A bond issuer may set aside some of the proceeds from a bond sale to cover a certain number of interest payments. This portion of funds is considered capitalized interest. It is a strategy that can be used by both municipal bond issuers and corporate bond issuers. This approach is attractive to both, for different reasons.
An example of a municipal bond issue is one that finances the building of a school. Adding the expected interest payments to the bond issue, then capitalizing them, gives the school district time to accumulate revenues before having to launch into interest payments on its bond borrowing. Interest payments that are expected to be made during the first three years, or in while the project is under construction and for up to one year after its completion, may be included in the bond issue and capitalized. The bond trustee holds the capitalized interest and uses it to pay interest on the bonds.
A municipal bond issuer must be extremely careful to comply with all Internal Revenue Service regulations on the use of proceeds from the bonds. Acceptable uses are: project costs; capitalized interest covering the initial interest payment obligations to bondholders; and bond issuance costs, which include the expenses charged by the investment banking firm and attorneys and accountants employed by the bond issuer for preparing and selling the issue. If the issuer fails to comply with the rules for setting aside money, accounting for its expenditure and reporting as necessary, the issuer can lose its tax-exempt status.
A corporation may capitalize the interest on bonds it issues, but it does so because the capitalized interest is listed as an asset on a corporation's income statement. Interest on business loans is generally tax-deductible, but capitalized interest must be applied as a cost of goods produced, and therefore it reduces the taxable profits. This means that the interest payable on bonds to build a new factory, or interest payable on a business loan to buy inventory, is capitalized as an asset. It represents the cost of the revenue produced by the factory or the sale of the inventory.
Interest must be capitalized on an asset that requires time to be readied for its intended use. Examples are factories that are being built, or inventory that is being manufactured or purchased and warehoused before sale. The asset must be for the exclusive use of the company. It can't be an airplane for the personal use of the chief executive officer. But if the company will be using it exclusively for business and leasing it out as a revenue producer for the company, the interest must be capitalized. Any revenues generated from it will be reduced by the capitalized interest as a cost of producing the revenues.
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