THE HIDDEN TAXES OF
TAX REFORM

The Tax Reform Act of 1986 represented a historic accomplishment by the United States Congress. For the first time in over thirty years, the Internal Revenue Code was completely reviewed and overhauled. Someone argued that the Act provides for a more equitable distribution of the tax burden on the general population. However, in the drive to generate additional revenue and to redistribute the tax burden among the populace, the Congress has imposed "hidden" taxes on individual and corporate taxpayers which have a direct impact on the ability of municipalities to finance their projects as inexpensively and efficiently as possible. These "hidden" taxes are embodied in the concepts of "arbitrage rebates" and an "alternative minimum tax."

ARBITRAGE REBATE PROVISIONS

"Arbitrage" can be defined as the investment of borrowed funds to earn a profit. In a typical municipal bond transaction, arbitrage is earned when a municipal issuer invests the proceeds of a bond issue at a higher rate of interest than is paid on the borrowed funds prior to their expenditure for project costs for the purpose of earning funds to offset the cost of borrowing. In previous years, some municipalities issued bonds specifically for the purpose of earning arbitrage. Beginning with the passage of the Tax Equity and Financial Responsibility Act ("TEFRA") the earning of arbitrage by issuers was restricted. With the passage of the Tax Reform Act of 1986, the concept of arbitrage has been virtually eliminated. Subsequent to TEFRA and prior to the Tax Reform Act, state and local governments were given a three year "temporary" period to spend the proceeds from a debt issuance and earn unlimited interest during that period. Under the new law, state and local governments still have three years to spend their bond proceeds but all arbitrage proceeds must be rebated to the Federal Government. Arbitrage can only be earned if all bond proceeds are now spent within a six month period following issuance of the bonds and the yield that can be earned on the funds is greatly restricted. The vicious circle created by the new rebate provisions was described by Betty Jo Harker, President of the Government Finance Officers Association (GFOA), in her article, "The Big Print Giveth and The Small Print Taketh Away", published in the Bond Buyer on June 1, 1987.

"The rebate requirement robs Peter to pay Paul. If borrowers are unable to earn interest on their unused bond proceeds, they issue more tax exempt debt to pay project costs. Investment earnings that could be used to reduce the amount of borrowing are paid over to the U.S. Treasury or are foregone by investing in lower yielding securities.

How can the Federal Government justify such an insane policy? Simple. An excuse is made up. According to the Joint Committee on Taxation's general explanation of the 1986 Tax Act (the "Blue Book"), 'arbitrage is an inefficient alternative to additional borrowing, because it is more costly to the Federal Government in terms of foregone tax revenue than the additional borrowing that would

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be necessary to produce the same amount of proceeds'."

In other words, greater cost to local government equals a more efficient Federal Government. ABSURD!

ALTERNATIVE MINIMUM TAX

In addition to the arbitrage provisions Congress has imposed a new tax called the "Alternative Minimum Tax" (AMT). The AMT was first enacted in 1978 to insure that all individual taxpayers paid some tax. Prior to tax reform, many items, including tax-exempt interest were excluded from the calculation of AMT. For corporations, the AMT is totally new. Previously, corporations were subject to an add-on minimum tax. The Tax Reform Act has served to change the purpose of the tax from insuring payment of some tax by all taxpayers to a revenue generating tool. The AMT causes bondholders to demand a higher interest rate for tax exempt bonds and consequently the cost of borrowing for state and local governments will increase because of higher interest payments.

The revisions to the AMT with respect to previously tax-exempt interest affect both individuals and corporations. Tax exempt interest is taxed at the rate of 20% for corporations and 21% for individuals. The impact of this tax falls principally in two areas. First, Private Activity Bonds, bonds where the proceeds are loaned to a private for-profit corporation, which were issued after August7, 1986 are subject to the individual AMT. Second, the change in the method of calculation of "book income" by corporations require that tax exempt interest be included in the reported profits of a corporation. The result of this calculation for corporations is all tax exempt bond interest, regardless of the date of issue or the use of the bonds is taxed at the 20% corporate minimum tax rate. This corporate portion of the AMT affects all bonds issued by a municipality including general obligation bonds and bonds issued for sewer,

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water and other public utility improvements. In other words, interest on tax exempt bonds isn't tax exempt anymore.

THE OUTCRY AND THE COUNTERATTACK

The effect of the rebate and AMT provisions on issuer's of tax exempt bonds is far reaching and totally hidden. The municipality borrowing for general obligation purposes must pay the higher interest rates demanded by bondholders or forego the borrowing of the funds. A municipality under an EPA or pollution control mandate to make repairs to a water or sewer system has little choice in the borrowing of funds. Ultimately, it is the taxpayers and ratepayers of local municipalities in Illinois and throughout the United States that pay for the rebate of arbitrage and the AMT paid by bondholders. This uncomfortable situation has become the subject of a constitutional challenge about to be mounted by the City of Atlanta, Georgia and the GFOA.

On June 2, Atlanta and GFOA threw down the gauntlet to the Federal Government. In a press release issued on that day Mayor Andrew Young and Patrick C. Glisson the incoming President of GFOA declared,

"These two provisions in the Tax Act are a direct attack on the doctrine of the intergovernmental tax immunity. We thought that doctrine was a tenet of our federal system of government. The doctrine provides that state and local governments may not tax the Federal Government and the Federal Government may not tax state and local government. The Federal Government has been chipping away at our ability to finance necessary state and local government facilities for almost twenty years now. It is time to call a halt. The 1986 law brings the issue to a head. We intend to fight it and to carry it all the way to the Supreme Court if necessary."

The statement continued by arguing that the new pro-

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visions are violations of the Tenth and Sixteenth Amendments to the Constitution of the United States and "contrary to the principles of federalism which the Framers of the Constitution took such pains to embed in that great document."

The Tenth Amendment to the United States Constitution is the final amendment of the original Bill of Rights that was appended to the Constitution at the time of its enactment. At the time that the Constitution was written, the Constitutional Convention was concerned that a system of government be fashioned which would provide for a central government that was strong enough to maintain control over a nation but not so strong as to interfere with the local control they felt was required to prevent the abuses of the British Monarchy. According to James Madison, one of the drafters, the Tenth Amendment was intended to reserve to the states "a residuary and inviolable sovereignty over all other objects." The Tenth Amendment provides that "The power is not delegated to the United States by the Constitution, nor prohibited by it to the states, or reserved to the states respectively, or to the people." The first test of this amendment came in the case of McCulloch v. Maryland in which the subject of intergovernmental tax immunity was addressed. In that 1819 case, Chief Justice John Marshall explained that the effect of the Tenth Amendment was to leave the question "whether the particular power which may become the subject of contest has been delegated to the one government, or prohibited to the other, to depend on a fair construction of the whole instrument." In other words, does the Constitution authorize the Federal Government to tax the obligations (bonds) of the states and their subdivisions?

The Sixteenth Amendment, certified as ratified in February of 1913, provided that "(t)he Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, . . ." This amendment came in response to an 1895 Supreme Court case, Pollock v. Farmer's Loan & Trust Company, which struck down an 1894 income tax law as unconstitutional. The Pollock case involved the application of the income tax law upon income from municipal bonds. In a unanimous opinion, the Court clearly stated the rule of law on taxation of municipal bonds,

"We have held in this case that, so far as this law operates on the receipts from municipal bonds, it cannot be sustained, because it is a tax on the power of the States, and on their instrumentalities to borrow money, and consequently repugnant to the Constitution." (Emphasis Added). This case has never been reversed.

While Atlanta and GFOA are busy preparing to mount their challenge, the City of Tucson, Arizona has won one small battle in the war. In the case of City of Tucson, Arizona v. Commissioner of Internal Revenue, 820 F2d 1283,56 U.S.L.W. 2024, The D.C. Circuit Court of Appeals overturned a decision of the Tax Court holding that a Treasury Department Regulation that "sinking funds" established to pay off municipal bonds were subject to arbitrage yield restrictions was "incompatible" with statutory proscriptions relating to arbitrage. This decision has held that the definition of "arbi-

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trage bonds" adopted by the Treasury Department exceeded the authority granted by the Internal Revenue Code of 1954 and was thus invalid. In the opinion the court chastises the Internal Revenue Service by pointing out that the regulatory powers granted to the Treasury Department and the IRS by statute "do not give . . . carte blanche in interpreting the tax laws. "The timing of this decision is almost as important as the decision itself. The Tax Reform Act of 1986 and the changes it makes to the Internal Revenue Code have caused a need to rewrite the Treasury Regulations and IRS rules relating to, among other things, arbitrage. This process is now occurring within the Department and the Service. Certainly, the implicit warning in this opinion is that the power of the Department and the IRS in interpreting the statutes is not unbridled. Hopefully, the drafters of the rules and regulations under the new code will heed this warning and refrain from "administrative legislating."

Like so many wars that municipalities fight to preserve their power and standing in the overall scheme of government, this one will be fought one battle at a time. The Tucson case, the GFOA challenge and the doubtless many that will follow will have to attack one usurpation of municipal power at a time. No grand offensive, or massive attack will succeed. Only patient, well-reasoned arguments will be the successful weapons. Unfortunately, this tedious, time-consuming process, if successful, cannot and will not compensate municipalities for additional costs of borrowing, not-borrowing and litigating these questions. •

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