COMMENTS ON
REGULATIONS UNDER SECTION 141
OF THE CODE AS THEY RELATE TO OUTPUT FACILITIES
Introduction | Part I | Part Ia | Part Ib | Back to Contents
INTRODUCTION
The Committee has organized its comments by focusing on the particular functions of
output facilities rather than dealing with these subjects together the way they are
handled in the Temporary Regulations. Thus, after discussing the law prior to the 1986 Act
and the effects of that Act on output facilities, we deal first with the impact of the
Temporary Regulations on electric generation facilities, next on the treatment of
transmission and distribution facilities, and finally on provisions that deal with both
types of facilities. We recognize that this approach may result in some duplication and
overlap, but we believe it is useful to evaluate separately how the Temporary Regulations
deal with these different types of facilities.
Because the Temporary Regulations for the first time apply the general provisions of
the 1997 Final Regulations to output facilities, we also discuss the application of the
1997 Final Regulations.
BASIC CONCEPT OF USE AND EFFECT OF
1986 LEGISLATION
Under the regulations applicable under the 1954 Code ("the Subparagraph 5
Regulations" or "Subparagraph 5"), the standard for judging sales of output
was whether the use of the output had the effect of "transferring to non-exempt
persons the benefits of ownership of such facilities and the burdens of paying the debt
service on governmental obligations used directly or indirectly to finance such
facilities, so as to constitute the indirect use by them of a major portion of such
proceeds." Reg. §1.103-7(b)(5). The legislative history of the 1986 Act is
inconclusive, but we believe the better reading is that Congress did not intend to change
this test except to the limited extent specified in that legislation. The Temporary
Regulations, however, substantially change the meaning of the benefits and burdens test in
a restrictive way that has no parallel in other similar areas of tax law. Because we
believe this question of the interpretation of the effect of the 1986 Act on prior law is
so fundamental, we discuss it at some length.
Introduction | Part I
| Part Ia | Part Ib | Back to Contents
1954 Code
The industrial development bond provisions had their genesis in proposed regulations
that were published in the Federal Register March 23, 1968.1
These regulations predated the enactment of statutory provisions regarding industrial
development bonds. All of the examples of transactions contained in those proposed
regulations involved actual use of a facility through ownership or lease. Similarly, when
statutory industrial development bond provisions were enacted by Congress later that year,
the subject of concern was financing facilities to be leased to, or owned by, private
business. In the legislative history of those provisions, there was no suggestion that use
of the output of a facility constituted use of the facility or the bond proceeds.
Regulations proposed on January 13, 1969, similarly discussed only transactions involving
ownership or lease and did not address the use of output of facilities.
During 1970, the IRS received two ruling requests involving electric facilities. In
one, half the output of a nuclear plant was to be sold by a municipal utility at cost to
an investor-owned utility pursuant to a take or pay contract for most of the life of the
facility. PLR 7011120430A (Nov. 12, 1970).2
In the other, a very significant portion of the output of a generating facility owned by a
municipal utility was to be sold to a rural electric cooperative for an extended period of
time until the municipal utility needed the capacity, under a contract providing very
favorable terms to the cooperative and giving the cooperative management and substantial
control of the facility. PLR 7101260590A (Jan. 26, 1971).3
The IRS then published proposed regulations on June 5, 1971 that, for the first time,
provided that sales of output could result in use of an output facility and the proceeds
of the bonds issued to finance the facility. Under these proposed regulations, take and
take-or-pay contracts were described merely as examples of the type of contracts that
could pass the benefits and burdens to a purchaser. A copy of these proposed regulations
is attached as Appendix A. On July 15, 1971, a ruling was requested on whether a
requirements contract for sale of output from a municipal utility to a cooperative that
was its biggest customer, providing about 28 percent of its revenues, gave rise to
impermissible use. The contract was for a term of 16 years, with a further period of 18
years during which a fixed amount of energy was to be purchased. A favorable ruling was
issued. PLR 7108270510A (Aug. 27, 1971). The final Subparagraph 5 Regulations were issued
the following year. Those final regulations did not refer to take and take-or-pay
contracts as examples, but rather as the type of contracts that did pass the benefits and
burdens.
This background underscores the significance of the fact that in the final Subparagraph
5 Regulations the IRS limited private use to take and take or pay contracts (and certain
underlying arrangements). The combination of the issuance of a favorable ruling on a
requirements contract in PLR 71082270510A and the change from the June 5 proposed
regulations (which contemplated that various types of contracts could pass the benefits
and burdens) to the August final Subparagraph 5 Regulations, which were limited to only
take and take or pay contracts, makes clear that the IRS intended to cover only contracts
similar to ownership or lease.
Moreover, it should not be surprising that the Subparagraph 5 Regulations contain no
exceptions for short -term contracts or for arrangements entered into subsequent to the
issuance of bonds. Nobody thought they were relevant. As discussed above, each of the
ruling requests that had come before the IRS involved contracts in existence at the time
bonds were to be issued, each involved sales for a term at least approximating the life of
the bonds, each involved substantial obligations on the part of the purchaser and each,
except perhaps the requirements contract situation, involved substantial attributes of
ownership. The IRS had concluded long-term contracts were the problem4 and believed tax-exemption was
determined on the date of issuance.5
The IRS’s alteration of its position on change in use6
was more than 20 years away.
During the period leading to the 1986 Act, there were significant developments in the
concept of "use" in connection with other provisions of the tax law. For
example, property "used by" a tax-exempt or governmental entity was not eligible
for the investment credit. IRC §48(a)(4)-(5) (prior to repeal by section 211 of the 1986
Act). "Used by" had been limited by regulation to property "leased
by," Reg. §1.48-1(j)-(k), and some extremely liberal rulings had been issued under
those regulations.7
Similarly, property used in the trade or business of a public utility was public utility
property subject to limited investment credit and potentially restricted depreciation. IRC
§46(c)(3)(B), 46(f) (prior to repeal by Section 211 by the 1985 Act), IRC §168(i)(10).
These rules on tax-exempt use and use by public utilities stemmed from the same type of
policy considerations involved in section 103, namely that when the nexus between property
eligible for tax benefits and a person not entitled to those tax benefits becomes
sufficiently close, the benefits should not be available.
These concerns led to the enactment of section 7701(e) in 1984 to provide criteria to
determine when a transaction styled as a service contract or other arrangement is
sufficiently similar to a lease that certain tax benefits should be denied. Section
7701(e) applies for all purposes of the Code and provides a list of facts and
circumstances that should be analyzed in determining whether the tax benefits should be
denied. These factors include physical possession, control of the property, significant
economic or possessory interest (itself a multi-factor test, taking into account whether
the property is dedicated to the service recipient for a substantial portion of the useful
life of the property, whether the service recipient shares the risk if the property
declines in value or benefits if it appreciates or shares in operating economies or bears
the risk of loss of the property), concurrent use to serve multiple parties, the
relationship of the price for services to the rental value, and the risk to the service
provider of failure to provide the service. While this provision does not control for
purposes of section 103, it provides guidance as to what Congress considered relevant in
cases involving remarkably similar considerations, and the 1986 Act should not be
considered to depart radically from this type of standard without a very clear statement
of intent to do so.
Introduction | Part I
| Part Ia | Part Ib | Back to Contents
The 1986 Act and the Legislative History
The Conference Report to the 1986 Act stated with respect to the bond provisions:
As part of this reorganization, the present-law rules contained in Code sections 103
and 103A are divided, by topic, into 11 Code sections (secs. 103 and 141-150). The
conferees intend that, to the extent not amended, all principles of present law
continue to apply under the reorganized provisions. [emphasis added] Conference Report at
II-686.
Aside from changing the quantitative limits on private use, the only relevant
amendments that were made to the private use provisions were (1) to provide that use by
all persons other than governmental entities (as opposed to persons other than exempt
persons) and other than as members of the general public is to be taken into account
(section 141(b)(6)) and (2) to direct the Treasury to amend its regulations to eliminate
the requirement of a 3 percent guaranteed minimum payment (section 7703(i) of the 1986
Act.)
These very limited statutory changes do not provide any basis for a sweeping change in
the basic concept of the benefits and burdens test. Clarification that use by the general
public is not private use should not be construed as a very restrictive provision, but
rather simply as clarification of a safe harbor. This conclusion is reinforced by the
statutory structure: the statute provides that general public use is not private use, not
that all use other than general public use is private use.8
The IRS adopted this analysis in the 1997 Final Regulations, which provide not only that
use by the general public is never private use, but also that there are activities other
than use by the general public that are not private business use.
Similarly, the direction that the 3 percent rule be repealed should not be read as
meaning that all but the smallest or shortest contracts should be ignored. The 3 percent
rule excluded persons each of which paid "annually" a guaranteed minimum payment
not exceeding 3 percent of the average annual debt service. Thus, what was contemplated by
the Subparagraph 5 Regulations was that people would be counted who acting together each
paid "annually" over an extended period of time, the contract term, more than 3
percent of debt service. The rule was considered to be the equivalent of excluding persons
who took 3 percent of the nameplate capacity for the contract term. In fact, footnote 12
of the Conference Report states that:
The conference agreement directs the Treasury Department to modify its present
regulations (Treas. Reg. sec. 1.103-7(b)(5)) for determining the portion of an output
facility that is privately used to reflect the reduced limits on such use. Specifically,
the Treasury is directed to delete the special exception under which users of three
percent or less of the output of a facility are disregarded in calculating whether the
issue satisfies the trade or business use and security interest test. [emphasis added]
Conference Report at II-689.
It is not surprising that, in an environment where private use of a facility is limited
to 10 percent or $15 million of proceeds, persons taking 3 percent of the output for the
contract term under guaranteed payment contracts should not be ignored, but the enactment
of this directive should not be read as requiring anything more than a correlative
reduction in the limitation for exclusion of guaranteed purchasers.
Nonetheless, the legislative history of the 1986 Act contains conflicting and confusing
statements regarding narrow categories of transactions that fall into the general public
use category, namely pooling transactions and 30 day spot sales. We believe these examples
should be regarded as safe harbors rather than exclusive examples. The IRS appears to
agree because both in the Temporary Regulations and in the 1997 Final Regulations, as
noted, the IRS recognizes that there is use other than use as a member of the general
public that is not private use. The leadership of Congress apparently also agreed, as
evidenced by its approval of a non-conforming pooling arrangement for WPPS. Blue Book, n.
63 at 1164. This conclusion is supported by other legislative history indicating that
prior law concepts involving actual or beneficial use are to be continued. Thus, the House
Report states:
The general concept of use applicable under present law is retained under the bill.
Thus, as under present law, a person may be treated as a user of bond proceeds or
bond-financed property as a result of (1) ownership, or (2) actual or beneficial use of
the property pursuant to a lease, a management or incentive payment contract, or an
arrangement such as a take-or-pay or other type of output contract. House Report at 521.
The same general approach is stated in a slightly different form in both the Senate
Report and the Conference Report. Senate Report at p. 812; Conference Report at II-687-88.
We think this general background is relevant to our specific comments below because it
demonstrates that, in the 1986 Act, Congress intended only limited changes to the
definition of private use.
Introduction | Part I
| Part Ia | Part Ib | Back to Contents |