The tax reform enacted by Congress last year in the Tax Cuts and Jobs Act provided a nice tax break for businesses. Among other companies, banks have benefited greatly from this windfall, and in addition to rising stock prices, many have announced raises for their employees. This must be good news for everyone, right? Well, as is often the case with tax law, the answer is “Not exactly.”
Many not-for-profit organizations recently have been receiving correspondence from their lenders, that is, banks holding their tax exempt bond indebtedness, informing them that as a result of the change in the maximum marginal statutory rate of federal tax imposed on corporations due to the new tax law effective on January 1, 2018, the interest rate being charged on their loans is going to increase. Whether intended by the new tax law or not, the reduction in income taxes often entitles a bank holding direct purchase tax exempt obligations to increase the amount of interest the borrower must pay. This somewhat ironic result is based on the premise that the lower tax-exempt rate payable by not-for-profit organizations is based on the “taxable equivalent yield” that holders of such debt obligations, such as banks, enjoy by purchasing tax exempt debt.
Buried deep in the documentation evidencing the tax-exempt debt are often provisions requiring the borrower (such as a not-for-profit organization) to pay an increased interest rate if the tax law changes and the income tax payable by the bank is reduced. The concept is to provide the bank with the same taxable equivalent rate of return on its loaned funds as it would have received if the tax rate did not change. So, if properly documented, the tax rate reduction results in the bank being authorized to charge a higher interest rate to make up for the “loss” in yield that resulted from the tax rate reduction. So, the bank pays less in taxes but at the same time can charge more in interest, at the cost of the not-for-profit. Confused yet?
There are two critical questions affecting a bank’s ability to charge more interest as a result of the tax reduction: (1) does the documentation expressly provide for a change in the applicable interest rate based on a change in the federal tax law, and (2) what is the method for calculating the “gross-up” of the interest rate to provide the same taxable equivalent yield? Some bond documents very clearly specify when and how the interest rate increases, and some are quite vague, and may not actually entitle the lender to increase the interest rate charged to the not-for-profit.
Any not-for-profit organization that receives communication from its lender saying that the interest rate is increasing should consult with bond counsel to review the documentation and determine if the interest rate increase is legally warranted. PLDO Partner John (Jay) R. Gowell, who is a nationally recognized bond counsel and listed in the Bond Buyer “Red Book,” is available to assist you and your organization. To contact Attorney Gowell, call 401-824-5100 or email [email protected].
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