Rodey Publications

The Economics of Industrial Revenue Bonds

Judging from occasional letters to editors of New Mexico newspapers, many citizens have an uncomplicated view of the economics of industrial revenue bonds. It is their belief that the bonds are corporate windfalls, pure and simple. For businesses that are contemplating the use of IRBs, however, the determination of the net benefit of the bonds can be anything but uncomplicated. While users of large IRB projects may at least feel comfortable that the bonds are worthwhile, companies proposing small industrial revenue bond projects may have significant difficulty in calculating whether the benefits of the bonds outweigh their costs.

There are three potential benefits of industrial revenue bonds: a property tax exemption, an excise (gross receipts and compensating) tax deduction, and, for some bonds, tax-exempt interest. Contrary to popular opinion, these benefits do not include any form of issuer guarantee or reliance on the issuer's credit, and the fact that the bonds are issued by a governmental entity does not make them easier to sell.

The property tax exemption results from legal title to the project property being held, while the bonds are outstanding, by the municipal or county issuer. State statutes authorize IRBs to have a maximum term of 30 years; thus, a bond issue may provide a property tax exemption of the same duration. Issuers of bonds, however, have power to reduce the bond term, and thereby limit the amount of the property tax subsidy. While many New Mexico local governments are willing to issue IRBs with 30-year terms, Albuquerque and Rio Rancho have adopted policies of not issuing IRBs for terms exceeding 20 and 25 years, respectively. Issuers are also free to limit the property tax subsidy in other respects. Rio Rancho, for example, does not wish the property tax exemption to reduce the revenues of the local school district, and therefore requires an annual payment-in-lieu-of-taxes, or PILOT, corresponding to what the district would receive as a result of the project if the property tax exemption were not in place. In addition, issuers may limit the amount and type of personal and real property included in the "project property" through narrow definitions, restrictive boundary locations, and so forth.

A company leasing a project is also deemed to be the agent of the issuer with respect to purchases of project property. Thus, the company in effect enjoys the same deductions from gross receipts and compensating tax as are given to governmental subdivisions under Sections 7-9-14 and 7-9-54 NMSA 1978. Those sections provide that sellers of tangible personal property to governmental subdivisions (other than tangible personal property that will become an ingredient or component part of a construction project) may deduct the receipts of such sales from their gross receipts in calculating their gross receipts tax liability. This means, in the IRB context, that purchases of project furniture, computer equipment, manufacturing equipment and the like (but not personal property that becomes part of the project real estate) are not subject to either the gross receipts or the compensating tax. As with the property tax exemption, however, the issuer may limit the tax subsidy by limiting the definition of project property. This may be accomplished by limiting the amount of the bonds to the estimated initial cost of the project, and/or requiring that all expenditures of bond proceeds be made within a designated time (three or four years after bond issuance, for example).

The third potential benefit of industrial revenue bonds is that interest on certain bonds may be excludable from federal gross income of bondholders. (Interest on all New Mexico IRBs is excludable from income for New Mexico income tax purposes; however, this will provide a benefit only if the bonds are sold to New Mexico residents.) This can be a very significant benefit, corresponding (depending on market conditions) to a reduction in interest expense of 2% or more. On the other hand, and as discussed in more detail below, an issue of tax-exempt IRBs cannot exceed $10 million and is subject to a variety of other restrictions.

For purposes of discussing the costs of industrial revenue bonds, it is useful to divide the bonds into three different types: (1) taxable bonds that are internally financed, (2) taxable bonds that are sold to third parties, and (3) tax-exempt bonds.

Internally Financed Taxable Bonds. Many larger IRB projects are financed by the benefiting company's own funds, or through a loan from a corporate affiliate, which acts as the bond purchaser. Frequently, the purchase price stays in a closed loop, going from the company to the affiliate, and then, as bond proceeds, back to the company. In such a case, there is no particular relationship between the actual financing of the project and the issuance of the bonds. Instead, the "bond financing" is entirely a legal fiction whose only purpose is to generate the property and excise tax subsidies discussed above. Because of the nature of such a financing, securities law issues are minimal, and IRB costs may be limited to the fees and expenses of bond counsel and the issuer's counsel. In a best-case scenario (i.e., an issue with minimal legal and political complications), such costs may be less than $20,000. However, if the issuer requires the preparation of a formal bond application, costs may increase by several thousand dollars. Some issuers may also require a variety of other concessions, ranging from periodic reports on the project to participation in hiring programs to cash donations to community functions. In the case of Albuquerque, such additional costs may total $10,000 or more even for small IRBs, and can be much greater for larger issues.

Taxable Bonds Sold to Third Parties. Taxable issues sold to third parties have all of the costs of self-financed bonds. In addition, such bonds, being "real" financings, are subject to the full array of federal and state securities laws and to all the costs incurred in connection with their placement. Depending on how and to whom the bonds are sold, these costs may include items such as a feasibility study and an offering document, an analysis of state securities law issues, preparation of securities filings, underwriters' or placement agents' fees, trustees' fees, fees of counsel to the underwriter and the trustee, and so on. Most such bonds are privately placed in order to avoid the requirement for a full-blown registration statement; however, if the bonds were sold publicly, the underwriting and securities costs could be increased significantly. Some bonds may be required to have a reserve fund of 10% (or more) to make them marketable. Alternatively, or in addition, the bonds may be credit enhanced, usually by a direct-pay letter of credit issued by a bank that is familiar with the company's credit and prospects. Although such credit enhancement may require an initial fee of 1-1½% of the bond amount, plus an annual fee of around 1-1½% of the outstanding principal, it should have the effect of substantially reducing bond interest rates. In some cases, credit enhancement may be a necessity to make the bonds salable, especially for smaller companies that are not well-known. Some bonds, especially if credit-enhanced, may be issued as "low floaters", in which a low interest rate is offered in return for the bondholder's ability to put the bonds on short notice. In return for the low interest rate, the company must accept the risk of interest rate fluctuations and the several thousand dollar additional annual cost of a remarketing agent. Of course, the more complications that are added to the transaction, the more complicated the bond documents will be, and the higher the corresponding attorneys' fees. Although the total cost of a taxable IRB marketed to third parties is subject to many variables, such a bond would be unusual if its total costs of issuance were less than $100,000, and would not be unusual at all if its issuance costs exceeded $200,000. (On the other hand, there is no legal impediment to funding some or all of such costs of issuance, and the reserve fund, from the proceeds of the bonds.)

Tax-exempt Bonds. Because of restrictions under federal tax law, tax-exempt bonds must be sold to third parties. Thus, tax-exempt bonds are subject to essentially all of the costs applicable to taxable bonds. (The only significant exception is that tax-exempt bonds are also exempt from registration requirements under federal securities law. Since, however, they remain fully subject to anti-fraud provisions, the disclosure requirements are the same.) In addition, the Internal Revenue Code imposes numerous restrictions on tax-exempt issues and the projects that they finance. A few of these restrictions are: (1) the total capital investment in the project for the period three years before and three years after the issuance of the bonds cannot exceed $10 million; (2) the project must be a manufacturing facility, with no more than 25% of the bond proceeds used for "ancillary" facilities; (3) no more than 2% of the bond proceeds may be used for costs of bond issuance; (4) no more than 25% of the bond proceeds may be used to purchase land; and (5) the average maturity of the bonds cannot exceed 120% of the average economic life of the project. Depending on the circumstances, the cost of analyzing and complying with the restrictions of the Code may add an additional $20,000 or more in bond issuance costs. Furthermore, issuance of tax-exempt IRBs requires that applicants secure an allocation, from the State Board of Finance, of a portion of the "state ceiling" annually available for issuance of private activity bonds. Since the demand for such allocations in a given year may exceed the available supply, this factor imposes additional costs in terms of timing and the risk that an allocation may in fact not be obtained.

In summary, the economics of industrial revenue bonds depends on a large number of variables. The most important of these are probably (1) whether the issuer imposes restrictions on the property and excise tax subsidies, or imposes other conditions for issuance, (2) the credit-worthiness of the company, either in the eyes of the bond purchaser or a credit enhancement provider, and (3) whether the bonds qualify for tax-exempt status. Frequently, total transactional costs for small bond issues are greater than for self-financed larger issues, and in every case, the transactional costs must be paid up front, while the benefits accrue over time. In other words, industrial revenue bonds may be anything but a windfall.