By Jillian L. Christiansen, Kutak Rock LLP
Special districts in California are authorized by various state statutes to issue tax-exempt bonds to finance certain governmental projects. This means the interest paid on the tax-exempt bonds to the bondholders will be excludable from gross income for federal income tax purposes and for California personal income taxes.
Special districts can finance the acquisition, construction, and improvements of a variety of facilities using tax-exempt bonds. Examples of recent projects that have been financed with tax-exempt bonds by California special districts include (a) a water district entering into a tax-exempt loan to finance improvements to the district’s water system, which consisted of demolishing and removing an existing concrete reservoir and furnishing and installing a new steel tank reservoir, (b) a recreation and park district leasing and energy efficient improvements for various district buildings, which consisted of solar and electric vehicle chargers, lighting, and HVAC improvements, (c) a public utility district entered into an installment purchase contract to finance solar and energy efficient improvements to district property and to the district’s water system, (d) a community service district executed a lease to finance a portion of its administrative facility, and (e) a water district executed an installment purchase contract to finance the construction, acquisition, and improvements of the district’s water and wastewater facilities, which consisted of constructing two retention basins to retain water flow. Even though many projects can be financed with tax-exempt bonds, it is important to remember that tax-exempt bonds are generally used to finance capital improvements and cannot be used to pay working capital of a project (such as current operating expenses).
Tax-exempt bonds provide a beneficial financing tool to special districts because tax-exempt bonds usually offer a lower interest rate than their taxable counterparts and are relatively low-risk investments. Because the interest payments received by the bondholders are not subject to federal and California personal income taxes, the bondholders are willing to accept a lower return on their investment. Additionally, by issuing tax-exempt bonds, the money that would have otherwise been used to pay for the tax-exempt bond financed facility can now be used elsewhere.
Generally, for bonds to be considered “tax-exempt,” they must be issued for a public purpose and not for private activity. Bonds will be considered private activity bonds when they meet both the private business use test and the private payment or security test, or they meet the private loan financing test. The private business use test is met when more than five percent of the property financed with the bonds is used by a nongovernmental unit in an unrelated trade or business.
For example, if a special district issues tax-exempt bonds to improve its water system but allows a car wash to purchase thirty percent of the water output for its business, the private business use test will be met because a nongovernmental entity is using the financed facility. However, there are certain exceptions to this rule for use of a tax-exempt financed facility by the general public. The private security or payment test is met when more than five percent of the payment of principal and interest on the bonds is secured by private payments or property than is or will be used for private business. The private loan financing test is met when the proceeds of the bonds are used to make a loan to a nongovernmental person or unit in an amount that exceeds the lesser of five percent of the bond proceeds or $5,000,000.
Some types of projects might appear to qualify for tax-exempt financing but actually must be financed on a taxable basis. For example, if a water district wants to improve the delivery capability of its surface water system, the district can issue tax-exempt bonds to finance this improvement and use revenue from a generally applicable tax or special assessment imposed on residents of the district to repay the bonds. However, the district is not allowed to issue the tax-exempt bonds and then repay the bonds using revenue from a special assessment that is only imposed on the landowners who are receiving the increased delivery of surface water. For tax purposes, this structure is treated as the district loaning the proceeds of the bonds to private individuals, i.e., the benefiting landowners. Loaning the proceeds of tax-exempt bonds to private individuals results in the private loan financing test described above to be met and will result in the bonds being classified as private activity bonds and therefore taxable. This is not to say that tax-exempt bonds cannot be repaid from special assessments imposed on residents of a special district, just that the special assessment cannot be imposed solely on those who will directly benefit from the project.
The complexity of the rules and regulations governing tax-exempt bonds makes it advisable for special districts to consult their bond counsel before borrowing or issuing debt.
#Finance