November 16, 2017 Update:
On November 16, 2017, the House of Representatives passed its proposed tax bill by a 227-205 vote. Among other things, the House tax bill would repeal the tax exemption for private activity bonds, effectively ending the availability of private activity bonds as a funding source for public-private partnerships and other qualifying projects. The Senate version of the tax bill, which preserves the tax exemption, continues to be revised and debated, and it is unclear if and when it will be put up for a vote. As the Senate bill differs significantly from the House bill, analysts expect that the competing legislations will be put before a conference committee in the event the Senate bill is also passed.
November 13, 2017 Update:
Supporters of the tax-exemption for interest income on private activity bonds claimed a victory on November 9, 2017, as the Senate Finance Committee introduced a version of the Tax Cut and Jobs Act that preserves the current tax exemption. In addition, the Senate bill retains the repeal of the alternative minimum tax previously proposed in the House bill. The alternative minimum tax applies to a corporation's adjusted income to the extent such alternative tax is greater than the original taxation rate. Tax-exempt interest on income related to private activity bonds issued after August 7, 1986, is added to a corporation's taxable income for purposes of calculating the base for its alternative minimum tax. As such, corporate investors in private activity bonds who pay the alternative minimum tax may stand to benefit from the Senate’s proposed legislation as currently drafted. Congress is expected to continue negotiations of the Tax Cut and Jobs Act in the coming weeks. The next mark-up session for the Senate bill is scheduled for November 13, 2017.
November 10, 2017:
“The owners of state bonds have no constitutional entitlement not to pay taxes on income they earn from the bonds, and states have no constitutional entitlement to issue bonds paying lower interest rates than other issues.”
In his 1988 majority opinion in South Carolina vs. J.A. Baker, United States Supreme Court Justice William Brennan confirmed that the long-standing federal interest income exemption in respect of bonds issued by states or municipalities could be granted, conditioned and repealed at the discretion of the federal government. From public works projects, such as the Big Dig in Boston, to public-private partnerships, such as the Rapid Bridge Replacement Project in Pennsylvania, governmental bonds have been a hallmark of domestic infrastructure improvement. The Tax Cuts and Jobs Act, which was introduced as a bill by House Republicans on November 2, 2017, repeals the tax exemption for a sub-set of governmental bonds known as qualified private activity bonds (PABs) and may have a significant impact on the financing of public-private partnerships, particularly in the transportation sector.
Qualified private activity bonds are, generally, governmental bonds that fund certain private activities which have a public benefit. The scope of qualified activities has been changed from time to time by Congress. While qualified private activity bonds have been successfully used to fund project costs in respect of a wide range of public-private partnerships, the most significant expansion to the scope of qualified activities occurred in 2005, when Congress passed legislation creating a $15 billion basket for tax-exempt private activity bonds used to fund the construction of a wide-range of transportation facilities based on allocations determined by the Secretary of Transportation. So far, approximately $6.6 billion of these tax-exempt bonds have been issued, with a $737 million issuance to finance construction of the Transform 66 Project slated to close on November 9, 2017.
The proposed legislation would repeal the federal tax exemption for qualified private activity bonds issued after December 31, 2017. Affected projects fall in two categories: existing projects with qualified private activity bond allocations and pipeline projects that could benefit from tax-free financing. Approximately $4.3 billion in qualified activity bonds have been allocated to projects and remain unissued. The proposed legislation puts significant pressure on these projects to reach financial close before the end of the year, particularly if a preferred proponent with committed financing has already been selected. For the Colorado I-70 East Project, which is expected to reach financial close with qualified private activity bonds in the first quarter of 2018, a change in law could have a significant impact on the project's costs, the availability of its committed financing and its overall financial model.
Projects in the pipeline face the potential for increased debt service costs. For an investor who will pay taxes on an investment in the 39.6% tax bracket, a taxable bond accruing interest at 8.00% is just as attractive as a tax-exempt bond accruing interest at 4.83%. However, from the perspective of project participants, assuming a $100 million issuance of qualified private activity bonds that are due at maturity with a 20-year tenor, a project would save approximately $64 million if it is financed with tax-exempt bonds as compared to taxable bonds. In the context of an availability deal, this would result in a direct saving to the granting authority that is required to service the debt. In a revenue deal, while debt is serviced by the private sector, the unavailability of a tax-exempt financing could decrease private sector interest or result in certain financing risks remaining with the granting authority.
However, one component of the proposed tax legislation cannot be viewed in a bubble, and, in assessing the current proposal, equity investors in public-private partnerships will need to consider whether corporate benefits, such as a lower corporate tax rate, outweigh losses. In addition, a variety of other financing models are available to public-private partnerships, particularly in the transportation sector, such as TIFIA loans. A repeal of the tax-exemption for qualified private activity bonds may promote an increase in innovative financing structures, such as the tax-exempt bank loans that recently financing the I-285/SR 400 Interchange Reconstruction Project in Georgia. As negotiation of the Tax Cuts and Jobs Act continues in Congress in the following weeks and months, stakeholders in public-private partnerships would be well-served to monitor the status of the tax-exemption for qualified private activity bonds.