The proposed regulations set forth a new three-part federal test that would define political subdivisions. If an entity is not a political subdivision, it would not be able to issue tax-exempt bonds.
On February 23, 2016, the Internal Revenue Service (IRS) proposed regulation that would redefine political subdivisions for purposes of tax-exempt bonds. The proposed regulations set forth a new three-part federal test that would define political subdivisions. If an entity is not a political subdivision, it would not be able to issue tax-exempt bonds. Every entity would have to meet all three tests to be a political subdivision. If an entity failed any of the tests, it would not be considered a political subdivision. The entity must: 1) have right to exercise a substantial amount of at least one of three sovereign powers (the power of eminent domain, the power of taxation and to police); 2) serve a governmental purpose; and 3) be controlled by a state or local government.
Penalties for non-compliance go even further, to outstanding municipal securities. For example, if a political subdivision does not meet any one of the tests, and it uses a facility financed with tax-exempt bonds that were issued by another entity, those bonds could become private activity bonds and thus taxable. Finally, if the entity cannot qualify for some other tax-exempt status, it could have to pay income tax, and its governmental employee benefits might also be at risk.
Concerned about the swift impact that this rule could have on tax-exempt debt, the Government Finance Officers Association surveyed members about the potential impact of the proposed regulations. Respondents acknowledged that the first of the three tests is already the established rule; political subdivisions are already required to have been delegated at least one of the three listed sovereign powers. The second two tests, however, are particularly problematic.
The second test, which requires that the political subdivision serve a governmental purpose, proposes authority over the government that created it. The state legislation that established the political subdivision contains the consideration of governmental purpose. The second test also requires that the entity continually operates "in a manner that provides a significant public benefit with no more than an incidental private benefit." Every benefit to a private entity or person would have to be examined to determine whether the benefit is incidental.