This white paper discusses a current earnings improvement opportunity associated with existing tax-exempt municipal bond portfolios held by banks.  It may come as a surprise to some, but most “tax-exempt” municipal bonds are not fully exempt from Federal Tax.  There is a seldom-discussed Federal Tax liability that comes from interest expense disallowance rules established by the Tax Equity and Financial Responsibility Act of 1982.  With interest expense on the rise, this added tax has become a meaningful drag on earnings for some institutions.  Below, we discuss a strategy employed by many banks over multiple decades that aims to improve after tax income from existing (and new) tax-exempt municipal bond investments. 

Income Opportunity in Municipal Bond Portfolios

Banks invest in municipal bonds primarily to generate income.  With the security portfolio often being the second largest earning asset on a bank’s balance sheet, it is important to take advantage of relative value opportunities when presented in the market.  During periods of excess liquidity in the financial system and tepid loan demand, generally upward sloping municipal yield curve can provide compelling investment opportunities.  In addition to wider spreads, certain municipal bonds provide meaningful call protection, which can help protect asset yield declines in low and declining rate environments.

Banks with higher performing portfolios, as measured by UBPR, often have a higher allocation to municipals.  There are many different types of municipals that differ with respect to their tax status, credit worthiness, geography, etc.  This is not to suggest that simply buying any municipal will add to profitability and improve portfolio yield.  Rather, the purpose of this paper is to illustrate how banks can profitably and efficiently own tax-exempt municipals, a sector of the market where banks have been able to find strong credit quality and wider spreads.  More specifically, the strategy discussed below is an effective way to increase after-tax income of these securities and enhance credit monitoring, including those that are already on the bank’s books without having to buy or sell assets.

Bank Qualified and General Market Municipal Bonds

Within the tax-exempt municipal bond market, there are two broad categories of municipal bonds, Bank Qualified (BQ) and General Market (GM).  While both types are bank permissible investments, BQ is the more common type for banks to own. (GM municipals are sometimes referred to as “non-bank qualified”, which can be a misleading term, because they are bank-permissible investments).  In fact, there are two main differences between BQ and GM municipals: supply and tax treatment.

Distinct Market Dynamics Impact Returns on BQ and GM Municipals

The first difference between BQ and GM municipals is supply.  For a bond issue to receive BQ status, the issuer is limited to issuing $10 million per calendar year.  This means that BQ municipals can be cumbersome to accumulate and manage due to their low supply, small lot sizes, and large CUSIP count.  For a bond issue to receive GM status, the issuer would need to issue more than $10 million per calendar year.  It is common for GM municipals to comprise over 90% of the yearly tax-free issuance in the municipal bond market.  As a result, the larger supply of GM bonds can offer several advantages over BQ.

• Better relative value (i.e., higher yields) for comparable duration and credit quality.
• Larger lot sizes can mean better liquidity.
• Larger municipalities often have more financial transparency to perform purchase documentation and ongoing credit due diligence.  This has been an area of growing importance among regulators.

Why would GM municipals have better relative value and higher yields than BQ municipals, all else equal?   The answer is the much lower supply of BQ securities (<10% of total tax-free municipal issuance) coupled with higher demand from banks, which causes prices for BQ securities to be higher (lower yields) relative to GM. 

Tax Treatment of Municipals – The TEFRA “Penalty”

For C-Corp institutions, BQ and GM municipals are both subject to interest expense disallowance, a.k.a., the TEFRA “penalty”.  Originating in 1982 from the Tax Equity and Fiscal Responsibility Act, the most relevant part of TEFRA relates to the ability to deduct interest expense for banks with tax-exempt securities (i.e. municipal bonds).  The tax code does not allow banks to deduct interest expense on liabilities associated with tax-free securities.  This was perceived as “double dipping” and is known as the 100% Disallowance Rule.  However, an exemption exists for BQ securities.  For BQ securities, 80% of the interest expense is deductible, and only 20% is “disallowed”.  For GM municipals, 100% is disallowed, meaning that the TEFRA penalty is five times as high for GM municipals compared to BQ municipals.

The TEFRA penalty depends on three factors: a bank’s interest expense (cost of funds), the tax rate, and the disallowance (20% for BQ and 100% for GM).  As examples of calculating an estimated interest expense disallowance and the additional Federal Tax, consider a bank with a cost of funds of 2% bps, tax rate of 21%, per $10mm of tax-free municipal bonds:

Interest Expense Disallowance (IED)

BQ_IED = (2%) x (20%) x ($10mm) = $40,000

GM_IED = (2%) x (100%) x ($10mm) = $200,000

Additional Federal Tax

BQ = BQ_IED x (21%) = $8,400

GM = GM_IED x (21%) = $42,000

Note: For most S-Corp institutions, there is no disallowance for BQ municipals.  However, GMs are subject to 100%.  29.6% blended tax rate can be used for S-Corp institutions to calculate estimated disallowance and additional federal tax.

As illustrated above, the additional federal tax associated with GM municipals is meaningfully higher vs. BQ.  The concern about a higher TEFRA penalty is the main economic reason why demand had historically been lower among banks for GM municipals during periods of higher rates (pre 2000s).  However, during economic cycles characterized by lower rates and ample liquidity, banks have significantly grown their GM municipal portfolios.

Now, with cost of funds rising significantly, the interest expense disallowance has increased exponentially affecting the bank’s federal tax liability and after-tax income.  The good news is there is a strategy component that enables banks to own tax-exempt municipals without being subject to interest expense disallowance.

Establishing a Subsidiary to Efficiently Own Tax-Exempt Municipals

With interest expense disallowance potentially reducing after tax returns of tax-exempt municipal bonds, many years ago banks began exploring ways to most efficiently own and manage these assets.   The answer was to establish a wholly-owned subsidiary of the bank to hold tax exempt municipals.  This element of the strategy was validated by the courts in 2007, when PSB Holdings, a subsidiary of Peoples State Bank (Wisconsin), brought a case against the IRS and prevailed in court.  The issue was whether tax-exempt obligations held by investment subsidiary of a bank, must be included in the bank’s interest expense disallowance (TEFRA) calculation.  The court ruled in favor of the Bank, and in 2008 the IRS declined to appeal the ruling.  It has not been challenged since.

Creating an investment subsidiary does not impact liquidity or capital ratios, nor does it impact Call Report filings.  In fact, the accounting entries are straightforward, and the subsidiary’s financial statements are consolidated with the bank’s.  The bank creates an “Investment in Subsidiary” asset account, which eliminates with the subsidiary’s “Capital” account.  The key element here is that the subsidiary does not have interest-bearing liabilities.  Therefore, there would be no interest expense, and correspondingly, no interest expense disallowance. 

Business Purpose of the Subsidiary

One necessary step to take when establishing a subsidiary is to have a valid non-federal tax business purpose to provide substance and support.  On-going business purpose activities typically include working with a third-party municipal credit advisor, such as HUB | Taylor Advisors, who works on a variety of components, including, but not limited to investment policy development, on-going credit monitoring and documentation, portfolio analytics, meeting facilitation, minutes’ preparation, just to name a few key elements.  This is done to better track financial and credit performance of a key strategic earning asset.

When it comes to business purpose, the bank needs to have a defendable answer to this key question: “What are you doing differently at the subsidiary vs. what you are currently doing at the bank?  Business purpose weakens without the use of a third party who has expertise in the municipal market and can assist in the management and monitoring of this asset class.  For example, the bank’s portfolio manager also performing credit analysis and surveillance of the subsidiary’s portfolio is not likely to be deemed an acceptable business purpose.  The need to fundamentally change how this segment of the portfolio is managed and monitored remains central to the strategy, but it is important to note the bank does not have to give up transaction control of the portfolio. 

Conclusion

The investment subsidiary strategy is a way to optimize your tax-exempt holdings by efficiently owning them to maximize after-tax returns with effective risk oversight and sound business purpose.  

The best way to learn more about the strategy is through a short presentation offered by HUB | Taylor Advisors to determine if your institution would be a good candidate.  This discussion would also review the elements of the strategy mentioned above, including a review of the earnings enhancement potential, TEFRA penalty quantification, business purpose, accounting implications, implementation and operational best practices.