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Recent Changes Affect Tax-Exempt Borrowing

on Tuesday, 3 July 2018 in Health Law Advisory: Zachary J. Buxton, Editor

Several changes to long-established tax law and guidance in the past year may restrict borrowers’ access to tax-exempt financing. Health care providers that are exempt organizations under Section 501(c)(3) of the tax code, or governmental subdivisions such as county hospitals, should be aware of these changes.

When the corporate tax rate dropped from 35% to 21% at the beginning of 2018, it reduced the potential tax savings for corporations that invest in tax exempt debt, and interest rates accordingly rose. At the same time, of course, rates of return across the entire bond market have gone up. As a result, tax-exempt financing today is at a significantly higher rate than in 2017, and the difference in interest rates between a standard commercial loan and a tax-exempt bond is not as great as in the recent past.

The new tax code also restricted a borrower’s ability to refinance tax-exempt debt. In the past it was relatively simple for a borrower to refinance a tax-exempt debt at least once during the loan’s lifetime. Now, such “advance refundings” can occur only within specified time frames. While new loans can be written to take advantage of some apparent loopholes in the restriction, loans that pre-date the new tax code generally provide for refinancing only after ten or twelve years.

Borrowers under such restrictions will in many cases have to wait for maturity to refinance their debt. There are complex structures that will permit a borrower to enter into a new loan, and use the proceeds to pay off existing obligations over time. However, such strategies may be so costly to administer that they will not benefit small borrowers.

Outside the tax code changes, the IRS also issued a new guidance in 2017, apparently changing some requirements of a safe harbor governing how for-profit entities may use space financed with tax-exempt debt. The new guidance sets a more subjective standard and was intended to increase flexibility. However, one consequence has been a new focus on how the tax-exempt borrower oversees the rates charged by its for-profit tenant or manager. This was not an issue under the prior safe harbor guidance. Exempt organizations accordingly should review their tax-exempt bond compliance policies with the new guidance in mind.

That being said, tax-exempt interest rates are still lower than for commercial debt, and new loan agreements may be drafted to provide maximum flexibility in refinancing. Tax-exempt borrowers also can explore other avenues. For example, USDA’s Rural Economic Development program provides low-interest loans to companies in rural areas. The recent legal changes are just additional factors to consider when weighing the value of taking on new debt.

Thomas S. Dean

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