Spike in issuer bank loan rates feared as drop in corporate tax rate looms
WASHINGTON – Tax-exempt bond issuers may see the interest rates on their bank loans go up if Congress slashes the corporate rate to 20% from 35%, according to municipal advisors and bond counsel.
That’s because most banks put corporate tax gross-up provisions in their loan documents that give them right to increase interest rates on the tax-exempt bonds they’ve purchased if corporate rates go down and the tax-exempts become much less attractive to them.
“The tax exemption is not worth as much at the lower corporate tax rate,” said Shelley Aronson, president of First River Advisory in Philadelphia.
“It’s one of those hidden consequences of the tax bill that I hope remains hidden,” said Dave Erdman, Wisconsin’s capital finance director.
He’s referring to the fact that some of these gross-up provisions are discretionary. The bank may decide not to invoke the provisions. But some are mandatory.
“Where the tax gross-up provision is mandatory, I do not expect the banks to waive it, because that would adversely affect the banks’ profitability," said Allen Robertson, an attorney at Robinson Bradshaw in Charlotte. “Moreover, waiving it may result in a reissuance of the bonds, which is a deemed current refunding. While this could be workable for governmental bonds, in the case of private activity bonds, if the authority to issue them is repealed [by the final tax bill] a reissuance would result in the bonds being taxable and bearing interest at a fully taxable rate. This would be a worse result than the grossed-up tax-exempt rate.”
Bonds are deemed to be reissued and subject to the latest tax law restrictions if any of their terms are significantly modified, such as interest rates.
“There’ve been some similar provisions over the past few years that banks didn’t invoke,” said Aronson. “But this is a big one” he said, adding, “I would expect it.”
“It’s up to a loan provider to decide whether to invoke that provision [in documents where it’s discretionary], but the mechanism is there,” said Erdman.
Erdman said his state entered into a $270 million bank loan in 2013 and recently started worrying about the gross-up provision. He said his loan rate could go up by 50 to 75 basis points, if the bank invokes the provision, which is discretionary.
Sources said it’s difficult to tell that a gross-up in interest rates could occur based on the disclosures about bank loans because the banks often redact rate information.
The National Association of Bond Lawyers talked about these gross-up provisions in a paper it released last July called “Direct Purchases of State or Local Obligations by Commercial Banks and Other Financial Obligations.”
NABL wrote: “In some cases, lenders may seek additional adjustments to the interest rate to cover other events, such as provisions requiring … an increase in the interest rate for tax-exempt debt upon a decrease in the marginal federal corporate tax rate, in order to maintain the lender’s expected after-tax yield.”
Issuers “sometimes request that ‘the door swing both ways’ so that the interest rate on the bonds will decrease if the lender’s marginal corporate tax rate increases.” NABL said.
Here are two examples of gross-up provisions provided by bond lawyers. Both are expressed as mathematical formulas.
The first example is in the definitions part of the loan document and suggests the bonds have variable rates.
“LIBOR Index Rate” means a per annum rate of interest established on each Computation Date equal to the product of (a) the sum of (i) the Applicable Spread plus (ii) the product of (1) the LIBOR Index multiplied by (2) the Applicable Factor multiplied by (b) the Margin Rate Factor. The LIBOR Index Rate shall be rounded upwards to the fifth decimal place.
“Margin Rate Factor” means the greater of (a) 1.0, and (b) the product of (i) one minus the Maximum Federal Corporate Tax Rate multiplied by (ii) 1.53846. The effective date of any change in the Margin Rate Factor shall be the effective date of the decrease or increase (as applicable) in the Maximum Federal Corporate Tax Rate resulting in such change.
“Maximum Federal Corporate Tax Rate” means the maximum rate of income taxation imposed on corporations pursuant to Section 11(b) of the Code, as in effect from time to time or, if as a result of a change in the Code the rate of income taxation imposed on corporations generally shall not be applicable to the Purchaser, the maximum statutory rate of federal income taxation which could apply to the Purchaser.
The second example is more descriptive and applies to fixed-rate bonds.
“In the event of a change in the bank’s corporate tax rate during any period where interest is accruing on a tax-exempt basis causes a reduction in the tax-equivalent yield on the bonds, the interest payable on the bonds [shall be increased] [may be increased by the bank] to compensate for such change in the effective yield to a rate calculated by multiplying the interest rate on the bonds by the ratio equal to (1 minus A) divided (1 minus B), where A equals the bank’s corporate tax rate in effect as of the date of the corporate tax rate adjustment as announced by the Internal Revenue Service and B equals the bank’s corporate tax rate in effect on the date of the original issuance of the bonds.”
Here’s how this formula works. Assume that the bank’s corporate tax rate is 35% at the time it makes a loan to the Issuer, and that the initial interest rate that the issuer has to pay is 3%. If the bank’s corporate tax rate declines to 20%, then, based on the above formula, the issuer’s interest rate would increase to 3.69%.
Some issuers refuse to accept these provisions in their loan agreements. Aronson said he’s seen issuers’ Requests for Proposals for bank loans that say banks should not respond if they want to include a gross-up provision.
“They’ll try to head it off at the RFP stage,” he said.
But more often banks will insist on including these provisions in the loan agreements, sources said.