Lease-Purchase Arrangements Provide
Creative Options for Capital Asset Financing
January/February 2003

By: Price D. Finley and Matthew L. Stout

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In this era of budget deficits and reduced local governmental revenues, municipalities need to look for creative ways to finance capital improvements1. Municipal leases provide a creative, yet relatively straight-forward tax-exempt financing alternative to traditional debt financing. Cities and villages, as well as other political subdivisions, such as school districts and townships, frequently acquire or construct improvements through the use of lease-purchase financings. Lease-purchase financing may also be attractive for a growing municipality that needs to fund the construction or renovation of facilities or the acquisition of equipment, but may have limited ability to finance such projects using general obligation debt because of statutory debt limitations. This article provides a general overview of lease-purchase arrangements and describes the pros and cons of such structures.

Overview of Lease-Purchase Structure

Municipalities have the ability, either through statutory authority or through their “home rule” power, to purchase or lease capital assets. Under a purchase contract, ownership of the asset transfers to the municipality upon the closing of the purchase transaction. Under a lease structure, the municipality contracts for the use of the asset but never acquires an ownership interest in the asset2. This type of lease is often referred to as a “true lease” because it is nothing more than a lease of the asset or as an “operating lease” (in order to distinguish it from a “capital lease, which is another name for a lease-purchase arrangement). A lease-purchase arrangement falls somewhere between a purchase arrangement and an operating lease. Under a lease-purchase arrangement the municipality leases the asset (and reserves the right to walk away from the transaction without penalty if it does not have sufficient funds to appropriate for the lease in subsequent years), but the municipality receives a credit for each lease payment so that, at the end of the lease term, the municipality acquires full ownership of the asset. If the municipality terminates the lease prior to the end of the term, the municipality does not get any credit for those lease payments.

Under a municipal lease structure, the municipality, as lessee, leases the capital asset over a specified period of years from a financial institution, as lessor. Typically the municipality makes monthly lease payments to the financial institution over the term of the lease, and each rent payment has a principal component and an interest component. Over the term of the lease, the total amount of principal component of each lease payment will equal the purchase price for the asset. If properly structured, the interest component of the municipal lease is tax-exempt under the Internal Revenue Code, which means that the imputed interest rate on the lease is lower than it would be for a lease to a private business. Thus, lease-purchase financing is attractive to both the municipality and the financial institution.

Statutory and Home Rule Power to Lease

Municipalities have specific statutory authority to finance capital assets on a lease-purchase basis, but most municipal leases are structured using the municipality’s “home rule” power instead of relying on a specific provision of the Ohio Revised Code. RC 715.011 governs real estate-related leases by authorizing municipalities to acquire “buildings, structures, and other improvements for any authorized municipal purpose” on a lease-purchase basis. The term of such leases cannot exceed 40 years, and the lease is required to provide that, at the end of the lease term, the asset financed, together with the land on which the asset is situated, becomes the property of the municipality “without cost.”

RC 715.011 also authorizes the municipality, in connection with the lease, to grant leases, easements, or licenses for lands under the control of the municipality. Finally, RC 715.011 specifies a particular competitive bidding procedure that the municipality must follow in awarding contracts for the construction and lease of the facility to be built or otherwise improved. This requirement that the municipality enter into the lease directly with the contractor serves as a barrier to the use of RC 715.011 as the basis for the lease-purchase arrangement. Relying on its home rule power, a municipality could undertake a lease-purchase arrangement, with a bank or other financial institution providing the financing mechanism, and a contractor (working under a competitive bidding and prevailing wage structure) undertaking the construction in the traditional way. That mechanism is discussed in more detail below.

Municipal Leases Are Not Debt

The major benefit of a municipal lease, other than its tax-exemption, is that it is subject to annual appropriation and, therefore, not considered debt of the municipality. Under a municipal lease, the governing board of the municipality must appropriate, on an annual basis, each year’s lease payments in the year that they are due. This annual appropriation provides an exception from the municipality’s normal debt limitations. In contrast to unvoted or voted general obligation debt, which is subject to the direct and indirect debt limitations under Ohio law3, municipal leases are not considered debt because the continuation of the lease from year-to-year is subject to appropriation of funds by council of the municipality. This reality makes municipal leases especially beneficial to smaller municipalities that have lower assessed valuations and are often restricted by the direct and indirect debt limitations or growing municipalities that have significant infrastructure needs.

Tax Advantages of Municipal Leases

Federal tax law treats a municipal lease like a bond or note of the municipality, resulting in the availability of a tax-exempt interest rate for the lease transaction. Just like municipal bonds, the lease financing must be for a qualified governmental purpose in order to be tax-exempt, and a private party cannot be the actual beneficiary of the tax-exempt financing. In addition, financial institutions generally find municipal leases to be attractive investments, especially if the municipal lease can be designated as a “bank-qualified” obligation. When a municipal lease is designated as “bank-qualified,” the financial institution can enjoy strong margins on a tax equivalent yield basis with respect to the municipal lease. Because smaller municipalities rarely issue debt in excess of $10 million during a calendar year, “bank qualification” is a common benefit for municipalities who desire to secure municipal lease financing from a financial institution.

Certificates of Participation

Lease-purchase financings involving capital assets with significant dollar amounts are often financed using certificates of participation (“COPs”) structure. COPs are securities that look and feel similar to typical tax exempt bonds in that they pay the holder principal and interest on the securities. The COPs themselves represent fractionalized interests in the lease payments made by the municipality under the lease-purchase documents. Because the COPs simply represent an interest in the lease, they do not represent indebtedness of the municipality for state law purposes. The proceeds of the sale of the COPs are used to pay construction costs in the same manner as bonds and notes are used to finance permanent improvement projects. Because of the risk of non-appropriation of funds associated with the lease payments, COPs typically bear interest at a slightly higher interest rate than the municipality’s general obligation debt would.

Structuring a Lease-Purchase Agreement

Putting together a lease-purchase agreement can be challenging from a documentation standpoint. Lease-purchase financing also should not be viewed as a panacea for the municipality’s financial issues. Money to make the lease payments still must be budgeted on an annual basis. No new revenue stream is created under a municipal lease structure - the municipality needs to identify a source of funds to make the rent payments under the lease. In addition, because the lease-purchase agreement is subject to annual appropriation of funds, credit institutions evaluating such arrangements require a higher interest rate than traditional tax-exempt bonds in order to account for the risk of non-appropriation.

Finally, financial institutions often use “standard” forms of municipal leases which have provisions that are not favorable to municipalities or include language that may result in the lease being classified as debt under Ohio law. This issue typically surfaces when the consummation of the lease transaction requires an opinion of legal counsel that the lease is a valid and binding obligation of the municipality. Some of the standard lease provisions that may require modification in order for legal counsel to be able to deliver the required legal opinions are discussed below:

Non-appropriation language. In order to avoid having a lease-purchase arrangement classified as unconstitutional (and, therefore, invalid) indebtedness of the municipality, the lease documentation must permit the municipality to terminate the lease at the end of any fiscal year, without penalty, if council fails to appropriate funds for the lease payments in the next succeeding fiscal year. Many standard form leases provide for termination upon non-appropriation but do so with certain strings attached, which threaten the exclusion of the lease as debt under Ohio law4.

Non-substitution clauses. Many leases include language which prohibits the municipality from acquiring equipment that is functionally similar to the equipment financed under the lease in the event that the lease terminates prior to its stated expiration as a result of the municipality’s failure to appropriate funds in any year. Although Ohio courts have not specifically addressed the issue, courts in other states have concluded that a non-substitution clause, by preventing the municipality from acquiring equipment in replacement of equipment financed under a lease-purchase arrangement for the remainder of the lease term, serves as a compulsion on the municipality to continue to appropriate funds for the lease. Courts analyzing the issue have concluded that this compulsion to appropriate funds converts the lease from a one-year contract to a long-term indebtedness, which, in most cases, is unenforceable.

Indemnification. Municipalities have no express or implied authority to grant indemnification under Ohio law and an indemnification clause in the lease should be removed.

Property taxes. Lease provisions that place the burden on the municipality for paying (or reimbursing the lessor for) property taxes that may be charged on the asset financed under a lease-purchase structure should be negotiated out of the lease. Instead, the lease should acknowledge that the municipality is a public entity exempt from property taxation.

Assignment. Standard leases typically give the leasing entity carte blanche authority to assign its interest in the lease to third parties. The ability of the leasing entity to assign its interest in the lease should be modified in order to be in compliance with RC 9.945,

Conclusion

Despite these drawbacks, municipal leases are a feasible alternative to general obligation debt financing for municipalities that should be considered. Municipal leases provide a tax-exempt form of debt financing that is attractive to both municipalities and investors and can also avoid Ohio debt limitations and the other issues associated with general obligation debt financing.

Footnotes

1. As used in this article, capital improvements which may be financed using a lease-purchase arrangement include items that would qualify as a “permanent improvement” under RC 5705.01(E), which is defined as “any property, asset, or improvement with an estimated life or usefulness of five years or more, including land and interests therein, and reconstructions, enlargements, and extensions thereof having an estimated life or usefulness of five years or more.” Thus, construction of buildings, additions to, or renovations of, existing buildings, and equipment (including computers) could all be financed using a lease-purchase arrangement.

2. Although many lease agreements provide a purchase option at the end of the lease term, the purchase price is the fair market value of the asset - there is no credit against the purchase price for prior lease payments.

3. Ohio law provides that a municipality cannot issue voted and unvoted general obligation debt in excess 10.5%, and unvoted general obligation debt in excess 5.5%, of the municipality’s total assessed valuation. These are referred to as “statutory” or “direct debt limitations.” Unvoted general obligation debt is also subject to the “ten-mill” or “indirect” debt limitation, a constitutional and statutory ceiling on the total amount of unvoted property taxes that can be levied by the municipality, school district, county, and other taxing authorities (township, county agencies, etc.) acting together.

4. Loss of equity in the asset financed by the lease as a result of termination for non-appropriation of funds is not viewed as an impermissible penalty. Most lease-purchase arrangements provide that ownership of the asset reverts to the lessor in the event that the lease terminates for non-appropriation of funds.

5. RC 9.94 prohibits third parties from selling fractionalized interests in any public obligations, including municipal leases, without the knowledge and express written approval or authorization of each public issuer and, further, requires a provision to that effect in each lease or other public obligation.

Reprinted from Finley’s Ohio Municipal Service, with the permission of the publisher and copyright owner, West Group.