One way cities can pay for various projects is by issuing tax-exempt municipal bonds. But there are many rules and regulations for cities to be aware of in this area.
Minnesota Cities talked with Brian Reilly of Ehlers, a financial advisory company for the public sector, about how cities can steer clear of problems when issuing bonds.
Minnesota Cities: The IRS provides guidance on “avoiding troubled tax-exempt bonds.” What types of traps exist?
Brian Reilly: Issuers should keep the following in mind:
Use of proceeds. If bonds are used for a private purpose, they could be taxable. Examples of private uses could include public facilities leased to or managed by private entities.
Private pay. If a private party directly or indirectly guarantees a city’s bonds, they could again be taxable. Common private pay arrangements include market value guarantees in a tax increment financing (TIF) project, and contracts with private users of public facilities (e.g., a golf league using a municipal golf course). Private pay can also exist where federal government revenues are the primary source of payments for bonds.
Use of project. Improperly structured lease or management agreements with private parties can create a private use and affect the tax status of bonds.
Reimbursement. Issuers may reimburse prior expenditures from proceeds of tax-exempt bonds within 18 to 36 months of the date the expenditure was made if they comply with specific rules, including documenting intent to make these reimbursements. If not properly documented, reimbursement must occur within 60 days of expenditure. Adopting a blanket reimbursement resolution authorizing staff to act in this regard can make it easier to comply with this requirement.
Arbitrage and yield restriction. Many rules and regulations govern investment of bond proceeds and related funds. As a result, too much money in a debt service or reserve fund can cause tax status problems. Issuers need to pay close attention to spend-down and other arbitrage requirements.
Duration of legal requirements. Many of these laws apply over the life of a debt issuance, which might stretch decades into the future. Ongoing monitoring is required to make sure a project that was initially compliant doesn’t become one that no longer is.
MC: Are there issues that small cities in particular should watch for?
BR: Be especially careful when financing costs that directly benefit a private party. For instance, if a community has a large utility user, debt used to finance utility capital projects might directly benefit that private party, in which case its user fees could trigger “private pay” provisions.
Development projects can also be a problem. Local financial institutions are often not fully aware of tax and other requirements surrounding municipal debt, and might not know what’s necessary to issue debt that’s both valid and tax-exempt.
MC: How does state law apply to debt issuance? How about federal law? City charters?
BR: A city’s authority to borrow is primarily dictated by state law, which must be followed in order to issue valid and binding obligations. And certain types of debt, such as special assessment and capital improvement bonds, have their own unique statutory requirements.
While federal law plays a large role in determining the taxability of local government debt, it doesn’t have the same impact on the process of how the debt is issued. There are new rules, such as the “Municipal Advisor” rule, but they directly regulate market participants, rather than issuers. There are, however, federal procedural rules that must be followed in some circumstances like when a nonprofit is involved.
Furthermore, federal law regulates how an issuer markets its debt, such as the use and contents of an official statement, and establishes continuing disclosure requirements.
City charters can also affect how a city borrows. A charter might restrict the kinds of debt that can be used for certain types of projects, require super-majority council approval for bonding, or impose other restrictions and conditions.
MC:What can happen if a bond doesn’t comply with these laws?
BR: If a bond issue doesn’t comply with state law or a city’s charter, it can be declared invalid. If that happens, revenues pledged to support the issue can be jeopardized, leaving the issuer at risk of having to find other sources of funds and bondholders at risk of not getting paid. This almost guarantees litigation. Failure to comply with state law can also lead to bonds being declared taxable under state and federal law. Finally, it can lead to a reduction in a city’s rating if the rating agencies think the city acted negligently.
On the other hand, municipal issuer compliance with federal securities laws is a current focus of the Securities and Exchange Commission. Failure to abide by disclosure regulations, for instance, can result in limited access to the capital markets as well as sanctions against the issuer and its officials.
MC: The IRS seems very concerned about “abusive transactions.” What does an abusive transaction look like?
BR: The federal tax exemption on certain municipal obligations is a relatively large cost to the federal government in the form of foregone tax revenue. Because the exemption is intended to benefit legitimate public projects, the IRS is particularly concerned about transactions that exist primarily to provide fees to professionals working on the deal, or generate arbitrage on behalf of the issuing entity.
As a general rule, if the deal can’t be explained in plain English, be wary. Ultimately, though, it’s the issuer’s responsibility to make sure a transaction is appropriate, which is one reason it’s so important to use the services of a competent municipal financial advisor.
MC: What types of conflicts of interest can arise during a bond transaction?
BR: There are a couple of things to consider when working with municipal finance professionals. First, many of them charge contingent fees, with payment due only upon closing or at certain intervals. This isn’t necessarily a problem, as long as the issuer understands those professionals have an interest in making sure the transaction closes. Hourly billing arrangements can be an alternative, although that often leads to more uncertainty about the eventual cost.
Second, state law allows some debt to be sold directly to an underwriter (negotiated offering) or placed directly with a financial institution without following a competitive sale process. In these cases, the issuer should be mindful that the buyers want the lowest price for the bonds, while the issuer wants the highest. An issuer should seek independent representation throughout the financing transaction.
MC: How can a debt management policy help cities?
BR: A debt management policy should be designed to fit the specific needs and policy goals of the city that’s adopting it. The policy may contain provisions about:
MC: What is arbitrage and why does a city need to be aware of it?
BR: Governmental issuers can issue tax-exempt bonds for many projects. The proceeds of those bonds can then be invested in taxable securities. Basically, “arbitrage” is the ability to earn a positive interest rate spread between the tax-exempt rates the issuer pays on the debt and the higher rates it earns on the taxable investments. And, governmental issuers do not pay income taxes on interest earned on those investments.
In other words, arbitrage costs the federal government twice: first, when it does not collect taxes on the interest the bond¬holder receives on the issuer’s debt; and second, when it does not collect taxes on the income the issuer receives on the rein¬vested bond proceeds. Therefore, the federal government has created a set of rules to govern and limit this practice. There are various exceptions under the rules, but these are very complex, with serious consequences for violations. Obtaining qualified financial and legal advice is particularly important in this area.
MC: Since bonds have long lives, how can a city maintain legal compliance over the long haul?
BR: Clear and robust financial policies help ensure compliance with constantly evolving state and federal laws. Regular reporting to the city council on key aspects of the policies and the city’s compliance with them is also important. Another important consideration is to hire competent financial professionals, who can provide unbiased advice and training to staff and elected officials.
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