Use by the ISO. When an MOU cedes control of its transmission facilities to an ISO, a number of questions are raised under the Temporary Regulations, including (i) whether the ISO is a user of the transmission grid, (ii) if so, the portion of the grid that the ISO is considered to use, and (iii) how to apply the grandfathering provisions. First, it should be noted that only transmission facilities are transferred to an ISO and distribution facilities should be unaffected by the transfer of the transmission facility to the ISO.

Second, to require the ISO to be a governmental entity or a 501(c)(3) organization (and that all future transmission facilities be financed with 501(c)(3) bonds) does not seem to further any particular federal policy. Most ISOs will clearly be not-for-profit organizations performing a quasi-governmental function. An ISO’s function with respect to transmission facilities under its mandate is entirely regulatory, so that it should not be treated as the user of the transmission grid. The ISO’s "use" of transmission facilities is analogous to the air traffic controllers’ "use" of airports. Air traffic controllers are federal employees (the federal government is not an exempt person), who regulate the use of airports and airways, controlling all traffic on them. There is no "contract" between the air traffic controllers and the airports that are qualified management contracts; the air traffic controllers’ use is statutorily mandated control. They control the use of the runways, but are not treated as users of them any more than the ISO should be treated as a user of the transmission grid.²⁶

Contracts between the ISO and the municipal user are state mandated arrangements pursuant to which the ISO controls the delivery of power across the transmission facilities, but the responsibilities of construction and maintenance are the MOU’s. Therefore, whether the "management contracts" between the ISO and the transmission owners meet the criteria established for determining whether a private party is a user of a hospital or manufacturing facility does not seem an appropriate standard. Arrangements with the ISO should not be treated as private use whether the ISO happens to be a governmental entity, a 501(c)(3) organization or simply a non-profit organization.²⁷ The ISO will own and operate its own computer systems and is a user of them, so that its access to tax-exempt financing for its facilities depends on its status. However, applying the management contract rules to conclude that the ISO is a user of the transmission wires, even though it has no economic interest in them, is no more appropriate (the consumer pays for the ISO’s services based on the energy used) than concluding that air traffic controllers use airport runways.

Example 5 of section 1.141-7T(h). In Example 5 of section 1.141-7T(h), it is determined that the management contract with the ISO did not meet the management contract rules. It is not clear in the example what fact(s) caused the arrangement to fail to meet the management contract rules. The example states that "the functions of the ISO include control of transmission access and pricing, scheduling transmission, control of operations in settlements and billing. In addition, under certain circumstances it may order the transmission owners to construct additional transmission facilities." The conclusion was that the "operation of the financed facilities by the ISO does not meet the exception from management contracts that do not give rise to private business use…because it is not a contract solely for the operation of the facility under the exception." It is not clear why the contract was not solely for the operation of the facility. Mandated construction of additional transmission likely could only occur if the ISO were a governmental entity or acting on a governmental entity’s behalf. In fact, the ISO may be able to have transmission facilities built on its own behalf, but it normally cannot mandate a transmission owner to build more facilities without the ISO paying for them. In addition, an ISO would not normally control pricing. The pricing is calculated on a regulated basis based on a statutory scheme. The ISO described in the example could only fail to be a manager if it were instead a governmental entity or acting as agent for a governmental entity. Its pricing control was not intended to generate either a profit for itself or the transmission owner or a subsidy for the consumer. Again, attempting to apply the management contract rules to a situation for which they were not intended seems in error. The management contract rules were not designed to answer questions concerning this type of arrangement and should not be applied to do so.

At a minimum, if a state wishes to create an ISO to meet a "management contract" limit, it would not know how to do so under the Temporary Regulations. If a "management contract" limitation is to be applied, it should be no more restrictive than the management contract limitation for other facilities, and the regulations should explicitly state what, if any, problem is posed by the contract in Example 5.

Section 1.141-7T(f)(5) – Special Exceptions For Transmission Facilities. The Temporary Regulations provide that entering into a contract for the use of transmission facilities²⁸ does not constitute a deliberate action if it is in response to (or in anticipation of) an order of the United States under Section 211 of the Federal Power Act or a state regulatory authority under provisions of state law provided certain conditions are met. This provision is intended to protect outstanding tax-exempt bonds (as well as current refundings that do not extend average life).

The Open Access Provisions Are Valid Regulations. On June 25, 1998, the chief of staff of the Joint Committee on Taxation, Lindy L. Paull, wrote to The Honorable Bill Archer, Chairman of the Committee on Ways and Means of the House of Representatives, concluding that "the Code and legislative history accompanying the 1986 Act contains no provisions to support the special exceptions contained in the Regulations allowing public power to enter into arrangements that would be treated as private business use for other issuers of tax-exempt bonds."

The letter states:

"Both before and after 1986, the Treasury Department administratively has provided alternative sanctions to retroactive loss of tax-exemption for post-issuance changes in use in certain cases when the change was not reasonably expected at the time the bonds were issued. These alternative sanctions require immediate surrender of the benefits of tax-exempt financing by redemption of outstanding bonds, or if immediate redemption is precluded by pre-existing bond terms, by immediate defeasance of the bonds through establishment of an escrow account funded with taxable debt accompanied by redemption on the first possible date."

If, as the context suggests, this statement was intended to refer to governmental bonds, it is flatly incorrect as to the situation in 1986. Moreover, there is nothing in the legislative history of the 1986 Act requiring the rule stated in the letter as to governmental bonds.

Prior to 1986, in certain cases involving bonds for private housing and small issue IDBs, and in the case of violations of information reporting and arbitrage rebate requirements, Congress had specifically provided that bonds would become taxable if action was not taken. In addition, in cases where 90% of proceeds of IDBs were to be spent on prescribed types of costs and were not, the IRS indicated that it would not challenge the exemption on the bonds if certain requirements, including early redemption, were met, e.g., Rev. Proc 79-5, 1979-1 C.B. 485. Finally, the IRS had ruled that certain deliberate acts to create arbitrage caused retroactive taxability, as to which no defeasance or redemption solution existed. The alleged rules described in the Joint Committee letter, however, were never generally applicable to public power bonds or other municipal governmental or exempt facility bonds prior to a change in Treasury policy in 1993.

The seminal authority on the effect of changes in use of output facilities on governmental bonds that finance the facilities is Revenue Ruling 77-416, which remained in effect until 1993. In that ruling, an MOU, which had expected to use its municipal utility system indefinitely at the time bonds were issued, decided to sell the system because of unforeseen changes in circumstances. The ruling concluded that this sale would have no adverse effect on the exclusion from income of interest on the bonds, notwithstanding that the bonds were defeased and would remain outstanding until maturity. Contrary to the statement in the Joint Committee letter, no requirement was imposed that the bonds be called at their earliest call date or otherwise prematurely removed from the market.

The rationale for this ruling is stated in GCM 37158 (June 13, 1977). In approving the conclusion proposed for Rev. Rule 77-416, the General Counsel of the IRS stated:

As a general matter the long standing Service position has been against altering a bond’s Code §103(a)(1) tax status due to subsequent sale of securing property. Of course, subsequent to the 1968 amendments that restricted the circumstances in which exemption of interest under Code §103 (a)(1) is allowed, efforts to circumvent these restrictions are more likely.

* * *

Code §103(b)(2)(A) and Treas. Reg. §1.103-7(b) define an industrial development bond as an obligation, "which is issued as part of an issue call, or a major portion of the proceeds of which are to be used directly or indirectly in any trade or business carried on by any person who is not an exempt person. There is, then, on the face of the statute, a strong implication that bonds are characterized as industrial development bonds (or not) at the time of issue.

* * *

Ultimately, an examination of legislative history provides a more convincing answer. Sen. Ribicoff, the sponsor of the industrial development bond provisions in the Senate, referred to industrial development bonds as "…corporate bonds [in which] the local government’s involvement is often little more than a sham," and as a "device or gimmick for allowing industrial corporations to claim the benefit of the lower interest rate…" Sen. Ribicoff went on to state:

The tax-exemption of State and local government bonds was originally intended to help our State and local governments meet these [government facility] needs at the lowest possible cost The federal tax-exemption was not intended to permit U.S. Steel, Armco Steel and other major corporations to gain tax advantages at the expense of other taxpayers. It was not intended to permit such private corporations to drain investment funds away from schools, hospitals, roads and other public facilities. In short, it was not intended as a method of permitting corporations to finance corporate facilities on a tax-exempt basis. [Debates, H.R. 156414, Revenue and Expenditure Control Act of 1968, 90th Cong., 2nd Sess., March 28, 1968, P.S. 3547]

We believe that the facts in the instant case clearly indicate that the transaction herein is a legitimate, non-prearranged sale, lacking any indication of being a "sham" or "gimmick" to obtain low cost financing. The City has owned and operated its system for some years, with the original intent to do so indefinitely; the obligations have been issued at various times since 19553 and the recent dramatic increases in fuel costs present an unforeseen intervening situation which would reasonably cause the City to alter its original intent to continue operating the plant. [footnotes omitted]

No one would suggest that compliance with national policy of open access to transmission and electric facilities constitutes a "sham" or a "gimmick."

The IRS still followed the holding of Rev. Ruling 77-416 at the time of the 1986 Act and continued to follow it thereafter. In fact, the IRS issued at least 17 private letter rulings approving continued exemption of bonds following a change in use. PLR 8747043 (Aug. 26, 1987), 87470029 (July 7, 1987), 874008 (Aug. 11, 1987), 8737021 (June 12, 1987), 8606018 (Nov. 7, 1985), 8544048 (Aug. 5, 1985), 8509094 (Dec. 6, 1985), 8509089 (Dec. 5, 1985), 8313016 (Dec. 22, 1982), 8312123 (Dec. 23, 1982), 8304074 (Oct. 26, 1982), 8236047 (June 9, 1982), 8204166 (Oct. 30, 1981), 8152099 (Sept. 30, 1981), 8124019 (Mar. 17, 1981), 8008184 (Nov. 30, 1979), 7917074 (Jan. 25, 1979). See also 9002031 (Oct. 16, 1989) (Rev. Rul. 77-416 followed, but requirements not satisfied). Only two of these rulings involved a statement that bonds would be called prior to maturity, and there is no indication that the early call was a requirement. See PLR 8544048, supra, 8509089, supra.

Most of these rulings contained language along more or less the same lines:

In Rev. Rul. 77-416, 1977-2 C.B. 14, the Service considered a transaction in which a city proposed the sale of a facility financed by bonds, the interest on which was exempt from taxation under section 103(a) of the Code. At the time of the proposed sale the city had operated the facility for many years. However, unforeseen changes in economic conditions had rendered the city’s continued operation of the facility unfeasible. The terms of the sale dictate that it was an arms length transaction. The facts surrounding the sale did not indicate that the transaction was a mechanism to transfer the benefits of tax-exempt financing to the purchaser.

In this case, continued deterioration of the Hospital’s financial condition has necessitated another change in the operation of the facility. The circumstances surrounding this change do not indicate that it is a mechanism to pass on the benefits of tax-exempt financing to a nonexempt person. Therefore, we conclude that the Hospital’s engagement of the Partnership through the management agreement and the consummation of the transactions contemplated in the agreement will not adversely affect the tax-exempt status of interest on the Bonds.

Thus, at the time of the 1986 Act there was clearly no general rule that bonds had to be called following a change in use, although the Code did contain certain provisions that provided for bonds becoming taxable (failure to meet certain requirements for single or multifamily housing bonds, violation of the capital expenditure limitation for small issue bonds, violation of the test period beneficiary rule for small issue bonds) and the IRS had ruled that bonds could become taxable arbitrage bonds because of intentional acts that were in substance actions taken in bad faith. The Conference Report to the 1986 Act recognized this:

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. [emphasis added] Conference Report at II-733.

The only change made to this regime was to codify the rule that intentional arbitrage would cause bonds to become taxable. Code section 148(a)(1). A close reading of all the statements in the legislative history regarding bonds becoming taxable indicates that they all refer to the above-described provisions, provisions that were not enacted, special situations being addressed for the first time by Congress, or the arbitrage provision. Set forth in Appendix B are all the references in the legislative history of the 1986 Act to bonds that were originally tax-exempt later becoming taxable. Thus, the legislative history of the 1986 Act does not support a rule that requires the issuer of governmental bonds for output facilities to call bonds when there is an unanticipated change in use as a result of bona fide reasons such as a change in national energy policy. In fact, the legislative history of the $15,000,000 volume cap requirement for output facilities supports the conclusion that bona fide, unexpected changes after bonds are issued are disregarded by stating that changes in expectations that arise before bonds are issued must be taken into account. Conference Report at II-739. See also Blue Book at 1195 and discussion below under "The Change In Use Rules Should Not Apply to Bonds Subject to the 1954 Code" at p.         .

We note that the transition rule for open access is not the only provision of the regulation under which subsequent acts can be disregarded. Under section 1.141-2(d)(5), subsequent acts of many general obligation issuers can be disregarded.

Accordingly, while the IRS may or may not have the authority to impose a change in use rule that requires accelerated retirement of bonds, the IRS clearly has the authority not to impose such a requirement in cases where the change in use results directly from a change in national policy.

In addition, extending the provision to current refundings is clearly within the authority of the IRS. For 27 years the regulations have provided that in a refunding the proceeds of the refunding issue are deemed to be used for the purpose for which the proceeds of the refunded issue were used. Reg. § 1.103-7(d). Further, preventing a current refunding of this type would merely prevent a reduction of the amount of tax-exempt interest being paid.

Part VII | Part VIIb | Part VIIb2 | Part VIIc | Part VIId | Part VIId3 | Part VIIe | Part VIIf

Technical Comments – Section 1.141-7T(f)(5)(i)(B). Temporary Regulations section 1.141-7T(f)(5)(i)(B) requires that, in order to be disregarded as a deliberate action, the contracts must be bona fide and arm’s length and the consideration paid must be consistent with the Federal Power Act. These requirements are neither clear nor necessary. There is no reason to believe that contracts would not be bona fide, at arm’s length and consistent with the provisions of the Federal Power Act. As the requirements are written, however, bona fide arm’s length contracts consistent merely with state law would not qualify. At a minimum, the provision should allow for contracts which are consistent with state law provisions.

Section 1.141-7T(f)(5)(ii)–Actions Taken to Implement Nondiscriminatory Open Access. This provision appears to be intended, based on Example 5 of section 1.141-7T(h), to permit the transfer of control of transmission facilities to an ISO or other open access arrangements without adversely affecting the tax status of outstanding bonds issued to finance the transferred facilities.

Section 1.141-7T(f)(5)(iii)–Application of Reasonable Expectations Test to Refundings. This section provides in significant part that an action is not taken into account as a deliberate act under the reasonable expectations test for an issue if "(B) The bonds of the issue are current refunding bonds that directly or indirectly refund bonds issued before July 9, 1996…." Given the novelty of the Temporary Regulations and the numerous bonds issued based on prior law, this rule should extend to advance as well as current refundings, as was the case in section 1313 of the 1986 Tax Act.

In addition, the July 9, 1996 date should be amended to February 23, 1998. Bonds issued to finance transmission facilities between July 9, 1996 and February 23, 1998, should be permitted to be refunded. There seems no federal policy reason to impose new restrictions on bonds which met the reasonable expectations test at the time such bonds were issued. Note that the July 9, 1996 date has no clear relevance to action taken pursuant to state regulations. Absent an extension of maturity, such refundings normally are undertaken solely to reduce interest rates (a requirement of reduction in interest rates could be imposed) and no federal purpose is served by preventing such refundings. The lack of notice of the terms of the provisions is apparent.

Further, for refunding bonds issued after February 22, 1998, an issuer should be permitted to elect to apply these provisions of the Temporary Regulations without opting into all the other novel rules contained in the Temporary Regulations. This approach is necessary because many of the refunding issues will involve generation as well as transmission facilities, and it will be impossible in many cases to comply with the new rules as a result of actions taken in the past.

In addition, the Temporary Regulations should be amended to provide that commercial paper programs that had not elected single issue treatment under section 1.150-1(c) of the Regulations should nonetheless be treated as having the same maturity as if such an election had been made.