FAQs: State and Local Government Tax-exempt Leasing

2. Who can be a lessee under a tax-exempt lease?
In order for the lease to qualify for the interest exclusion, a lessee under a tax-exempt lease must be a state or possession of the U.S., the District of Columbia, or a political subdivision thereof. Volunteer fire departments may also qualify under certain circumstances. Political subdivisions include cities, towns, counties and other municipalities as well as state entities "which have not an insubstantial amount of the sovereign powers". The sovereign powers include (1) taxation, (2) eminent domain, and (3) police power. Such entities may include hospital districts, school districts, water districts, agencies, authorities, boards and commissions. Those entities which qualify as political subdivisions will vary from state to state, depending on the amount of "sovereign powers" which have been delegated to the entity by the state. State law, or attorney general opinions and case law where applicable, must be analyzed in each case. Additionally, the lease must be an obligation incurred by the lessee pursuant to its borrowing power.

3. How does a state or local government arrange tax-exempt lease financing?
A state or local government arranges tax-exempt lease financing in one of two ways: negotiated procurement or bid. Negotiated procurement is a process whereby the state or local government contacts vendors on its "approved vendor list" and asks for proposals with respect to the acquisition and/or financing of certain equipment. Negotiated procurement is generally a less formal process than arranging financing through the bid process. One-on-one negotiations may occur and the flow of the transactions resembles negotiations on a commercial transaction. Many state and local governments limit, by dollar amount, the transactions which can be arranged through negotiated procurement. Under the bid process the state or local government (prospective lessee) issues an Invitation to Bid. The time, place and manner of response to the bid are regulated by local law.

4. What is "debt" for state law purposes and what is its impact on tax-exempt leasing?
Debt, as used here, is defined as monies owed by a state or possession of the U.S., the District of Columbia, or a political subdivision thereof, beyond its current appropriation period. The definition of debt and the procedures which must be followed to incur debt will vary from state to state. Most lessees under tax-exempt leases view their obligations thereunder as current expenses and not as debt. Their view is founded on the inclusion in the document of a non-appropriation clause, which limits the lessee's obligations for rent to the then current appropriation period. The incurrence of debt often requires the state or local government to follow rigorous procedures involving publication, and sometimes voter referenda, and is subject to certain maximum limitations.

5. Does the lessor own the equipment leased pursuant to a tax-exempt lease?
Legal title may be retained by the lessor in the lease document until all payments have been made or may be granted to the lessee at lease inception, with the lessor retaining a security interest. Some states prohibit passage of title at lease inception unless the lessee has complied with applicable laws and procedures for incurring debt. Leases in other states provide for passage of title without such qualification. Knowledge of state laws is imperative.

6. What purchase option amount is common in a tax-exempt lease?
Typically, a dollar purchase option is used. Although the purchase option amount is not-legally mandated, the general industry practice is to stipulate a nominal amount in order to avoid characterization of the tax-exempt lease as a true lease for federal tax purposes.

7. Do state and local governments combine bid requests for equipment acquisitions and lease financing?
Yes. Equipment suppliers may be requested, or required, to provide a financing bid along with the equipment bid. The prospective lessee would then look to the supplier for a complete package rather than to another entity for financing.

8. What is a "non-conforming" bid?
A non-conforming bid is a bid which does not meet all of the requirements of the Invitation to Bid. In some instances, depending on the extent and nature of the non-conformance, the lessee may be permitted under applicable law to entertain such a bid. In other instances, a lessee may not have the authority to accept a non-conforming bid and would be required by law to reject it. Such rejected bids are frequently labeled "non-responsive."

9. What is a "bid bond"?
A bid bond is essentially a performance bond which many prospective lessees require to be posted by prospective lessors at the time of a bid. The amount of the bond may vary. If the lessor is awarded the transaction and, through no fault of the lessee, fails to proceed with the transaction, the bond may be subject to forfeiture.

10. What makes tax-exempt lease documentation unique?
Tax-exempt lease documentation typically includes:

• non-appropriation clause
• non-substitution clause
• hell or highwater clause
• resolution
• UCC-1 Financing Statement
• legal opinion
• 8038-G or -GC
• schedule of rental payments
• insurance certificate
• essential use representation

11. What is "essential use" property?
This is property which is necessary and important for the normal, ongoing governmental operations of the lessee. A representation by the lessee as to the essential use of the property (essential use letter) will typically become a part of the tax-exempt lease documentation package. In the essential use letter, the lessee usually represents that the use of the equipment is essential to its proper, efficient and economic operation. The more essential the use of the property, the less likely a lessee would exercise its rights under a non-appropriation clause.

12. What is a non-appropriation clause?
This is a clause which permits the lessee to terminate the lease agreement at the end of any appropriation period without further obligation or payment of any penalty, if and only if, the lessee was unable to obtain appropriation for funds to meet future scheduled lease payments and a formal resolution or ordinance is passed. Often, this type of clause will contain a "best efforts" requirement, i.e. the lessee promises to use its best efforts to seek and obtain the necessary appropriation for the lease. This provision is common in tax-exempt leases and is designed to enable the lessee to account for the lease obligation as a current expense instead of debt.

13. What is a non-substitution clause?
This is a clause which provides that if the lease is terminated for non-appropriation, the lessee would be prohibited from replacing the leased equipment with equipment which performs the same or similar function. A non-substitution period of 365 days is common, with shorter time periods also used. Decisions regarding the length of the non-substitution period are based in part on the perceived essential nature of the equipment. Generally, the more essential the equipment is, the shorter the non-substitution period will be. Given the lessee's right to cancel a lease under the non-appropriation clause, the non-substitution clause is intended to provide some comfort to the lessor.

14. In a tax-exempt lease, who is responsible for maintenance, insurance, property tax and other operating expenses?
A tax-exempt lease is a "net lease", i.e., the lessee is responsible for such expenses. In some cases, however, the lessee may contract with the equipment supplier to provide maintenance and other services.

15. May a state or local government permit leased equipment to be used for a private commercial purpose?
If a state or local government permits equipment leased pursuant to a tax-exempt lease to be used by a commercial entity or for a commercial, non-governmental purpose, the tax-exempt status of the interest component of the rental payments may be jeopardized. Although there are certain limited circumstances under which the tax-exempt status of the interest component may be retained, in most cases such status will be forfeited. In general, the facts and circumstances of the possible use of the equipment in a non-governmental activity or by a non-governmental entity should be carefully analyzed under applicable law. A common lease provision includes a warranty by the lessee that the equipment will not be used in a trade or business.

16. What are the risks to the lessor if the state or local government is not authorized to enter into the transaction?
The lease may be deemed void and/or the tax-exempt status of the interest component of the rental payments may be jeopardized. If the lease is deemed void, the lessor may lose any rights to collect payment and any rights to the leased equipment.

17. How does a lessor evaluate the creditworthiness of a lessee in a tax-exempt lease?
The lessee typically provides the lessor with 3 years of audited financial statements. Lessor then reviews the information to assess the lessee's financial strength. In addition to the lessee's financial condition, the lessor will review the proposed transaction to ensure that the equipment is essential use property and to understand any unique risks associated with the transaction.

18. Are credit ratings for state and local governments the same?
No. In fact, state and local governments are not rated: only specific debt obligations issued by those entities are rated. A rating will only be assigned upon request of an issuer or its financial or legal representative and upon fulfillment of specific requirements of the rating agency. Only a small percentage of issues are rated.

19. Under what circumstances would the lessee be permitted to assign its obligations and its rights to use the equipment under a tax-exempt lease?
Though usually prohibited, if there is no specific prohibition in the documents, a lessee would be permitted to make an assignment. In order to preserve the tax-exemption for interest, the lessee should be prohibited from assigning the lease to another entity if such assignment would adversely impact the tax-exempt status of the interest component of the rental payments (e.g., assignment to a lessee for use in a private, non-governmental activity).

20. May the lessor assign a tax-exempt lease to a third party?
The answer depends on the terms and conditions contained in the Invitation to Bid. Some Invitations to Bid will specify that the lessor must hold the transaction for its own account. If the Invitation to Bid, state and local laws, and the lease-purchase documents do not contain a prohibition against assignment, then the lessor may assign. An assignment not meeting the registration form requirements of Internal Revenue Code Section 149 may jeopardize the tax-exempt treatment of the interest component of the rental payments.

21. What forms of leases other than tax-exempt leases are entered into by state and local governments?
State and local governments may enter into various other types of leases, including true leases and short-term rental agreements. Cost, future value expectations, period of use, financing policies, incurrence of debt and flexibility are some of the factors that a potential lessee considers in choosing the appropriate type of lease transaction.

22. Do true leases create tax-exempt income for the lessor?
No. True leases to state and local governments are treated as rental agreements. They are not treated as lease-purchases or conditional sale agreements. The lessor is the legal and tax owner of the equipment. Payments made to the lessor are treated by the lessor as rental income and are fully taxable. The tax benefits of ownership are subject to special depreciation rules.

23. What is the de minimus exception?
The de minimus exception is an exception to the general tax rules denying a deduction for interest on debt used to purchase or carry tax-exempt obligations. Under the de minimus (also known as "insubstantial holdings") exception, if the average amount of tax-exempt obligations is less than 2% of the average total assets of the corporation, the IRS will not infer that corporate debt can be traced to tax-exempt holdings.

24. What is arbitrage?
Arbitrage is the difference between the interest on obligations exempt from federal tax under the Internal Revenue Code and the yield on securities and obligations that are not exempt from federal tax, in which the proceeds of the tax-exempt financing are invested. The Internal Revenue Code imposes strict limits on arbitrage.

25. Can tax-exempt financing be used to reimburse a lessee for equipment previously purchased with cash?
In order to enter into a tax-exempt transaction involving any reimbursement of cash, the lessee must first pass a reimbursement resolution declaring official intent to reimburse expenditures with tax-exempt proceeds. Once the resolution is passed, the proceeds of the tax-exempt offering may be used to reimburse for expenditures made up to 60 days prior to the declaration of official intent. In any event, the financing must be closed and the reimbursement made within 18 months after the date the expenditure was paid for or the date on which the property was placed in service, whichever is later.

26. What is a public tax-exempt offering?
Public offerings are usually done for large issues ($15 million - $250 million). SEC regulations govern disclosure since the debt is sold to the public. These transactions typically involve real estate as well as equipment and terms are as long as 30 years.