Comments on §141 Related to Output Facilities: Executive Summary

Section of Taxation
Committee Comment: Tax Exempt Financing

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

Executive Summary

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Congress, in enacting the industrial revenue bond provisions of the Internal Revenue Code of 1954 (the "1954 Code"), did not explicitly suggest that use of the output of a bond financed facility is tantamount to use of the facility and of the proceeds of the bonds that financed the facility. The Internal Revenue Service, after proposing regulations regarding output facilities that were somewhat vague, issued final regulations under the 1954 Code that equated use of output with use of the facility only in situations where there is a clear transfer of the benefits of ownership (or rights similar to a leasehold interest) and the burdens of paying debt service. In areas other than tax-exempt financing, the IRS and Congress also generally have followed that same approach in analyzing use of the output or services provided by a facility.

While the legislative history of the Internal Revenue Code of 1986 (the "1986 Code") is somewhat conflicting, Congress expressly stated that, except as "amended," the prior law was to continue as before. The temporary regulations under the 1986 Code regarding output facilities (the "Temporary Regulations"), however, substantially depart from the prior regulations under the 1954 Code in ways not suggested by the statutory amendments enacted in 1986. The departures are both technical and qualitative. The temporary regulations create a regime that treats use of the output of a facility as use of the facility in ways that would be considered totally unwarranted in other areas of the tax law, and contain rules that are more difficult to apply and interpret. Thus, while appreciative of the effort that clearly went into the Temporary Regulations, the drafters of this report have substantial comments on the Temporary Regulations, including the following:

The concept that preferential rights give rise to private use is vague and unworkable.
The concept of substantially certain payments is difficult to apply in the context of applying the burdens of debt service test. The Regulations should clarify that a user of the output of a facility should be considered to have the burden of debt service only in the case of a take or take or pay contract, except where the underlying circumstances make clear that there is such certainty that payments will be made that the contract is in effect a take or take or pay contract.
The provisions treating contract termination payments as substantially certain payments should be limited to payments that relate to the facility that was financed.
The provisions regarding wholesale requirements contracts will be very difficult to administer and are contrary to the prior interpretation of the IRS under both the 1954 and the 1986 Code. If a new approach is to be adopted, the Temporary Regulations should take into account other relevant factors beyond those set forth in the Temporary Regulations. In addition, the transition rule for existing contracts should recognize that changes to such contracts that do not change the scope of the requirements covered or the term of the contract should not be considered new contracts.
The provision regarding retail requirements contracts is appropriate.
The provision regarding swapping and pooling is generally appropriate, although minor changes could improve it further.
The concept of measuring use through reserved capacity may be appropriate as an anti-abuse measure for facilities such as peaking facilities but, as a universal rule, it is an unwarranted departure from prior regulations.
The return to nameplate as a general measure of available output is appropriate in a field that requires a bright line test, but is undermined by the reserved capacity rule as presently written and by the limited source of supply rule.
All of the new rules that require subjective determinations raise the further question as to when the determination should be made. We believe the appropriate time is at the time of the initial financing. This determination should govern subsequent financings and refundings.
We generally agree with the provisions of section 1.141-8 relating to the $15,000,000 limitation, although we suggest certain modifications.

Regarding transmission facilities, our comments are:

Addressing the private use of facilities that provide ancillary services will involve difficulties that far outweigh the benefit to the fisc. Thus, in the case of both existing bond financed facilities and future facilities, the use of such facilities to provide ancillary services should not be considered use by the entity controlling transmission, rather than as use by the municipal utility, unless a principal purpose of the construction of the facility is to provide such services.
The report discusses at some length likely future transmission arrangements and concludes that in many cases there will not be private use.
Use of transmission facilities by an independent system operator (an "ISO") should not, if the ISO is nonprofit and governmentally controlled, be considered private use. The management by the ISO should be analyzed based on the unique circumstances involved. If, instead, the IRS concludes that ISOs are to be evaluated under management contract rules, the IRS should reconsider Example 5 of section 1.141-7T(h), where an arrangement that appears to meet the management contract rules nonetheless gives rise to private use. If the IRS believes the arrangement described in the example violates the management contract rules, it should specify the reasons, and those reasons should only be reasons that are generally applicable to management contracts.
The grandfathering rules relating to open access to transmission are appropriate and valid regulations, although certain technical changes would be useful. The open access rules regarding stranded generating costs are less useful. The inapplicability of the rules to advance refundings after July 8, 1996 and current refundings of obligations issued after that date is unwarranted, however, as is the rule that, for current refundings issued after the effective date of the Temporary Regulations, the new regulations must be elected in whole in order to be subject to the grandfathering rules.

The following comments apply to bonds issued to finance both generation and distribution facilities:

The provision regarding specific performance rights should be dropped or replaced with a rule similar to that contained in section 7701(e) of the Code relating to service contracts treated as leases.
There should be a significant safe harbor for short term contracts that do not in any real sense pass meaningful benefits of ownership or burdens of debt service.
The de minimis contract provision is inappropriate. The IRS instead should adopt the approach of the Proposed Regulations issued in 1994, which used a 1 percent test, but the rule should be limited to guaranteed payments and should be applied after first applying the generally applicable rules for determining which payments are allocable to which bonds.
The general rules relating to measurement periods require some modification as applied to output facilities.
It is essential that the regulations allow private use to be allocated to the equity financed portion of a facility. Otherwise the $15,000,000 limitation will not work as described in the legislative history. It is also important that a municipally owned utility ("MOU") be able to allocate system sales to the equity-financed portion of its system.
Purely financial contracts of the type described in this report should not affect bond financed facilities.
Options should be analyzed in accordance with their nature.

The following comments have broader application than simply to output facilities:

The $15,000,000 per issue limitation of section 141(b)(5), generally applicable to bonds issued under the 1986 Code, and applicable to grandfathered advance refundings of bonds for output facilities pursuant to section 1313(b)(5), should be subject to a multi-project rule as was the case under Notice 87-69.
Rules regarding refundings should allow measurement of use over the term of the refunding bonds, the original term of the refunded bonds, or the combined term, as long as the analysis of the refunding bonds is not inconsistent with the tax-exempt status of the refunded bonds.
The regulations should recognize that there may be anticipatory remedial action.
The "cliff" approach to remedial action leads to arbitrary and capricious results and should be abandoned.

The following additional comments relate to transition rules:

The change in use rules should not apply to bonds that are subject to the 1954 Code.
Where it is necessary to apply section 141(b)(4) to a refunding of bonds issued before the effective date of the regulations, the regulations should not be used to determine the non-qualified amount with respect to the prior issue unless the issuer elects to do so.
The requirement for an election in whole should not apply to election of the open access rules, to actions taken before the effective date of the regulations, or to bonds issued under the 1954 Code.