Discussion Topics Bond Options Tax-Exempt Bonds versus Taxable - - PDF document

4/4/2019 1 Tax-Exempt Bonds – Issues for Governmental and 501(c)(3) Healthcare Institutions

April 11, 2019

• D. Michael Moyers
• W. Taylor Marshall

501-370-1492 501-370-3388 mmoyers@fridayfirm.com tmarshall@fridayfirm.com

Discussion Topics

• Bond Options
• Tax-Exempt Bonds versus Taxable Bonds
• Can your institution take advantage of tax-exempt bonds?
• What are the strings attached to tax-exempt bonds?
• Hot Topics in the Bond World
• Audit Risk – Costs of issuance in 501(c)(3) bond issues
• SEC Rule 15c2-12 Amendments
• No tax-exempt advance refundings
• GASB/FASB lease changes implications for bond financial

covenants

• LIBOR phase-out

4/4/2019 2

Bond Options

• Discussion encompasses “bond issues” and tax-exempt bank

loan transactions – not typical commercial bank loans.

• Capital project financings – not working capital
• Bond options applicable to a particular healthcare institution

will depend on the ownership and management structure of an institution.

• Government owned/managed?
• Government owned and leased to 501(c)(3)?
• Government owned and managed by 501(c)(3)?
• Government owned and managed by for-profit?
• 501(c)(3) owned and managed?
• For-profit owned and managed?
• Important to consult legal counsel to determine what options

are available based on individual circumstances.

Bond Options – Based on Purchaser

• Public Issue
• Underwriter sells bonds to investors (individuals, banks, institutions)
• Official Statement (prospectus) is used to market bonds
• Market drives the rates and the deal provisions
• Private Placement
• Bank buys the obligation
• Bank may book the obligation as a loan or an investment
• Negotiate terms with bank/purchaser

4/4/2019 3 Bond Options – Based on Purchaser, continued

USDA – Rural Development

• Rural areas of up to 20,000 in population
• Must be unable to finance proposed project from own resources or through commercial credit

at reasonable rates/terms

• Feasibility study necessary
• Public entity or non-profit
• Non-profits must demonstrate significant ties to the local community (board makeup) and

local support ($ contributions towards the project)

• Financing parameters:
• New construction, renovations, equipment
• Refinancing under certain circumstances
• Maximum term 40 years
• No maximum amount
• Interim financing “bridge loan” typically required for construction period
• USDA is not responsible for obtaining interim financing – reach out to banks or retain a placement

agent

• Bond Counsel is needed
• “Take-Out Letter”
• USDA-RD provides permanent financing once construction completed or close to

completion.

• Grants may also be available.

Bond Options – Based on Security

Common types of bond issues based on security:

• Hospital revenues bonds
• Pledge of revenues of entity operating hospital (owner and/or lessee)
• Mortgage/Guaranty may be necessary
• Real estate/lease payment security
• RE holding company serves as “borrower” and owns building, then

leases to affiliated operating entities

• Secured by lease payments to RE holding company and mortgage
• Sales and use tax bonds
• Must be government owned, but lease to 501(c)(3) is okay
• Requires an election
• Government owned and operated institutions may also pursue a

supporting sales tax (without debt) for operation, maintenance, improvement, renovation, expansion, equipping

• Government owned and leased institutions may also pursue a

supporting sales tax (without debt) for maintenance, improvement, renovation, expansion, equipping (not payroll or operation)

4/4/2019 4

Access to Tax-Exempt Bond Market

• Tax-Exempt Bonds - Investors demand a lower return on their

investment if they do not have to pay income tax on the interest income, and this lowers borrowing costs.

• Governmental entities have the authority to issue tax-exempt

bonds.

• Government owned institutions
• Also government owned institutions that are leased to 501(c)(3)s
• For 501(c)(3) owned facilities - 501(c)(3)s can access the tax-

exempt bond market through a governmental “conduit issuer”

• Arkansas Development Finance Authority
• City or county public facilities board

Strings Attached to Tax-Exempt Bonds

In effect, tax-exempt bonds are a federal subsidy, and there are strings attached.

• Private business use limitations (PBU is a special legal entitlement

for use of a bond-financed property to a nongovernmental entity or the federal government)

• In 501(c)(3) context, must look at unrelated use, use by non-affiliated

501(c)(3)s and for-profits.

• The federal government is a “bad user” for this purpose.
• Arbitrage limitations and investment restrictions
• Spend money within reasonable time (generally 3 years)
• Adverse findings at audit?
• IRS taxes bondholders
• IRS settles
• Formula rate percentage of interest for the past three years (2018 was

27.8%).

4/4/2019 5

Private Business Use

Most common types of Private Business Use (PBU) for healthcare institutions

• Management and other service agreements (discussed on

the next slide);

• Leases/Subleases;
• Research contracts;
• Shared-use arrangements;
• Sale or disposition of tax-exempt bond financed property;

and

• Any other agreement or arrangement that grants a special

entitlement for the use of bond-financed property to a nongovernmental entity. Always ask if a facility is financed with tax-exempt bonds.

Management and Service Agreements

• Facilities operated or services provided by an outside

entity

• Management of entire facility by healthcare company
• Management by doctor groups (ER, radiology,

anesthesiology, etc.)

• Food service/cafeteria
• Pharmacy
• Any other outsourcing

4/4/2019 6

Revenue Procedure 2017-13

Revenue Procedure 2017-13 provides a safe-harbor. If a management/service agreement meets the safe- harbor provisions, it does not constitute PBU.

• No net profits arrangements
• Contract must not, in substance, impose upon the service

provider the burden of bearing any share of net losses from the operation of the managed property.

• Limited term, depending on economic life of property.
• Governmental/501(c)(3) must exercise a significant degree of

control over the use of the managed property.

• Budget approval
• Governmental/501(c)(3) must bear the risk of loss upon

damage or destruction of the managed property.

Revenue Procedure 2017-13, continued

• Service provider must agree that it is not entitled to and will

not take any tax position that is inconsistent with being a service provider to the governmental/501(c)(3) with respect to the managed property.

• Language needs to be added to the management agreement.
• Service provider will not claim any depreciation or amortization

deduction, investment tax credit, or deduction for any payment as rent with respect to the managed property.

• Service provider must not have any role or relationship with

the governmental/501(c)(3) that, if effect, substantially limits the governmental/501(c)(3)’s ability to exercise its rights under the contract.

• Governing body

4/4/2019 7

Structuring a Financing

• Financing transactions can be structured so that actual or

anticipated PBU of a particular facility will not be a problem.

• Combine tax-exempt bonds with other funding sources
• Taxable bonds/debt
• Reserves
• Grants
• A taxable component can provide flexibility
• Spread between tax-exempt and taxable might not be much
• Market-driven
• Discuss plans and ideas with financing team on the front end.

Remedial Actions

• The tax regulations provide mechanisms to cure a deliberate

action (the use of proceeds that causes the PBU test to be met).

• For instance, a governmental hospital deciding to lease to a

501(c)(3) or a hospital selling or leasing to a for-profit.

• Regs have differing mechanisms, depending on the facts and

circumstances:

• Redeem or defease bonds
• “Reissue” bonds as qualified 501(c)(3) bonds
• There are limitations on eligibility for remedial actions
• For instance, deliberate action should be bona fide, arm’s length, for

FMV.

• Did not reasonably expect to take deliberate action on closing date
• Voluntary Compliance Agreement Program

4/4/2019 8

IRS Form 990 Schedule K – Audit Concerns

• The IRS tax-exempt bond group has implemented a data

driven audit focus (as opposed to a random focus)

• Soft-Contact Compliance Checks
• Letter 4408 and Form 14002
• Concern with IRS Form 990 Schedule K in this environment
• “Cross-selling” between IRS groups

Form 990 Schedule K, continued

• Part III
• 1 – Was the organization a partner in a partnership, or a member of

an LLC, which owned property financed by tax-exempt bonds?

• 2 – Are there any lease arrangements that may result in PBU of

bond financed property?

• 3a – Are there any management or service contracts that may result

in PBU of bond-financed property?

• 3c – Are there any research agreements that may result in private

business use of bond-financed property? Are any of these answers “Yes”?

4/4/2019 9 Form 990 Schedule K, continued

• 4 – Enter the percentage of financed property used in a PBU by entities
• ther than a 501(c)(3) organization or a state or local government
• 5 – Enter the percentage of financed property used in a PBU as a result
• f unrelated trade or business activity carried on by your organization,

another 501(c)(3) organization, or a state or local government

• 8a – Has there been a sale or disposition of any of the bond-financed

property to a nongovernmental person other than a 501(c)(3)

• rganization since the bonds were issued?
• 9 – Has the organization established written procedures to ensure that

all nonqualified bonds of the issue are remediated in accordance with the requirements under Treas. Reg. 1.141-12 and 1.145-2?

• Part V
• Has the organization established written procedures to ensure that

violations of federal tax requirements are timely identified and corrected through the VCAP program if self-remediation is not available under applicable regulations?

Hot Topics – Excessive Costs of Issuance Audit Risk for 501(c)(3) Bond Issues

• For qualified 501(c)(3) bonds, not more than 2% of the

proceeds of a tax-exempt issue can be used to pay costs of issuance.

• Sometimes this means that the 501(c)(3) has to borrow a “taxable

tail” or pay some costs in cash.

• The IRS has announced a TEB audit initiative for excessive

costs of issuance.

• Costs of issuance are reported on the IRS Form 8038 and the IRS

Form 990 Schedule K.

• Ask bond counsel before using bond proceeds to pay (or be

reimbursed for) costs of issuance/closing costs after closing.

• Examples are counsel fees, CPA fees, publication costs.

4/4/2019 10

Hot Topics – SEC Rule 15c2-12 Amendments

• SEC Rule 15c2-12 contains continuing disclosure requirements for public bond issues

(sold through an underwriter)

• Public issues after February 27, 2019 have two new “listed events” for which notice

must be filed.

• # 15 Incurrence of a "financial obligation" (as defined below) of the obligated person, if

material, or agreement to covenants, events of default, remedies, priority rights, or other similar terms of a financial obligation of the obligated person, any of which affect security holders, if material; and

• #16 Default, event of acceleration, termination event, modification of terms, or other similar

events under the terms of a financial obligation of the obligated person, any of which reflect financial difficulties

"Financial Obligation" is defined as a (i) debt obligation; (ii) derivative instrument entered into in connection with, or pledged as security or a source of payment for, an existing or planned debt obligation; or (iii) guarantee of (i) or (ii). The term financial obligation does not include municipal securities as to which a final official statement has been filed on EMMA pursuant to Rule 15c2-12.

• “Debt obligation” includes debt, debt-like, and debt-related obligations
• Does not include ordinary financial and operating liabilities incurred in the normal course of

business.

• A "debt obligation" can consist of short-term or long-term indebtedness, but it can also consist
• f a lease instrument or other instrument if such lease or other instrument operates as a

vehicle to borrow money.

Notices must be filed within 10 business days after the occurrence of the event.

Hot Topics – No Tax-Exempt Advance Refundings

• Tax Cuts and Jobs Act passed in December 2017 removed tax-

exemption for “advance refunding” bonds

• Issuers cannot issue tax-exempt refunding bonds if the redemption date

for the bonds being refunded is over 90 days from the refunding issuance date

• Affects timing of refinancing transactions
• Taxable bonds can be used to advance refund

4/4/2019 11

Hot Topics – GASB/FASB Lease Changes

• GASB 87 and FASB ASC 842
• Review financial covenants in bank loan documents to

determine how leases are taken into account in “Annual Debt Service.”

• Particularly a potential issue in debt service coverage ratio

covenants where a broad definition of “Annual Debt Service” is used as the denominator.

• Clarify that operating leases should not be included in

“Annual Debt Service”

• For the purposes of this Loan Agreement and the definition of

Annual Debt Service, any revision to GAAP which might result in the recognition of a lease liability for leases [currently] [previously] classified as operating leases, the payments associated with those lease obligations shall be disregarded for purposes of determining Annual Debt Service.

Hot Topics - LIBOR Phase-Out

• The London Interbank Offered Rate is being phased out
• Issues with manipulation
• End of 2021 is discussed as the phase-out target
• Secured Overnight Financing Rate (SOFR)
• If any loan documents for a variable rate issue base the rate
• n LIBOR, it is important for the documents to make provision

for LIBOR’s phase-out and an alternative.

4/4/2019 12

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