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What Qualifies as a Tax-Exempt Instrument?

By   Sean Finley, Willy Hanson

May 22, 2017

Financial institutions have historically been one of the largest purchasers of tax-exempt debt instruments. In addition, many institutions underwrite loans that qualify for tax-exempt treatment. Even with potential tax reform on the horizon, tax-exempt debt instruments likely will continue to be an integral part of many financial institutions’ investment strategies. With that said, one of the most frequent questions that arises regarding tax-exempt debt instruments is, what qualifies for tax-exempt treatment?

Tax-Exempt Notes Versus Bonds

The statutory exemption provided in IRC §103 applies to interest on any state or local bond. However, a state or local bond is defined as an obligation of a state or political subdivision of the state (the term “state” includes the District of Columbia and any possession of the United States). Furthermore, an obligation must be documented or embodied in some written instrument executed by the state or a political subdivision thereof, in the exercise of its borrowing power. Therefore, for tax purposes there is no distinction between tax-exempt notes and tax-exempt bonds.

Role of Sovereign Power

The first question a financial institution must determine is whether the issuer is a political subdivision of a state. The term political subdivision denotes any division of a state or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit.

The three generally acknowledged sovereign powers of states are the power to tax, the power of eminent domain, and the power to police. It is not necessary that all three of these be delegated; however, possession of only an insubstantial amount of any or all sovereign powers is insufficient. All of the facts and circumstances must be taken into consideration, including the public purposes of the entity and its control by the government.

Nonprofit and Churches

One common misconception is that a loan made to a nonprofit would be considered tax-exempt. However, loans made to these types of organizations are not considered tax-exempt and thus the interest earned on these instruments is taxable.

Impact of Discounts

Knowing whether a bond or a loan will be treated as tax-exempt is vital when weighing the benefits of such instruments against their alternatives. Additionally, it is important to know the impact of discounts on municipal securities. As many readers are well aware, in a rising rate environment, bonds priced at discounts are more common. If securities are purchased at a discount on the issue date (original issue discount bonds), the difference between the purchase price and the par value is accreted into income and is treated as tax-exempt income. On the other hand, if municipal securities are purchased at a discount subsequent to the issue date, the discount accretion is typically taxed as ordinary income. Therefore, a municipal security purchased at a discount may not have the same tax savings as one purchased at par value. This is important to consider when an institution is comparing the tax equivalent yield of different investment options.

Please contact your tax advisor as your fi institution encounters questions regarding investments in tax exempt obligations.