What Is a Private Activity Bond (PAB)?
A PAB or Private Activity Bonds are issued by local governments to attract private investments for projects with public or common utility.
Private activity bonds (PAB) are tax-exempt bonds issued by or on behalf of a local or state government. There are strict rules to qualify. However, they provide special financing benefits for qualified projects. The financing is most often for joint-use projects, and the government generally does not pledge its credit. However, with little else to offer and tight municipal budgets, the PAB structure incentivizes private equity investment in public projects.
Private activity bonds not only benefit private entities but the public as well. Additionally, they provide increased infrastructure spending. Private activity bonds are sometimes referred to as conduit bonds.
PAB Private Activity Bonds – a Closer Look
Private activity bonds are tax-exempt municipal bonds. They are used to attract private investment for projects that have some public benefit. However, there are strict rules as to which projects qualify. Qualified projects that may be financed by private activity bonds include airports, private universities, hospitals, and affordable rental housing. Additionally, programs to provide mortgages for first-time lower-income borrowers and funding and refinancing student loans. PABs may not be used to finance an airplane, certain health club facilities, a gambling facility, stadium, golf course, oil refinery, or a liquor store. For projects that do qualify, the bond results in reduced financing costs because of the exception of federal tax.
Through private activity bonds, states and cities can borrow on behalf of private companies and nonprofits. This lowers borrowing costs for entities that might otherwise turn to corporate bonds or bank loans. Private activity bonds are issued to attract businesses that provide underserved regions with public benefits. Suitable projects qualify the bond for tax-exempt status. These bonds pay taxable interest unless specifically exempted by the federal government.
PAB Qualification Requirements
A PAB is issued by local governments for the purpose of extending special financing benefits for qualified projects. In general, PABs finance projects for a private user, which means the local government doesn’t usually pledge its credit. In this way, they are used to attracting private investments for projects that have public or common utility. For municipal security to be considered a PAB, it must meet two conditions set out in Section 141 of the Internal Revenue Code.
- The first condition is that more than 10% of the proceeds must be used for a private business project and that at least 10% of the payments of the principal or interest comes from property used for private business use.
- Secondly, a PAB requires “the amount of proceeds of the issue used to make loans to non-governmental borrowers exceeds the lesser of 5 percent of the proceeds of $5 million, which is the “private loan financing test,” according to MSRB.
PAB Tax Implications
Assets that fall under PAB are considered exempt facility bonds. However, they must finance types of facilities used by private entities. These include airports and other transportation-related facilities, local utilities, and certain residential rental projects, among others.
Most private activity bonds qualify for an alternative minimum tax (AMT). This is an alternative method of deriving federal income tax. Since the Tax Reform Act of 1986, all private activity bonds are subject to AMT. Exceptions to the AMT are hospital and non-profit college bonds. Under usual circumstances, private activity bonds provide higher yields due to their underlying tax treatment. It is estimated that investors get an additional 0.25% to 0.5% per year in additional income compared with similarly rated municipal bonds.
PAB Tax Considerations
- Interest – Interest on private activity bonds is not excluded from gross income unless the bond is a qualified bond.
- Alternative minimum tax (AMT) – Interest from private activity bonds became subject to the Alternative Minimum Tax (AMT) after the Tax Reform Act of 1986, except for the hospital and non-profit college bonds.
- Higher yields – All things equal, yields on private activity bonds are higher due to this tax treatment.
PAB Benefits to Government Issuers
State and local governments receive direct and indirect tax benefits under the IRC. These benefits lower borrowing costs on their valid debt obligations. The interest paid to bondholders on these obligations is not included in their gross income for federal income tax purposes. As a result, bondholders are willing to accept a lower interest rate than they would accept if the interest was taxable. These benefits apply to many different types of municipal debt financing arrangements. These include bonds, notes, loans, lease purchase contracts, lines of credit, and commercial paper (collectively referred to as “bonds” in this publication). To receive these benefits, issuers must ensure that the requirements under the IRC are met. Generally, these benefits endure for as long as the bonds remain outstanding.
According to Section 141 of the IRC, a municipal bond will be deemed a private activity bond if more than 10% of the proceeds from the bond issue are used for any private business, and the principal and interest payment on more 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 amount of proceeds of the issue used to make loans to non-governmental borrowers exceeds 5% of the proceeds of $15 million, whichever is lesser.
The Bottom Line
Private activity bonds can be a major boon to municipalities – but only if the project succeeds. It’s clear by the underlying trend that PABs are being used more diligently to incentivize private participation in public works projects. Municipal bond investors should take heed of this trend.
Passage of the private activity bond legislation reflects the Federal Government’s desire to increase private sector investment in U.S. transportation infrastructure. Providing private developers and operators with access to tax-exempt interest rates lowers the cost of capital significantly, enhancing investment prospects. Increasing the involvement of private investors in highway and freight projects generates new sources of money, ideas, and efficiency. The law limits the total amount of such bonds to $15 billion and directs the Secretary of Transportation to allocate this amount among qualified facilities. The $15 billion in exempt facility bonds is not subject to the state volume caps. (Source: transportation.gov)
Up Next: What is Buying Power?
Buying power is the total amount of cash and equity available in a trading account that a trader can allocate to buy additional securities.
It is sometimes also referred to as excess equity. Simply put, it is the money an investor has available to buy securities. It equals the total cash held in the account plus any available credit the account has on margin.
The term can take on a different meaning depending on the context or academic discipline. In finance, buying power refers to the total cash funds plus any credit available to purchase securities using leverage. A leveraged brokerage account is referred to as a margin account. Traders can take out a loan based on the amount of cash and securities held as collateral in their brokerage account.
