Page images
PDF
EPUB

Revenue Effect

The provision is estimated to decrease fiscal year budget receipts by $14 million in 1987 and to have a negligible effect on budget receipts thereafter.

TITLE XIII-TAX-EXEMPT BONDS

A. Tax-Exempt Bond Provisions (secs. 1301, 1302, and 1311-1318 of the bill; secs. 25, 103, 103A, and 7871 and new secs. 141-150 of the Code)1

Prior Law2

Overview

Interest on obligations of States, Territories, and possessions of the United States, and the District of Columbia, generally is exempt from Federal income tax under both prior and present law (Code sec. 103). Similarly, interest on obligations of political subdivisions of these governmental entities generally is tax-exempt.*

In determining whether interest on a particular obligation of a qualified governmental unit is tax-exempt, a three-part inquiry is made. First, the authority of the issuer to issue the tax-exempt debt must be established. Second, the activity being financed, and thereby the type of bond being issued, must be determined. (The type of bond generally is determined by the use of the bond proceeds.) Finally, compliance with Internal Revenue Code rules governing tax-exempt bonds for the activity being financed must be established.

Under these rules, qualified governmental units may finance governmental projects or services, including facilities such as schools, roads, and water and sewer facilities. Additionally, under prior and present law, qualified governmental units may provide tax-exempt financing for use by religious, charitable, scientific, or educational organizations (section 501(c)(3) organizations) and for certain activities of other nongovernmental persons (under prior

1 For legislative background of the provisions, see H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, secs. 701-703; H. Rep. 99-426, pp. 492-573; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, secs. 1501-1516 and 1518; S. Rep. 99-313, pp. 809-861; and H. Rep. 99-841, Vol. II (September 18, 1986), pp. 683-762 (Conference Report).

2 To the extent not changed by the Act, the provisions of prior law are retained. The fact that these provisions may be described in the past tense, in the discussion of Prior Law, is not intended to imply that any rules not so changed by the Act no longer apply to bonds issued under the Internal Revenue Code of 1986.

3 Governments of States, U.S. possessions and the District of Columbia, and their political subdivisions, are hereinafter referred to collectively as qualified governmental units.

4 Under a special rule, Indian tribal governments were permitted to issue tax-exempt bonds to finance essential governmental functions of the tribal governments. These governments could not, however, issue IDBS and other conduit-financing bonds.

In certain cases, tax-exempt bonds may be issued on behalf of States or local governments. (See, e.g., Treas. Reg. sec. 1.103-1(b); Rev. Rul. 63-20, 1963-1 C.B. 24; and, Rev. Proc. 82-26, 1982-1 C.B. 476.) References to bonds issued by States or local governments herein generally include bonds issued on behalf of those governmental units under the rules established in these Treas ury Department regulations and rulings.

Bonds issued by qualified scholarship funding corporations, and by certain volunteer fire de partments, also are treated as obligations of qualified governmental units (secs. 103(e) and 103(1) of prior law).

law, by means of certain industrial development bonds (IDBs), student loan bonds, and mortgage revenue bonds). Interest on financings for activities of nongovernmental persons (other than the activities of section 501(c)(3) organizations) was taxable under prior law unless an exception was provided in the Internal Revenue Code for the specific activity being financed.

Bonds for governmental activities

Obligations to finance government operations

Qualified governmental units may issue tax-exempt bonds to finance general government operations and facilities, without regard to most of the restrictions (including volume limitations) that apply to bonds used to finance activities of nongovernmental persons.5 Under these rules, for example, qualified governmental units may issue notes in anticipation of tax or other revenues (so-called tax anticipation or revenue anticipation notes (TANs or RANs)) to finance cash flow shortfalls.

In addition to issuing bonds as evidence of indebtedness, qualified governmental units may undertake debt, the interest on which is tax-exempt, by means of installment sales contracts or finance leases. For example, a qualified governmental unit may purchase road construction equipment pursuant to a lease purchase agreement or an ordinary written agreement of purchase and sale. Šimilarly, qualified governmental units may enter into installment purchase or other transactions similar to mortgage loans (e.g., certificates of participation). Interest paid on such acquisitions is taxexempt if the amounts are true interest (as opposed to other payments labeled as interest). See, e.g., sec. 1273; Rev. Rul. 60-179, 1960-1 C.B. 37; and Rev. Rul. 72-399, 1972-2 C.B. 73. These other types of financings must satisfy the same Code requirements as if a bond actually were issued. Interest paid by qualified governmental units other than pursuant to exercise of their borrowing power (e.g., interest on tax refunds) is not tax-exempt.

Definition of governmental bond

Prior law did not directly define when bond proceeds were used for governmental activities. Rather, bonds were treated as governmental (and the interest thereon was tax-exempt) unless a prescribed amount of the bond proceeds was used for activities of nonexempt persons (i.e., persons other than qualified governmental units or section 501(c)(3) organizations).

Use in trades or businesses

The first case in which bonds issued by qualified governmental units were treated as nongovernmental was when the bonds were IDBS. IDBs were obligations issued as part of an issue (1) all or a

In general, prior law treated bonds for the benefit of section 501(c)(3) organizations in a manner similar to bonds used to finance governmental operations. While denominated private activity bonds under the Act, these bonds in many respects remain exempt from rules applicable to other private activity bonds.

The United States (including its agencies and instrumentalities) and all persons other than States or local governments (or organizations described in sec. 501(c)(3)), were nonexempt persons under these rules.

major portion of the proceeds of which was to be used (directly or indirectly) in a trade or business carried on by a nonexempt person (the "trade or business use test") and (2) the payment of all or a major portion of the principal of (or interest on) which was to be derived from, or secured by, money or property used in a trade or business (the "security interest test") (sec. 103(b)). The security interest test was satisfied when payments were formally pledged as security for payment of the bonds and also when any underlying arrangement provided for such payments. (See, e.g., Rev. Proc. 8312, 1983-1 C.B. 674 and Rev. Rul. 85-68, 1985-1 C.B. 37.)

Interest on IDBS was taxable unless the bonds were issued to finance certain specified exempt activities, were used for development of industrial parks sites, or were exempt small issues (as described below).

Use to make loans

The second case in which obligations of qualified governmental units were treated as nongovernmental was when the bonds violated a private loan bond restriction.8 Private loan bonds were defined as obligations that were part of an issue five percent or more of the proceeds of which was reasonably expected to be used, directly or indirectly, to make or finance loans to persons other than exempt persons.

As in the case of IDBs, interest on private loan bonds was taxable unless a specific exception was provided in the Code for the type of loan for which the bond proceeds were to be used. Prior law included exceptions to the private loan bond restriction for activities of nonexempt persons with respect to which Congress had provided specifically in the Code that tax-exempt financing was to be available. Thus, exceptions were provided for IDBs, qualified student loan bonds, qualified mortgage bonds, and qualified veterans' mortgage bonds.9

Additionally, an exception was provided for loans to nonexempt persons to finance taxes or assessments of general application for an essential governmental function (tax-assessment bonds). Under this exception, the existence of loans to nonexempt persons was disregarded in determining whether interest on the bonds was taxexempt. Rather, the determination of whether such interest was tax-exempt was made by determining whether the ultimate use of the bond proceeds qualified the interest on the bonds for tax-exemption. For example, the fact that a qualified governmental unit permitted residents generally to pay mandatory assessments levied in connection with sewer, water, or similar specific governmental projects over a period of years generally was disregarded in deter

7 Treasury Department regulations defined a major portion as more than 25 percent of the bond proceeds.

The term private loan bond was substituted for the prior-law term "consumer loan bond" by Title XVIII of the Act, relating to technical corrections to the Deficit Reduction Act of 1984 (the 1984 Act).

9 Certain private loan bond programs in existence when this restriction was enacted also were not subject to the requirement. (See, sec. 626(b) of the 1984 Act.) These programs included certain supplemental student loan bond programs; a veterans' land bond program that had been continuously in effect in substantially the same form for more than 30 years before the enact ment of the 1984 Act; and two small-scale energy conservation programs authorized by section 243 of the Crude Oil Windfall Profit Tax Act of 1980.

mining whether interest on bonds for the water or sewer facilities was tax-exempt. That determination instead was made by reference to the use of the bond-financed property. Thus, if a water or sewer system was owned and operated by a governmental unit, the bonds were governmental bonds, notwithstanding the indirect loans arising from deferred payment of assessments for the system. By contrast, if the system was operated in a manner that caused the bonds to satisfy the trade or business use and security interest tests of the Code, the bonds were IDBs.

The private loan bond restriction applied whether bonds were used to finance loans for businesses or to finance personal loans. For example, an issue was an issue of private loan bonds if five percent or more, but no more than 25 percent, of the proceeds were used to make loans that would be considered IDB financing if more than 25 percent of the proceeds were so used. Similarly, a bond could, in some cases, violate the private loan bond restriction although the bonds were not IDBS because the security interest test pertaining to IDBs was not violated (sec. 103(b)(2)(B)).

The concepts of use and loan

Concept of use

General rules.-The use of bond proceeds and of bond-financed property is the basis for determining whether bonds are issued for general government operations or for an activity of a nongovernmental person. Under prior law, the principal application of the use concept was the determination of whether a bond was an IDB. Additionally, the satisfaction of numerous requirements for specific types of tax-exempt IDBs was determined by applying the use concept.

The ultimate beneficiary of the tax-exempt bond financing generally was treated as a user of bond proceeds and of bond-financed property. A person could be a user of bond proceeds or a user of bond-financed property whether the use was direct or indirect. In general, a person was a user of bond proceeds if that person used any bond-financed facility other than as a member of the general public. Thus, a person could be treated as a user of bond proceeds or bond-financed property as a result of (1) ownership of property or (2) actual or beneficial use of property pursuant to a lease, a management contract, or an arrangement such as a take-or-pay or output contract. (See, Treas. Reg. sec. 1.103-7(b)(3), (b)(5) and (c).)

Use pursuant to certain management contracts.-Under prior law, the determination of whether use pursuant to a private management contract involved a trade or business use was made on a facts and circumstances basis. The Treasury Department had stated that, under certain specified conditions, it would issue an advance ruling that a facility managed by a private management company was not considered to be used in that company's trade or business. Such a ruling generally would be issued only if

(1) the management services were provided in return for a reasonable, periodic flat fee, under a contract not exceeding 5-years' duration (including renewal options), with the exempt owner having the option to cancel the contract at the end of any 2-year period; or

« PreviousContinue »