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Overview of final private activity bond tax regulations.

Internal Revenue Code Final Regulations, which broadly affect governmental tax-exempt bonds, focus on the level of permissible private business involvement in a bond issue.

Introduction

This article provides an overview of selected aspects of the recent final private activity bond tax regulations under Section 141 of the Internal Revenue Code (the "Final PAB Regulations").(1) These important rules broadly affect governmental tax-exempt bonds. They focus on the level of permissible private business involvement in a bond issue. Bonds are classified as private activity bonds if they meet a two-part 10 percent private business use test and private payment or security test, or a separate private loan test. Except for tax-exempt financing for certain specific private facilities (e.g., certain exempt facilities, housing mortgages, small issue manufacturing facilities, and certain 501(c)(3) nonprofit organization facilities), tax-exempt bonds generally may be issued only for governmental purposes and are taxable if the level of private business involvement causes them to be private activity bonds. Thus, the goal typically is to fail to be a private activity bond.

Effective Dates and Unfinished Parts. In general, the Final PAB Regulations apply prospectively to bonds issued on or after May 16, 1997. An issuer may elect to apply the Final PAB Regulations in whole, but generally not in part, to outstanding bonds issued earlier. An issuer also may elect to apply certain specific provisions individually to earlier outstanding bond issues, including those on permitted private management contracts, change of use remedies, and research agreements.

Certain parts of the Proposed PAB Regulations were not finalized, including those for output contracts (e.g., electric power contracts) and mixed-use facility allocations. These reserved parts are understood to be well underway.

Selected Highlights. Overall, the Final PAB Regulations adopt more workable standards than previous guidance in many areas. Selected positive highlights include

* more flexible standards for testing private business use, based on ownership, leasing, special legal entitlements to general public use property (e.g., roads), and special economic benefits from property unavailable for general public use (e.g., prisons);

* consideration of private management contracts under all the facts and circumstances, together with broad new safe harbors under Rev. Proc. 97-13 which permit qualified private management contracts for up to 15-year terms at 95 percent fixed fees or up to 10-year terms at 80 percent fixed fees (and 20-year terms in each case for public utility property);

* a broader general public use exception to private business use which focuses on intended and actual 'reasonable availability for use by "natural persons" (regulation code word for human beings);

* a more sensible measure of private business use which generally looks at average use over the entire term of the bond issue;

* more flexible treatment of facilities that can qualify for a general public use exception, including favorable examples for certain airport runways, airport parking, and isolated road facilities;

* more workable treatment of tax assessment bonds, including deletion of certain proposed rules which negatively impacted developer agreements in these financings; and

* change of use remedies which are more workable in certain respects and which permit certain eligible bonds with up to 10 [degrees]-year call provisions to be defeased without further action such as tender offers.

On the other hand, however, the Final PAB Regulations are notable for the sheer number of rules and their complexity. Selected negative highlights include

* a more restrictive private payment or security test, which broadly counts certain payments on tax-exempt bond-financed property during periods of private business use even if not made by a private business user;

* some harsh eligibility conditions on otherwise favorable special rules (e.g., the myriad conditions on the special rule for certain large general obligation bond programs for more than 25 purposes) that limit their usefulness in practice;

* various detailed accounting rules that limit state and local government flexibility;

* restrictive treatment of issuer equity used for facilities partially financed with tax-exempt bonds;

* a restrictive condition to the change of use remedies which effectively limits the available remedy to redemption of all nonqualified bonds when an issuer reasonably expects, on the issue date, that the bonds will exceed the private activity bond limits at any time during the entire term of the bonds;

* restrictive treatment of installment sales of bond-financed facilities under the change of use remedies; and

* a restrictive measure of the amount of "nonqualified bonds" for which certain change of use remedial actions need to be taken.

Overview of PAB Tests

Section 141(a)(1) defines a "private activity bond" issue to include an issue in which both of the following tests are satisfied (together, these are called the "private business tests"):

* private business use test: more than 10 percent of the bond proceeds are to be used, directly or indirectly, in a trade or business of any person other than a state or local governmental unit and

* private payment or security test: the payment of the principal of, or the interest on, more than 10 percent of the proceeds of the bond issue is (under the terms of the issue or any underlying arrangement) directly or indirectly: 1) to be derived from payments (whether or not to the issuer) in respect of property, or borrowed money, used or to be used for a private business use or 2) secured by any interest in property used or to be used for a private business use or payments in respect of such property.

Subsequent sections of this article discuss these two tests in greater detail.

Separate Private Loan Test. Section 141(a)(2) independently treats bonds as private activity bonds if more than the lesser of 5 percent or $5 million of the bond proceeds are to be used, directly or indirectly, to make or finance loans (excluding certain permitted tax assessment loans) to nongovernmental persons (the "private loan test"). Private loans may arise even if there is no private business use at all (e.g., consumer loans).

The Final PAB Regulations provide that bonds may be private activity bonds if either 1) the issuer reasonably expects, as of the issue date, that the bonds will meet the private activity bond tests over the stated term of the issue or 2) the issuer takes a deliberate action, after the issue date, that causes the bonds to fail the private activity bond tests. This standard basically is an "actual facts" test for actions within an issuer's control. Several special rules temper these standards, but they are tricky and have many conditions.

A special rule permits an issuer to disregard an action that is reasonably expected as of the issue date and that otherwise would violate the private activity bond tests if, as of the issue date, the issuer 1) reasonably expects to use the financed property for a substantial period of time (undefined), 2) is required to redeem all nonqualified bonds within six months of the action, 3) has no arrangement with a private business as of the issue date regarding the action, and if 4) the mandatory redemption meets the general conditions for change of use remedies. This special rule sensibly allows bond redemption to cure expected, but unpredictable, future private involvement. It seems harsh in requiring the bond redemptions in amounts in excess of disposition proceeds received.

A special safe harbor disregards an action that is either an involuntary or compulsory conversion under Section 1033 or a response to a federal regulatory directive. For example, this special rule might cover Federal Energy Regulatory Commission (FERC)-mandated wheeling of electricity to private utilities. Treasury and the Internal Revenue Service (IRS) are considering whether to extend this exception to cover state regulatory initiatives.

A helpful special rule disregards certain dispositions of personal property in the ordinary course of an established governmental program. A transaction qualifies if 1) the weighted average maturity of the applicable bonds is not greater than 120 percent of the reasonably expected actual governmental use of the property, 2) the issuer reasonably expects on the issue date that the fair market value of the property on the disposition date will not exceed 25 percent of its cost, 3) the property is no longer suitable for its governmental purposes (e.g., old police cars), and 4) the issuer deposits the disposition proceeds in a commingled fund with substantial tax and other governmental revenues and reasonably expects to spend those amounts within six months thereafter.

Another special rule permits a general purpose governmental issuer that issues general obligation bonds for certain programs that finance at least 25 purposes (but that do not "predominantly" finance fewer than four purposes) to rely solely on reasonable expectations as of the issue date for private activity bond compliance, without regard to future actual use of bond proceeds (except for a new "spot check" verification procedure). This special rule may ease private business tracking for an issuer who can hurdle its myriad eligibility conditions. Those conditions, however, are so cumbersome that they make the rule largely unworkable in practice.

Private Business Use Test

In General. The private business use test generally is met if nongovernmental persons ("private businesses") directly or indirectly use more than 10 percent of the proceeds of a bond issue or bond-financed property in the aggregate. Private businesses include any persons besides state or local governmental units, including 1) the federal government; 2) 501(c)(3) organizations; and 3) any other persons or entities, whether or not incorporated, that carry on a business. Unless a specific exception applies, the Final PAB Regulations treat a person as a private business user of bond-financed property based on ownership, leases, nonqualified management contracts or incentive pay contracts, certain output contracts (but do not make these rules final), or a catch-all category of certain other actual or beneficial uses based on either "special legal entitlements" to property available for general public use or "special economic benefits" from other property. Although the scope of these new catch-all standards is somewhat vague, on balance the Final PAB Regulations provide fairly workable standards for the private business use test.

Ownership. Private business ownership of bond-financed property for general federal income tax purposes is private business use.

Leases. A private business lease of bond-financed property for general federal tax purposes is private business use. This determination considers, among other facts and circumstances, the following: 1) the degree of private business control over the property and 2) whether the private business bears risk of loss on the property.

Management Contracts. The Final PAB Regulations provide liberalized rules and new safe harbors on private management contracts. This liberalized guidance may assist privatization of operations of appropriate tax-exempt bond financed facilities. The determination of whether a private management contract causes private business use is based on all the facts and circumstances. In general, a management contract causes private business use if it provides for any compensation based on net profits from the operation of the facility.

The Final PAB Regulations provide the following specific management contract exceptions to private business use:

* incidental service contracts: service contracts solely incidental to a financed facility's primary governmental function (e.g., janitorial, office equipment repair, hospital billing, or similar services);

* hospital admitting privileges: mere granting of admitting privileges by a governmental hospital to a doctor, subject to certain conditions;

* expense-sharing arrangements for public utility property: a service contract to operate predominantly public utility property if the only compensation is the reimbursement of actual and direct expenses of the service provider and, in a helpful expansion, reasonable administrative overhead expenses; and

* other expense-sharing arrangements: a service contract in which the only compensation is the reimbursement of the service provider for actual and direct expenses paid by the service provider to unrelated parties.

New Management Contract Safe Harbors. Notably, the IRS issued new liberalized private management contract safe harbors in Rev. Proc. 97-13.(2) These new safe harbors permit 15-year contracts for 95 percent fixed fees and 10-year contracts for 80 percent fixed fees, subject to an 80 percent useful life limitation (with 20-year contracts permitted in each case for certain public utility property).(3) A subsequent article in the next issue of Government Finance Review will examine these new safe harbors in detail.

Output Contracts. The Final PAB Regulations do not provide final rules on when output contracts (e.g., take-or-pay contracts for electricity generation) cause private business use. The IRS and Treasury are considering further the potential dramatic effects of deregulation in the electric power industry.

Research Agreements. The Final PAB Regulations adopt a facts-and-circum-stances test to determine whether a private business-sponsored research agreement causes private business use. The IRS also issued new research safe harbors in Rev. Proc. 97-14,(4) which expand covered basic research modestly to include any original investigation for the advancement of scientific knowledge not having a specific commercial objective, including such research in the social sciences, arts, and humanities.

Special Legal Entitlements to General Public Use Property. For bond-financed property that is available for general public use, a catch-all rule under the Final PAB Regulations provides that private business use arises when a private business has special legal entitlements to beneficial use of the property. This treatment of general public use property is a notable positive highlight of the Final PAB Regulations. This special legal entitlement standard generally seems workable in that it looks to objective legal rights granted to private businesses to use bond-financed facilities.

Special Economic Benefits from Nongeneral Public Use Property. For bond-financed property that is unavailable for general public use, a catch-all rule under the Final PAB Regulations provides that private business use arises more broadly when a private business receives special economic benefits from the property, based on all the facts and circumstances. Factors which expressly weigh towards private business use under this standard include 1) a functional relationship or physical proximity of the bond-financed property to other private business use property, 2) a small number of private businesses receiving the special economic benefit, and 3) the cost of the property being depreciable by a private business. Overall, the scope of this special economic benefits standard seems somewhat vague and will need to be developed through future interpretation.

Private Business Use Exceptions

In General. Specific exceptions to private business use under the Final PAB Regulations include 1) general public use (e.g., road users); 2) use as an agent of a governmental unit; 3) use solely incidental to financing arrangements (e.g., nominal private ownership in sale-lease backs to governmental lessees); 4) certain short-term, nonownership uses; 5) certain temporary use by developers; 6) certain, mostly nonpossessory, incidental uses of up to 2.5 percent of proceeds; and 7) certain qualified improvement uses.

General Public Use Exception. The Final PAB Regulations provide an important liberalized general public use exception to private business use. Use generally qualifies as general public use if the property is both intended to be available and is in fact reasonably available for use either free or at generally applicable and uniformly applied rates by natural persons who are not engaged in a trade or business for a period not to exceed 180 days.

Priority rights or preferential benefits are impermissible. A special rule treats rates as generally applicable and uniformly applied even if 1) different rates apply to different classes of users, such as volume purchasers if the differences are customary and reasonable, or 2) a specially negotiated rate applies because federal law prohibits a generally applicable rate and the rates are reasonably comparable (e.g., certain federal contract uses).

In an interesting reversal of a prior position, the Final PAB Regulations have an example which treats use of an airport runway as general public use under certain circumstances. To qualify, however, the private airline terminal leases cannot be measured on a "residual" basis to take into account runway landing fees.

Agents. Private business use excludes a private business' use solely as an agent for a governmental unit.

Use Incidental to Financing Arrangements. Private business use excludes certain use solely incidental to financing arrangements (e.g., certain sale-leasebacks to governmental lessees).

Certain Short-term Uses. The Final PAB Regulations provide two revised short-term use exceptions. One exception covers certain arrangements involving terms of use, including all renewal options, of not more than 90 days in the aggregate, of property unavailable for general public use, but at generally applicable or uniformly applied rates (e.g., certain arrangements for federal use of prisons). A second exception covers certain arrangements for terms of use, including renewal options, of not more than 30 days in the aggregate, at arm's length, negotiated fair market value compensation. These exceptions focus on the aggregate term of use, not the term of the contract. They generally seem helpful and should cover a fair number of rate-scale use arrangements, particularly for facilities like convention centers.

Temporary Developer Use. Private business use excludes temporary developer use of essential government function improvements during an initial development period. The issuer and the developer must reasonably expect on the issue date to proceed with all reasonable speed to develop the improvement and to transfer the improvement to a governmental unit, and in fact so transfer the improvement. This expanded exception should assist longer-term tax assessment bond developments.

Two-and-one-half Percent Incidental Use. Certain incidental uses of up to 2.5 percent of the proceeds of a bond issue fall within the private business use exceptions. To qualify, the use must 1) involve no transfer to a private business of possession and control of physically separate space (except that vending machines, pay telephones, kiosks, and similar uses can qualify) and 2) not be functionally related to that private business' other use of the same facility. This exception continues an existing exception.(5)

Qualified Improvements. In a similar continued exception, private business use excludes certain qualified improvements to governmentally owned buildings (e.g., enhancements to electricity or air conditioning). To qualify, the improvement must 1) involve a building placed in service more than one year before the improvement begins, 2) not enlarge the building or involve interior space exclusively occupied by a private business, 3) not result in an improved building or related payments that count towards the private security test, and 4) not result in more than 15 percent of the improved building being used for private business use.

Measurement of Use

In a notable positive liberalization, the Final PAB Regulations generally measure the 10 percent private business use test based on the average annual percentage of private business use over a measurement period roughly equal to the term of the bond issue. Subject to an antiabuse principle for certain arrangements, private business use generally starts when there is a right to actual use. The measurement period generally begins on the later of the bond issue date or the date the financed property is placed in service, and ends on the earlier of the last day of the reasonably expected economic life of the financed property (determined on the issue date) or the final maturity date of the bonds. Special rules apply to certain short-term obligations and certain reasonably expected redemptions.

For property owned by a private business, however, a restrictive "highest-one-year-use" percentage rule applies to measure private business use. In addition, under an antiabuse rule, the IRS Commissioner also may employ this restrictive measure in certain circumstances.

The measure of private business use in any year generally is the average percentage of private use to total use in that year. The measure of use over the entire measurement period is based on the average of the annual percentages of such use. No present-value concept applies. This approach is administratively easier than the application of some present value computation.

A host of technical rules tell how to determine the amount of different kinds of private business use. For a financed facility in which governmental use and private business use occur at different times, the average amount of private business use generally is based on the amount of time of actual use relative to total time of actual use but disregarding periods of vacancy or nonuse. This disregard of nonuse, however, may impose some administrative tracking burdens because it can produce a changing denominator in the private business use percentages. Simultaneous governmental use and private business use generally is treated as private business use. If simultaneous use is on the same basis, (e.g., unassigned parking spaces), however, then a pro rata rule to allocate use applies. Similar pro rata allocation rules apply to common areas and neutral costs of a bond issue (e.g., issuance costs). A special rule provides that use of a discrete portion of a facility (e.g., a floor in a building) may be determined based on treating that discrete portion as a separate facility. Yet another special rule provides that if private business use is reasonably expected as of the issue date to have a "significantly greater" fair market value than governmental use, then the relative reasonably expected fair market values of use must be considered instead of a time basis measure.

Private Payment or Security Test

The private payment or security test basically focuses on the extent of private business sources of payment of and security for a bond issue. In general, this test is met if payment of the principal of, or the interest on, more than 10 percent of the proceeds of the bond issue is, directly or indirectly, 1) to be derived from payments (whether or not to the issuer or any related party but presumably in some way) in respect of property, or borrowed money, used or to be used for a private business use or 2) secured by any interest in property used or to be used for a private business use or payments in respect of such property. Private payments and private security are aggregated but are not double-counted.

The Final PAB Regulations include some restrictive rules on this test which appear to be aimed largely at IRS administrative concerns to try to minimize the necessity of tracking indirect private business payments which secure a tax-exempt bond issue. One clear case which should not give rise to private payments or security is the case of an issuer who makes a "grant" of bond proceeds to a private business for a facility used for private business use but receives no payments or security in return, either directly or indirectly, from private businesses or the general public with respect to the financed property. Thus, an issuer appropriately can make the policy choice to use tax-exempt bonds for a private business use if it pays and secures its bonds solely from a governmental source (e.g., generally applicable taxes).

The private payment or security test employs a present-value calculation. The private payment or security test is met if, as of the issue date, the present value of all private payments or security over the term of the bond issue exceeds 10 percent of the present value of the debt service on the bond issue. The Final PAB Regulations provide various mechanical rules on how to do this present-value calculation, generally based on the arbitrage yield, with certain modifications.

Under the private security portion of the calculation, pledged property is valued at fair market value when it first secures the bonds.

Private Payments. Private payments include direct and indirect payments, made by private business users (whether or not to the issuer), to the extent allocable to that private business use. In addition, the Final PAB Regulations also include as private payments any payments (whether or not to the issuer) "in respect of property financed," directly or indirectly, with the bond proceeds, even if not made by a private business user. This broad provision can be viewed as giving effect to "indirect" private payments, subject to an important limitation - to be private payments, the payments derived from bond-financed property during a period of private business use must somehow find their way, directly or indirectly, to pay or secure the bonds.

In certain circumstances, this broad provision counts payments from the general public as private payments. An example shows that payments made by hospital patients to a city for services at a city-owned hospital count as private payments if a private business uses the hospital under a bad management contract. Note, however, that in this example, those hospital patient revenues are used to pay the bonds.

The Final PAB Regulations cap private payments at the percentage of private business use. For example, if a private business uses 7 percent of a bond-financed facility over the term of the bond issue, then, even if that private business makes private payments equal to 50 percent of the bond debt service, those payments count as private payments only up to an amount whose present value does not exceed the present value of 7 percent of the bond debt service.

Private payments exclude amounts properly allocable to certain ordinary and necessary business expenses under Section 162 that are directly attributable to the operation and maintenance of the bond-financed property. General overhead or administrative expenses do not qualify for this exclusion.

The Final PAB Regulations provide numerous technical rules on how to allocate private payments among different sources of funding, such as tax-exempt bonds, taxable bonds, or equity. These allocation rules necessitate careful advance planning to assure compliance for a tax-exempt bond issue with multiple funding sources. Most generally, allocations among different sources of funding are based on nexus concepts and pro rata principles, such as relative amounts from each source.

The Final PAB Regulations are more restrictive than the Proposed PAB Regulations on an issuer's ability to allocate private payments first to equity. Here, the obvious benefit of an allocation to equity is that the covered amounts are free of tax-exempt bond restrictions. A targeted allocation to equity first may be done only if the issuer adopts an official intent similar to those used for reimbursement bonds within 60 days after the expenditure and makes the allocation within 18 months after the later of the expenditure or the placed-in-service date.

These accounting restrictions inexplicably show a tax policy preference for an issuer's use of taxable debt over its use of its own equity funds. There would seem to be no sound tax policy basis for disparate treatment of two comparable sources of issuer funding other than tax-exempt bonds.

Private Security. Private security includes any broadly defined "interest" in property used or to be used for private business use or any payments that secure a bond issue (e.g., a mortgage on private business use property), whether or not the bond issue finances that security, or any private payments that serve as the source of payment for a bond issue. Similar to the broad rule on private payments, private security includes payments in respect of property used for a private business use, including payments from the general public for use of such property, to the extent they secure the bonds. Except in the case of bond-financed property and private payments, however, amounts count as private security only to the extent they are provided, directly or indirectly, by a private business user. Private security excludes certain pledged bond proceeds before being spent or lent.

The Final PAB Regulations helpfully permit private security to be allocated on a reasonable basis that takes into account bondholders' rights to the payments or property upon default. For example, this rule should permit recognition of differences in senior and subordinate debt.

An important exception to the private payments or security test is provided for generally applicable taxes. A generally applicable tax is an enforced contribution pursuant to legislative authority in the exercise of the taxing power. Such a tax must have uniform rates applicable to similarly classified persons and a generally applicable manner of determination and collection. A special charge for privileges or services is not a generally applicable tax.

The Final PAB Regulations list various impermissible and permissible agreements relating to payment of taxes that bear upon whether or not a tax has a general manner of determination. Impermissible agreements include special imposition of personal tax liability, provision of credit support, minimum fair market value on property subject to property tax, and nonchallenge of a tax. Permissible agreements include use of a grant for specific purposes and related grant rescission, a representation of expected value of property after improvement, insurance or restoration of property, and an agreement to reduce or limit taxes collected to further a governmental purpose.

Private Loan Test

The private loan test independently treats bonds as private activity bonds if more than the lesser of 5 percent or $5 million of the bond proceeds are to be used (directly or indirectly) to make or finance loans to nongovernmental persons (excluding permitted tax assessment loans). Private loans may arise even if there is no private business use at all, such as with a consumer loan. Here, a loan includes any loan under general federal income tax purposes and certain broadly described economic equivalents. For private loan test purposes, a prepayment for property or services is a loan if a principal purpose of the prepayment is to provide a benefit of tax-exempt financing to the seller, subject to certain limited exceptions. A grant is not a loan.

Tax Assessment Loan Exception. The Final PAB Regulations provide an exception for certain qualifying tax assessment loans. A tax assessment loan is a loan that arises when a governmental unit permits or requires property owners to finance certain prescribed governmental taxes or assessments of general application. Such loans are used in certain types of land-based financings in some jurisdictions, such as tax assessment bonds or special tax bonds (e.g., California Mello Roos bonds) for private development of infrastructure improvements (e.g., streets, lighting, sewers, or undergrounding of utilities). The bonds are repaid over time through special assessments on the beneficiaries of the improvements. Absent this special exception, these assessments paid over time may constitute impermissible private loans.

The Final PAB Regulations address many concerns about the proposed version of this exception and provide a more workable standard. To qualify, the tax or assessment must meet three requirements: 1) it must be a mandatory tax or assessment, 2) it must be for an essential governmental function, and 3) it must meet an equal basis test. The following paragraphs briefly explain these requirements.

The tax or assessment must be an enforced contribution imposed or collected to raise revenue for a specific purpose, such as to defray the capital cost of an improvement. Fees for services do not qualify. The tax or assessment must be imposed pursuant to a state law of general application that can be applied equally to natural persons not acting in a trade or business and persons acting in a trade or business. The Final PAB Regulations dropped a criticized proposed rule that would have required assessments to be in proportion to the benefit received by the taxpayer.

The tax or assessment must be for an essential governmental function. An expanded definition of essential governmental function includes utility and system improvements if governmentally owned and available for general public use. Examples include sidewalks; streets; street lights; electric, telephone, and cable TV systems; sewage treatment and disposal systems; and municipal water systems. For other types of facilities, the essential governmental function test focuses on the extent to which governmental units "customarily" provide the particular service.

Owners of both business and non-business property benefitting from the improvements must be eligible, or required, to make deferred payments of the tax or assessment on an equal basis. The terms of payment of the tax or assessment must be the same for all assessed persons. An issue and area of ambiguity is whether all benefitted persons must, in fact, be assessed.

In addition, in an expanded guarantee exception, the Final PAB Regulations permit guarantees of bonds or assessments by borrowers so long as it is not reasonably expected as of the issue date that payments will be required to be made on the guarantee.

Unrelated or Disproportionate Use

The Final PAB Regulations provide guidance on an obscure test known as the unrelated or disproportionate use test. In general, this test reduces the private business test percentage limitations from 10 percent to 5 percent if the amount of private business use and private payments or security that is either unrelated to governmental use or disproportionate to that governmental use exceeds 5 percent of the bond proceeds. Briefly, the Final PAB Regulations provide that whether private business use is unrelated to governmental use is based on the facts and circumstances, emphasizing operational relationships and physical proximity. For example, a governmentally used school may be related to a private school cafeteria located at the school, but may be unrelated to a private cafeteria for administration at a remote site. Private business use generally is disproportionate if it exceeds related governmental use.

Change of Use Remedies

The Final PAB Regulations provide detailed guidance on ways to cure so-called "changes of use" of tax-exempt bond financed property from qualified to nonqualified use that otherwise might impair the tax-exempt status of the bonds. Satisfaction of the permitted remedies generally protects the tax-exempt status of the bonds against certain violations, mainly the private activity bond tests. Change of use issues arise often with state and local government privatization initiatives. A subsequent article in the next issue of Government Finance Review will examine these change-of-use remedies in detail.

Accounting and Antiabuse Rules

The Final PAB Regulations provide that expenditures of bond proceeds for private activity bond purposes must follow certain arbitrage accounting rules. Thus, expenditures generally may be made using any reasonable, consistently applied accounting method. The accounting method also must be consistent for both private activity bond and arbitrage purposes.

In addition, the Final PAB Regulations amend certain arbitrage accounting rules. If an issuer fails to maintain sufficient accounting records for a bond issue, the issuer is deemed to use a specific tracing method. Notably, a new timing rule requires that an issuer account for expenditures of bond proceeds not later than 18 months after the later of the date the expenditure is paid or the placed-in-service date. In an in artful apparent effort to recognize that some issuers do their accounting at the five-year arbitrage rebate installment dates, the Final PAB Regulations further provide that, in any event, an issuer must account for expenditures by not later than 60 days after the fifth anniversary date of the bond issue or 60 days after bonds are retired.

A broad general antiabuse rule applies if an issuer enters into a transaction with a principal purpose of transferring to a private business significant benefits of tax-exempt financing in a manner that is inconsistent with the purposes of Section 141. This rule further grants to the IRS Commissioner broad authority to recast a transaction in various ways to reflect economic substance.

Conclusion

The Final PAB Regulations represent a major regulatory initiative that will have a broad effect on state and local governmental practices for traditional governmental tax-exempt bonds. For the most part, the final standards on how to determine private business use are analytically sound and workable. The measurement of private business use over the life of a bond issue is more flexible and administratively easier than existing annual measurement approaches. The preferential treatment of property available for general public use represents a sea change in tax policy and should enhance the financing options for public infrastructure. Still, one is left with a troubling impression that the Final PAB Regulations represent overregulation in too many respects. The Final PAB Regulations may increase compliance costs and interfere unnecessarily with legitimate state and local governmental financing practices in many circumstances. In any event, issuers and tax counsel should consider the significant impact of the Final PAB Regulations very carefully.

STADIUM EXAMPLE ON PRIVATE PAYMENTS

The Final Regulations include a stadium example to illustrate the scope of the private payments test. The facts show that a private professional sports team uses more than 10 percent of the stadium for private business use. One variation finds private payments from a narrowly based ticket tax that is attributable to team events, secures the bonds, and exceeds 10 percent of the debt service. A second variation finds no private payments from a broad-based ticket tax that is imposed on a number of entertainment facilities in the issuer's jurisdiction, including the stadium.

NOTES

1 The Final PAB Regulations refer to Treas. Reg. [sections] 1.141-1 through 1.141-16 and related guidance under Treasury Decision 8712 published in the Federal Register on January 16, 1997. Unless noted, section references are to the Internal Revenue Code of 1986 and the Final PAB Regulations. The December 1994 proposed private activity bond regulations are referred to as the "Proposed PAB Regulations." For ease of reading, most regulation section references are omitted.

2 See Rev. Proc. 97-13, 1997-5 I.R.B. 18 (February 3, 1997) ("Rev. Proc. 97-13").

3 The next issue of the Government Finance Review will include a separate article by the author on these new private management contract safe harbors.

4 See Rev. Proc. 97-14, 1997-5 I.R.B. 20 (February 3, 1997) ("Rev. Proc. 97-14").

5 See IRS Notice 87-69, 1987-2 C.B. 378 ("Notice 87-69").

JOHN J. CROSS III is a tax partner at the law firm of Hawkins, Deiafield & Wood, resident in its Washington, D.C. office, who assists and advises the GFOA on legislative issues and has provided many background briefings to the GFOA's Committee on Governmental Debt and Fiscal Policy. He has a B.A. degree from Brown University (1978), a J.D. degree from Vanderbilt University School of Law (1981), and an L.L.M. in taxation from Georgetown University Law Center (1988). He formerly worked in the Chief Counsel's office at the IRS from 1990 to 1993. He is the current chair of the General Tax Matters Committee for the National Association of Bond Lawyers. For further information on this topic, contact the author at 202/682-1487. A more comprehensive version of this article is in the Summer 1997 issue of the Municipal Finance Journal published by Aspen Law & Business. An earlier version was in the seminar materials for the 1997 Tax Seminar sponsored by the National Association of Bond Lawyers, which was chaired by the author.
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Final regs. for exempt organization disclosure requirements.

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