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Boosting Manufacturing Bond Limits
Allowed Capital Expenditures Doubled for “Small Issue” Tax-Exempt Bonds
Congress recently passed legislation long-awaited by local governments and the domestic manufacturing industry. Advantageous tax-exempt financing has been available to manufacturing companies for decades, but, in recent years, the so-called "$10 million capital expenditure limitation" has limited the pool of manufacturers eligible for this financing. Congress has now raised the limit to $20 million beginning in 2007, which will make tax-exempt financing available to a greater number of manufacturing enterprises.
When we step into the voting booth, we often encounter lengthy referendum questions about the issuance of bonds for new school buildings, roads, water and sewer facilities or new park land. These "general obligation bonds" are backed by the full faith and credit of the local government unit that issues them, and must be approved by the voters since ultimately the local government pays the bonds with our tax dollars.
Tax-exempt bonds issued for manufacturing facilities (sometimes called "small issue industrial development bonds," or "IDBs") are a cousin of general obligation bonds. Rather than financing public infrastructure, IDBs are meant to stimulate private economic development. While these IDBs are issued by a public body, usually a local development authority, they do not show up on the ballot because the public body has no responsibility to repay the bonds. The sale proceeds of IDBs are typically loaned to a private company, and the loan payments made by the private company are used to pay debt service on the bonds. IDBs belong to the "revenue bond" family since they are payable only from the revenues generated, or other security provided, by the private company.
IDBs are attractive to private manufacturers because they can provide long-term capital financing at low interest rates. The interest rates on IDBs are low because interest collected by investors in IDBs is excluded from federal and sometimes state income taxation. These low rates are passed on to the manufacturer. In terms of financing structure, IDBs are flexible and can be issued with variable or fixed interest rates, liberal prepayment terms and maturities of differing lengths.
Prior Capital Expenditure Limitation
In order for the interest paid on an IDB to be tax-exempt, development authorities and borrowers must comply with a number of provisions of the Internal Revenue Code and regulations. One of the key rules limiting the availability of IDBs prior to 2007 was the so-called $10 million capital expenditure limit.1 This rule provided that interest on an IDB was exempt from federal income tax only if the sum of (a) the total principal amount of outstanding IDBs issued in favor of a manufacturing facility (and its related entities2) in a given jurisdiction,3 plus (b) the total capital expenditures4 at the facilities5 during the time period beginning on the date that is three years prior to the issuance of the bonds and ending on the date that is three years following the issuance of the bonds (not counting twice capital expenditures paid for out of the proceeds of the IDBs), did not exceed $10 million.6 So, for example, if a manufacturing company, ABC Widget Co., was the beneficiary of a $6 million IDB on June 1, 2006, and had made $2 million in capital expenditures over the three years prior to June 1, 2006, ABC could not make more than $2 million in additional capital expenditures before June 1, 2009 without breaking through the bond and capital expenditure cap and losing the benefit of the tax-exempt financing.
History of the Capital Expenditure Limitation and Need for Increase
A capital expenditure limit of $5 million was first introduced in the tax code in 1968. Before that time, there was no limit on the principal amount of IDBs that could be issued for the benefit of a private company. In fact, in the mid-1960s, this law firm handled a $125 million bond issue in the city of Hawesville, Ky., to finance a large aluminum smelting plant for Southwire Company. In 1978, the capital expenditure limit was bumped up to $10 million, and since then has not been increased or adjusted for inflation, despite the fact that today the dollar has less than half of its 1979 purchasing power.7
In our public finance practice prior to 2007, we often heard from small- to medium-sized manufacturers who would have liked to use IDBs, but were not able to do so because of the capital expenditure limit. Many already had in excess of $10 million in capital expenditures over the previous three years and therefore were not eligible. Others were just too close to the limit for comfort. For example, if ABC had 2006 financing needs of $5 million and capital expenditures over the prior three years of $4 milllion, ABC could use tax-exempt bonds to finance its current needs, but then would have a cushion of only $1 million in capital expenditures that could be made over the next three years. While there are techniques, such as equipment leasing,8 which can be employed by a company trying to live within the cap, these methods have a cost associated with them that creates drag and makes the tax-exempt financing less cost-effective. And the penalty for going over the limit is the loss of the tax exemption on the bonds going forward,9 even if the breach is inadvertent.
In spite of the old limitation, SGR closed a number of IDBs in recent years, including IDBs for operations as diverse as food processors, printers, air products manufacturers, cabinetmakers, metal formers, and automotive equipment manufacturers.
The recent changes made by Congress are both simple and timely. In 2004, Congress passed a measure increasing the $10 million capital expenditure limit to a more palatable $20 million.10 While this increase was great news to manufacturers, the provision was not set to become effective until September 30, 2009. However, on May 11, 2006, as a result of intense lobbying, Congress passed legislation moving up the effective date of the increase to January 1, 2007.11
Although the new law doubles the capital expenditure limit, it keeps the maximum amount of IDBs that can be issued at $10 million. In other words, beginning in 2007, if ABC Widget Co. has financing needs of $12 million and has made capital expenditures of $4 million over the last three years, ABC can finance up to $10 million of its needs with tax-exempt bonds (the other $2 million could be financed conventionally). The key is that ABC would still be comfortably within the $20 million limit, with the ability to make another $4 million in capital expenditures over the next three years.
With more breathing room under the cap, manufacturers should have less need to hedge against uncertain capital expenditures in the future and should feel more comfortable using IDBs up to the $10 million maximum. Since the cost of putting an IDB transaction in place is relatively high on the front end, a larger bond issue more easily justifies the costs and can result in greater net savings over time.
The increase in the capital expenditure limit will not apply to bonds issued to refinance outstanding IDBs.12 If old bonds are refunded on or after January 1, 2007, the $10 million limit will continue to apply to the refunding bonds. For example, assume ABC had $5 million of bonds issued on its behalf on July 1, 2005. Then, on January 10, 2007, ABC issues $5 million of bonds to refund those old bonds and $4 million of new IDBs to finance additional manufacturing equipment for its plant. With respect to the 2005 bonds, ABC must continue to comply with the $10 million limit. The $4 million in capital expenditures in 2007 will count against the limit, leaving only $1 million in capital expenditures that can be made prior to July 1, 2008. The new 2007 bonds will benefit from the new $20 million limit. The new limit is not particularly helpful to ABC prior to July 1, 2008, since ABC's spending is constrained by the 2005 bonds.
While the capital expenditure limit is just one of the many rules applicable to IDBs, it had been largely responsible for the decline over time in the usefulness of these bonds. The change made by Congress is a first step in the right direction. There are other legislative efforts under way -- e.g., to raise the principal amount of IDBs that can be issued to $20 million and to liberalize rules limiting assets on which bond money can be spent (for example, to finance the production of intellectual property such as software). The tax code recognizes the importance of the domestic manufacturing industry, and these additional changes would help keep the sector strong. However, given the new composition of Congress after last fall's elections, the fate of the additional changes is uncertain.
I.R.C. §144(a)(4). ↩
I.R.C. §144(a)(3). ↩
Bond issues must be added together for purposes of the limit if they finance facilities which are (a) located in the same city or are located in the same county (but not in any incorporated municipality) and (b) are used by the same principal user or a related user. I.R.C. §144(a)(2). ↩
A "capital expenditure" is defined broadly as any expenditure properly chargeable to a capital account, regardless of any rule that would permit the company to treat the expenditure as a current expense. See Treas. Reg § 1.103-10(b)(2)(ii)(e). ↩
Capital expenditures must be aggregated if they are made for two or more facilities which are (a) located in the same city or are located in the same county (but not in any incorporated municipality) and (b) are used by the same principal user or a related user. I.R.C. §144(a)(4)(B). ↩
See I.R.C. §144(a)(4). An IDB up to $1,000,000 can be issued without regard to the capital expenditure test. See I.R.C. §144(a)(1). An affirmative election must be made to issue up to $10,000,000, and this triggers the capital expenditure limits. See I.R.C. §(a)(4)(A). ↩
According to the Consumer Price Index Calculator provided by the U.S. Department of Labor, one dollar in 1979 is worth the equivalent of 36 cents today. U.S. Department of Labor Consumer Price Index Calculator, http://www.bls.gov/cpi/ (visited November 14, 2006). In other words, $10,000,000 in 1979 dollars is equal to $3,600,000 now. ↩
When properly structured, a true equipment lease is not considered a capital expenditure ↩
See I.R.C. §144(a)(4)(D). ↩
American Jobs Creation Act of 2004, Pub. L. 108-357, § 340, 118 Stat. 1423, 1485 (2004). The change permits a user to disregard up to $10,000,000 in addition to the $10,000,000 of capital expenditures permitted by I.R.C. §144(a)(4)(A)(ii), effectively bumping up the limit to $20,000,000 for bonds issued after December 31, 2006. See id. ↩
Tax Increase Prevention & Reconciliation Act of 2005, Pub. L. 109-222, §208, 120 Stat. 345, 351 (2006). ↩
See I.R.C. §144(a)(4)(E). While the new law purports to apply to all bonds issued after January 1, 2007, arguably including refunding bonds, there is not a clear legislative intent to override the general rule of I.R.C. §144(a)(4)(E) which provides that a refunding bond can only be issued if the prior issue would have continued to be a qualified small issue IDB notwithstanding the refunding. ↩