Now that a month has passed since President Trump signed the Tax Cuts and Jobs Act into legislation, the ripple effect of the changes is being felt. The drop in corporate tax rates has a positive impact for many. However, exempt organizations with outstanding tax-exempt bonds may be facing higher interest rates this year and going forward.
Many bond documents are written with language that includes a provision allowing for an increase in the interest rate charged to the exempt organization if income tax rates decrease. Initially, the logic of this may not make sense. If income tax rates decrease, resulting in additional cash – in theory – for investors, why would the interest expense for tax-exempt bonds increase?
It all has to do with the attractiveness of the investments. When income tax rates are high, tax-exempt bonds are attractive because the income earned is tax free to investors. With a higher demand for the bond, lenders can charge a lower interest rate to the exempt organizations.
However, when income tax rates decrease, so does the attractiveness of tax-exempt income to the bond holders. Lenders charge a higher interest rate to the exempt organizations to make the tax-exempt bonds more attractive to potential investors.
We are already seeing lenders notify exempt organizations about the increase in their interest rates due to the decrease in income tax rates. Depending on the principal outstanding, a small percentage increase in the interest rate may result in a sizeable amount of additional interest expense for the exempt organization.
So, what can an exempt organization do?
The first step is to double check your loan documents to see if a provision is included regarding a change in income tax rates. Some bond documents include this provision, while others do not. The provision may be a specific formula or it may be something more general, such as a yield protection provision. If you find no provision in your loan agreement, it may still be prudent to check with your bond counsel.
If the provision is included, the next step is to contact your bond counsel and your lending institution. There may be an opportunity to renegotiate the terms. The bank may be willing to adjust the interest rate in exchange for a longer payment term. Be cautious that a renegotiation of terms may cause a reissuance of the debt.
Your bond counsel can advise you on the steps to take to ensure the bond remains tax-exempt if a deemed reissuance occurs. Meanwhile, be prepared for the additional cash outlay each month due to the higher interest rate.
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