Comments on §141 Related to Output Facilities

Section of Taxation
Committee Comment: Tax Exempt Financing

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

APPLICATION OF SECTION 141(b)(5) (AS APPLICABLE TO OUTPUT FACILITIES THROUGH SECTION 1313(b)(5) OF THE 1986 ACT) TO MULTI-PROJECT ISSUES

Section 141(b)(4) of the Code imposes a $15,000,000 limitation on the nonqualified amount with respect to bonds outstanding to finance a "project." Section 141(b)(5) imposes a similar limitation (but only involving the volume cap) with respect to an issue. The question arises as to how section 141(b)(5) should be applied where one issue finances two or more projects. In Notice 87-69, the Service in effect provides that, in such a case, there would be a permissible non-qualified amount for each project, as follows:

(e) NONQUALIFIED AMOUNT, ETC. If proceeds of an issue (hereinafter referred to as the "multi-project issue") are to be used with respect to more than one project, section 141(b)(4), (5), and (8) of the Code are applied by treating the portion of the proceeds of the multi-project issue to be used with respect to each project as a separate issue; provided that, if any bond issued as part of the multi-project issue is thereby treated as a private activity bond, all bonds issued as part of the multi-project issue are treated as private activity bonds.

Under this rule, an issuer with two $100,000,000 projects, each with 10 percent private use, could finance both projects together without having to use volume cap. Without this rule, an issuer could still finance the two projects without using volume cap, but would have to finance the projects with two separate issues.

The rule of the Notice seems a sensible one, and because the rule provides that, if any bond issued as part of the multi-project issue is treated as a private activity bond, all bonds issued as part of the multi-project issue are treated as private activity bonds, the rule does not allow an issuer to bury an impermissibly large amount of private use for a project in a large issue.

Section 1.150-1(c)(3) provides a rule that is very similar to the rule of the Notice except that it explicitly excludes section 141(b)(5). It is understood that, when section 1.150-1(c)(3) was adopted, there was no intent to override Notice 87-69. Now that Notice 87-69 has been declared obsolete, however, we recommend that the exclusion of section 141(b)(5) be removed from section 1.150-1(c)(3) of the regulations.

COMMENTS REGARDING REFUNDINGS

Period for Testing Refundings

A large portion of the public power bonds currently outstanding and to be issued in the foreseeable future are refunding bonds, the treatment of which was reserved in the Final Regulations. The only guidance in the existing regulations is contained in section 1.103-7(d), which provides generally that "the proceeds of the refunding issue will be considered to be used for the purpose for which the proceeds of the issue to be refunded were used. The rules of this subparagraph shall apply regardless of the date of issuance of the issue to be refunded and shall apply to refunding issues to be issued to refund prior refunding issues." This regulation is ill equipped to cope with change in use and gives no guidance at all as to the application of the payment test.³² Thus, guidance is needed as to the proper treatment of these obligations.

Any regulation on this subject needs to deal with both measurement of use and payments over time, and changes in use. For example, it should be possible to issue a governmental bond to refund or advance refund a private activity bond provided that the private involvement has ended or been brought within allowable limits for governmental bonds.³³ Similarly, it should not be possible to issue exempt facility or other private activity bonds to advance refund governmental bonds. These examples suggest that use and payments should be measured only over the term of the refunding issue. Other examples, however, suggest that the entire term should be the measurement period. If the original issue is structured so that the permissible private use for the entire term is put into the front end of the issue, it should not be possible to refund and have additional private use in the second part of the financing. Similarly, if the original issue has no private use, the permissible private use after the refunding bonds are issued should not be limited by the shorter term of the refunding issue.

Finally, an issuer that originally front loaded its private use, but now wishes to issue refunding bonds with accelerated debt service because of concern about future competition should not be worse off than an issuer that simply retires an existing bond early. For example, an issuer that originally financed a facility with bonds having a 30 year term for normal business reasons, but who sells the first 3 years of output to a private user, is not precluded from retiring the bonds early because the measurement period is suddenly shorter. The result should be the same where the issuer issues shorter refunding bonds.

We suggest that the issuer should be able to test either the use during the period of the combined issue or during the term of the refunding issue alone, but that the ability to test the term of the refunding issue alone should be limited to those cases where the use during the period of the refunding would not adversely affect the status of the refunded bonds had they remained outstanding. In addition, we believe issuance of refunding bonds with shorter terms than the refunded bonds should not reduce the measurement period.

Application of Section 1.150-1(c)(3) to Refundings

This section allows an issuer to treat multipurpose issues as separate for most purposes except the $15,000,000 per issue limit of section 141(b)(5). We have previously suggested that it be amended to clarify that it does not change the express rule of Notice 87-69 allowing an issuer to bifurcate a multipurpose issue for purposes of that limitation. In addition, however, there is an issue with the effective date of the section 1.150-1(c)(3) multipurpose issue rule. The rule itself provides that "all allocations under this paragraph (c)(3) must be made in writing on or before the issue date." In addition, section 1.150-1(a)(2) provides that:

Except as otherwise provided in this paragraph (a)(2), this section applies to issues issued after June 30, 1993 to which § 1.148-1 through 1.148-11 apply. In addition this section (other than paragraph (c)(3) of this section) applies to any issue to which the election described in § 1.148-11(b)(1) is made.

While the purpose of this limitation is not clear, it probably was intended to prevent an issuer from claiming that a bond changed its nature after the fact. For example, an issuer might claim that bonds subject to the alternative minimum tax were partially governmental so a refund should be due on the governmental part. The rule could, however, be read to have unintended consequences in the case of a refunding.

Where an issuer wishes to refund a multipurpose issue where the election under -1(c)(3) was not made, either because the issue predated the effective date of the election and so the election was impossible, or because no election was considered necessary at the time of the issuance of the prior issue, it seems clear that there is no problem because the issuer can simply make the election with respect to the refunding. Where, however, the issuer only wishes to refund one portion of that prior issue, it would appear that literally no election can be made since the refunding issue itself is not a multipurpose issue. The absurdity of this result can be seen by following this interpretation to its logical conclusion. If, for example, an issuer wishes to refund the governmental portion of a prior issue, for purposes of the rule prohibiting advance refundings of a private activity bond, it can do so under section 1.149(d)-1(1). However, for other purposes, it would appear that, while the advance refunding could be tax-exempt, it would be a private activity bond and thus subject to the alternative minimum tax.

Section 1.150-1(c)(3) should be clarified to indicate that it permits partial refundings of prior issues that were not themselves the subject of an election.

COMMENTS REGARDING REMEDIAL ACTION

Rules Regarding Mandatory Redemption for Expected Intentional Action

Substantial Period of Time. Section 1.141-2(d)(2)(ii) provides that an action that is reasonably expected on the issue date may be disregarded if, among other things, the issuer is required to take remedial action when the action occurs and if the issuer reasonably expects, as of the issue date, that the financed property will be used for a governmental purpose for a substantial period before the action.

Since the rule does not apply when there is an arrangement with a non-governmental person as to private use of the issue date, we think a year (or perhaps even less) can be a substantial period of time.

Also, there are gaps between this rule and the general rule that an issuer must reasonably expect to meet the governmental use requirements for the entire term of the issue in that the mandatory redemption rule assumes the issuer has reasonable expectations that some identifiable intentional act will occur and when it will occur. The case where the issuer expects "something" to happen, but does not know what or when, is not covered. For the foreseeable future, that is the plight of issuers in the utility industry. In these cases the requirement that governmental use continue for a substantial period of time should be satisfied by an expectation that it will continue for an unknown period of time. This interpretation provides adequate protection against abuse since the mandatory redemption provision requires that there not be any arrangement with a non-governmental person regarding intentional action as of the issue date.

Special Rule for Reasonably Expected Mandatory Redemptions

Measurement Period. This rule provides that, if on the issue date the issuer reasonably expects that an action will occur during the term of the bonds to cause the private business or loan test to be met and is required to redeem bonds to meet the reasonable expectations test of 1.141-2(d)(2), the measurement period ends on the reasonably expected redemption date.

It appears that the reference to "reasonably expected redemption date" is a reference to expectations on the date of issue. Frequently, the redemption date will not be known. In such cases, the reasonably expected redemption date probably is a moving target and the burden is on the issuer to be sure that, at any given time, the cumulative private use is not so high as to exceed the limitation if the bonds have to be redeemed on the soonest reasonably expected date.

The Percentage of Nonqualified Bonds Should Exclude Permissible Private Use and Be Based on Use Over Time

The Temporary Regulations contain no special rules for determining the percentage of nonqualified bonds for output facilities. Under the general rule of section 1.141-12(j)(1), the percentage of outstanding bonds that constitutes nonqualified bonds "equals the highest percentage of private business use in any one year period commencing with the deliberate action." This rule is inappropriate for two reasons: first, it takes no account of permissible private use, and second, it bases the impermissible use on use during a measurement period that includes only the time after the deliberate act and only the worst single year within that period.

This approach can yield capricious results. For example, an issuer that sold 10 percent of the output of the facility for the 30 year term of a financing and then sold an additional 10 percent for one-year would be required to redeem 20 percent of the bonds although the private use was less than 11 percent over the term of the issue and the impermissible use under the law was only 1 percent. On the other hand, an issuer who sold 30 percent of the output for 10 years of the 30 year term and then sold 10 percent of the output for the last 20 years would be required to redeem only 10 percent of the bonds although the total private use was over 16 percent and the impermissible use under the law was six percent.

These arbitrary, contradictory results have been rationalized on the ground that the rule is justified given the generous approach to "use over time" in the new Final Regulations. Whatever virtue this justification may have for other bonds, it has no application to output facilities. Use of output facilities has always been determined over time. There is no suggestion in the 1986 Act or the legislative history thereof that Congress intended to change this approach. The IRS has recognized this lack of congressional intent in at least two private rulings.

Nonetheless, the measurement of use over time does involve special considerations with respect to the amount of nonqualified bonds. Where the percentage of private use in the early years exceeds the statutory percentage so that the use is permissible only because there is to be a lower percentage in the later years, that aspect must be taken into account in determining the nonqualified percentage. For example, assume an issuer finances an output facility over 30 years and sells 20 percent of the output for 15 years with $150,000,000 of bonds. In the 16th year , the issuer sells 10 percent of the output per year for the remaining 15 years. In this case the total private use of the bond proceeds is 15 percent. The nonqualified percentage of bonds should be five percent, but it should probably be applied against the original amount of bonds.

A similar approach should be applied to the $15,000,000 nonqualified amount rule. In the above example, if the original bond issue was $150,000,000, the original sale was within the $15,000,000 limit. The second sale increases the nonqualified amount to $22,500.000. Since the nonqualified amount is applied to the original amount of the bonds, the issuer would be required to take corrective action with respect to $7,500,000 of bonds.

Allocation of Disposition Proceeds

Section 1.141-12(c)(3) of the 1997 Final Regulations provide:

If property has been financed by different sources of funding, for purposes of this section, the disposition proceeds from that property are first allocated to the outstanding bonds that financed that property in proportion to the principal amounts of those outstanding bonds. In no event may disposition proceeds be allocated to bonds that are no longer outstanding or to a source not derived from a borrowing (such as revenues of the issuer) if the disposition proceeds are not greater than the total principal amounts of the outstanding bonds that are allocable to that property. [emphasis added]

Anticipatory Remedial Action. The rule that disposition proceeds may not be allocated to bonds that are no longer outstanding should not apply where, rather than taking deliberate action and then defeasing bonds, the issuer adopts a plan of retiring bonds early so as to be able to make private sales later.³⁴ In fact many MOUs are adopting plans to retire their debt early. This strategy should not be disadvantaged as compared to leaving the debt out (perhaps backed by a sinking fund) until the private transaction actually occurs. There may be other cases where an issuer acquires additional governmental property in anticipation of a disposition of property. We think there is little possibility of abuse of a rule that allows deliberate action to be cured by anticipatory remedial action as long as the remedial action meets the applicable requirements (such as retiring a strip or longer of the maturities) and the issuer documents the purpose of the remedial action. We do not believe, however, that the documentation requirement should apply to remedial action taken prior to any notice of such a requirement. We suggest an addition to Treasury Regulations section 1.141-12(I) as follows:

(3) if a remedial action is taken prior to the date that the deliberate action resulting in private business use or a private loan occurs, such remedial action will be treated as meeting the requirements of paragraph (d),(e) or (f) of this section if it would have met the requirements of one of those paragraphs if the deliberate action had been taken on the date the remedial action was taken and if the issuer documented its intention that the remedial action was taken in anticipation of the possibility of future deliberate actions that may result in the private business use or private loan tests being met. The documentation requirement shall not apply to remedial action taken prior to [the date the final regulations are final].

Allocation of Disposition Proceeds First to Obligations. The provision that requires an allocation of disposition proceeds first to borrowings (presumably including taxable borrowings) up to the amount thereof is bad policy to the extent it foreshadows a rule that requires an issuer to allocate private use of a facility financed with a combination of debt and equity first to the debt, or pro rata to the debt and equity.

TRANSITION RULES

The Change in Use Rules Should Not Apply to Bonds Subject to the 1954 Code

The change in use rules were developed in the early 1990s. Prior to that time, it was relatively settled law that eligibility for tax-exempt status was generally determined on the basis of arrangements in place or expected on the date of issue. See Rev. Rul 77-416. See also G.C.M. 36555, note 4, supra, which stated that it was long established policy to determine eligibility for tax-exempt status on the date of issue absent some scheme to pass on the benefits of the financing to a private party. Congress expressly reflected the notion that the determination is made on the date of issue in its discussion of the advance refunding rule of section 1313(b) of the 1986 Act. Thus, the Conference Report states:

Generally, the portion of the proceeds of the refunding bonds attributable to private use will be determined at the time the original bonds are issued. Similarly, in the case of a second advance refunding, this private use portion is determined by reference to the original bond issue, including bonds issued before 1986. However, if there is a change in facts or circumstances, not originally anticipated at the time of the original issuance, which alters the percentage of private use of the underlying facility, the percentage of private use of the refunding bonds is to take into account the change in circumstances. Thus, for example, if a governmental participant owner of an output facility sells a portion of its ownership interest in the facility to an investor-owned utility (which sale was not anticipated at the time of original issuance), the percentage of private use of refunding bonds issued after such sale must reflect the increased percentage of private use resulting from the sale. Similarly, if a private participant sells its interest to a governmental participant, the reduction in percentage also is to be taken into account in a later refunding issue. Conference Report at II-738,739.

Based on this legislative history, the change in use rules should not apply to 1954 Code bonds, a clarification that would go a long way toward solving the problems of the public power industry with respect to present and future excess power generation from large output facilities financed in the early and mid-1980s.

Electing the Regulations in Whole Should Not Be Required for Pre-existing Transactions

In these comments, we have generally attempted to identify cases in which the Temporary Regulations change existing law in such a manner as to create private use where none previously existed. In many instances, the effect of those changes will be to preclude election of the Temporary Regulations in whole because the election would be fatal to bonds already outstanding and future refunding bonds because of transactions that have already occurred. The reason for requiring the election in whole presumably is to encourage compliance with the requirements of the regulations along with allowing that which the regulations permit. Nothing can be done, however, about what occurred in the past. Therefore, we suggest that the requirement that the regulations be elected in whole not apply to transactions entered into before the effective date of the regulations.

Effective Date of Regulations for Purposes of Applying Sections 141(a)(4) to Refundings

Section 141(a)(4) requires that the nonqualified amount with respect to an issue and all prior outstanding issues not exceed $15,000,000. Where refunding bonds are issued under the Temporary Regulations, an issue arises as to how the nonqualified amount with respect to prior issues not subject to the Temporary Regulations should be determined, i.e., whether the nonqualified amount of the prior issue should be determined under the Temporary Regulations, notwithstanding that the Temporary Regulations did not exist at the time of the prior issue. We think the answer should depend on whether the issuer elects to apply the Temporary Regulations to the prior issue. For example, assume bonds were issued to finance half the cost of a facility prior to the publication of the Temporary Regulations and contractual arrangements were structured in such a manner as to allow the balance to be financed without exceeding the $15,000,000 limit. Now the issuer wishes to finance the balance of the cost and, under the Temporary Regulations, the nonqualified amount of the first issue would be greater than was expected. The nonqualified amount of the first (but not the second) issue should be determined without application of the Temporary Regulations unless the issuer elects to apply the Temporary Regulations to the prior issue.

Effective Date—Application to 1954 Code Bonds

There is an ambiguity in the effective date provision of both the 1997 Final Regulations and the Temporary Regulations regarding their application to refunding bonds that are grandfathered under section 1313 of the 1986 Act.

Under section 1.141-15(b), the 1997 Final Regulations apply to bonds issued on or after May 16, 1997 "that are subject to section 1301" of the 1986 Act. Section 1.141-15(c) provides that the Final Regulations do not apply to any bonds issued on or after May 16, 1997 to refund a bond to which the Final Regulations do not apply unless the weighted average maturity of the refunding bonds is longer than the weighted average maturity of the refunded bonds or, in the case of short-term financings such as bond anticipation notes, longer than 120 percent of the weighted average economic life of the facilities financed. Parallel provisions apply to the Temporary Regulations. Thus, under section 1.141-15T(f), the Temporary Regulations apply to bonds issued on or after February 23, 1998 "that are subject to section 1301" of the 1986 Act. With respect to refunding bonds, section 1.141-15T(g) provides that the Temporary Regulations do not apply to bonds issued on or after February 23, 1998 to refund bonds to which the Temporary Regulations do not apply unless the weighted average maturity of the refunding bonds is longer than the weighted average maturity of the refunded bonds, or, in the case of short-term financings such as bond anticipation notes, longer than 120 percent of the weighted average economic life of the facilities financed. In neither case is the application to refunding bonds explicitly limited to refundings to which section 1301 applies.

Under section 1313, current and advance refundings of bonds subject to the 1954 Code are not subject to section 1301 of the 1986 Act if, among other things, the 120 percent average life limit is met. Thus, where a refunding of a 1954 Code bond has weighted average maturity greater than that of the refunded bonds, the 1997 Final and the Temporary Regulations might be interpreted as applying, even though the weighted average maturity does not exceed the statutory 120 percent limit of section 1313. That this result was not intended is suggested by the provisions applying the 120 percent limit to refundings of short-term obligations. It would be most peculiar if refunding bonds with a term of 120 percent of the life of the assets financed could escape the Final and Temporary Regulations, if the refunded issue was short, whereas a refunding of a longer issue could not if it extended the maturity by even a day.

Moreover, to apply the Final and Temporary Regulations, with their myriad rules that had no counterparts under the 1954 Code, to refundings grandfathered by Congress would clearly violate legislative intent. Congress provided the exemption from the limitations of section 1301 of the 1986 Act. The IRS should not take that exemption away by regulation without authority from Congress to do so. The Final and Temporary Regulations should be clarified to limit their mandatory application to refunding bonds issued after the relevant date that not only extend maturity, but that also are subject to section 1301 of the 1986 Act.

Election of Regulations in Whole—Should Not Apply to 1954 Code Bonds

A large portion of the public power bonds currently outstanding are bonds governed by the transition rules of section 1313 of the 1986 Act. Many of the rules of the Temporary Regulations are different than those under which such financings were structured. An issuer of such bonds wishing to take advantage of provisions such as the stranded cost rule or the open access rule (in the latter case with respect to bonds issued after May 23, 1998) cannot be reasonably expected to have complied with all of the new rules of the new Regulations, many of which are specific to the 1986 Act or its legislative history, and are not applicable to those grandfathered transactions in any event. Thus, the requirement for electing in whole should not apply to these bonds.

Cross Reference to Discussion of Other Transition Provisions

At page 21 we discuss the need to broaden the transition rule for requirement contracts if the new rule is retained. At pages 50–57 we discuss the transition provisions relating to open access to transmission.