Which of the following is true regarding the tax treatment of municipal bonds?

Description of Bank Qualified Bonds

Banks, like other investors, purchase municipal bonds in order to obtain the benefit of earning interest that is exempt from Federal income taxation. Historically, commercial banks were the major purchasers of tax-exempt bonds.  Banks' demand for municipal bonds changed in 1986 with the passage of the Tax Reform Act of 1986 (the "Act"), now under section 265(b) of the Internal Revenue Code of 1986, as amended (the "Code"). 

Under the Code, banks may not deduct the carrying cost (the interest expense incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds. For banks, this provision has the effect of eliminating the tax-exempt benefit of municipal bonds. An exception is included in the Code that allows banks to deduct 80% of the carrying cost of a "qualified tax-exempt obligation."  In order for bonds to be qualified tax-exempt obligations the bonds must be (i) issued by a "qualified small issuer," (ii) issued for public purposes, and (iii) designated as qualified tax-exempt obligations.  A "qualified small issuer" is (with respect to bonds issued during any calendar year) an issuer that issues no more than $10 million of tax-exempt bonds during the calendar year.(1)  Qualified tax-exempt obligations are commonly referred to as "bank qualified bonds."

Effectively two types of municipal bonds were created under the Act; bank qualified (sometimes referred to as "BQ") and non-bank qualified.  Although banks may purchase non-bank qualified bonds they seldom do so.  The rate they would require in order for the investment to be profitable would approach the rate of taxable bonds.  As a result, issuers obtain lower rates by selling bonds to investors that realize the tax-exempt benefit. In contrast, banks have a strong appetite for bank qualified bonds that are in limited supply. As a result, bank qualified bonds carry a lower rate than non-bank qualified bonds. 

Interest Rate Differential 

Any rate differential between bank qualified and non-bank qualified bonds only impacts the maturities purchased by banks.  Few studies have analyzed the rate difference between bank qualified and non-bank qualified bonds. Based on bond purchase proposals and bids received, WM Financial Strategies believes that prior to 2008 the rate differential was generally between 10-25 basis points (.10% to .25%) on maturities purchased by banks. Generally banks purchased shorter maturities of bonds (maturing in ten or fewer years). With the credit crisis of 2008, the rate differential increased to as much as 50 basis points and applied to maturities as long as twenty years. With the passage of the American Recovery and Reinvestment Act of 2009 the rate differential substantially declined and was often undetectable. (1)  With the expiration of these provisions,the rate differential returned to the 10-25 basis point range. With the passage of the Tax Cuts and Jobs Act of 2017 the corporate tax rate was reduced from 35% to 21% thereby substantially reducing the benefit of tax-exempt obligations for banks. Based on observations of sales,WM Financial Strategies believes the benefit of bank qualified bonds is now less than 10 basis points.
 

Issuing Bank Qualified Bonds

Any issuer that is planning to issue less than $10 million of tax-exempt securities in a calendar year should consider designating the issue as bank qualified in order to obtain the associated interest cost savings. Issuers requiring more than $10,000,000 may be able to take advantage of bank qualification by issuing two series of bonds. For example, for a $20,000,000 financing, a $10,000,000 issue could be sold this year and one could be sold next year to obtain 2 bank qualified issues.  Similarly, for a $25,000,000 financing, $10,000,000 could be sold as bank qualified bonds this year and a non-bank qualified $15,000,000 issue could be sold next year.   

A detailed cost analysis should be made prior to splitting an issue.  First, a determination should be made as to whether the interest cost savings from bank qualification will offset the added costs of issuance associated with two bond issues.  Second, in today's volatile market, a small deferral of a bond sale can result in dramatically higher interest rates that more than offset the rate reduction from bank qualification. For example, from
October 7, 2010 to December 6, 2010 interest rates rose by approximately 130 basis points (1.30%).  From November 16, 2016 to December 16, 2016 interest rates rose by approximately 75 basis points (0.75%). Accordingly, even a short-term deferral of a bond sale could be extremely costly. 

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(1)  Under the American Recovery and Reinvestment Act of 2009 (the "2009 Act"), the $10 million bank qualified bond limit was changed to $30 million.  In addition, borrowers that participated in a pool or borrowed through a conduit issuer issuing more than $30 million in a calendar year were entitled to bank qualification as long as the borrower's total tax-exempt financings were under $30 million in the calendar year.
 

Which of the following is true about the taxation of municipal bond funds quizlet?

Which of the following statements are true regarding the taxation of a municipal security?

Are all municipal bonds tax free?

Why are municipal bonds tax free?