WASHINGTON — Rep. Dave Camp's proposed tax reform plan would eliminate or modify some of the federal tax code provisions in a way that would discourage nonbank corporations, banks, and property-casualty insurance companies from buying municipal bonds.
Federal Reserve documents show that at the end of the third quarter of last year, muni holdings totaled $404.0 billion for banks, $28.6 billion for nonfinancial corporations, and $331.9 billion for property-casualty insurance companies.
Not only would the House Ways and Means Committee chairman eliminate bank-qualified bonds, which currently encourage banks to buy bonds of small localities that otherwise could not access the market, but it would also move to a pro-rata disallowance scheme for deductions for nonbank corporations and property-casualty insurance companies.
The Michigan Republican's elimination of bank-qualified bond provisions would be a major blow, said muni issuers and dealers that have lobbied hard for an expansion of them.
Currently, banks can buy the bonds of "qualified" small issuers — those who issue $10 million or less of tax-exempt bonds per year — and deduct 80% of their carrying costs, the interest expense they incur from purchasing or carrying an inventory of tax-exempt bonds. Banks would no longer be able to take the deduction under Camp's plan.
"That's really going to hurt small issuers," said Michael Decker, managing director and co-head of munis for the Securities Industry and Financial Markets Association.
"It "would take [small issuers] out of the market or raise [their] cost of borrowing," said Ben Watkins, Florida's bond finance director and the chair of the Government Finance Officers Association's debt management committee.
Non-bank, non-dealer corporations have for years invested their excess cash in tax-exempt money market funds, tax-exempt notes or other short-term munis that are liquid for cash management purposes. But the Camp plan would discourage such investments by subjecting these corporations to a pro-rata disallowance rule that is harsher than the deduction provisions that currently apply to them.
Under current law, corporations can deduct most interest expenses, except for those associated with borrowing to buy tax-exempt bonds. Corporations must show they are in compliance with this provision either by being able to trace where their money came from to buy tax-exempts, or they can avoid the tracing by applying a 2% de minimis rule, under which their tax-exempt bond holdings do not exceed 2% of their total assets.
Camp would eliminate the 2% de minimis rule for a pro rata disallowance, under which a nonbank company's interest expenses would be disallowed according to the percentage of its assets that are tax-exempt bonds. If 5% of its assets are tax-exempt bonds, it loses 5% of its interest deduction.
"It would be harsher," said Decker.
The Camp plan would also discourage property-casualty insurance companies from buying munis by also subjecting them to a pro-rata disallowance scheme, Decker said. These companies are cross-over buyers that buy munis when tax-exempt bond yields reach certain thresholds, keeping borrowing costs down for state and local governments.
Under current law, these insurance companies can take deductions for contributions they make to reserves to cover anticipated losses. The deduction is reduced by 15% of the amount of tax-exempt interest they earn. If a PCI insurer earns $100 of tax-exempt interest, it must disallow $15 of its deduction for loss reserve contributions.
Under the Camp plan, its disallowance of deductions would instead by based on the tax-exempt bonds it holds as a percentage of its assets. "For most property- casualty companies, that would be a larger deduction disallowance," Decker said.
