On Dec. 20, 2017, Congress passed the Tax Cuts and Jobs Act (TCJA), the purpose of which was to stimulate economic growth through a major overhaul of the Internal Revenue Code. The legislation was signed by President Donald Trump on Dec. 22, 2017, and many key provisions of the law went into effect on Jan. 1. One such provision that recently went into effect is a reduction in the federal corporate income tax rate, from 35 percent to 21 percent. We anticipate that this reduction in the federal corporate income tax rate will trigger requests to increase the interest rates charged by financial institutions for current outstanding loans. An increase in the interest rate could be triggered under a number of provisions in loan documents, and presents unique problems for conduit borrowers, such as 501(c)(3) tax-exempt organizations, and lenders under tax-exempt bank loan structures.
For existing tax-exempt borrowings, the applicable tax-exempt interest rate or rates would have been set based upon the tax position of the bond or note bank purchaser/lender in the 35 percent corporate income tax rate universe, and considering the impact of Section 265 of the Internal Revenue Code’s restrictions on bank holders of tax-exempt obligations. Generally speaking, these rates have historically been expressed (for variable rate debt) as a percentage of LIBOR or Prime plus a specified margin. Fixed rates have been determined through similar considerations, although many borrowers may not be aware of these mechanics.
However, with a decrease in the federal corporate income tax rate, bank holders of tax-exempt debt are facing a reduction in yield, as these existing tax-exempt rates no longer provide the same after-tax equivalent yield of rates on similar taxable loans. Because of these considerations, banks will no doubt be anxious to seek rate increases on their outstanding tax-exempt debt holdings to bring the yield back into line with the lender’s original expectations. However, the bond and loan documents, being contracts, will set forth the relative rights of the bank holder and the borrower with respect to potential interest rate adjustments based on the corporate income tax rate reduction.
Existing loan documentation may or may not expressly contemplate the possibility of an adjustment in the interest rate in connection with a change in the income tax rates of the holder of the tax-exempt bond or note. For those that do, the provisions may be as clear as a specific formula for adjusting the interest rate based on the prior and post-change income tax rates of the holder. Interest rate change provisions also may take the form of more general so-called “yield protection” provisions, which require that a borrower make a compensatory payment or payments to the lender upon changes in law that result in a loss of yield to the lender. The reach of such yield protection provisions may or may not be clear depending on the actual language of the provision, as many of them were initially drafted to primarily protect the bank from additional expense or yield loss should additional capital adequacy or reserve requirements be imposed by the regulators stemming from the bank’s tax-exempt lending activities. Other loan documentation, particularly for loans that have been outstanding for many years, may not include either a rate adjustment formula or yield protection provisions.
For these reasons, it is prudent and advisable for conduit borrowers to anticipate a rate-adjustment request or other yield protection accommodation from their tax-exempt lenders, and undertake a prompt review and analysis of the documentation governing their tax-exempt loans. Under loan documents that clearly provide a unilateral right to the lender to adjust the rate, the exercise becomes a math problem. Regarding loan documents that contain only general yield protection provisions not specifically addressing holder tax rate changes, these will present interpretation issues which could very well differ as between the parties and result in lengthy negotiations. Lenders could choose to assert a right to increase an interest rate based on these provisions, or request a one-time yield protection payment. For example, a lender could request that a borrower make a payment based on the present value of the difference in yield through maturity (or first call date) between the existing tax-exempt rate and the tax-exempt rate that would be in effect based on the lender’s new federal income tax rate.
In the case of documents that don’t contain either yield protection or specific rate adjustment provisions, the borrower would be under no obligation to agree to a rate increase or additional payments, which could lead to a breakdown in relations between the lender and the borrower and prompt the lender to exercise its tender rights to call the loan at the first opportunity if the documents so provide.
A borrower facing a possible interest rate increase or yield protection payments on its outstanding tax-exempt debt should also undertake an analysis of the impact that the increase or payment would have on its loan document financial covenants, such as debt service or fixed charge coverage ratios. In the case of a requested yield protection payment, an analysis must be untaken as to the proper characterization of the payment under the financial covenants, with the danger being that inclusion of a large extraordinary debt service payment in any reporting period could result in a covenant violation for that period. It is critical that the borrower understand, particularly if there exists significant rate increase exposure, its capacity to increase debt service payments under its covenant formulations and the further impact it could have under any loan document interest rate formulations that key off coverage ratio levels. Lenders should similarly be concerned about the additional debt capacity of their borrowers and the potential for pushing rates to, or requesting yield protection payments at, levels unduly squeezing capacity or causing covenant defaults. This is also an area on which the rating agencies are expected to focus regarding tax-exempt borrowers having outstanding rated debt.
Finally, serious tax issues could arise in connection with a change in the interest rate of a tax-exempt obligation. Under Treasury Regulation Section 1.1001-3, certain modifications of a debt instrument may result in a deemed exchange of the pre-modification instrument for the post-modification instrument. In the tax-exempt world, this results in a refunding and reissuance of the tax-exempt obligation, and the obligation must be retested at the time of the modification to determine whether the obligation maintains the same tax-exempt attributes it possessed before the modification.
Generally speaking, unless the loan documentation provides a clear unilateral right to the lender to adjust the interest rate or yield to reflect a change in income tax rates, a change in the interest rate or yield may result in a deemed reissuance of the obligations. Even where the loan documentation does contain such a unilateral right, the parties may desire to negotiate the level of the interest rate change or the amount of the yield protection payment, or make other changes to the documents, perhaps in an effort to make the increased interest rate or yield protection payment requested by the lender more palatable to the borrower. A change or changes that result in a reissuance for tax purposes of the obligation could be particularly problematic for an obligation originally issued as “bank-qualified” under Section 265 of the Internal Revenue Code, as the reissued obligation may no longer meet the requirements to be “bank-qualified.” Obligations which were originally issued under Internal Revenue Code provisions that have since sunset would also be at risk. Experienced bond counsel must be consulted as part of this process to avoid unpleasant and unintended adverse tax consequences to all parties from a rate re-negotiation.
Daniel J. Malpezzi and Timothy J. Horstmann are attorneys practicing in the financial services and public finance group of McNees Wallace & Nurick in Harrisburg and Lancaster. Malpezzi and Horstmann regularly advise financial institutions and 501(c)(3) tax-exempt organizations in connection with the structuring of tax-exempt loans through public offerings of securities and private placements.