At the Margins

Restrictions on tax-exempt bonds complicate soft capital investments

by Corbin Santo

We’ve spoken with health system finance leaders from across the country about how their organization’s capital strategy is shifting as the industry transitions from volume to value. One thing we’ve learned is that more nonprofit organizations are exploring alternatives to tax-exempt bond financing. In many ways, this trend is simply a result of the shift in underlying assets being emphasized in capital plans. But other forces in the bond market are also at play.

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One primary benefit of nonprofit status is the ability to issue tax-exempt bonds to finance capital projects. Hospitals and health systems have long relied on this form of debt to finance large infrastructure projects, expand existing capacity, and modernize facilities. Investments of this type have long depreciable lives and are used solely by the tax-exempt provider to further its charitable mission, thus making them ideal candidates for tax-exempt bond financing.

Complications arise when organizations seek to finance non-traditional capital assets with shorter—or nonexistent—depreciable lives. Consider two of today’s top capital priorities: information technology and care management initiatives like medical homes and ACOs. Because these investments are IT- or process-based—with shorter depreciable lives—they may be difficult to finance through traditional means.

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Since IRS regulations governing tax-exempt bonds limit their maturity to 120% of the useful life of the financed assets, the maturity on bonds used to finance some of these assets is too short. The impact of shorter maturity periods on organizations’ debt service obligations may be significant enough to jeopardize credit ratings and the ability to satisfy other bond covenants.

Another complication with tax-exempt financing stems from the restrictions on private business use. IRS regulations prohibit using more than five percent of tax-exempt bond proceeds on property put to “private business use.” Stated simply, these rules disallow any use of financed property by a nongovernmental business or for purposes that would generate unrelated taxable business income. The limitation presents a significant barrier for organizations seeking to expand their ambulatory network offerings through partnerships with other investors.

Exploring non-traditional financing options

To overcome some of the limitations associated with tax-exempt financing, providers have revisited options like issuing taxable debt and partnering with third parties who can provide capital for certain investments.

Driven by outside market forces that have continued to narrow the tax-equivalent yield relative to tax-exempt bonds, organizations with strong credit ratings have become increasingly willing to pay a slight premium for the relative flexibility accorded to taxable bond proceeds. More and more organizations have also begun working with capital partners who, in many cases, finance the construction and operation of a facility with little up-front capital expense to the health system. These observations reflect just a sampling of what we’re hearing from our members.

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