Chapter 4. Federal and State Tax Law Requirements

Under the Internal Revenue Code of 1986 (Tax Code) and regulations adopted by the Internal Revenue Service (IRS) pursuant to the Tax Code (Regulations), the interest on bonds issued by a state or local government is generally excluded from gross income for federal income tax purposes. For purposes of the Tax Code (and as used in this chapter), the term “bond” means any evidence of indebtedness, including notes or financing leases (which are treated as installment sale agreements for federal income tax purposes). These bonds are often referred to as being “tax exempt” or as bearing tax exempt interest, which generally means that investors in tax exempt bonds will not pay federal income tax on the interest they receive as a bondholder.76 As a result, investors will purchase the bonds at a lower interest rate than if interest on the bonds were taxable, reducing the cost of borrowing for state or local governmental issuers. Although the interest on the bonds is tax exempt, the interest may be taken into account in determining other federal income tax consequences, such as the alternative minimum tax, interest expense deductions, and taxation of social security benefits. Further, bondholders may experience a taxable gain upon the sale or disposition of a bond.

The federal income tax exemption for bonds is an indirect federal subsidy to state and local governmental issuers. Federal subsidies of debt can take forms other than tax exemption. For example, “tax credit” bonds allow the bondholders to take credits against their other tax liabilities, and “direct subsidy bonds” provide for payment of an amount equal to a percentage of the interest cost of the bonds directly to the governmental issuer of these bonds (e.g., Build America Bonds). Although such programs require satisfaction of additional or alternative conditions, most of the requirements are similar to the requirements for tax exempt bonds discussed in this chapter. New issues of tax credit and direct subsidy bonds were, however, eliminated by the Tax Cuts and Jobs Act of 2017 77 enacted in December 2017.

Although Section 103 of the Tax Code provides a general rule that interest on state or local bonds is excludable from gross income for federal tax purposes, there are numerous specific requirements that must be met in order for bonds issued by state or local governments to qualify as tax exempt. These requirements tend to fall into three broad categories, characterized by the following questions:

What will the proceeds of the bonds finance, and how will that bond financed project be used? Bonds that finance a capital project that will be owned, leased, or otherwise used by a private business will generally be private activity bonds that will not qualify as tax exempt bonds, unless the project and the bonds meet the specific requirements for qualified private activity bonds.
How will the proceeds of the bonds be invested until spent on the project? The purpose of these restrictions is to prevent state and local governments from borrowing at a federally tax exempt interest rate and investing the proceeds at a higher rate. There are several exceptions that allow proceeds to be freely invested for a period of time after issuance, but if the restrictions are not met, bonds will be classified as “arbitrage bonds” and will not be eligible for tax exemption.
Do the bonds meet the other substantive and procedural federal income tax requirements? Both the Tax Code and Regulations impose other requirements for bonds to be qualified as tax exempt bonds, including that debt service on the bonds cannot be federally guaranteed and an information return (Form 8038 or 8038-G) must be filed for the bonds.

This chapter follows the route to federal income tax exemption for purposes of covering the federal income tax requirements for issuance of tax exempt bonds.

ROUTE TO FEDERAL INCOME TAX EXEMPTION

Bonds must be issued by a state or a political subdivision of a state. (See Section 4.2)

Bonds must be “debt” under general federal tax law principles. (See Section 4.3)

Bonds must finance capital expenditures or cash flow working capital borrowings. (See Sections 4.4 and 4.5)

Bonds must not be an issue of private activity bonds unless qualified private activity bonds. (See Sections 4.6 and 4.7)

Bonds must not be an issue of arbitrage bonds. (See Section 4.8)

Bonds must satisfy other Code requirements. (See Chapter 8, Post-Issuance Debt Management Requirements, Including Tax Compliance and Ongoing Disclosure Obligations and Chapter 9, Investment of Bond Funds)

Bond issuer must satisfy Code procedural requirements. (See Chapter 8, Post-Issuance Debt Management Requirements, Including Tax Compliance and Ongoing Disclosure Obligations and Chapter 9, Investment of Bond Funds)