As investors, banks generally may not write off the carrying costs associated with holding municipal securities when determining their federal tax liability. This prohibition negates many of the tax advantages and appeal of municipal bonds for banks. The Internal Revenue Code provides an exception for “Bank Qualified Debt.” Under section IRC 265(c), banks may deduct up to 80 percent of the carrying costs associated with holding municipal securities from “small qualified issuers,” which are qualified tax-exempt issuers that issue less than $10 million in a calendar year.
Prior to the Tax Reform Act of 1986, banks held a large portion of the municipal market. With the added limitations on deductibility of carrying costs for municipal securities, the market began to shift to a retail investor dominated one. Despite these changes, many smaller issuers continue to have their credit needs met by mostly regional and community banks through the use of directly placed bank qualified debt. The arrangement lowers the borrowing costs for small issuers for two reasons: 1) by allowing them to work with regional institutions who will frequently accept lower yields since there is less uncertainty around the issuer’s risk; and 2) reduced transaction costs associated with a direct placement.
Simply put, $10 million in 1986 is not $10 million in 2021. Under the American Recovery and Reinvestment Act (ARRA), the $10 million threshold was temporarily raised to $30 million allowing a significantly broader array of smaller issuers to tap into this useful tool. Since 2010, however, the threshold has remained at its 1986 level of $10 million meaning a number of small community issuers have lost access to the bank qualified market as a result of inflation.
Municipal bond champions in Congress have long supported efforts to modernize and permanently enhance these provisions. Most recently introduced in the 116th Congress, the Municipal Bond Market Support Act of 2019 (H.R. 3967) would expand bank qualified debt issuance through three modifications to the statute:
- Permanently raising the threshold from $10 million to $30 million;
- Index the threshold to inflation for future years;
- Apply the threshold to the borrower and not the issuer, which would allow small 501c(3) organizations to tap into the market despite working through conduit issuers who may exceed bank qualified thresholds.
NAST does not have an official position on bank qualified debt modernization, but in general State Treasurers and debt managers believe it to be good policy that would expand affordable credit access for small local issuers in their state. Every statewide issuer far exceeds $30 million in issuance, meaning these modifications would have little direct impact for state debt managers. Nonetheless, state debt professionals frequently work with small local issuers who are generally supportive of these changes. Furthermore, state conduit issuers may be able to better help meet the credit needs of 501(c)3 organizations in their states, including colleges and medical facilities, with the proposed changes.