Tax Rule Change Could Disrupt Municipals Market
NEW YORK (AP) _ Congressional tax-writers, struggling to find new sources of revenue, are considering a new restriction on corporate borrowing that could spell bad news for municipalities.
The measure is contained in the U.S. House version of a tax-and-spending package that will have to be reconciled with a version passed by the Senate Finance Committee on Thursday and now awaiting full Senate approval.
The House version would modify a 1972 Internal Revenue Service ruling that enabled corporations to offset some indebtedness with tax-exempt bonds.
In principle, corporations are not allowed to deduct the interest they pay on their own bonds, if they turn around and put those tax savings into tax- exempt debt.
Under the ″de minimus″ rule, however, the IRS has said it would not try to trace such deductions, if a corporation’s holdings of tax-free debt amounted to 2 percent or less of its total assets.
The ruling had the effect of turning corporations into a major source of demand for municipal bonds and other tax-exempt instruments.
But that would probably change drastically, if House tax-writers have their way in conference committee, analysts say.
The reason is that the House version would reduce the amount of a corporation’s permissible tax-free holdings to the lesser of 2 percent of a company’s assets or $1 million.
Neal Attermann, municipal research director of the investment firm Kidder Peabody & Co., predicts that if the measure becomes law, the result will be ″a chilling effect″ on demand for municipal bonds.
″Firms will say, ‘Instead of running into tax problems, let’s avoid munis altogether.’ So the question comes down to, how many will be in a position of being so discomforted that they will drop out of the market and seek alternative cash investments?″ he said.
The biggest losers, of course, would be municipalities that rely on the tax-free market as an important source of capital, not only for large projects, such as sports stadiums, sewer systems and the like, but more importantly, for short-term cash flow needs.
It is in this short-term end that corporate buying has been particularly strong - amounting to something between 30 percent to 50 percent of the market, analysts say.
As a result, ″if this feature goes into law, corporations wouldn’t buy,″ said John V. Sebastian, chief economist at the Chicago securities firm of Clayton Brown & Associates. ″If they don’t buy, municipalities will have to issue longer-term debt - and pay higher interest costs.″
″You take away some of the demand, with the same supply - and interest rates would rise,″ he said.
Of course, the rule change could make tax-free bonds and mutual funds more attractive to individual investors in higher tax brackets, not to mention the funds themselves.
Analysts warned, however, that another byproduct of the shrinking demand could also be a rise in market volitility, as gains and losses are exaggerated by the market’s diminished mix of participants.
How severe such disruptions could become remains an open question.
″We feel it will appear gradually over next year,″ Attermann said.
But, he added, ″we’re not certain as to what the impact will be on the short-term market or even on all the corporations that invest in munis.″
″The real problem is figuring out what it means, when Congress didn’t hold hearings on it,″ he said.
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