DEFINITION of 'Tax-Exempt Commercial Paper'

Tax-exempt commercial paper is an unsecured short-term loan, usually issued to finance short-term liabilities, that provides the debt holders (bondholders) some level of tax preference on the earnings from their debt investment at a local, state or federal level, or a combination thereof. Tax-exempt commercial paper is issued with a fixed interest rate and must mature in less than 270 days. Commercial paper is typically issued in increments of $1,000.

BREAKING DOWN 'Tax-Exempt Commercial Paper'

Commercial paper is essentially a promissory note backed by the financial intuition's health. No federal government policy covers losses incurred from commercial paper. The Federal Deposit Insurance Company (FDIC) does not insure against losses from investing in tax-exempt commercial paper. An investor can ensure the commercial paper's safety by checking the ratings listed by rating agencies such as Standard & Poor's or Moody's. Because of default risk and timeliness issues, interest rates on commercial paper are typically higher than other short-term cash instruments. Tax-exempt commercial paper interest rates increase as the economy grows.

Impact of Taxation

Tax-exempt commercial paper is beneficial for issuers; the interest rate on tax-exempt debt is lower than taxable debt. Likewise, tax-exempt paper is potentially beneficial for purchaser, as the effective interest rate may be higher than taxable commercial paper.

Tax-exempt commercial paper issued by the government results in government support of certain entities or institutions. Instead of the government directly funding the institution, the government forgoes taxes that would have otherwise been collected on the interest income. Thus, tax-exempt commercial paper is an instrument of public policy as lost tax income is replaced with support of an institution.

Buyers and Sellers

Only companies with an investment-grade rating may issue commercial paper. Corporations and governments typically issue tax-exempt commercial paper, while banks, mutual funds, or brokerage firms buy tax-exempt commercial paper. These institutions may hold the commercial paper as an investment or act as an intermediary and resell the investment to their customers. There is a limited market for tax-exempt paper issued directly to smaller investors.

Due to the financial recession, starting in 2008, legislation restrictions were enacted to limit the type and amount of commercial paper that could be held in money market funds.

Tax-Free Commercial Paper Rates

The Federal Reserve Board (FRB) publishes current borrowing rates on commercial paper on its website. The FRB also publishes the rates of highly rated commercial paper in a statistical release occurring each Monday. Information relating to the total amount of outstanding paper issued is also released once per week.

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