Ch 6: Munis Part II (Taxes, Interest)

Question 1

in almost every case, muni security…

Answer 1

is exempt from federal income tax

tax-exempt/tax free investments!!!

Bc of this, muni issuers are able to borrow at a lower interest cost; in fact, the interest is usually LOWER than US gov bond

Question 2

Tax Reform Act of 1986

Answer 2

restricted fed income tax exemption of interest for muni bonds to PUBLIC PURPOSE BONDS (bonds issue do finance projects that benefit citizens rather than particulate private interests)

If a bond directs more than 10% of its proceeds to private parties, it’s considered a private activity bond and is not automatically granted tax exemption.

Question 3

If investor lives in the issuer’s state, muni bond interests are…

Answer 3

free of state income tax as well

Question 4

***tax-equivalent yield fo ra muni bond issued by an entity within a state with a state income tax will…

Answer 4

have a higher tax-equivalent yield to a resident of that state bc of the “double” tax exemption

Question 5

***for the exam, note that you never recommend munis to investors unless…

Answer 5

they are in the HIGHER tax bracket

Question 6

Original Issue Discount (OID) bonds

Answer 6

common to have a muni bond issued at discount on its IPO.

For other muni bonds: For tax, when a muni bond is bought in the 2nd market at a discount, that discount is accreted on a straight-line basis. That accretion is considered TAXABLE INCOME! Like any other muni bond, the coupon interest is tax-free.

For OID bond, the IRS considers the discount to be part of the issuers’ payment of interests. Therefore, that accretion on an OID bond is tax-free!

Question 7

gains/losses of munis

Answer 7

munis are treated like nay other investment

Question 8

AMT bonds

Answer 8

industrial rev bonds are issued for a corp’s benefit

Under Tax Reform aAct of 1986, the interest on these nonpublic purpose bonds (or private purpose bonds) may be taxable bc the act reserves tax exemption for PUBLIC PURPOSES. Bc these bonds are used for a nonpublic purpose, the interest income may be subject to Alternative Minimum Tax (AMT).

Question 9

AMT was enacted to…

Answer 9

make sure that high income taxpayers do not escape paying taxes.

favorable tax treatment items (items that must be added back into taxable income for the AMT) include:

• tax-exempt interest on private purpose, nonessential gov service muni bonds
• certain costs associated with DPPs (research and development costs and excess intangible drilling costs)
• local taxes (ie. state income and property) and interest on investments that don’t generate income, and
• accelerated depreciation on investment property

Question 10

***language o the Internal Rev Code (IRC) says that taxpayers are required to add the excess of the AMT over…

Answer 10

the regular tax to determine their total tax liability

Question 11

Taxable Munis

Answer 11

some munis where interest is NOT tax-exempt.

Most commonly, it’s the Build America Bonds (BABs)

Question 12

***BABs ?

Answer 12

Build America Bonds

created under Economic Recovery and Reinvestm Act of 2009 to assist in reducing costs to issuing munis and stimulating the economy

While bonds to fund muni projects have traditionally been tax-exempt, BABs are taxable!!! Bondh PAY TAX ON INTEREST RECEIVED FROM BABs.

However, tax credits are provided in lieu of the tax-exempt status usually afforded the interest on munis.

These bonds attracted investors who would normally NOT buy tax-exempt munis and expanded the pool of investors to include those in lower-income tax brackets, investors funding retirement accts where tax-free sec would normally not be suitable, public pension funds, and foreign investors.

2 types of BABs: tax credit BABs and direct payment BABs

***program could be reinstated in the future and the types of BABs offered could change as well; these expired in Dec of 2010

Question 13

2 types of BABs

Answer 13

Tax Credit BABs - provides bondh with a federal income tax credit = to 35% of the interest paid on the bond in each tax yr

• if bondh lacks the tax liability to fully use that yr’s credit, the excess credit may be carried forward

Direct Payment BABs - provides NO CREDIT to bondh but instead provides muni issuer with payments from the US Treasury = to 35% of interest paid by the issuer

Question 14

Section 529 Plans

Answer 14

tax-adv savings plan offering benefits to those saving for future education costs

2 types of 529 plans: prepaid tuition plans and college savings plans (both are funded with after-tax dollars) and earnings grow tax-deferred; withdrawals take for qualified edu expenses are generally tax-free

Question 15

prepaid tuition plans

Answer 15

allow donors to lock in future tuition rates at today’s prices, thus offering inflation protection

Question 16

college savings plan

Answer 16

allows the donor to invest a lump sum/periodic payments

• money typically invested into target-date funds; as target date approaches (the date the money is needed) the portfolio gets more conservative

Up to $10,000 per yr can be used for K-12 tuition purposes

contributions can be made int he form of periodic payments BUT they follow the tax rules for gifts. Thus, unless willing to pay a gift tax, contributions are limited to an indexed max amount per yr per donor ($15K as of now)

Question 17

***BECAUSE 529s ARE STATE-SPONSORED, INDIVIDUAL STATES HAVE…

Answer 17

THEIR OWN VERSION OF THE PLAN

Question 18

ABLE accounts

Answer 18

tax-adv savings accounts for individuals with disabilities and their families.

The ABLE act limits eligibility to individuals with significant disabilities where the age of onset of the disability occurred before turning 26.

Question 19

LGIPs provide other gov entities (such as cities, counties, school districts, other state agencies) with…

Answer 19

Local gov investment pools

states establish LGIPs to provide other gov entities (cities, counties, school districts, state agencies) with a ST investm vehicle to invest funds.

generally formed as a trust in which munis can buy shares/units in the LGIP’s investment portfolio

While NOT a mm fund, most LGIPs operate similar to one. An LGIP may be permitted to maintain a fixed $1 NAV. Maintaining a stable NAV, similar to a mm mutual fund, facilities liquidity and min price volatility.

LGIPs are NOT required to register with SEC, so no prospectus. But LGIPs do have disclosure docs, which generally include info statem, investm policy and operating procedures.

Question 20

MSRB

Answer 20

Sec Act Amend of 1975 established the MSRB as an INDEPENDENT SELF-REGULATORY ORG (SRO); governs the issuance and trading of munis securities. The rules require munis underwriters and dealers to protect investors’ interests, be ethical in offering advice, and be responsive to complains and disputes.

MSRB rules apply to all firms and individuals engaged int eh conduct of muni sec biz. The MSRB does not regulate issuers.

MSRB has no authority to enforce the rules it makes. They are specifically enforced by FINRA with SEC oversight.

For market participants, enforcement is in the hands of various banking agencies, including

• the Office of Comptroller of the Currency
• Fed Reserve Board
• Fed Deposit Insurance Corp (FDIC)

Question 21

Records of Associated Persons (Rule G-7)

Answer 21

Recordkeeping for Muni Sec Firms

A muni securities dealer must obtain and keep on file specific info about its associated persons. The MSRB defines an associated person as anyone with a securities registration (including reps, principals, but NOT clerical help)

most of the required info (employm history, disciplinary actions, residence, and personal data) are on U4 and U5.

any material change must be UPDATED WITHIN 30 DAYS. these records must be kept for a min of 3 YEARS AFTER TERMINATION OF ASSOCIATED PERSONS.

Question 22

Record maintenance requirements specify the length of time that various records must be kept. Records are categorized into these 3 maintenance periods:

Answer 22

• records kept fo the lifetime of the firm
• records kept for 6 yrs
• records kept for 4 yrs (all those not specifically designated as lifetime or 6-yr records)

Question 23

***MSRB lists customer complaints as what type of record?

Answer 23

6 yr record; FINRA rules only require a 4-yr period

Question 24

***MSRB Rule G-8 and G-9 require that…

Answer 24

Books and Recordkeeping requirements

G-8 lists the various records to be made and G-9 states the retention requirements.

G-8 (record maintenance requirements) specify that the length of time that various records must be kept. Generally, records are categorized into 3 maintenance periods:

• records kept for lifetime of firm
• records kept for 6 yrs
• records kept for 4 years (all those not specifically designated as lifetime or 6-yr records)

*** MSRB rules list customer complaints as 6-yr records (whereas FINRA only requires 4 years)

***MSRB rules require that designations of principals must be maintained for 6 yrs. ALL records must be readily available for 2 yrs.

*** a muni principal who’s appointed by a committee to manage the money for an LGIP must keep docs appointing him to this role for 6 yrs too

Question 25

MSRB Rule G-15

Answer 25

requires members to provide customer with written confirmation of transactions.

also includes a detail on computing yields and dollar price.

We know that calling a premium bond invariably results in a lower yield to the investor than holding the bond to maturity. Therefore, this rule states that in computing yield and dollar price,

• the yield or dollar price computed and shown should be computed to the lower of call or nominal maturity date; and
• for purposes of computing YTC or dollar price to call, only those “in whole calls” are included

Question 26

MSRB Rule G-17

Answer 26

shortest but MOST IMPORTANT MSRB RULE.

In the conduct of muni securities or muni advisory activities, each BD and muni advisor shall deal FAIRLY WITH ALL PERSONS AND SHALL NOT ENGAGED IN ANY DECEPTIVE, DISHONEST, OR UNFAIR PRACTICE.

aka don’t cheat, steal, or lie.

Question 27

Advertising

Answer 27

advertising - any matierial designed for use in the public media

includes abstracts and summaries of the OS; offering circulators, reports, market letters, form letters (prof, product, and new issue ads)

A muni securities principal/general sec principal of the dealer must approve ALL advertising before use, and a copy of each ad must be KEPT ON FILE FOR 4 YEARS.

Question 28

G-22: Control Relationships / Disclosure of Control

Answer 28

muni firms that has a control relationship with respect to a munis security is subj to additional disclosure requirements.

A control relationship exists if the dealer controls, is controlled by, or is under common control with that of a security’s issuer.
Ex: officer of a muni dealer sits on the BOD of an issuer.

Question 29

Political Contributions

Answer 29

Prohibits munis from engaging in muni biz with an issuer for 2 years if any political contribut. was made to an official of that issuer.

Muni biz refers to negotiated underwritings, not to competitive underwritings. The idea is to prevent firms from making large political contributions in return for being selected as underwriter for that issuer.

Rule applies to contributions by the firm, its MFPs, and by political action committees controlled by the firm or its reps. Do minimal contributions of up to $250 per election are permitted by MFPs, as long as these individuals are eligible to vote for the issuer official.

Question 30

MFP

Answer 30

muni finance prof (MFP ) is an associated person of a BD who is primarily engaged in muni securities activities other than retail sales to individuals. This also includes anyone who solicits muni securities biz for the BD, or is in the supervisory chain above another person with the MFP designation.
- could include senior officials of BD, execs, mgmt committee members of the BD

note: MSRB is clear that anyone designated as an MFP is subj to the rules regarding political contrib and required to report contrib to MSRB, as well as any other payments made to state/local political party!

Question 31

Financial Advisors

Answer 31

MSRB has established ethical standards and disclosure requirements for muni securities dealers that acct as FAs to muni securities issuers.

fin advisory relationship exists with a muni dealer provides financial advisory or consulting services to an issuer with respect to a new issue FOR A FEE/OTHER COMPENSATION (includes advice regarding structure, timing, etc).

Underwriting = bringing a new issue public (debt or equity)

Question 32

For munis, what document is used?

Answer 32

For muni bonds, the disclosure doc used in an official statement rather than a prospectus.

Question 33

Conflicts of Interest

Answer 33

arise if firm acts as both a member of the underwriting syndicate and financial advisor for the same issue. The MSRB has the following requirements:

• The MSRB simply prohibits a BD who serves as a financial advisor to a muni issuer for any issue sold on either a negotiated or competitive bid basis from switching role and underwriting the same issue.
• basically, if a BD is acting as a financial advisor to the issuer, the BD may NOT participate in underwriting the bonds of the issuing muni

Customers purchasing new sec from a BD who’s acting in an advisory capacity to a muni must be informed that the advisory relationship exists at/before confirmation of the sale.

Question 34

Assistance with the Official Statement (OS)

Answer 34

As part of its financial advisory services to an issuer, muni securities dealer may help prepare the final OS for a new issue.

If it preps the OS, the advisor must make a copy of that statem available to the managing underwriter PROMPTLY AFTER THE AWARD IS MADE AND AT LEAST 2 DAYS BEFORE SYNDICATE MANGER DELIVERS SECURITIES TO THE SYNDICATE MEMBERS.

Question 35

Use of ownership info

Answer 35

while acting in a fiduciary capacity for an issuer, a muni securities dealer often obtains confidential info about its bondholders. this CANNOT be used to solicit buys/sells of munis securities or to pursue other financial gain without the issuer’s consent.

Question 36

Examples of fiduciary capacities include (but not limited t0)

Answer 36

acting as paying agent, transfer agent, registrar, or indenture trustee for an issuer.