A decrease in the maximum corporate income tax rate would normally result in a decrease in the effective tax equivalent yield, which is the yield a bond owner needs on an investment that is subject to income taxes to equal the yield on the tax-exempt investment.  For example, if a bond has a 3% tax-exempt interest rate, with a maximum corporate income tax rate of 35%, the tax equivalent yield is 4.62%. With a maximum corporate income tax rate of 21%, the tax equivalent yield is 3.80%.

However, in recent years many bond documents executed in connection with direct placements with banks and other financial institutions have included provisions intended to preserve the investor’s equivalent yield if the maximum corporate income tax rate were to change. 

Thus, it is not uncommon in direct placements for the bond documents to provide that, in the event of a decrease in the maximum corporate income tax rate, the interest rate on the bonds would increase in order to provide the investor with the same yield as the investor earned prior to the change in the maximum corporate income tax rate.

Because of the magnitude of the maximum corporate income tax rate decrease, these provisions can result in a significant increase in the interest rate payable by the borrower. 

For instance, in the example above, the borrower’s interest rate would increase from 3% to 3.65% in order to provide the investor with the same effective yield as the investor earned prior to the adoption of the Federal Tax Act.

As a result, we anticipate that many borrowers with bond documents containing provisions preserving the investor’s yield may be discussing a modification to those documents in order to reduce the impact of the maximum corporate income tax rate change on the interest payable under their bond documents. 

Borrowers should be aware that a change to bond documents can result in a deemed reissuance of the bonds, which can result in the loss of the bonds’ tax-exempt status, and that such change should only be undertaken with advice from bond counsel on how the change can be accomplished while maintaining the tax-exempt status of the bonds.

Under the Treasury Regulations, a deemed reissuance occurs when bond documents are amended to modify the interest rate to a rate which changes the yield on the bonds by the greater of 25 basis points or 5% of the yield on the unmodified instrument.

In the example above, the interest rate change occurring by the operation of the bond documents would result in an increase in the rate from 3% to 3.65%.  However, if the borrower and the investor were to agree instead to split the difference and increase the rate to only 3.325%, that agreement would result in a reissuance of the bonds.  To avoid a reissuance, the interest rate could not be modified below 3.40%, which rate is 25 basis points below the rate established pursuant to the bond documents.