As a result of the reduction in corporate income tax rates that was effected under the recently enacted tax law changes, the concept of “gross-up” in tax-exempt financings has been raised by some of the banks that hold tax-exempt bonds on a direct placement basis. The “gross-up” concept is based upon a provision in the typical direct placement bond documents that allow the bank to unilaterally increase the bond interest rate if there is a decline in corporate tax rates.
The intent behind the gross-up right is to allow the banks to maintain their after-tax yield regardless of changes in the corporate tax rate. At this time, it is not clear whether all banks that hold tax-exempt bonds will implement gross-up provisions, and perhaps equally importantly, how they will calculate gross-up.
If a bank pursues a gross-up, the result may be that the rate for its tax-exempt financing will increase to a point where the benefits of the tax-exempt financing do not outweigh its burdens (including transactions costs and restrictions on use of the bond financed buildings). If that is the case, borrowers may be better served to refinance the effected bonds either in the public markets or with taxable debt.
This would be unfortunate for the borrowers, as they would be forced to incur additional transactions cost. Similarly, this would be unfortunate for the applicable banks which would lose the non-credit services they provide the borrowers, which may be the most profitable elements of their relationship for the bank. Moreover, for borrowers with an investment grade credit rating or with significant tax-exempt debt outstanding, refinancing on a tax-exempt basis in the public markets (where the ultimate buyers of bonds are individuals still subject to higher income tax rates) is a viable option.
But assuming a bank intends to implement a gross-up, how should the bank calculate the gross-up? On the surface, it may appear simple—increase the interest rate on the bonds by the same percentage as the percentage decrease in the corporate tax rate. To illustrate, using a fixed rate example for convenience:
If the tax exempt interest rate was 2.55% when corporate tax rates were 35% and corporate tax rates decreased from 35% to 21% (a 40% reduction); then the rate (2.55%) could arguably increase 40% to 3.57; an increase (gross-up) of 1.02 percentage points (1.02%).
While this approach may be straightforward, it gives the bank a windfall as is illustrated when this approach is contrasted with the approaches outlined below.
Another way of calculating gross-up is to apply the old tax rate to the original stated interest rate, determine the taxable equivalent yield, and then apply the new tax rate to the original stated interest rate and determine a new taxable equivalent yield, and gross-up the original stated interest rate by the amount of the difference between the taxable equivalents.
If the original stated tax exempt rate was 2.55% when corporate rates were 35%, the taxable equivalent yield was 3.9231% (2.55% / (1-0.35); with corporate tax rates now at 21%, the taxable equivalent yield is 3.2278% (2.55% / (1-0.21); the difference between these two yields is 0.6953 percentage points (0.6953%) which, accordingly, would be added to the original stated interest rate (2.55% + 0.6953%).
A third way to calculate gross-up is to take into consideration the offsetting deduction that a bank enjoys when funding a loan with money derived from deposits or other borrowed funds. Under the Tax Equity and Fiscal Responsibility Act (TEFRA), a bank is not allowed to deduct from taxes its ‘cost of funds’ (disallowance) and then shield taxes on the income from the tax-exempt asset (loan or bond). Instead, the originally stated tax-exempt rate has been calculated taking into consideration the disallowance.
Assume again an originally stated tax exempt interest rate of 2.55%; now assume the bank’s cost of funds is 2.24%; when income tax rates were 35% and, disregarding the TEFRA disallowance, the bank could have deducted 35% of that 2.24% (0.784%). That said, because of the disallowance, in order to correctly calculate the bank’s taxable equivalent yield, the 2.55% tax-exempt rate must be reduced by the disallowance of 0.784% before it is grossed-up by one minus the corporate tax rate (2.55% - 0.784% = 1.766%). So its real after-tax equivalent yield is 2.717% (1.766 divided by (1-0.35%)).
Subsequently, under the new tax act, the offsetting bank deduction (disallowance) is less (21% x 2.24% = 0.4704% vs. 0.784%) which benefits the bank by reducing the bond yield by a lower disallowance (2.55% – 0.4704 = 2.0796% vs. 1.766%). Yet, the bank’s taxable equivalent yield is now grossed-up by a lower corporate tax rate of 21%. So now its real after-tax equivalent yield is 2.632% (2.0796% divided by (1-0.21%)).
When the bank compares the two scenarios where 100% of the cost of funds is disallowed under the TEFRA Act, the result in gross-up would be a 0.085% increase, illustrated as follows:
(2.55% - (2.24% x 0.35)) = 2.717%
(1 - 0.35%)
(2.55% - (2.24% x 0.21%) = 2.632%
(1 - 0.21%)
2.717% - 2.632% = 0.085%
So, depending on how the gross-up is calculated, the borrower could suffer as much as a 102 basis point increase in cost, or as little as a 8.5 basis point increase in cost.
In fairness, the bank that imposes only a 8.5 basis point increase in cost in these circumstances is being fully compensated for the reduction in corporate tax rates effected by the 2017 income tax act, taking into consideration the offsetting deduction it gets for the deposits or other borrowed funds it used to finance the transaction.
But perhaps more importantly, if the bank recognizes this, it will protect its relationship with its customer, including the more profitable non-credit services elements, and in so doing eliminate the pressure on its customer to either look for another bank which recognizes the conclusion outlined above and imposes a lesser gross-up, or to look at public market tax exempt or taxable alternatives.