A governmental entity that has expended its own funds to pay equipment costs prior to the funding of its lease financing may be reimbursed for those costs from the proceeds of its lease financing without jeopardizing federal tax-exemption (which is of paramount importance to the lender) only if the governmental entity complies with “reimbursement regulations” under the federal tax law. To be reimbursed from lease proceeds, a governmental entity must declare an official intent to reimburse the expenditure no later than 60 days after payment of such expenditure. Unless the governmental entity has declared its official intent to reimburse by adoption of a resolution or the taking of other official action prior to the funding of its lease financing, reimbursement for a governmental entity’s prior expenditures should be limited to those made not more than 60 days prior to the funding of the lease financing.

The Internal Revenue Code provides that if more than 10% of the proceeds of a tax- exempt borrowing, such as a municipal lease financing, are to be used for any private business use, and if the payment of the principal or interest on more than 10% of the proceeds of such a borrowing is directly or indirectly: (a) secured by any interest in property used or to be used for a private business use (or for payments made with respect to such property) or; (b) to be derived from payments or property, or borrowed money, used or to be used for a private business use, then such borrowing will constitute a “private activity bond”  within the meaning of Section 141 of the Internal Revenue Code.

The Internal Revenue Code defines “private business use” to mean use (directly or indirectly) in a trade or business carried on by any person other than a governmental entity as defined under Section 103 (a) of the Internal Revenue Code, (use as a member of the general public is not taken into account).  Interest on a private activity bond will typically be or become subject to federal income taxation. Consequently, municipal leases limit the right of the governmental entity to sublease or otherwise allow the use of the leased property by any entity or person other than the governmental entity or a subordinate entity thereof.

A municipal lease is deemed to be “bank-qualified” when the municipal entity (together with all of its subordinate entities) issues less than $10,000,000 of tax exempt obligations in the calendar year in which the particular lease financing is being funded.  A municipal lease-purchase financing is deemed to be "non-bank qualified" when the municipal entity (together with all of its subordinate entities) has issued or intends to issue more than $10,000,000 of tax-exempt obligations in the calendar year in which the particular lease financing is being funded.

The Internal Revenue Code provides a deduction to a financial institution for the portion of its interest expense that is allocable to its purchase or carrying of qualified tax-exempt obligations, which would include tax-exempt municipal leases.  By rule, a “qualified tax-exempt obligation” is one that: (1) is not a qualified private activity bond (other than a qualified 501(c)(3) bond); and (2) is issued by an issuer that reasonably anticipates to issue (together with subordinate entities) no more than $10,000,000 of tax-exempt obligations (other than qualified private activity bonds as described above) in the calendar year in which the particular lease financing is being funded.  The benefit of a municipal lease being “bank qualified” is that credit for this deduction, if you will, is usually passed on to the municipal lessee in the form of a lower interest rate.

A non-appropriation clause enables the lessee to terminate the lease agreement at the end of the current appropriation period without further obligation or penalty. This may be done only in cases where the lessee was unable to obtain funding for future payment obligations on the lease. Typically, the clause will contain a "best efforts" requirement whereby the lessee must use its best efforts to obtain the necessary appropriation for the lease payments. The non-appropriation clause enables the lessee to account for the lease obligation as a current expense instead of debt.

A non-substitution clause maintains that if a lease is terminated for non-appropriation, the lessee may not replace the leased equipment with equipment that performs the same or similar functions. Lawyers are generally skeptical as to the enforceability of a non-substitution clause, which to a large extent has not been tested in the courts. Consequently, a non-substitution clause is frequently qualified by the phrases “to the extent permitted by law” or “to the extent that the validity of this lease will not be adversely affected.” 

Unlike general obligation bonds, revenue bonds, or fund specific obligations, financings such as installment sale contract financings and lease-purchase financings are subject to the annual budget appropriations of the agency’s governing body.  They are not backed by the full faith and credit of the municipality, and they do not have a specific source of funds dedicated to their repayment.  This makes these types of financings riskier from a lending standpoint.  This risk is lessened when the financing is for assets that are essential, or critical, to the agency’s operation or delivery of governmental services.  Then, the likelihood of an agency continuing payment through the term of the financing is increased because the agency can not complete its function without the asset.  In the event of non-appropriation, the agency would lose the use and possession of the asset.

Depending upon applicable law and the terms of the existing leases to be refinanced, a public organization may use a new lease financing to refinance its existing leases.  Typically, public organizations consider a refinancing of existing leases if the interest rates received would result in lower lease payments.  Additional reasons public organizations elect to refinance are: