Posted by Karen Munoz, EA

Private Activity Bond (PAB)

Private Activity Bond (PAB)

What is a private activity bond (PAB)?

PABs are tax-exempt bonds distributed by or on behalf of a state or local authority to provide special financial benefits for eligible projects. Funding is usually for private user projects, and the government usually does not compromise your credit. Private activity bonds (PABs) are sometimes referred to as conduit bonds.


Understanding PAB

Bonds with private assets are municipal bonds used to attract private investment for projects with some public benefit; however, there are strict rules regarding projects' qualification. Eligible projects that can be bond-financed with private assets include financing and refinancing student loans, airports, private universities, hospitals, affordable rental properties, mortgages for low-income borrowers, etc.

Under no circumstances may the proceeds of a private commercial bond be used to finance an airplane, certain health club facilities, gaming facilities, a stadium, a golf course, an oil refinery, or a liquor store. This type of bond results in a reduction in financing costs thanks to the federal tax exemption.

Through private bonds, states and cities can borrow on behalf of private companies and nonprofits, reducing borrowing costs for entities that might otherwise consider corporate bonds or bank loans. PABs are issued to draw businesses and labor to a region for a public benefit, considered its tax exemption. These bonds pay taxable interest unless the federal government expressly waives them.


Thoughts

Per Section 103(a) of the Federal Revenue Code (IRC), interest on PAB is not excluded from gross income except the bond is a qualifying bond. Interest on PAB was subject to the Alternative Minimum Tax (AMT) under the Tax Reform Law of 1986, except for nonprofit hospitals and universities' bonds. All other things being equal, yields on PAB are higher due to this tax treatment.

According to Article 141 of the IRC, a municipal bond will be considered a PAB if more than 10% of the bond issue proceeds is used for private activity and the principal and interest payments are greater than 10% of the sale proceeds of the issue is secured by private business property. Secondly, a municipal bond will be classified as a private activity bond if the value of the returns of the issue used to make loans to non-government borrowers exceeds $ 5 million, or 5% of the proceeds, whichever is less.


Types of financeable projects

  • "Exempt" facilities: PAB may also be issued to provide certain eligible projects, such as certain multi-family rental projects, solid waste disposal facilities, hazardous waste disposal facilities, water supply facilities, sewers, certain electrical installations, certain local heating or cooling systems airports, and transit facilities, public educational institutions, green buildings and sustainable design projects and some freight transfer facilities, all exempt from the limits of small issues. This category includes airports, docks, wharves, and public transportation facilities, but although these facilities can be leased to private companies, they must be owned by a government unit.

  • Widespread use of taxable bonds: Taxable bonds may be allotted for any project permitted by state law. While they are widely varied, state laws allow taxable bonds for a wide variety of production and non-production projects, which can include warehousing, distribution, offices, research and development, utilities, service, retail, business, and medical services.

  • Disqualified uses: Although federal law allows up to 5% of private equity returns to be used for purposes other than capital or other unqualified costs, applicable national law may be more restrictive. If bond income is used for issuance costs, it will be calculated relative to this 5%. Under no circumstances can a PAB's proceeds be used to provide an airplane, a private luxury cabin, certain spa facilities, game facilities, or a liquor store.

  • Manufacturing and Processing Facilities: It is possible to issue 'small issue' to PAB for properties and facilities used in the production, manufacturing, or processing of personal property, on-site related and ancillary offices, and other premises (no more than 25% of bond proceeds can be applied to ancillary use). At least seventy percent of the proceeds of "small issue bonds" must be used to finance properties used directly in the manufacture, production, or processing of personal goods (goods used directly are referred to as "core manufacturing assets"). 

Owned items used for storage or movement of raw materials and inventory, for example, are not core manufacturing assets but are often functionally linked to the manufacturing process. IRS rules sometimes require companies wishing to use bonds for production plants to exclude from financing some of these parts of their total investment projects to avoid exceeding the limit of 25% of the financed assets, which are not core manufacturing assets but "ancillary." Investment in real estate used for functions such as storage, manufacturing, packaging, and shipping that are functionally related to the manufacture of goods on-site and are subordinate (in that the investment share of these functions is lower than the investment in goods with financed production) are treated as "ancillary" costs subject to the 25% limit.

  • Redevelopment projects: As part of a redevelopment plan, an issuer may issue tax-exempt redevelopment bonds to acquire, repurchase, and restore real estate in certain blighted designated areas for resale at market value to individuals. The bonds must be secured primarily by generally applicable taxes, including increases in property taxes attributable to increases in valuation due to the requalification plan's execution. These bonds may take the form of "tax allocation bonds" or other financings for tax increment.

  • Restrictions on used equipment and buildings: PAB, except bonds for section 501(c)(3) organizations and eligible enterprise zone business, cannot be used for the purchase of already used properties, except for used buildings and other structures that may be financed if a sufficiently qualified rehabilitation is carried out -15% for the buildings (and such integrated equipment) and 100% for the other structures.

  • Section 501(c)(3) Nonprofit Organizations: PAB may be issued to fund not-for-profit organizations under Section 501(c)(3), such as schools, charities, and some health care facilities. Certain tax-exempt PAB in section 501(c)(3) may be designated as "eligible" for purchase by banks with full tax benefits.


Summary

  • Certain projects must be eligible, such as funding for hospitals or airports, and the titles are exempt from taxes.

  • Interests on PABs are not excluded from gross income unless the bond is a qualifying bond.

  • PABs allow governments to lend on behalf of private companies, acting as an alternative to corporate bonds.

  • Private Activity Bonds (PABs) are issued by or on behalf of governments for projects with special financial benefits.



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Karen Munoz, EA
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