Volume Cap for Tax-Free Bonds in Illinois
Andrew J. Hamilton
Executive Director
January 2020
The Federal Tax Code allows some private companies to receive favorable financing or municipal financing that is generally reserved for units of government like cities and counties. The Code requires that a governmental body act as an “issuer” of bonds on behalf of private entities like manufacturers and housing developers. The issuer has no liability to make payment if the project fails. The issuer is simply a conduit or middleman that lends their governmental name to the project so it will qualify for tax-free financing, which lowers the overall interest rate on the borrowing generally by 2-3 percent. What is meant by the term tax-free financing is that the lender or party that buys the bond does not have to pay federal income tax on that interest income.
Let’s take a simple example of an investor buying a taxable instrument, like a Certificate of Deposit (CD) that pays 6.0% interest. I would give the bank one dollar and then at the end of the first year they would pay me six cents in interest. This is income on which I have to pay federal taxes. If I am in a tax bracket where I have to pay two cents in taxes, the net “after tax” result to me is four cents or a four percent return. If I buy a tax-exempt bond that pays a 4% rate, then it is essentially identical to buying a six percent taxable instrument. (Please bear with me simplifying the numbers for illustration). It is actually more complicated than this, but the concept is the same. So in this process, the “Bond Buyer” is hooked up directly with the “Borrower” and then passes this lower rate through to the Borrower.
In Illinois, a borrower has several choices of using a local (city), regional (regional development authority) or statewide (state finance authority) issuer. Under the eyes of the Federal Tax Code, the product is identical if it is issued by any qualified unit of government. It really doesn’t make a difference to the buyer of the bonds who is the issuer, they generally care about the interest they earn on the loan not being subject to federal income tax. The major factor in determining the most appropriate issuer is which entity can obtain an allotment of a mysterious thing called “Volume Cap.”
"In a simple sense Volume Cap is not money. It is an annual allocation of “tax exemptness” that is given to states by the federal government."
It might be helpful if I provide some background on what actually is Volume Cap. In a simple sense Volume Cap is not money. It is an annual allocation of “tax exemptness” that is given to states by the federal government. When Congress passed the Federal Tax Code, it felt that there were certain activities that were so important to the welfare of the U.S. economy that they should be able to borrow at a tax-free rate (i.e., airports, mass transit districts, etc.). Some of these eligible activities include a private manufacturer that is spending less than $20 million, a private solid waste disposal facility, a private housing project that benefits individuals in a certain income level, etc. When Congress passed this law, they set a maximum dollar amount each year of this type of bond that can be issued in each State. In 2019, this maximum is $105 per resident (per capita). Illinois received a little over $1.3 billion which is split into three pools, one for large cities (Home Rule), small cities (Non-Home Rule) and state agencies.
The Home Rule (large city) Pool is over $856 million for cities that are 25,000 or over in population or have voted themselves home rule. Under Illinois Volume Cap allocation law, on the first business day in January, Home Rule cities are automatically allocated an amount of $105 times their census population. For example, a city that is 30,000 in population has $3, 150,000. So feasibly, that city could issue one bond for up to this amount if they close by December 31st without anyone’s approval. The Small City Pool is over $240 million, but small cities must make an official request for allotment on the first business day of the calendar year.
The Home Rule (large city) Pool is over $856 million for cities that are 25,000 or over in population or have voted themselves home rule. Under Illinois Volume Cap allocation law, on the first business day in January, Home Rule cities are automatically allocated an amount of $105 times their census population. For example, a city that is 30,000 in population has $3, 150,000. So feasibly, that city could issue one bond for up to this amount if they close by December 31st without anyone’s approval. The Small City Pool is over $240 million, but small cities must make an official request for allotment on the first business day of the calendar year.
This pool is formula allocated. The total amount available is divided by the total requested. For example, if $480 million is requested, everyone gets 50% of what they asked for and are required to close in sixty days. If they fail to close, then the allotment is automatically returned and reallocated to another project by lot.
The State Agency Pool is also over $240 million. Statewide and regional authorities can also make an official request in January. This allotment is made by the Governor under internal criteria.
As I mentioned earlier, large cities obtain an automatic allotment in January, but under state rules they are required to obligate this allotment by May 1st of each calendar year or it automatically goes back to the State for a re-allotment on June 1st. It is a “use” or “lose” situation. A large city can transfer their Volume Cap prior to the May 1st deadline, and once transferred, it can be used until December 31st.
A decade ago when the per capita allocation was only $50 instead of $100, the demand on Volume Cap was enormous. Some cities actually sold their volume cap to the highest bidder. Investment bankers would contact large cities asking to buy volume cap on behalf of their client’s projects and this fee would be paid at closing cost. Nowadays, this is rare since the amount of Volume Cap available has more than doubled. If an issuer fails to close on a project by December 31st, they can “carry forward” their volume cap, but it loses some of its “potency.”
For example, it can no longer be used for a manufacturing project. You must elect the carry-forward purpose by February 15th of the following year. Some eligible purposes include multi-family housing, water, solid waste disposal, etc. Once the volume cap is carried forward, it cannot be transferred. In some cases where you only have a portion of the volume cap you need to close a project, you can elect to close with convertible bonds. At closing, there would be a Series A –Tax-Exempt Bond and Series B – Taxable Bond. Both series would be wrapped by the same letter of credit from a bank, which backs the bond.
The tax exempt series would be for the amount of volume cap that at the time of closing and the taxable Series B would be the remaining eligible costs. The Series B – Taxable Bond would start off taxable and then convert to tax-exempt if/when volume cap is acquired in the future. These are called “Cinderella Bonds.” Some refer to this as a “Two-Headed Bond” or the Series B as a “Taxable Tail.” The rate of interest on the taxable series including cost of issuance is generally near if not identical to the rate if borrowed on a conventional basis, so there would be little or no opportunity cost loss.
This is a simplified description of Volume Cap to provide a background explanation on its complexity. There are numerous other issues that would need investigation in order to issue a tax-exempt bond. It is important to have a member of a professional team who is familiar with the process involved at all times.