Andrew J. Hamilton
April 2018
Industrial Revenue Bonds (IRBs) are debt instruments issued by units of government to assist manufacturing companies in financing the acquisition of land, buildings, equipment, new construction or renovation. Some soft costs such as architectural, engineering, legal and administrative fees associated with the sale of the bonds can be paid from the bond proceeds, subject to a 2% limitation. A manufacturing firm can basically use almost any unit of government to be the “Issuer” of the bonds. They have a choice of using a local unit of government, like a city or county, a regional unit, like the Upper Illinois River Valley Development Authority or a state-wide financing authority. In the eyes of the federal tax code, this product is identical. It is federally tax-exempt bonds.
The bonds usually require credit enhancement like a letter of credit from a local bank, which backs the bonds. Thus, the company seeking the bonds must be considered creditworthy by the financial institution. By lending their name to the deal, the issuer or political subdivision issuing the IRB allows the borrower to reduce the rate of interest he/she would normally obtain on a conventional loan by 2-3%.
Tax-exempt IRBs are issued at rates lower than conventional sources because the interest paid on the bonds is exempt from federal and sometimes state income tax. No more than $10 million in bonds may be issued in a single locality. No company can have more than $40 million outstanding nationwide. Companies using an IRB may not invest more than $20 million in one location, regardless of fund sources, for a period of three years prior to the issue and three years after it. Companies may choose to lease all or part of their equipment and therefore eliminate that portion from the $10 million limit. IRBs are not generally cost-effective for amounts under $1.5 million because of the fees involved in issuing a bond.
The land acquisition cost must be less than twenty-five percent (25%) of the total bond issue. When a building is purchased, an allocation of the purchase price between the land and the building must be made to determine compliance with this requirement. If the bond proceeds are used to finance the acquisition of an existing building, at least fifteen percent (15%) of the proceeds must be spent on renovation of the building within two years. Bond proceeds may not be used to purchase used equipment except in limited situations, for example if the equipment is deemed “substantially re-built”. Costs of issuance may not be paid out of bond proceeds in re-financing. Any costs incurred by the borrower may not be reimbursed out of bond proceeds if such expenditures are made more than 60 days prior to the adoption of an inducement resolution or a similar official action taken by the issuer.
All new money issues must receive an allocation of volume cap. Not more than 5% of the bond proceeds may be used to finance current expenses such as working capital, interest following construction or inventory. This 5% includes the 2% which may be used to pay issuance costs. The Internal Revenue Code defines manufacturing facility as any facility, which is used in the manufacturing or production of tangible personal property (including the processing resulting in a change in the condition of such property).
Property financed with the proceeds of an industrial revenue bond must be depreciated under the Alternative Depreciation System of Section 168 (g) of the Internal Revenue Code. Generally, this requires using the straight-line method over a recovery period equal to the property’s class life asset depreciation range mid-point life. Personal property with no class life is to be recovered over 12 years, and real property is to be recovered over 40 years. The proceeds of the bond issue must be spent on a project in the jurisdiction within 10 miles of the issuer. 95% or more of the net proceeds of the bonds must be used to acquire, construct, reconstruct or improve land or depreciable property.
New money financings are subject to the alternative minimum tax for investors buying the bonds. The bonds must be issued no later than one year after the date the facility is placed in service, i.e., when the facility is 90% occupied or operating at 90% capacity. All of the bond proceeds must be spent within three years of the date of issuance of the bonds.
Until the passage of the Internal Revenue Code of 1986, banks and thrifts were able to deduct the cost of carrying tax-exempt municipal bonds. However, the passage of this law resulted in changes affecting the purchase of tax-exempt securities. Banks, thrift institutions and corporate investors are not allowed the deduction to carry tax-exempt bonds as an investment. The previous existing alternative minimum tax (“AMT”) was modified and book income based AMT was imposed. Although the AMT was designed to assure that taxpayers who realized real economic gains paid taxes on those gains, the interest income from municipal bonds was historically exempt. However, the 1986 Code changed the status of interest income from municipal bonds for both individuals and corporations.
For individuals, the law treats certain municipal bonds as preference items, which are subject to the AMT. No municipal bond issued prior to August 8, 1986 is subject to the AMT. Bonds issued after August 8, 1986 are subject to the AMT if such bonds are deemed “private activity” bonds. IRBs fall into this category. There are two provisions in the law that regulate the calculation of the AMT for corporations. The first provision is identical to that for individuals for bonds issued after August 8, 1986. The second provision places a 10% implicit tax on municipal bond interest income, regardless of the date of issuance. Corporations are subject to the AMT on all tax-exempt interest income on a formula basis.
Steps in the Bond Approval Process
STEP ONE – Preliminary Inducement: The borrower submits an application with basic information on the project. A meeting is scheduled for the issuer to approve a preliminary inducement resolution. This resolution should be approved early, because the rules permit a company to reimburse itself for capital expenditures up to 60 days prior to the inducement resolution. The borrower may fold in certain soft expenses such as survey work, architectural and engineering fees up to a limit. The resolution does not bind the borrower to anything. It just establishes that the Issuer, in good faith, is willing to issue the bonds and the borrower, in good faith, will look for a buyer of the bonds.
STEP TWO – Assembly of the Professional Team: This meeting is in the form of a meeting or telephone conference call and is arranged by issuer staff. It includes a kick-off discussion of the financial structure of the bonds, the timetable for review of documents and closing on the bonds.
STEP THREE – Credit Enhancement: The borrower generally negotiates the approval requirements of a letter of credit with its bank. The bank can provide a term sheet or commitment letter. Most bond issues are supported by credit enhancement that has a bond rating of investment grade or better. In some cases the bonds can be placed privately to sophisticated buyers who do their own evaluation of the borrower’s credit worthiness.
STEP FOUR – Bond Placement: The borrower generally hires a placement agent, investment banker or underwriter to find a buyer for the bonds. In some cases the bank may do a direct purchase of the bonds instead of a letter of credit.