New Muni Interest Disallowance Rules

8/13/2009

One of the bank-friendly provisions from The American Recovery and Reinvestment Act of 2009 relates to the amount of interest expense that is disallowed in the common situation where a bank carries tax-exempt bonds. Under existing law, banks must disallow 100% of the interest expense for carrying tax-exempt bonds unless the bond is "bank-qualified." If bank-qualified, the interest disallowance drops from 100% to 20%, or, in other words, 80% of the interest to carry such bonds becomes deductible for tax purposes. Generally, bank-qualified refers to tax-exempt bonds where the issuer (or pooled group of issuers considered a single issuer) doesn't expect to issue more than $10 million in tax-exempt obligations during a calendar year. There are tax forms the issuer files with the IRS certifying that it meets the $10 million limit. A bank investing in such a bond will usually request a copy of this IRS form to substantiate that it is indeed a bank-qualified bond in which the bank is investing.

Given the current economy, Congress desires to improve the marketability of tax-exempt bonds. Knowing that banks are one of their key investors, it has, albeit temporarily for 2009 and 2010, expanded the tax-exempt bonds which will qualify for 20% disallowance treatment beyond just those deemed bank-qualified. The amount of non-bank-qualified bonds qualifying under this new rule is determined by taking 2% of the banks average tax basis in its total assets. For example, if the banks average total assets are $50 million, 2% of this would be $1,000,000. Thus, the bank could subject up to $1,000,000 of non-bank-qualified tax-exempt bonds issued over the period of 2009 and 2010 that it purchases to the 20% interest disallowance rule. It should be noted that the bonds must be issued in 2009 or 2010, but can be purchased in 2009, 2010, or later. Of further benefit is the fact that the 20% disallowance will always apply to these bonds, not just for these two years.

Anything over the $1 million in our example would be subject to the 100% disallowance since they are not otherwise bank-qualified bonds. In this case, the question arises as to which bonds are included in the $1 million and which bonds over the $1 million should enter into the 100% disallowance calculation. There are other detailed calculation questions that await further IRS guidance. Until further guidance is issued, it may be wise to track each bond purchase separately. This will also aid the 20% calculation that continues after 2010.

In conjunction with the foregoing changes, the bank-qualified bonds are also getting a two-pronged boost. First, for 2009 and 2010, a qualified small issuance can be up to $30 million in a calendar year (up from the above mentioned $10 million). Second, the ultimate borrower on each bond is not necessarily aggregated in meeting the $30 million limit as is the case with the current $10 million limit. As long as each borrower in a pooled financing doesn't exceed $30 million, the entire pooled financing will be considered bank-qualified. For example, if a bond is issued for $100 million with $25 million going to each of four qualified political subdivisions as the ultimate borrowers, then the entire $100 million would be considered bank qualified. Change the example to where one borrower gets $35 million, while the other three each get less than $30 million, and the entire issuance is now not bank-qualified. It is Congress' hope that this will entice banks to lend at favorable rates to a broader range of entities.

There are enough nuances in these new rules that a thorough discussion of the particular facts in your situation should be had with your tax professional.