In late October 2015, the United States Department of the Treasury released comprehensive final regulations governing allocations and accounting under the “private activity bond” rules of Section 141 of the Internal Revenue Code. Section 141 of the Code generally restricts the amount of private business use of assets financed with tax-exempt governmental purpose bonds or qualified 501(c)(3) bonds and private payments made or security pledged with respect to debt service on those bonds. The final regulations are designed to address critical questions about how tax-exempt bond proceeds are allocated to assets for purposes of assessing compliance with the private activity bond rules.
The final regulations are generally applicable to bonds sold after January 24, 2016, and to so-called “deliberate actions” (such as sales or other dispositions of bond-financed assets) taking place after that date. In many cases, the provisions of the final regulations can be applied by issuers and borrowers to bonds sold on or before January 24, 2016.
Allocations to Mixed-Use Projects
One of the key features of the final regulations is the treatment of “eligible mixed-use projects” that will have a mix of uses by state or local governmental units (or, in the case of qualified 501(c)(3) bonds, by 501(c)(3) organizations carrying out their exempt missions) and by private business entities. Under the regulations, if an eligible mixed-use project is funded contemporaneously from multiple sources that include an issue of tax-exempt bonds and other financing sources (i.e., from “qualified equity” sources), it may be possible in some circumstances to allocate the private business uses of the project first to the “qualified equity” and only thereafter to the tax-exempt bonds.
Such an allocation methodology will be helpful to issuers and borrowers of tax-exempt bonds, as the portion of the project that is funded with qualified equity will not be constrained by the private activity bond limitations of the Code.
Partnership Treatment
Another highlight of the final regulations is the treatment of partnerships. Historically, federal tax law has taken two differing views of how partnerships should be treated for general tax accounting purposes. Under one view (known as the “entity theory”), a partnership is treated as an entity that is separate and distinct from its partners. Under the other approach (referred to as the “aggregate theory”), a partnership is characterized as simply an aggregate of its partners, each of whom has or owns some representative share of assets and income of the partnership.
Prior to the release of the final regulations, the possibility that the Internal Revenue Service would apply the “entity theory” to partnerships owning assets that have been financed with tax-exempt bonds has created some concern, because the partnership, as a separate and discrete entity, might not share the identity of its state or local governmental (or 501(c)(3) organization) partners. This in turn could lead to the conclusion that the partnership-owned assets financed by the bonds are being entirely “used” by a private business entity, contrary to the requirements of Section 141 of the Code.
The final regulations helpfully resolve this historical tension by endorsing the “aggregate theory” of partnerships for purposes of the private activity bond rules. Under this approach, if a partnership in which a state or local governmental unit (or a 501(c)(3) organization) is a partner—together with private business entity partners—owns an asset, the private business entities’ use of the asset will be measured on the basis of the greatest percentage share of certain specified partnership items (income, gain, loss, deduction, or credit) during the period in which the partnership owns the asset. The remaining percentage of use of the asset will be attributable to the governmental unit (or 501(c)(3) organization) and thus can be financed with tax-exempt bonds (assuming that the other applicable federal tax law rules, including those relating to qualified management contracts, are satisfied).
Anticipatory “Remedial Action”
The final regulations also clarify that issuers and borrowers can remediate an anticipated “deliberate action” that may cause the private activity bond limitations to be exceeded with respect to a bond issue. Issuers and borrowers generally will be permitted to do so in advance of such a deliberate action, by redeeming the allocable bonds (or creating a yield-restricted defeasance escrow), if they declare an intention to do so, identifying the bond-financed assets to which the anticipatory remedial action relates and describing the deliberate action that potentially may cause the applicable private activity bond limitations to be exceeded.
Practice Pointers
In light of these final regulations, several “good practice” points may be observed. First, as in the past, it will be critical to make a clear record of the specific assets, or portions of assets, that issuers and borrowers intend to finance with tax-exempt bonds. In addition, issuers and borrowers should be prepared to maintain detailed records regarding other funding sources that are used, together with tax-exempt bond proceeds, to finance assets. The same will be true with respect to any partnership arrangement that may touch bond-financed assets. And finally, as always, it will be important for issuers and borrowers to be mindful of the potential for a sale or other disposition of any asset that is financed in whole or in part with tax-exempt bond proceeds, and to take steps proactively, including seeking bond counsel’s advice, to ensure that those dispositions do not adversely affect the tax-exempt status of the bonds.
* * * * *
The preceding is a brief summary of Treasury’s final allocation and accounting regulations under Section 141 of the Internal Revenue Code. Please contact Antonio Martini directly at 617-378-4136, or any other member of Hinckley Allen’s Public Finance Practice Group for more information about these regulations, or if you have any other tax-exempt bond compliance matter you would like to discuss.