Congressional Efforts At Tax Reform
And The Impact On Municipal Bonds

By KURT P. FROEHLICH
Evans & Froehlich, Champaign, Illinois

ALTHOUGH NOT EVEN ADOPTED, THE TAX REFORM ACT OF 1985 WITH ITS JANUARY 1, 1986 RETROACTIVE EFFECTIVE DATE IS STOPPING OR IMPOSING ADDITIONAL COSTS ON MANY BOND ISSUES. AS USUAL, SMALL ISSUES AND SMALL PROJECTS ARE HURT THE MOST. THERE ARE MANY NEW TRAPS FOR THE UNWARY.

On December 17, 1985 the U.S. House of Representatives passed H.R. 3838, the Tax Reform Act of 1985. The U.S. Senate is now considering the bill. Public statements by Congressional leaders suggest that a bill might be enacted sometime this summer. Nevertheless, the bill is severely affecting present transactions in the public and private sectors because it has a general effective date of January 1,1986. Adopted by the House in 1985, despite nonbinding resolutions of both houses that the bill should be changed to have a later general effective date, its impact is now retroactive.

The bill is the evolutionary result of the Treasury Department's report of November 1984 to the President, "Tax Reform for Fairness, Simplicity and Economic Growth." Although questions of fairness are open to endless debate — and the 1982 and 1984 tax reform acts in the area of tax exempt finance comprehensively addressed such matters with unprecedented new restrictions — the bill is hardly simple (Of the 1,369-page bill, 160 pages address State and local tax exempt finance.), and the bill does not encourage economic growth. Severely affected is every feature of State and local financing, not just IDBs. The bill's retroactive date is paralyzing a great number of public and private sector projects.

A careful reading of the bill, together with its related 99 pages of explanation on tax exempt finance contained in the House Ways and Means Committee report (Rpt. 99-426), is necessary to begin to follow the broad scope of the changes, much less the many nuances and subtle points. A selection of the bill's provisions concerning tax exempt bonds follows.

The Name Game

The bill defines two basic categories of bonds: (1) nonessential functions bonds and (2) essential function bonds. Nonessential function bonds are bonds the lesser of $10,000,000 or 10% of which are "used" by, or the lesser of $5,000,000 or 5% of which are loaned to, persons other than governmental units. In addition to ownership, "use" will result from, among other things, leases, licenses, concessions, operating, management or incentive pay contracts and "take or pay" or other "output" contracts. The reservation of parking spaces in a municipal parking ramp for the use of a motel can result in a "use" that might result in making bonds taxable. The same results from a management contract for an otherwise public golf course. If the "use" exceeds $1,000,000, the cap (described below) on nonessential function bonds applies. The bill clearly foreshadows the end of a great number of public/private joint ventures and will result in unwittingly compromising or losing a tax exemption for bonds.

Many urban renewal programs will be affected. The bill describes new restrictions on "qualified rehabilitation loans" and "qualified home improvement loans".

The category of so-called nonessential function bonds includes:

(A) exempt facility bonds (government owned airports, docks and wharves, mass commuting facilities other than vehicles, and government or privately owned water, sewer, solid waste disposal and residential rental facilities and projects),

(B) qualified mortgage bonds,

(C) qualified veterans' mortgage bonds,

(D) qualified small issue bonds (what we now consider industrial, commercial or economic development bonds — small issue IDBs),

February 1986 / Illinois Municipal Review / Page 17

(E) qualified 501 (c) (3) bonds,

(F) qualified student loan bonds, or

(G) qualified redevelopment bonds (covering many tax increment finance project purposes).

No longer eligible for exempt facility bond financing are certain facilities for conventions and trade shows, sports, parking, electric, air or water pollution control and industrial parks. However, such facilities may fit under the rules (including the $10,000,000 capital expenditure limit that in 1985 would not have applied) applicable to the qualified small issue bonds (IDBs).

Reduction in Volume Cap

The bill imposes new and very restrictive volume caps on the issuance of the "qualified" bonds listed above. In general the dollar amount of such "qualified" bonds cannot exceed $175 per person per calendar year for Illinois (to be reduced to $125 when qualified mortgage bonds sunset in 1988). A present rule now in effect imposes a cap of $150 per person per calendar year for "private activity bonds" — including IDBs used for industrial and economic development facilities. Excluded from that $150 volume cap are, among other things, bonds for certain residential rental property. Certain single family mortgage projects were subject to their own separate volume cap under a 1980 tax law. Now all of the "qualified" bonds, including for many facilities almost subject either to no cap or a separately stated cap, are subject to the $175 cap. The result is not an increase from $150 to $175 in the volume cap, but a quite substantial and severe reduction.

Until the Governor or the General Assembly would act to effect changes, as provided in the bill, after setting aside $25 of the cap for so-called 501 (c) (3) bonds, 50% of the remaining cap is set aside for housing (not less than 1/3 for qualified mortgage bonds and 1/3 for qualified residential rental properties) and 50% is for other "qualified" bond purposes. And as is the case now for the $150 cap on private activity bonds, neither the Governor nor the General Assembly may alter the effect of the bill's provisions that assure home rule units a full $175 per person per calendar year cap. After reserving to Illinois home rule units their inviolate $175 amount, until the Governor (in an interim manner) or the General Assembly would otherwise provide, the bill allocates the remaining cap 50% to the State (and its agencies) and 50% to other local issuers.

Experiences in 1985 with the $150 cap on private activity bonds has shown clearly that the set aside for home rule results in the loss of much of the State's issuing capacity. Since the Governor and the General Assembly cannot alter the formula protecting home rule units (which may work well for a very large issuer like Chicago), the aggregate amount of unused and wasted cap is quite substantial. In 1985 the State and home rule units took actions by way of reallocations to avoid this, but with 100 home rule units there was a substantial amount of waste.

Tax Increment Finance

Of the $175 cap, the bill provides that $8 is for "qualified redevelopment bonds" in any State which issued more than $25,000,000 of tax increment financing obligations between July 18, 1984 and November 21, 1985. The H.R. 3838 term for tax increment bonds is "qualified redevelopment bonds".

Compared to the provisions of the Illinois Real Property Tax Increment Allocation Redevelopment

Page 18 / Illinois Municipal Review / February 1986

Act, the bill provides substantial and more severe restrictions. Under the Illinois tax increment law there are quite expansive definitions for a project area (at least 1 1/2 acres qualifying as a "blighted" or "conservation" area under numerous criteria) and for redevelopment costs or purposes. The designated blight area must be at least 1/4 square mile (160 acres), the qualifying criteria are much fewer in number and the assessed value of all designated blight areas cannot exceed 10% of the total assessed value of all real property within the municipality. Qualifying redevelopment purposes are very limited: (i) acquisition of real property by eminent domain or its threat; (ii) clearing and preparation of land and transfer to nongovernmental persons at fair market value (no "write down"); (iii) rehabilitation (not new construction or additions) of real property; and (iv) relocation of occupants. In an unprecedented manner the IRS may be involved in municipal land use and planning matters, and unlike the usual Illinois rule in such matters, there will likely be no "presumption of validity" as to municipal actions and decisions.

For Illinois with 1,153 municipalities, none of which are required to report tax increment bonds to the State, it is difficult to know if the $25,000,000 in bonds has been issued which triggers the $8 set aside. In addition, the General Assembly has passed S.B. 1156 which permits tax increment financing to include use of the State and municipal sales and use taxes, electric and gas taxes and telecommunication taxes. Since HR-3838 addresses only real property taxes, its impact on these other taxes is unclear. [However, more unclear is the Governor's amendatory veto on S.B. 1156 which provides that the use of the newly authorized sales and use incremental taxes applies to tax increment financing adopted prior to January 1,1987 pursuant to the rules and regulations of the Department of Revenue to be established after January 1, 1987!]

Arbitrage

In general, with many exceptions, rules and sub-rules, bond proceeds may not be invested at a yield materially higher (1/8%) than the yield on the bonds. To be permitted an unrestricted yield, under H.R. 3838 bond proceeds used in acquisition, whether or not in connection with construction, must be spent within 30 days of issuance in construction projects upon substantial (90%) completion, and in any event when an amount equal to the bond proceeds has been spent (including funds from other sources — equity etc.) and the earlier of 3 years from the date of issuance or commencement of construction. Unless all bond proceeds are spent within 6 months of issuance (a series of bonds will be treated as one issue), with some exceptions any net earnings on the investment of bond proceeds are to be "rebated" to the federal government at 5-year intervals equal to 90% of the amount due with a final installment 30 days after the last bond is retired.

Five percent (5%) of bond proceeds must be spent within 30 days of issuance. [This rule, perhaps more clearly than others, illustrates a lack of understanding of the mechanics of advertising, bidding, planning and spending money by most local governments. A great many councils and boards, and related committees, meet only once or twice a month, making this quite burdensome and risky.] Except for the allowed reserve (150% of debt service, but not in excess of 15% of bond proceeds), all bond proceeds must be spent within 3 years.

Information Reports

The 1982 revisions in tax law required issuers to report to the IRS certain matters related to the issuance of IDBs and use of proceeds. The IRS devised the Form 8038 for that purpose. The bill extends a similar report requirement to all bonds whether classified as essential function bonds or as nonessential function bonds. Technically, and to be certain, a report on an issue closed January 2, 1986 should be filed before May 15 under a law that isn't expected to pass until summer! And the IRS might reject it because the bill is not law!

Depreciation, Alternative Minimum Tax and Preferences

Under present law IDB financed property is depreciated on a straight-line basis over applicable accelerated cost recovery system (ACRS) periods. For real property that is usually 19 years, and for equipment and other personal property that is usually 3, 5 or 7 years. H.R. 3838 requires depreciation of real property generally over 30 years, and over 40 years on a straight-line basis if financed with qualified small issue bonds (IDBs). Equipment and other personal property would fall into one or more of the proposed 10 asset classes, and under the next longer asset class period if financed with qualified small issue bonds (IDBs).

February 1986 / Illinois Municipal Review / Page 19

The bill proposes an alternative 25% minimum tax on individuals' and corporations' nonessential function bonds. Essentially the tax exemption would be worth 25% less on nonessential function bonds than on essential function bonds.

Interest paid on depositor's accounts is deductible by banks and other financial institutions. The 1982 and 1984 tax acts reduced the amount such financial institutions can deduct on the cost of carrying any tax exempt bonds first to 85% and then to 80%. This was done by imposing a "preference" tax on the cost of carrying such bonds, in the 1982 act at 15% (increased in the 1984 act to 20%). The bill increases the "preference" tax on nonessential function bonds to 100%, essentially reducing to zero the ability to deduct the cost of carrying them.

Miscellaneous

H.R. 3838 carries forward, with some changes, almost all of the comprehensive restrictions and limitations on IDBs and private activity bonds imposed by the 1982 and 1984 tax acts. As noted above, many of those provisions are now directed at all types of bonds. The bill would remove the existing sunsets on IDBs. Substantial and more restrictive requirements would be imposed on mortgage subsidy and residential rental property bonds.

Conclusion

The bill provides numerous areas in which there are substantial new risks for issuers, including issuers of essential function bonds. For example, if 5% of the bond proceeds are not spent within 30 days, the issue is taxable from the date of issuance, even if a mistake is not discovered or recognized until many years later. Violation of many of the new rules will result in taxability retroactive to the date of issuance. There are very few express cure periods.

Simply stated, H.R. 3838 in its present form would essentially do away with most of IDB financing used for industrial and economic development financing. In usual tax law draftsmanship, the bill does not simply prohibit such financings, but the effect of the innumerable changes, mainly the alternative minimum tax and the 100% bank preference tax on interest paid to carry such bonds, will have that result. The financing of such projects in almost all cases will have to be underwritten, basically a money center business. Local commercial banks will be removed from the process. Also as usual with such changes, the small issuer, the small business and the small project are the most impacted. The terrible complexities of the proposed new rules can be accommodated by the big issue and the big project.

The Gramm-Rudman Law (The Balanced Budget and Emergency Deficit Control Act, PL 99-177) is now devastating revenue sharing and many other municipal programs. This underscores the need to maintain maximum flexibility in the area of State and local finance, including all aspects of economic and community development incentives. IDBs, tax increment finance and other State and local government programs create jobs and tax base, including federal income taxes. Several accounting studies have shown this. H.R. 3838 will render such programs almost useless, and especially as to the smaller issuer, project and issue. •

Page 20 / Illinois Municipal Review / Febuary 20