, and is contiguous to 1 or more LICs (not including other LICs in this category) [The Department of Housing and Urban Development has a list of qualifying empowerment zone communities on its Web site and the CDFI Fund’s mapping program.]; or
    (d) Targeted populations, which include certain individuals or an identifiable group of individuals, including an Indian tribe, who (A) are low-income persons or (B) otherwise lack adequate access to loans or equity investments.

Basic rules regarding RECAPTURE: NMTCs subject to recapture for 7 years after QEI is made in CDE.  The amount of the recapture is NMTCs allowed for all prior taxable years + Interest at the IRS underpayment rate.

Recapture is triggered if: (a) CDE ceases to be a qualified CDE; (b) QEI proceeds no longer satisfy the substantially all requirement; (c) QEI is redeemed by CDE; or (d) certain other abuses. CDE must give 60 days’ notice of becoming aware of a recapture event.  In addition, or to clarify what this means:

  • Investors may not redeem their investment in the CDE prior to the conclusion of the seven year period.
  • Repayments to a CDE of capital or principal from QLICIs must be reinvested in another QLICI within 12 months
  • Principal prepayments are generally not allowed

Recapture not triggered if: (a) CDE enters bankruptcy; (b) QALICB goes out of business; (c) Foreclosure of the mortgage on commercial rental real estate.

Cure: If the CDE fails to meet the 85% (substantially all) requirement and the CDE corrects the failure within 6 months after the CDE becomes aware (or should have become aware), such failure is not a recapture event.  One cure period per QEI!

Money Flows:

  • NMTCs: Treasury -> CDFI Fund -> CDE -> Investor

Use in Leveraged Financings and Public Finance Issues:

General Public Finance Issues in NMTC Transactions:

Consider the following issues relating to general public finance matters:

  • Relationship between the public entity (e.g., the entity providing additional loans for the project) and the QALICB:
    • Which parties will use the financed facilities?
    • Landlord/tenant relationship matters
    • Sale or ground lease of the site?
    • Control of the QALICB?
    • Statutory authority to create or be a member
  • Leasing powers:
    • Sale/ground lease? (public bidding and terms)
    • True lease requirement
    • Restrictions on length of lease terms
    • Annual appropriation
    • Use of rent to support the loan repayments on QLICI loans
    • Attornment, nondisturbance, subordination
  • Using public funds for leverage/source of financing:
    • Statutory authority
    • Leverage lender/source lender
    • Amortization/balloon requirement
    • Lender/creditor rights and remedies (impact of fund, sub-CDE operating agreements; relationship of remedies to put and call, give the 7-year investment requirement for NMTCs)

Tax Issues Relating to Use of Tax-Exempt Bonds as Leverage Loan:

Consider the following issues relating to the use of tax-exempt bonds as the leverage loan source:

  • Governmental and 501(c)(3) bonds:
    • Private business tests:  Apply ultimate use of proceeds to look through investor and CDE? (See discussion below)
    • Private loan test:
      • Can the loan to the investment fund be disregarded?  If the governmental body is the leverage lender (using bond proceeds) and is also the end user (e.g., lessee of the project), is it really a loan?  Can bond counsel rely on “ultimate use of proceeds” and ignore intermediate steps?
      • Loans to lenders and California Health Facilities Authority vs. IRS case.
  • Private activity bonds (other than 501(c)(3) bonds) and tax credit bonds:
    • Use of proceeds:  Are proceeds used to “provide” the facility?
    • Tracing proceeds when there are multiple loans, and when there are payments between related parties (investment fund and the CDE)
  • All bonds:
    • Allocation of proceeds to expenditures
    • Acquired purpose obligation yield:  Analyze loan between the issuer and the investment fund, or look at all levels from the issuer to QALICB?  Tax credits as investment yield?

The investor entity may be treated as a user of bond proceeds in connection with leveraged tax-exempt bond financings (leveraged in the sense that tax-exempt bond proceeds are loaned to the leveraged lender or investment fund and then further loaned to the QALICB).  Some firms are comfortable giving the tax-exemption opinion based on the conclusion that the ultimate use of the moneys (use by the QALICB) is the use that must be considered for tax-exempt bond purposes.  Other firms believe that the investor entity is treated as the user of the proceeds (because the investor entity receives the tax credits over the seven-year period), thereby disqualifying the bonds from governmental or qualified 501(c)(3) bond status.  In unleveraged structures, it is generally okay to use tax-exempt bonds together with NTMCs, however.

The following types of private activity bonds might be useful for the leverage loan:

  • Enterprise Zone Bonds
  • GO Zone Bonds
  • Liberty Bonds
  • Midwestern Disaster Bonds
  • Solid waste disposal bonds
  • QECBs, QSCBs, private activity QECBs
  • Recovery Zone Facility Bonds
  • Small Issue Exempt Facility Manufacturing Bonds
  • Cannot use multifamily housing bonds under I.R.C. § 142 because of mutually exclusive rules regarding residential rental housing!

Security for the bonds is a significant issue because the NMTC seven-year standstill requirement.  The NMTC investor requires a priority security interest, too.

Case study for a private 501(c)(3) college:

  • Project consists of renovation of existing dormitories and construction of a mixed-use building for use as a student center and hub for several key community outreach programs administered by students and faculty of the College.
  • Total development budget is $17.3 million:  $15 million in equity from a NMTC investor and $11.5 million leverage loan in the form of a tax-exempt loan purchased directly by a bank, which was also the ultimate parent of the CDE lender.
  • Issues:
    • College itself could not satisfy the NMTC requirements to be a QALICB.  To solve the issue, a portion of the College’s business was underwritten as the “QALICB” using the “portion of the business” rule under I.R.C. § 45D.
    • NMTC funds may not be used to finance businesses that are engaged in the rental of residential rental property.  Dormitory space had to be carefully analyzed in order not to violate this rule.

Some bond counsel take the position that combining NMTC with tax-exempt bonds is not limited to certain private activity bonds and can also be used in connection with qualified 501(c)(3) bonds and governmental non-private activity bonds.  Such bond counsel base this conclusion on the fact that the proceeds of the bonds are ultimately used for a qualified bond project without creating impermissible private use from the bond loan to the CDE.  Those bond counsel look to the following reasoning to conclude that the use of the tax-exempt bonds should look through the QEI loan to the QLICI assets that, in the case of private activity bonds, are eligible uses under I.R.C. §§ 145 and 141:

  • The Treas. Reg. § 1.141-3 regulations state that the ultimate use of the proceeds or the direct and indirect use of proceeds are what govern the qualification of the bond issue under I.R.C. §§ 141 and 145.
  • Prior IRS approval that loans to private lenders may not have impermissible private business use derived from the loan of the proceeds to the lender where the lender is required to loan the proceeds to a qualified housing development (the so-called “loans-to-lenders” ruling).
  • Prior case law holdings that the substance, not the form, of the transaction governs the tax law analysis:  California Health Facilities Authority v. Commissioner, 90 T.C. 832 (May 2, 1988); and GCM 39455 (March 30, 1984).

Other Leverage Matters:

NMTCs may be combined with other types of tax credits, including the Historical Tax Credits under I.R.C. § 47, energy tax credits under I.R.C. §§ 46 and 48 and various state and federal grants.  NMTCs, however, cannot be used together with loan income housing tax credits under I.R.C. § 42.

Frequently Asked Questions:

Q: What is the “equity” investment?
A: The “equity” investment is the investment by the investor in the CDE (or in the corporation established by the CDE).

Q: When does a NMTC allocation to the CDE expire?
A: The CDFI allocates NMTC allocations annually to select CDEs through a competitive process.  The CDE must use that allocation within five years.

Q: When does a NMTC allocation to a project expire?
A: The taxpayer’s cash investment received by a CDE must be invested in a QEI within the 12-month period beginning on the date the cash is paid by the taxpayer to the CDE (Treas. Reg. 1.45D-1(c)(5)(iv) and (d)(2)(i))The CDE’s allocation from the CDFI Fund, however, does not expire until after five years (Section 45D(b)(1)(C)).

Q: Can a CDE in one geographical area make an allocation to a project located in a different geographical area?
A: Each CDE has an assigned “service area” that is established at the time the CDE applies to be recognized as a CDE.

Q: What is the relevance of the Historic Boardwalk Hall case?
A: In a decision in August 2012 by the U.S. Court of Appeals for the Third Circuit, the court held that a tax credit investor was not a bona fide partner because the investor lacked a meaningful stake in the success or failure of the project owner.  Consequently, the project owner was not a valid partnership for tax purposes, and the investor partner was not entitled to any rehabilitation tax credits.  This decision could have far-reaching implications for various federal tax credit investments and affect the structure and economics of many tax credit transactions.  Investors in such credits may have to assume additional risk in order to be regarded as having a meaningful state in the partnership’s entrepreneurial risk.  Whether such added risk will entitle investors to a larger share of partnership profits or a lower pricing model for the tax credits is yet to be determined.  If a tax credit investor has no realistic possibility of upside and is insulated from construction, operational and tax risk, the investor may lose the tax credits.  According to the Third Circuit, complete risk mitigation may be inconsistent with a tax credit investor’s status as a partner.  The investor was Pitney Bowles.  See Bond Attorneys’ Workshop materials for 2013 for additional information.

Rating Agency Criteria and Other Information

November 10, 2009

Fitch Ratings:

  • Rating Guidelines for Special Tax Bonds: Provides useful insight into various factors contributing to the ratings assignment by Fitch to bonds supported by special tax revenue sources. (Fitch Site | View)

Standard & Poor’s Ratings Services:

  • General Criteria: Methodology and Assumptions: Approach to Evaluating Letter of Credit-Supported Debt, July 6, 2009 (General S&P Criteria)
    • Goal: Clarifies when ratings on LOC-supported debt may be different from rating on the LOC provider, discusses S&P (a) assumptions regarding preference risk in a number of different contexts, (b) assumptions relating to LOC enforceability, (c) assumptions regarding operational risks that relate to debt administrator preference
    • Common Risks in LOC-Supported Structures:
      • Recapture risk related to obligor bankruptcy: Assumption is that obligor becomes bankrupt immediately after making a payment to investors. Are those payments safe from “recapture” under bankruptcy filings?
        • Under section 547 of the Code, a bankrupt debtor’s estate may void and recapture certain property transfers.
        • Transferred funds may be subject to recapture if they were made during the 90 days that preceded the debtor’s bankruptcy filing.
        • Payments by a municipality are not subject to recapture according to section 926 of the Code.
        • Various payment structures affect recapture differently: (a) Direct-pay is most common – here payments are made to investors from the bank directly, so a bankruptcy of the obligor does not give rise to any recapture. (b) Prioritized direct-pay provides LOC funds on a secondary basis where obligor’s funds are not sufficient to pay debt service – documents usually provide that obligor funds must “age” for the appropriate preference period with the trustee before they can be used to pay investors. (c) Standby LOC is also common – here, the LOC funds are used only to cover payment shortfalls (what is the difference to prioritized direct-pay LOCs?). Documents usually provide that standby LOC will cover moneys that are recaptured from investors, and that standby LOC remains in effect until the longest applicable preference period has expired and the trustee has received a certificate of “no bankruptcy filing” from an authorized officer of the obligor.
        • S&P also looks at how the purchase price is paid in remarketings. Documents usually prohibit the obligor from purchasing the Bonds, thus preventing the obligor’s moneys, which may not be preference proof, from reaching investors.
        • Certain sources of funds mitigate obligor-related recapture risk, including initial debt sale proceeds, LOC draws, remarketing proceeds, funds held by the trustee for at least 90 days (or the applicable preference period, if longer), insurance proceeds paid directly to the trustee, proceeds from a refunding debt issue.
        • Recapture risk also arises where an LOC provider is granted new or additional collateral for agreeing to support previously issued debt. See In re Air Conditioning and In re Compton Corp.
      • Risk of insufficient LOC coverage
      • Enforceability risk
      • Risk of credit event
      • Risk of put termination
      • Document-related timing risk
      • Commingling risk and eligible accounts
      • Investment risk
      • Operational risks relating to debt administrator performance
      • Legal defeasance
    • Background on Confirming LOCs: [to come]
    • Joint Support Methodology: [to come]
    • LOCs and Liquidity Facilities Contrasted:
      • LOCs support debt issues, and the LOC provider bears liquidity risk and obligor credit risk.
      • Liquidity facility providers are purchasers of last resort and usually only cover liquidity risk, which is the risk that bond principal cannot be paid.

Credit to Holders of Qualified Tax Credit Bonds (I.R.C. § 54A)

November 6, 2009

General Rules

Qualified tax credit bonds may be issued as direct pay bonds under I.R.C. 6431.  Note that a de minimis premium requirement applies when the bonds are issued as direct pay bonds, similar to the limit that applies to tax credit and direct pay build America bonds.  See Notice 2010-35.

Claiming Tax Credits

See Form 8912 regarding claiming tax credits for qualified tax credit bonds.  See also the description in the instructions to such form relating to determining the credit, when bonds have been partially redeemed.

Stripping Tax Credits

See TAM 200512020.

See IRS Notice 2010-28.

Expenditure Period

Section 54A(d)(2)(B)(ii) provides that for purposes of the relevant sections of the code, the term “expenditure period” means, with respect to the issue, the three-year period beginning on the date of issuance.  Such term can be extended with the consent of the Secretary.  There have been several private letter rulings describing extensions of the expenditure period.  All relate to unexpected events occurring after the issue date.  Here are a few of those rulings:

PLR 201609005 (Nov. 23, 2015):  New clean renewable energy bonds.  Permits expected to be received from a state agency weren’t received in time despite the issuer’s reasonable expectations.  The delay was the responsibility of the state entity.

PLR 201330003 (July 31, 2013): Extension of time to spend QSCB proceeds.  Subcontractors unexpectedly default.

PLR 201309012 (Dec. 3, 2012): Extension of time to spend QSCB proceeds.  Lower than expected project costs resulting in delays in making project adjustments.

PLR 201332004 (May 14, 2013): Extension of time to spend QSCB proceeds as a result of unexpected delays in moving students out of building to be rehabilitated.

PLR 201514005 (Dec. 8, 2014): Extension of time to spend QSCB proceeds because the school experienced unexpected funding cuts giving rise to reprioritization of expenditures. Extension was by 16 months.

PLR 201613012 (Mar. 28, 2016): An authority, an instrumentality of a state, was granted an extension of the original three-year expenditure period for the available project proceeds of qualified zone academy bonds for rehabilitating, repairing, and equipping various public school buildings located throughout the city. The authority failed to expend its allocable portion of the available project proceeds due to reasonable cause and the expenditures of the proceeds for qualified purposes would proceed with due diligence.

Davis-Bacon Act; Buy American Provisions

Projects financed with proceeds of QTCBs must comply with the Davis-Bacon Act, which requires that workers be paid wages at rates not less than those prevailing on similar work in the locality.  Such projects do not, however, need to satisfy the Buy American provisions of the American Recovery and Reinvestment Act of 2009.  Therefore it does not appear that these projects are subject to Mr. Trump’s executive order of April 2017 concerning buying American and hiring American.