On December 20, 2017 Congress passed the Tax Cuts and Jobs Act (TCJA). The legislation was signed by President Trump on December 22, 2017 and many key provisions of the law became effective on December 31, 2017.
The purpose of the TCJA was to stimulate economic growth through a major overhaul of the Internal Revenue Code. One of the signature elements of the TCJA is the reduction of the federal corporate tax rate from 35% to 21%. While this may be good news to the business community generally, the rate reduction presents potential unique problems for conduit borrowers, such as 501(c)(3) organizations, and lenders under tax-exempt bank loan structures.
For existing tax-exempt borrowings, the applicable tax-exempt rate or rates would have been set based upon the tax position of the bond or note bank purchaser/lender in the 35% corporate income tax rate universe and considering the impact of Section 265 of the Internal Revenue Code’s restrictions on bank holders of tax-exempt obligations. These rates have historically been expressed (for variable rate debt) as a percentage of LIBOR or Prime plus a specified margin, and fixed rates have been determined through similar considerations. However, with a decrease in corporate tax rates, bank holders of tax-exempt debt are facing a reduction in yield as these existing tax-exempt rates no longer provide the same after-tax equivalent yield of rates on similar taxable loans.
Because of this, banks will no doubt be anxious to seek rate increases on their outstanding tax-exempt debt holdings to bring the yield back into line with the lender’s original expectations. However, the bond and loan documents, being contracts, will set forth the relative rights of the bank holder and the borrower with respect to potential interest rate adjustments based on the corporate income tax rate reduction.
Existing loan documentation may or may not expressly contemplate the possibility of a change in the income tax rates of the holder of the tax-exempt bond or note. For those that do, the provisions may be as clear as a specific formula for adjusting the interest rate based on the prior and post-change income tax rates of the holder, or may take the form of more general so-called “yield protection” provisions requiring compensatory payments upon changes in law resulting in a loss of yield to the lender. The reach of such yield protection provisions may or may not be clear depending on the actual language of the provision, as many of them were initially drafted to primarily protect the bank from additional expense or yield loss should additional capital adequacy or reserve requirements be imposed by the regulators stemming from the bank’s tax-exempt lending activities. Other documentation, particularly for loans that have been outstanding for many years, may not include either a rate adjustment formula or yield protection provisions.
For these reasons, it is prudent and advisable for conduit borrowers to anticipate a rate-adjustment request from their tax-exempt lenders by undertaking a prompt review and analysis of the documentation governing their tax-exempt loans. Under loan documents that clearly provide a unilateral right to the lender to adjust the rate, the exercise becomes a math problem. Regarding loan documents that contain only general yield protection provisions not specifically addressing holder tax rate changes, these will present interpretation issues which could very well differ between the parties and result in lengthy negotiations. In the case of documents that don’t contain either yield protection or specific rate adjustment provisions, the borrower would be under no obligation to agree to a rate increase, which could lead to a breakdown in relations between the lender and the borrower and prompt the lender to exercise its tender rights to call the loan at the first opportunity if the documents so provide.
Further, a borrower facing a potential interest rate increase on its tax-exempt debt should also undertake an analysis of the impact that the increase would have on its loan document financial covenants, such as debt service or fixed charge coverage ratios. It is critical that the borrower understand, particularly if there exists significant rate increase exposure, its capacity to increase debt service payments under its covenant formulations and the further impact it could have under any loan document interest rate formulations that key off coverage ratio levels. Lenders should similarly be concerned about the additional debt capacity of their borrowers and the potential for pushing rates to levels unduly squeezing capacity. This is also an area on which the rating agencies are expected to focus regarding tax-exempt borrowers having outstanding rated debt.
Finally, unless the documentation provides a clear unilateral right to the lender to adjust the interest rate to reflect a change in income tax rates, there are serious tax issues that will arise if a lender and borrower negotiate the new rate. Such a negotiated rate could cause the tax-exempt instrument to lose its interest exemption for federal tax purposes through a deemed “reissuance.” This means that the bond or note having the negotiated new rate could be treated as a refunding obligation under federal tax law, and the instrument would have to be requalified for favorable tax treatment at that time under then-existing law. This could be particularly problematic for “bank-qualified” (BQ) bonds or notes where the original issuer does not then meet tax law requirements for issuing BQ debt. Experienced bond counsel must be consulted as part of this process to avoid unpleasant and unintended adverse tax consequences to all parties from a rate re-negotiation.
