Comments on §141 Related to Output Facilities: Appendices

Section of Taxation
Committee Comment: Tax Exempt Financing

COMMENTS ON REGULATIONS UNDER SECTION 141
OF THE CODE AS THEY RELATE TO OUTPUT FACILITIES

APPENDIX A
PROPOSED REGULATIONS REGARDING OUTPUT FACILITIES

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APPENDIX B
REFERENCES IN 1986 LEGISLATIVE HISTORY TO TAX-EXEMPT BONDS BECOMING TAXABLE

Set forth below are all the references to tax-exempt bonds becoming taxable in the legislative history of the 1986 Act.

HOUSE REPORT

Failure to comply with the set-aside and rental requirements at any time during the qualified project period results in the interest on the bonds becoming taxable, retroactive to the date of issue. Under Treasury Department regulations, however, if noncompliance with the requirements is corrected within a reasonable period (60 days) after the noncompliance reasonably should have been discovered, the tax-exempt status of the bond interest is not affected (Treas. Reg. sec. 1.103-8(b)(6)). House Report at 498.

The above was a discussion of an existing special statutory provision applicable only to housing bonds.

If the $40 million limit is exceeded for any owner or principal user as a result of a change during the test period, interest on the issue of IDBs that cause the limit to be exceeded is taxable from the date of issue. The tax- exempt status of interest on other, previously issued, IDBs is not affected. House Report at 500, n.14.

The above describes an existing statutory provision.

Issuers of IDBs, student loan bonds, bonds for section 501(c)(3) organizations and all mortgage subsidy bonds must report certain information to the Internal Revenue Service about the bonds issued by them during each preceding calendar quarter…Interest is taxable on bonds with respect to which the required report is not made. House Report at 514.

The above discussion reflects a specific statutory rule.

Many States provide for the creation of tax or utility districts that are themselves qualified governmental units to provide essential governmental functions to an area within a larger such governmental unit. During an initial development period, the land in such a district may be owned by a single developer (e.g., a redevelopment agency), or a limited group of developers, who are proceeding with all reasonable speed to develop and sell the land to members of the general public for residential or commercial use. The committee intends that bond proceeds used in such situations to finance facilities for essential governmental functions such as extensions of municipal water systems; street paving, curbing (including storm water collection), and sidewalk and street-light installation; and sewage disposal generally not be treated as used in the trade or business of the developers. Rather the tax status of the bonds generally will be determined by reference to the ultimate (i.e., after the initial development period) use of the facilities. Such bonds may be treated as essential function (i.e., governmental) bonds, or as exempt-facility bonds, provided that (1) the facilities are designed to serve members of the general public in the governmental unit on an equal basis; (2) ultimate ownership and operation of the facilities is with persons other than the developers (e.g., the governmental unit); and (3) development of the district for sale and occupation by the general public proceeds with reasonable speed. Failure of the developers to complete the district for use and occupancy by the general public, or financing of any facilities to be used by one or a limited group of persons, results in interest on the bonds being taxable from the date of issue. See also, the discussion of the private loan bond restriction, below, for rules regarding the treatment as ‘excluded loans’ of mandatory taxes or other assessments of general application that may be levied in connection with certain types of improvements. House Report at 523.

The above discussion is an expression of intent addressing a special situation not previously addressed.

The bill provides two penalties for failure to comply with the set-aside and rental use requirements during the qualified project period. First, as under present law, interest on the bonds used to finance the project becomes taxable, retroactive to the date of their issuance. In addition to this present-law rule, failure to correct any noncompliance with the set-aside requirement after it is discovered or reasonably should have been discovered, or termination of use as rental property, results in all interest on bond-financed loans being nondeductible, effective from the first day of the taxable year in which the noncompliance occurred.⁴⁶ If the noncompliance arises solely because of failure to satisfy the set aside requirement, interest incurred on bond financed loans after a project is again in compliance with that requirement is deductible. Interest on the bonds, however, remains taxable (as under present law). House Report at 534.

The above is a discussion of statutory rules specific to single family housing.

If an issue of section 501(c)(3) organization bonds causes the $150 million limitation to be exceeded, only the issue that causes the limitation to be exceeded is taxable. If the $150 million limitation is violated with respect to an issue by a change of owners or principal users of bond-financed facilities at any time during the three-year test period, the interest on that issue is taxable from the date the bonds were issued. In no case does this restriction affect the tax-exemption of interest on bonds issued prior to January 1, 1986…House Report at 540.

The above discussion describes the operation of a specific statutory provision.

The bill codifies the application of the present-law reasonable expectations test as it applies to subsequent acts to earn arbitrage . As under present law, the determination of whether bonds are arbitrage bonds generally is based upon the reasonable expectations of the issuer on the date of issue. If subsequent intentional acts are taken after the date of issue to earn arbitrage, however, the reasonable expectations test will not prevent the bonds from being arbitrage bonds. See, e.g., Rev. Rul. 80-91, 1980-1 C.B. 29, Rev. Rul. 80-92, 1980-1 C.B. 31, and Rev. Rul. 80-188, 1980-2 C.B. 47.

For purposes of this continuing requirement, any investment with respect to which impermissible arbitrage earnings accrue will results in the bond interest becoming taxable, retroactive to the date the bonds are issued. The committee intends that the determination of whether intentional actions to earn arbitrage have been taken is made on a case-by-case basis, taking into account all facts and circumstances that a prudent investor would consider in determining whether to invest bond proceeds. House Report at 553.

The above discussion describes a statutory provision applicable only to arbitrage.

The bill includes new rules to prevent the early issuance of bonds. Under these rules, an amount equal to at least five percent of bond proceeds must be expended for the governmental purpose of the borrowing within 30 days after the date the bonds are issued. Additionally, an amount equal to all bond proceeds (other than amounts invested in a reasonably required reserve or replacement fund) must be expended for that purpose within three years after the date of issuance. The Treasury Department is permitted, upon specific request of the issuer, to extend the 30-day and 3-year periods in cases where the delay in expenditures results from events not within the control of the beneficiary of the bonds or the issuer (e.g., Acts of God). Failure to comply with this restriction renders the interest on the bonds taxable, retroactive to the date of issue. House Report at 558.

The above discussion describes a provision that was not enacted.

The committee understands that, in certain cases, statements (i.e., accounts payable) may not have been received in the normal course of business within 30 days after construction is more than 90 percent completed. The committee intends that where undue hardship otherwise would result, the Treasury Department may upon application by the issuer permit retention of bond proceeds in an amount not exceeding these accounts payable until the amounts may be ascertained with certainty and paid at the earliest date after being so ascertained. For purposes of this rule, so-called ‘retainage’ is not treated as an unascertained amount payment of which may be delayed. Any unreasonable delay in payment of all accounts payable accompanied by a failure to redeem excess bonds renders the interest taxable from the date of issue. House Report at 559.

The above discussion describes a provision requiring expenditure of all proceeds which was not enacted.

Under present law, interest on bonds may become taxable, either retroactively to the date of issue or (if specifically provided in the Code) prospectively, if certain events occur. The bill provides, that in addition to any loss of tax-exemption provided under present law, certain expenditures by persons using property financed with nonessential function bonds are nondeductible for Federal income tax purposes in certain circumstances.⁷⁰ Under this provision, interest (including the interest element of user fees) becomes nondeductible if property financed with the proceeds of these bonds is used in a manner not qualifying for tax-exempt financing at any time before the bonds are redeemed.⁷¹ The interest or other user charges are nondeductible, effective from the first day of the year in which the change of use occurs and continue to be nondeductible until the date on which the property again is used in the use for which the bonds were issued, or the date on which the bonds are redeemed, if earlier.

If the use of governmentally owned bond-financed property changes from a use qualifying for tax-exempt financing to a nonqualified use and a governmental unit continues to own the property, a portion of any rent or other user fee paid by the non-governmental person using the property in the nonqualified use is nondeductible. The nondeductible portion is an amount of rent or other user fees equivalent to the interest payments on that portion of the bonds attributable to the portion of the facility used in a nonqualified use. For example, if a governmentally owned airport terminal were converted to an office or retail complex, each non-governmental user of the converted property would be denied deductions for rent and other user fees with respect to the property, to the extent of the interest payments on an allocable portion of the bonds. If the allocable bond interest payments exceed otherwise deductible any rent or other user charges, the full amount of those deductions is denied. If bond-financed property is required to be governmentally owned, but ceases to be, interest (including the portion of any rent or other user charges that is treated as interest for Federal income tax purposes) paid by the new owner with respect to the property is nondeductible. House Report at 560-1.

Neither paragraph of this discussion of the proposed change in use rules denying tax deductions states any general rule of taxability for change in use, although a general rule might be an inference from the structure of the first sentence. In this respect, however, the text of the Conference Report clarifies that there is no general rule of taxability. It is unclear what footnote 70 is referring to but it states no general rule.

SENATE REPORT

As indicated above, the low- or moderate-income occupancy requirement is reduced from 20 percent to 15 percent in targeted areas. For purposes of this reduced low- or moderate-income occupancy requirement, the term targeted area means (1) a census tract in which 70 percent or more of the families have incomes that are 80 percent or less of the applicable statewide median family income, or (2) an area of chronic economic distress as determined under statutory criteria (sec. 103A(k)(3)). Failure to comply with the low- or moderate-income occupancy and rental requirements at any time during the qualified project period results in the interest on the bonds becoming taxable, retroactive to the date of issue. If noncompliance with the requirements is corrected within a reasonable period (at least 60 days) after the noncompliance reasonably should have been discovered, the tax-exempt status of the bonds is not affected (Treas. Reg. sec. 1.103- 8(b)(6)) . Senate Report at 815-16.

The above is a discussion of a specific statutory provision.

Issuers of IDBs, student loan bonds, bonds for section 501(c)(3) organizations, and all mortgage revenue bonds must report certain information to the Internal Revenue Service about bonds issued by them during each preceding calendar quarter. This report is due on the 15th day of the second month after the close of the calendar quarter in which the bonds are issued. Interest is taxable on bonds with respect to which the required information report is not made. Senate Report at 824-5.

The above discussion describes an existing statutory provision.

Ninety percent of the rebate required with respect to any issue must be paid at least once each five years, with the balance being paid within 30 days after retirement of the bonds. Failure to rebate arbitrage profits as required renders the bonds taxable as of the date of issue. Senate Report at 21.

The above is a discussion of a specific provision.

The bill provides two penalties for failure to comply with the low- or moderate-income occupancy and rental use requirements during the qualified project period. First, as under present law, interest on the bonds used to finance the project becomes taxable, retroactive to the date of their issuance. In addition to this present-law rule, failure to correct any noncompliance with the low- or moderate income occupancy requirement within a reasonable period after it is discovered or reasonably should have been discovered, or termination of use as rental property, results in all interest on bond-financed loans being nondeductible, effective from the first day of the taxable year in which the noncompliance occurred.³⁵ If the noncompliance arises solely because of failure to satisfy the low- or moderate income occupancy requirement, interest incurred on bond financed loans after a project is again in compliance with that requirement is deductible. Interest on the bonds, however, remains taxable (as under present law). Senate Report at 835-6.

The above is a discussion of a specific provision.

The bill codifies the application of the present-law reasonable expectations test as it applies to subsequent deliberate and intentional acts to earn arbitrage. As under present law, the determination of whether bonds are arbitrage bonds generally is based upon the reasonable expectations of the issuer on the date of issue. If subsequent deliberate and intentional acts are taken after the date of issue to produce arbitrage, however, the reasonable expectations test will not prevent the bonds from being arbitrage bonds. (See, e.g., Rev. Rul. 80-91, 1980-1 C.B. 29, Rev. Rul. 80-92, 1980-1 C.B. 31, Rev. Rul. 80-188, 1980-2 C.B. 47, and Rev. Rul. 85- 182, 1985-46 I.R.B. 4 (Nov. 4, 1985).).

Violation of this continuing requirement results in the bond interest becoming taxable, retroactive to the date the bonds are issued. The committee intends that the determination of whether deliberate and intentional actions to earn arbitrage have been taken is made on a case-by-case basis.⁴⁸ Senate Report at 844-5.

The above is a discussion of a specific statutory provision.

The bill provides that a special penalty, in lieu of loss of tax-exemption, applies to certain failures to rebate arbitrage profits in the case of governmental bonds and qualified 501(c)(3) bonds. Under this rule, issuers are liable for a penalty equal to 100 percent of any amount not rebated when due. The penalty may be waived by the Treasury Department if the error is due to inadvertence on the part of the issuer. If an issuer corrects any underpayment (and pays any penalty due) within six months of being notified by the Treasury Department, the bonds do not become taxable (assuming no willful disregard of the rebate requirements). If the issuer fails to pay all amounts due within this six-month period or acts in willful disregard of the rebate requirement, the bonds are taxable retroactive to the date of issuance. Senate Report at 847.

The above is a discussion of a specific statutory provision.

Under present law, interest on bonds may become taxable, either retroactively to the date of issue or (if specifically provided in the Code) prospectively, if certain events occur. The bill provides that, in addition to any loss of tax-exemption provided under present law, certain expenditures by non-governmental persons using property financed with IDBs, mortgage revenue bonds, qualified 501(c)(3) bonds, and other private loan bonds for which tax- exemption is permitted are nondeductible for Federal income tax purposes in certain circumstances. Under this provision, interest (including the interest element of user fees) becomes nondeductible if property financed with the proceeds of these bonds is used in a manner not qualifying for tax-exempt financing at any time before the bonds are redeemed.⁵² The interest or other user charges are nondeductible, effective from the first day of the year in which the change of use occurs and continue to be nondeductible until the date on which the property again is used in the use for which the bonds were issued, or the date on which the bonds are redeemed, if earlier.

Governmentally Owned property

If bond-financed property is required to be governmentally owned, but ceases to be, interest (including the portion of any rent or other user charges that is treated as interest for Federal income tax purposes) paid by the new owner with respect to the property is nondeductible. If the use of governmentally owned bond-financed property changes from a use qualifying for tax-exempt financing to a nonqualified use and a governmental unit continues to own the property, a portion of any rent or other user fee paid by the non-governmental person using the property in the nonqualified use is nondeductible. The nondeductible portion is an amount of rent or other user fees equivalent to the interest payments on that portion of the bonds attributable to the portion of the facility used in a nonqualified use. For example, if a governmentally owned airport terminal were converted to a private office or retail complex, each non-governmental user of the converted property would be denied deductions for rent and other user fees with respect to the property, to the extent of the interest payments on an allocable portion of the bonds. If the allocable bond interest payments exceed otherwise deductible rent or other user charges, the full amount of those deductions is denied Facilities (other than owner-occupied housing) owned by non-governmental persons (other than section 501(c)(3) organizations). If non-governmentally owned bond-financed facilities are converted to a use not qualifying for such tax-exempt financing, interest on loans financed with bond proceeds becomes nondeductible. This restriction applies in the case of a change in ownership accompanied by a change in use as well as a change in use where the same person continues to own the property for Federal income tax purposes.⁵³ The bill provides a special rule for multifamily residential rental projects that fail to meet the 20- or 25-percent low- or moderate-income occupancy requirements applicable to such projects, or which otherwise cease to be used in a manner qualifying for tax-exempt financing. Under this special rule, the owners of the project are denied interest deductions with respect to bond-financed loans. However, as under the present-law rules on loss of tax- exemption, if post-issuance noncompliance is corrected within a specified period after it is discovered or reasonably should have been discovered, there is no loss of deductions. (See, the section on IDBs for multifamily residential rental property, above, for a more complete discussion of this exception.)

Mortgage revenue bond-financed housing

If a residence financed with qualified mortgage bonds or qualified veterans’ mortgage bonds ceases to be the principal residence of at least one of the mortgagors for a continuous period of 1 year or more, the mortgagors are denied a deduction for interest paid with respect to the bond-financed mortgage loan on the residence. For purposes of these rules, the term principal residence has the same meaning as under section 1034 of the Code (regarding non-recognition of gain on the sale of a principal residence). The Treasury Department is authorized to waive this penalty in cases where undue hardship otherwise would result and the non-compliance arises from circumstances beyond the control of the mortgagors (e.g., a residence occupied by minor children of a deceased mortgagor). The committee further is aware that certain housing comprised of fewer than five units, one of which is occupied by the owner, is treated as single-family housing under the qualified mortgage bond rules. In the case of such housing, whether the owner uses the property as his or her principal residence is determined by reference to use of the owner-occupied unit (or units).

Qualified 501(c)(3) bond-financed property

If the use of property financed with qualified 501(c)(3) bonds changes to a use not qualified for such financing (at the time the bonds were issued), the section 501(c)(3) organization benefiting from the bonds is treated as using the property in an unrelated trade or business (see, sec. 511) from the first day of the year in which the change in use occurs. Interest on the bond-financed loans is treated as incurred in that unrelated trade or business and is nondeductible against any income of the business. In the case of a change in ownership of section 501(c)(3) property (other than a transfer to a qualified governmental unit or another section 501(c)(3) organization), the new owner of the property is denied deductions for interest (including all amounts treated as interest for Federal income tax purposes) incurred in connection with the acquisition of the property. Proportionate disallowance in the case of partial change in use The Treasury Department is authorized to prescribe regulations for allocating interest on bond-financed loans in the case of a change in use (or ownership) of only a portion of a facility (or a portion of the facilities financed by an issue). In the case of partial changes in use (including a change in ownership) where an interest element is imputed as a portion of another user fee (e.g., rent), the maximum amount treated as nondeductible will be the amount of the rent or other user fee. In general, the committee anticipates that these regulations will provide that interest is allocated proportionately to all users of the facility based upon factors such as relative cost, floor space occupied, relative rental value, or another comparable method. In making this allocation, each user (owner) is treated as the sole user (owner) of all common elements of a facility. Senate Report at 851-853.

See analysis of similar provisions in House Report.

CONFERENCE REPORT

Present Law

Tax-exempt bonds generally are not required to be redeemed if the use of bond- financed property changes from a use qualifying interest on the bonds for tax-exemption to a nonqualified use. In certain cases, however, interest on the bonds becomes taxable.

House Bill

The House bill provides that a change in use of property financed with private activity bonds to a use not qualifying for tax-exempt financing generally results in loss of income tax deductions for rent, interest, or equivalent amounts paid by the person using the property in the nonqualified use. Section 501(c)(3) organizations realize unrelated business income with respect to any such use. These consequences apply in addition to any loss of tax-exemption on bond interest provided under present law.

Senate Amendment

The Senate amendment follows the House bill.

Conference Agreement

The conference agreement follows the House bill and the Senate amendment. Effective date.—This provision applies to changes in use of bond-financed property occurring after August 15, 1986, with respect to financing provided after that date. Conference Report at II-733.

The above discussion speaks for itself.

House Bill

Profit Limitations

The House bill modifies the profit limitations applicable to all tax-exempt bonds in several ways. First, the House bill clarifies that the present-law reasonable expectations test does not protect subsequent intentional acts to create arbitrage profits. Thus, if an issuer intentionally acts to create arbitrage profits in excess of that permitted under the general arbitrage restrictions after the date of issue, the bonds are taxable arbitrage bonds

Conference Agreement

Profit limitations

Subsequent intentional acts to create arbitrage

Under the conference agreement (as under present law), the determination of whether bonds are arbitrage bonds generally is based upon the reasonable expectations of the issuer on the date of issue. If subsequent intentional acts are taken after the date of issue to earn arbitrage, however, the reasonable expectations test does not prevent the bonds from being arbitrage bonds. See, e.g., Rev. Rul. 80-91, 1980-1 C.B. 29, Rev. Rul. 80-92, 1980-1 C.B. 31, and Rev. Rul. 80-188, 1980-2 C.B. 47. For purposes of this continuing requirement, any investment with respect to which impermissible arbitrage earnings accrue may result in the interest on the issue becoming taxable, retroactive to the date the issue was issued. For example, if after the expiration of an allowable temporary period, the issuer continued to invest the bond proceeds at a materially higher yield in order to earn impermissible arbitrage, interest on the bonds would become taxable, retroactive to the date of issue. The conferees intend that the determination of whether intentional actions to earn arbitrage have been taken is made on a case-by-case basis, taking into account all facts and circumstances that a prudent investor would consider in determining whether to invest bond proceeds Conference Report at II-746.

The above discussion describes specific statutory provisions relating to arbitrage.

BLUE BOOK

While the Blue Book is not generally considered to have the same standing as Committee Reports, the Blue Book discussion is consistent with the foregoing analysis. Blue Book at 1135, 1137 n.20, 1152, 1174, 1187, 1201, 1219, 1220 n. 192.

APPENDIX C
TRANSMISSION CONGESTION CONTRACTS, CONGESTION CHARGES, AND RELATED MATTERS

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