HOW TO BECOME THE hometown bank hero

Northwestern Financial Review, Mar 15-Mar 31, 2004 by Oman, Sherrill R

There is a way for banks located in smaller communities to play a role with tax-exempt financing in assisting in the development and construction of hospitals and other health care facilities, senior and affordable housing projects and student housing projects related to local colleges while deducting the cost to carry the tax-exempt paper. The key is the project must be owned by a nonprofit corporation that has received an exemption from payment of federal income tax under section 501(c)(3) of the Internal Revenue Code. Everyone wins. The bank finances needed improvements for its community; the bank holds debt, the interest on which is exempt from federal income taxation; the bank can deduct its cost to carry that debt; the borrower pays a lower rate of interest on the debt; and the community benefits.

As a general rule, no income tax deduction is allowed to be taken by a bank for the interest it pays on funds it borrows (for example, from the Federal Reserve) to acquire obligations the interest on which is exempt from federal income taxation. This normally means that banks, especially smaller banks, that might be interested in making loans by purchasing tax-exempt bonds or notes have no incentive to do so.

There is an exception to this general rule for public purpose bonds (typically bonds issued for such things as streets, water and sewer and other infrastructure and schools) and for bonds issued on behalf of a 501(c)(3) organization.

In addition, the bonds must be issued by a "qualified small issuer," defined as an issuer (a city, county, or other governmental unit) that does not reasonably expect to issue more than $10,000,000 of tax-exempt obligations during the calendar year in which the bonds intended to be "bank qualified" are issued. The qualified small issuer is required to designate the issue as bank-qualified. This is typically done in the resolution adopted by the issuer giving preliminary approval to the issuance of the bonds so that they may be marketed to banks as "bank-qualified."

If the timing is right, it is possible to finance projects needing more than $10,000,000 of debt by issuing debt in consecutive calendar years. A group of banks can do these financings together through participation-type structures, selecting a lead bank.

Here is an example. A 501(c)(3) organization whose purpose is to assist the local college wants to build student housing for the college. The housing will cost $4,000,000. The rents the students can afford are too low to support debt service at taxable interest rates. The local bank wants to make the loan but cannot loan the entire $4,000,000. The local bank finds other banks interested in participating in the loan and asks the city where the college is located to issue a tax-exempt note. The city acknowledges that it will not issue more than $10,000,000 of tax-exempt obligations during the calendar year in which the bonds intended to be "bank qualified" are issued and issues its tax-exempt note payable to the local bank. The local bank takes all the usual security interests in the land and buildings, rents and profits. The local bank issues certificates of participation to participating banks and makes the loan to the 501(c)(3) organization.

The benefit to the borrower comes from lower costs of issuance for bank-qualified bonds and a lower interest rate. The benefits to the banks are tax-exempt interest on the debt and a lower cost of borrowing the funds necessary to make the loan to the borrower, thus encouraging smaller, local banks to participate in improving their communities. The benefit to the community is housing to support its college.

SHERRILL R. OMAN

Bank & Finance Group

612.492.7131

soman@fredlaw.com