Private Activity Bonds (“PABs”) are a type of municipal bond. A large segment of municipal bonds are issued to support infrastructure projects that serve public purposes. While PABs similarly concern infrastructure projects, offer some public benefit, and are issued by a governmental entity, PABs’ distinguishing feature is that their proceeds chiefly benefit a private business. Governmental entities issue PABs to encourage private sector investment in infrastructure projects when those projects serve certain defined public purposes. For example, PABs worth $702 million are helping to finance the Ohio River Bridges public-private partnership. The $2.6 billion project aims to build two bridges over the Ohio River that will connect Indiana and Kentucky. http://www.bondbuyer.com
PABs, like other bonds, involve three main participants: issuers, investors, and underwriters. Issuers are governmental entities that borrow funds for public purposes, including state and local governments, agencies, and authorities. When PABs are used, a governmental entity issues debt on behalf of a private business. Investors, also called bondholders, are institutions or individuals who purchase bonds that entitle them to interest payments and repayment of principal. Underwriters are financial institutions, such as investment banks. The underwriters provide financial services to issuers by handling or advising issuers about the bond structure, offering, resale, market, and other aspects of creating and managing PABs.
Tax Treatment Of PABs
Several federal and state laws impact the use of PABs. To understand PABs, analysis should begin with the federal Internal Revenue Code (“the Code”) and federal Income Tax Regulations. In addition to the general rules outlined below, the Code sets forth many specific rules, requirements, and exceptions relating to PABs. As with other complicated legal issues, it is important to consult your attorney and understand the effects of state and federal law on the use of PABs in construction projects.
The Code defines PABs as any bond issue that satisfies 1) the private business use test and the private security or payment test, or 2) the private loan financing test. Bonds generally meet the private business use test when more than 10% of the bond proceeds will be used for any private business use. Similarly, bonds generally meet the private security test when more than 10% of the proceeds are indirectly or directly secured by private business funds or property. If the private business use does not relate to or is disproportionate to the governmental purpose of the issue, a 5% limit may apply instead. PABs generally meet the private loan financing test if the proceeds that are used to make or finance loans to persons other than governmental units exceed the lesser of $5 million or 5% of the proceeds. The Code defines private business use as a business or trade carried on by a person or entity that is not a governmental unit. See 26 U.S.C. § 141 (2012).
Proceeds from PABs are subject to federal income tax. However, the Code distinguishes taxable PABs from qualified PABs, which are excludable from gross income and thus exempted from the federal income tax because they achieve a recognized public purpose. Qualified PABs include exempt facility bonds, qualified mortgage bonds, qualified veterans’ mortgage bonds, qualified small issue bonds, qualified student loan bonds, qualified redevelopment bonds, or qualified 501(c)(3) bonds. Of these qualified purposes, construction projects frequently employ exempt facility bonds. The Code permits use of exempt facility bonds when 95% or more of the net proceeds of an issue will be used towards: airports, docks and wharves, mass commuting facilities, facilities for the furnishing of water, sewage facilities, solid waste disposal facilities, qualified residential rental projects, facilities for the local furnishing of electric energy or gas, local district heating or cooling facilities, qualified hazardous waste facilities, high-speed intercity rail facilities, environmental enhancements of hydroelectric generating facilities, qualified public educational facilities, qualified green building and sustainable design projects, or qualified highway or surface freight transfer facilities. See 26 U.S.C. § 142 (2012).
Although the Code excludes income earned on qualified PABs from regular federal income tax, income earned on qualified PABs is calculated into a bondholder’s Alternative Minimum Tax (AMT). Qualified PABs are taxable when individual or corporate taxpayers compare the federal AMT. Since proceeds from qualified PABs are captured by the federal AMT, some people refer to qualified PABs as “AMT bonds.” As this complex tax treatment indicates, the Code has a significant impact on investors’ and issuers’ decisions to use qualified PABs as a financing option for construction projects.
Perhaps of most significance to construction projects, the Code subjects many qualified PABs to a volume cap, which originated with the Tax Reform Act of 1986. The Code’s volume cap establishes an annual, population-based aggregate limit on the issuance of qualified PABs by state. See 26 U.S.C. § 146 (2012). For each state, the volume cap is either $291,870,000 or $95 per state resident, whichever is greater. The national volume cap for 2013 is expected to total $33.17 billion. Because the volume cap functions as a ceiling on a governmental entity’s ability to issue qualified PABs, the cap limits the use of PABs as a financing option for construction projects.
Some qualified PABs are not limited by the volume cap. For example, the volume cap does not apply to exempt facility bonds for airports. In addition, the volume cap does not apply to qualified freight transfer and highway facilities. Although the federally imposed, state-based volume cap does not apply to such projects, a national aggregate cap of $15 billion applies. The U.S. Department of Transportation reports that as of February 2013, it allocated over $4.6 billion and issued over $3.15 billion in qualified PABs in order to attract private-sector investment to these types of transportation infrastructure projects. For example, the Department of Transportation used PABs to finance the Capital Beltway HOT Lanes in the Washington, D.C. metropolitan area. U.S. Department of Transportation Federal Highway Administration,
Today’s economy impacts the future use of qualified PABs. Sequestration, high deficits, the debt ceiling, the job market, the fiscal cliff, and strict budgets for governmental entities pose challenges to and incentives for using qualified PABs to finance construction projects. They also emphasize a lingering concern for bondholders, which is whether the parties responsible for servicing the debt will be able to pay the future interest and principal payments they will owe. Should a private business that is responsible for the debt default on its payments, construction companies, bondholders, and governmental entities may face litigation over PABs.
Despite this concern, PAB supporters advocate an increased use of qualified PABs in construction projects because they think the majority of states approach their volume cap. One method by which supporters want to achieve greater use of qualified PABs is increasing or eliminating the volume cap. Another method is by amending the Code so that more facilities are exempted from the volume cap. Many supporters argue that current economic conditions highlight the need for increased private sector financing of public projects. They view qualified PABs as an alternative means of fulfilling public needs when states and the federal government are constrained by severe budget and revenue reductions to invest in infrastructure development and rehabilitation. Some supporters argue that increasing the use of qualified PABs will enable the private sector to finance more projects for the public benefit, to spur economic activity, and to avoid political negotiations caused by volume caps that force states to prioritize among infrastructure projects.
In contrast, critics use the current economic landscape to argue against the use of qualified PABs. Some critics see the need for additional tax revenue as a reason to lower the volume cap or to eliminate the tax exclusion. Generally, they view qualified PABs as a forgone tax or a subsidy. These critics argue that tax revenues, and thus the federal budget, would increase if Congress eliminates the tax-exempt status of qualified PABs. One estimate stated that tax-exempt bond financing of infrastructure projects reduced tax revenue by about $26 billion annually for 2008 to 2012. “One estimate stated that tax-exempt bond financing of infrastructure projects reduced tax revenue by about $26 billion annually for 2008 to 2012: Robert Puentes and Joseph Kane, Cut to Invest: Exempt Private Activity Bonds (PABs) from the Alternative Minimum Tax 3 (2012), available at http://www.brookings.edu/~/media/Research/Files/Papers/2012/11/13%20fedreralism/13%20private%20infrastructure%20funding.pdf (using Joint Committee Taxation estimates).
Proponets of the use of qualified PABs also favor changing the AMT rules. They recommend that Congress exclude qualified PABs from the corporate and individual AMT, just as they are excluded from the regular federal income tax. These supporters reason that PABs improve issuers’ ability to perform construction projects because qualified PABs reduce borrowing costs, enable targeted private-sector investments, streamline development, promote private and public sector interactions, and spread financial risks.
Opponents’ revenue-based criticisms extend to an AMT exclusion for qualified PABs. For example, one study found that an AMT exclusion would annually reduce federal tax revenues by approximately $49 million for 2012 to 2017. For example, one study found an AMT exclusion would annually reduce federal tax revenues by approximately $49 million for 2012 to 2017. Id. However, PAB proponents counter that the benefits of an AMT exclusion would far outweigh forgone revenue because the exclusion would generate economic activity estimated to be worth billions of dollars.
These competing policy arguments demonstrate that current economic conditions are an important consideration for the use of qualified PABs in financing infrastructure projects. Regardless of the outcome of the debates regarding the expanded use of PABs and their tax treatment, PABs are likely to remain a part of the greater landscape of infrastructure financing for the foreseeable future.