Tax-Exempts – How “Exempt” Are They?

By Roger Poulin September 5, 2018

Banks have many ways to invest their depositors’ money and one specifically is in municipal bonds and loans. The major tax advantage that results from this type of investment is that the interest may be exempt from federal taxes and even possibly for state taxes, depending on the specific state tax laws. As is often the case, not all things are created equal and this is true of municipal bonds and loans.

Under IRS rules, interest on the obligation of a state, territory, possession, or any political subdivision thereof is exempt from taxation. The state and local governments use tax-exempt financing to raise capital to finance public capital improvements and other projects, including infrastructure facilities that are very important to sustained economic growth.

Banks purchase municipal bonds and lend funds to municipalities in order to obtain the benefit of earning interest that is exempt from income taxation. Demand for these bonds declined with the Tax Reform Act of 1986, which contained a provision requiring banks to add back a portion of their interest expense on municipal bonds/loans. Basically, banks may not deduct the carrying cost (the interest expense incurred to purchase or carry an inventory of securities) of tax-exempt obligations – this carrying cost is determined by a formula based on the ratio of average tax-exempt assets to average total assets of the bank. For banks, this provision has the effect of eliminating the tax-exempt benefit of municipal obligations.

However, to mitigate this impact on the marketability of municipal obligations, especially for smaller communities, an exception was added that allows banks to deduct 80% of the carrying cost of a “qualified tax-exempt obligation.” In order for an obligation to be a qualified tax-exempt obligation, it must be (i) issued by a “qualified small issuer,” (ii) issued for public purposes, and (iii) designated as a qualified tax-exempt obligation. A “qualified small issuer” is (with respect to bonds issued during any calendar year) an issuer that issues no more than $10 million of tax-exempt bonds during a calendar year. These obligations are commonly referred to as “bank qualified bonds.” Therefore, as a result of the Tax Reform Act of 1986, two types of tax-exempt obligations were created: bank qualified and non-bank qualified. With many non-bank qualified obligations, the rate that would be required in order for the investment to be profitable could approach the rate of taxable obligations, and therefore they are much less attractive compared to “bank qualified” ones.

As the marginal federal corporate tax rate declined with the Tax Cuts & Jobs Act effective January 1, 2018 from a high of 35% to 21%, the fully taxable equivalent yield on tax-exempt obligations also declines, making these investments much less attractive to banks and other corporations. Although the top tax rates for individuals are still nearly as high as they were previously, the extent to which banks have invested in municipal bonds and loans in the past indicates that in order to remain competitive, municipal bond/loans rates will need to increase in order for Banks to continue investing in these types of obligations. This is just speculation, of course – time will tell whether market yields will remain competitive.

If you would like to discuss these matters further, contact Roger Poulin or your BNN advisor at 1.800.244.7444.