In a conduit financing, the entity issuing the bonds passes the proceeds to another governmental entity or to a nongovernmental entity, such as a private business or charitable organization, usually pursuant to a loan agreement.
Interest on state and local bonds is exempt from federal income taxes, so long as the bonds are used to finance public projects, such as government office buildings or parks. Bonds that primarily benefit private individuals or companies, private activity bonds are generally taxable, unless they are used for certain purposes outlined in federal law. Among other things, these “qualified private activity bonds” may be used to build low-income housing or facilities for charitable organizations.
Because this subset of private activity bonds is tax, money may be borrowed by the government at lower interest rates than if the private entity issued its own taxable bonds. Thus, a governmental issuer, the “conduit issuer,” issues the bonds, and typically loans the proceeds to the private entity, or “conduit borrower.” The private entity is responsible for associated principal and interest payments.