What is “tax exempt finance”? It is a way to save a lot of money on interest costs. How does that work? If there is no income tax due on an interest payment received by an investor, whether it be a person or a bank, the taxpayer can accept a lower rate than for taxable debt. That means that you pay a substantially lower interest cost if you borrow using “tax exempts”.

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“Tax Exempt” finance was originally created due to the recognition that the federal government could not tax the income on obligations of a state or political subdivision (a local government, for example). Traditionally it is used for things like public infrastructure, buildings, streets, curbs and gutters and the like by those governments. (No obligation can be “tax exempt” unless it is “issued” by such a governmental entity.) As it evolved, it ultimately allowed tax exempt obligations to be issued by governments but the proceeds could be “re-loaned” to a private company, and the loan would retain its tax exempt status. These are called “private activity” obligations and while there are restrictions on what types of private activities can be funded, virtually everything a company in the solid waste, recycling or renewable energy industry wishes to fund will be eligible!

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To arrange these lower rates for you, we work with a governmental issuer in your state and a “Municipal Advisor” on the team with whom we’ve worked for decades. There are usually many such issuers in each state—and we can help you select the right one. There are two main types of the obligations they issue, either “bonds” or “notes”. The former are generally sold to institutional investors and the latter are obligations are directly “purchased” by a bank. The notes (“direct purchase notes”) and have been the most common form of borrowing for our clients since 2015. Without getting into the details, the effect of this is that instead of your bank making you a loan and paying taxes on the interest it receives, it will, in effect make you a tax exempt loan and won’t have to pay any tax on the interest. 

 

Why is the rate lower? Not surprisingly, the current rate on these “notes” is the conventional rate less the corporate tax rate or, about 79% of the interest rate on a regular loan. In other words, the bank passes on its tax savings. In most cases with a reasonable sized borrowing, that discount is enough to save a lot of money for a borrower. So, instead of paying 4% on a loan, you would pay 3.16%. On a $15 million loan, instead of paying $600,000 in annual interest at the 4% rate, you would pay only $474,000, a savings of $126,000 per year. Obviously, over a ten year term on a loan, that adds up to some significant savings. And, if the corporate tax rate should be increased in the future, the discount will also increase.

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It is true that the costs of doing a tax exempt financing are greater than for a conventional loan because the borrower has to pay the fees of the governmental issuer, specialized “bond counsel’, the underwriting fee for bonds and other costs. But, if the borrowing is more than $5-7 million or so and is used to purchase longer lived assets, it has proven to be very worthwhile for our clients and most of them have most of their debt in this form. In California, even smaller transactions work because the major state issuing authority has a cost subsidy program for businesses with less than 500 employees. Our financing team can assist you in determining whether they make sense for you. For lots more information on tax exempt financing, click here.