Overview of final private activity bond tax regulations.

• Author: John, Cross

Internal Revenue Code Final Regulations, which broadly affect governmental tax-exempt bonds, focus on the level of permissible private business involvement in a bond issue.

Introduction

This article provides an overview of selected aspects of the recent final private activity bond tax regulations under Section 141 of the Internal Revenue Code (the "Final PAB Regulations").(1) These important rules broadly affect governmental tax-exempt bonds. They focus on the level of permissible private business involvement in a bond issue. Bonds are classified as private activity bonds if they meet a two-part 10 percent private business use test and private payment or security test, or a separate private loan test. Except for tax-exempt financing for certain specific private facilities (e.g., certain exempt facilities, housing mortgages, small issue manufacturing facilities, and certain 501(c)(3) nonprofit organization facilities), tax-exempt bonds generally may be issued only for governmental purposes and are taxable if the level of private business involvement causes them to be private activity bonds. Thus, the goal typically is to fail to be a private activity bond.

Effective Dates and Unfinished Parts. In general, the Final PAB Regulations apply prospectively to bonds issued on or after May 16, 1997. An issuer may elect to apply the Final PAB Regulations in whole, but generally not in part, to outstanding bonds issued earlier. An issuer also may elect to apply certain specific provisions individually to earlier outstanding bond issues, including those on permitted private management contracts, change of use remedies, and research agreements.

Certain parts of the Proposed PAB Regulations were not finalized, including those for output contracts (e.g., electric power contracts) and mixed-use facility allocations. These reserved parts are understood to be well underway.

Selected Highlights. Overall, the Final PAB Regulations adopt more workable standards than previous guidance in many areas. Selected positive highlights include

* more flexible standards for testing private business use, based on ownership, leasing, special legal entitlements to general public use property (e.g., roads), and special economic benefits from property unavailable for general public use (e.g., prisons);

* consideration of private management contracts under all the facts and circumstances, together with broad new safe harbors under Rev. Proc. 97-13 which permit qualified private management contracts for up to 15-year terms at 95 percent fixed fees or up to 10-year terms at 80 percent fixed fees (and 20-year terms in each case for public utility property);

* a broader general public use exception to private business use which focuses on intended and actual 'reasonable availability for use by "natural persons" (regulation code word for human beings);

* a more sensible measure of private business use which generally looks at average use over the entire term of the bond issue;

* more flexible treatment of facilities that can qualify for a general public use exception, including favorable examples for certain airport runways, airport parking, and isolated road facilities;

* more workable treatment of tax assessment bonds, including deletion of certain proposed rules which negatively impacted developer agreements in these financings; and

* change of use remedies which are more workable in certain respects and which permit certain eligible bonds with up to 10 [degrees]-year call provisions to be defeased without further action such as tender offers.

On the other hand, however, the Final PAB Regulations are notable for the sheer number of rules and their complexity. Selected negative highlights include

* a more restrictive private payment or security test, which broadly counts certain payments on tax-exempt bond-financed property during periods of private business use even if not made by a private business user;

* some harsh eligibility conditions on otherwise favorable special rules (e.g., the myriad conditions on the special rule for certain large general obligation bond programs for more than 25 purposes) that limit their usefulness in practice;

* various detailed accounting rules that limit state and local government flexibility;

* restrictive treatment of issuer equity used for facilities partially financed with tax-exempt bonds;

* a restrictive condition to the change of use remedies which effectively limits the available remedy to redemption of all nonqualified bonds when an issuer reasonably expects, on the issue date, that the bonds will exceed the private activity bond limits at any time during the entire term of the bonds;

* restrictive treatment of installment sales of bond-financed facilities under the change of use remedies; and

* a restrictive measure of the amount of "nonqualified bonds" for which certain change of use remedial actions need to be taken.

Overview of PAB Tests

Section 141(a)(1) defines a "private activity bond" issue to include an issue in which both of the following tests are satisfied (together, these are called the "private business tests"):

* private business use test: more than 10 percent of the bond proceeds are to be used, directly or indirectly, in a trade or business of any person other than a state or local governmental unit and

* private payment or security test: the payment of the principal of, or the interest on, more than 10 percent of the proceeds of the bond issue is (under the terms of the issue or any underlying arrangement) directly or indirectly: 1) to be derived from payments (whether or not to the issuer) in respect of property, or borrowed money, used or to be used for a private business use or 2) secured by any interest in property used or to be used for a private business use or payments in respect of such property.

Subsequent sections of this article discuss these two tests in greater detail.

Separate Private Loan Test. Section 141(a)(2) independently treats bonds as private activity bonds if more than the lesser of 5 percent or $5 million of the bond proceeds are to be used, directly or indirectly, to make or finance loans (excluding certain permitted tax assessment loans) to nongovernmental persons (the "private loan test"). Private loans may arise even if there is no private business use at all (e.g., consumer loans).

The Final PAB Regulations provide that bonds may be private activity bonds if either 1) the issuer reasonably expects, as of the issue date, that the bonds will meet the private activity bond tests over the stated term of the issue or 2) the issuer takes a deliberate action, after the issue date, that causes the bonds to fail the private activity bond tests. This standard basically is an "actual facts" test for actions within an issuer's control. Several special rules temper these standards, but they are tricky and have many conditions.

A special rule permits an issuer to disregard an action that is reasonably expected as of the issue date and that otherwise would violate the private activity bond tests if, as of the issue date, the issuer 1) reasonably expects to use the financed property for a substantial period of time (undefined), 2) is required to redeem all nonqualified bonds within six months of the action, 3) has no arrangement with a private business as of the issue date regarding the action, and if 4) the mandatory redemption meets the general conditions for change of use remedies. This special rule sensibly allows bond redemption to cure expected, but unpredictable, future private involvement. It seems harsh in requiring the bond redemptions in amounts in excess of disposition proceeds received.

A special safe harbor disregards an action that is either an involuntary or compulsory conversion under Section 1033 or a response to a federal regulatory directive. For example, this special rule might cover Federal Energy Regulatory Commission (FERC)-mandated wheeling of electricity to private utilities. Treasury and the Internal Revenue Service (IRS) are considering whether to extend this exception to cover state regulatory initiatives.

A helpful special rule disregards certain dispositions of personal property in the ordinary course of an established governmental program. A transaction qualifies if 1) the weighted average maturity of the applicable bonds is not greater than 120 percent of the reasonably expected actual governmental use of the property, 2) the issuer reasonably expects on the issue date that the fair market value of the property on the disposition date will not exceed 25 percent of its cost, 3) the property is no longer suitable for...