Federal Income Tax Issues in Municipal Lease Financing

Transcription

1 Federal Income Tax Issues in Municipal Lease Financing Gregory V. Johnson Patton Boggs LLP 1660 Lincoln Street, Suite 1900 Denver, CO Tel: (303) Fax: (303)

2 TABLE OF CONTENTS INTRODUCTION... 1 Page Benefits from Leasing... 1 Legal Requirements for Tax Exemption... 1 REQUIREMENT OF AN ISSUER... 2 Definition of a Political Subdivision... 2 Instrumentalities of Political Subdivisions... 3 Joint Powers Entities Corporations... 4 Indian Tribes... 5 REQUIREMENT OF AN OBLIGATION... 5 Capital Leases... 5 Nonappropriation Clauses... 6 Mixed Asset Financings... 6 BANK QUALIFIED OBLIGATIONS COST OF CARRY DEDUCTION... 6 OTHER TAX REQUIREMENTS... 8 Prohibition of Federal Guaranteed Obligations... 8 Prohibition on Advance Refundings... 8 Information Reporting Requirements... 8 Bond Registration... 8 Prohibition on Hedge Bonds... 9 CONCEPTS OF PUBLIC USE AND PRIVATE USE... 9 Private Activity Bonds General Public Use Certain Short-Term Use Arrangements Measurement of Private Business Use Qualified Management Contracts Research Agreements QUALIFIED PRIVATE ACTIVITY BONDS General Types of Qualified Private Activity Bonds General Requirements Applicable to Qualified Bonds Use of Proceeds Public Use Requirement Volume Cap Requirement Substantial User Requirement Maturity Limitation Limitation on Land Acquisition Acquisition of Existing Property Certain Prohibited Uses i -

3 Public Approval Requirement Restrictions on Financing Issuance Costs Alternative Minimum Tax QUALIFIED 501(c)(3) BONDS CHARITABLE BORROWERS MANUFACTURING FACILITIES AND ENTERPRISE ZONE FINANCINGS Qualified Small Issue Financings Capital Expenditures Manufacturing Facilities Enterprise Zone Facility Obligations INVESTMENT LIMITATIONS THE MEANING OF ARBITRAGE Definition of Proceeds Negative Pledge Accounts Reasonable Reserve Funds Rebate Reimbursement Financings Summary ii -

4 INTRODUCTION The purpose of this discussion is to present an over view of the federal income tax requirements necessary to achieve and preserve the tax exempt treatment of interest on lease obligations with states and political subdivisions. As described below, the Internal Revenue Tax Code contains a variety of limitations and requirements that must be met to achieve this objective. Benefits from Leasing. There are many advantages for states and units of local government in considering lease financing for the acquisition of capital assets. In virtually every state, units of government are constrained in some fashion by constitutional and statutory limitations on their financing activities. These limitations may limit the purposes for which bonds or other tax-exempt obligations, such as leases, may be issued or may limit the aggregate amount of such obligations or require prior electoral approval or impose other limitations that impact financing transactions. Lease purchase financing can be a way in which political subdivisions are able to accomplish their financing needs without suffering the burdens of such limitations. In some states, lease purchase financings are exempt from prior voter approval requirements; particularly if they are subject to annual renewal by the lessee. Lease purchase financing also may fall within exceptions to aggregate debt limitations, and they may allow a broader use of funds as a source of repayment than might be the case with other forms of financing. All of these opportunities make lease financing for states and local governments appealing from a financial perspective. The advantage most focused upon, however, in lease financing for governments is the potential availability of an exemption from federal income taxation of the interest component of the lease obligation. The origin of this advantage is in the provisions of Section 103(a) of the Internal Revenue Tax Code of 1986, as amended (the Tax Code ). That Section of the Tax Code provides that interest on obligations issued or incurred by a state or any of its political subdivisions, or on behalf any of such entities, is excludable from gross income for federal income tax purposes. This means that an investor in a governmental lease obligation may exclude from his gross income the interest component of the lease obligation. In most states, interest on municipal obligations (at least those issued within the state) is similarly exempt from state income taxation. This is a substantial advantage to an investor. For instance, if an investor were willing and interested in acquiring a taxable obligation at 8% per annum, that same investor would likely be willing to accept a lower interest rate (for instance 6.5% per annum) if the investor knows that he will not be required to pay federal or state income taxation on the interest component. Thus, the tax-exempt equivalent of an 8% obligation is, in this example a 6.5% obligation. From a governmental entity s perspective, availing itself of the exemption from federal and state income taxation on its obligations, including lease obligations, means a cheaper cost of capital. Cheaper capital means public projects are less expensive to finance and, in some cases, the availability of tax exempt finance is a critical difference between a project which is feasible and one which cannot be financed by the government. Legal Requirements for Tax Exemption. The United States Congress, the Internal Revenue Service and the federal courts have generally held that access to tax-exempt financing

5 by states and local governments is not an absolute right. For more than 40 years, Congress has legislated and the IRS has issued regulations and rulings in the area of tax-exempt financing. These regulations, rulings and legislation have limited the types of issuers who qualify for taxexemption, have regulated the nature of the projects that may be financed, have placed limitations on the ability of political subdivisions to invest the proceeds of such financings, and have generally limited, restricted and regulated access to tax-exempt financing. Indeed, members of Congress and the Executive Branch have indicated more than once their belief that it is well within the power of Congress to deny all access by political subdivisions to tax-exempt finance. No such draconian step has been formally announced, but Congress and the Internal Revenue Service have regulated access to tax exempt finance in a wide variety of ways. The legislative and regulatory activities of Congress and the IRS have made tax-exempt financing one of the most complicated and complex areas of the tax law. Notwithstanding these facts, access to tax-exempt financing by political subdivisions remains a key element in almost every capital undertaking that states and local governmental units pursue today. The benefits of tax-exempt financing are uniformly viewed as being worth the cost of compliance with the very technical requirements imposed on governmental issuers of obligations. In order to qualify for tax-exemption, a lease obligation with a governmental unit must meet all the requirements that have been imposed in this area, to the same extent as would be true with a bond or any other traditional form of governmental borrowing. REQUIREMENT OF AN ISSUER Only certain types of local governmental entities may borrower on a tax-exempt basis. The beginning point for determining whether tax-exempt finance is available for a proposed project, therefore, is the identity of the borrower or other obligated party under the proposed financing. The proposed borrower (or lessee in the case of a lease financing) must be a state, a political subdivision of the state, or an instrumentality authorized to issue obligations on behalf of a state or a political subdivision. States are easy to identify, but political subdivisions and instrumentalities oftentimes are far more complex in nature. If the lessee or other obligated party is not a tax-exempt issuer, the transaction cannot be accomplished on a tax-exempt basis. Definition of a Political Subdivision. The determination of whether an entity qualifies as a political subdivision, and therefore has the ability to act as a borrower or issuer of taxexempt obligations, requires an examination of whether the entity possesses governmental powers. These powers typically are characterized as involving the power of taxation, the power of condemnation, and the power to impose governmental-type regulations that is commonly referred to as police power. The tax law states that if an entity is to be a political subdivision, it must possess a substantial quantity of these powers. Thus, the question of whether an entity is an issuer for tax-exempt purposes typically turns on how much governmental power it has been delegated under state law. An entity may be created by statute, may look like a government, but may not necessarily be a political subdivision. Divisions, agencies, bureaus or departments of political subdivisions, while normally thought of as governmental units, may not themselves have the power to borrow and therefore are not issuers for tax-exempt purposes. In these circumstances, a parent organization, such as a board of county commissions, the state legislature, or perhaps the 2

6 executive of the governmental unit, may be required to approve the financing in order for the borrowing powers of the political subdivision to come into play. For instance, a lease obligation with the Department of Social Services of a particular governmental unit may not qualify for taxexemption unless the governing board of the governmental unit approves the execution of the agreement and the terms of the financing. Oftentimes, counsel must examine the underlying statutory authority to determine whether the agency or bureau in question has been delegated the power to borrower money and incur obligations which would be viewed by the Internal Revenue Service as obligations of the political subdivision. In absence of such statutory authority, the obligation may not be tax-exempt. Instrumentalities of Political Subdivisions. For a variety of reasons, political subdivisions over the years have created entities or instrumentalities to act on their behalf. Sometimes such entities are created in order to insulate the political subdivision from financial exposure. In other circumstances, agencies or entities are created and invested with specific powers to finance projects in areas requiring specialized expertise. For instance, most states have housing finance agencies or other statewide entities created by statute for the purpose of financing public housing projects or other housing improvements. The key element of the statutory authority of these entities in each case is the specific grant of power and authority to the agency in question to issue obligations or incur obligations on behalf of the state government that creates the agency. If they have such powers, these entities qualify as tax-exempt issuers even though they may have no power to tax, no power to condemn property, and no real police powers of any appreciable extent. If such entities have been specifically invested under state statute with the power to undertake financings, the IRS has recognized that they nonetheless qualify as tax-exempt issuers. See Revenue Ruling Under that ruling, the IRS recognized that a state industrial development agency which was created to issue obligations to finance projects was nonetheless a tax-exempt issuer, even though it had no power to tax, no power to condemn property, and no police powers. The entity was viewed as a instrumentality of the state since the legislature had acted to empower that agency as an issuer to issue obligations on its behalf. Note, for this purpose, that the power to issue obligations on behalf of a political subdivision need not mean that the credit of the political subdivision is affected. State conduit issuers, such as state housing finance agencies, are authorized to issue revenue bonds secured by their own credit, not the state s credit. Such entities nonetheless are deemed to issue their bonds on behalf of the state. Joint Powers Entities. Many states have adopted statutory arrangements that allow political subdivisions to join together in a common enterprise and to create joint powers boards or other joint action agencies for the purpose of financing undertakings. Where these joint powers agencies have been invested with the power to issue obligations and incur other obligations to accomplish their purposes, they too are treated as issuers for purposes of the Tax Code and therefore may qualify for tax-exempt financing. This is true, even though a joint powers board may lack to power to tax, may lack the power to condemn property, and may lack any substantial police powers. Again, it is the grant of legislative authority to a joint powers agency to issue obligations on behalf of the respective political subdivisions comprising the joint powers entity, or on behalf of the state itself, which is the source of the authority to act as a taxexempt issuer. 3

7 63-20 Corporations. In other circumstances, even more exotic entities have been created for the purpose of issuing obligations or other obligations on behalf of political subdivisions and, in many cases, these entities qualify for tax-exempt financing. For instance, it is common in many states for local governments to create wholly nongovernmental entities to issue obligations on their behalf. Oftentimes, these entities are created specifically for the purpose of allowing a lease financing to occur. For instance, a city may desire to finance a public improvement, such as a jail or a courthouse, but be unable to secure electoral approval for obligations to be issued by the city. In response to these circumstances, many units of local government have created nonprofit corporations to issue obligations on their behalf for the purpose of allowing such financings to occur, notwithstanding the absence of electoral approval. A typical form for such entity is a nonprofit corporation under state law. The IRS has recognized the ability of such entities to issue obligations on behalf of the underlying political subdivision if certain requirements are met. Under Revenue Ruling 63-20, and subsequent rulings, the ability of nonprofit corporations or other nongovernmental entities to issue obligations on behalf of local governments has been recognized and accepted by the Internal Revenue Service. Revenue Ruling outlines the terms and conditions under which a nonprofit corporation may be deemed to be an on behalf of issuer and therefore be entitled to issue taxexempt obligations or incur tax-exempt leases on behalf of the political subdivision that creates it. The general requirements under Revenue Ruling for a nonprofit corporation to be treated as an on behalf of issuer for tax purposes include the following: (a) The political subdivision must specifically authorize the creation of the nonprofit corporation as a finance entity; (b) The political subdivision must approve the issuance of obligations or the incurrence of a lease or other obligation by the nonprofit corporation; (c) The nonprofit corporation must act solely for charitable or other purposes, and no private person or entity may benefit directly or indirectly from the activities of the nonprofit corporation; and (d) The political subdivision must have the right to acquire unencumbered title to the financed property when the bonds, leases or other obligations of the instrumentality have been retired. Using the authority of Revenue Ruling 63-20, it has been common for political subdivisions to create nonprofit corporations to issue revenue obligations to finance public improvements. The proceeds of the revenue obligations are used to construct or acquire the capital asset, which is then leased to the political subdivision under a lease purchase or other similar agreement. Typically, the lease purchase obligation contains a provision that allows the political subdivision to terminate the lease obligation on an annual basis without penalty. These nonappropriation clauses typically result in the lease obligation not being treated as a debt of the underlying political subdivision for state law purposes. These financing structures can therefore allow a political subdivision to obtain long-term tax-exempt financing for a capital asset without creating a debt for state law purposes, thereby avoiding requirements of voter approval and other limitations and requirements applicable to bond issues. 4

8 Indian Tribes. The definition of a state for purposes of the requirement of an issuer under the Tax Code is treated as including an Indian tribal government, as long as the financing is undertaken for certain purposes. Such purposes include obligations issued for essential governmental functions and certain obligations issued for manufacturing facilities located on Indian lands that are owned and operated by the Indian tribe and meet certain employment requirements. Legislative history from congressional action indicates that an essential governmental function for this purpose will be met if the facility is comparable to facilities that are customarily acquired or constructed and operated by states and local governments. Examples that should comply include administrative offices and equipment, police and fire facilities and jails, clinics and hospitals, roads, sidewalks, sewers, water facilities and utilities, schools, libraries and museums, as well as parks. Generally, Indian tribes may not issue private activity obligations with the exception of certain manufacturing facilities. In order to qualify under that exception, (a) 95% or more of the proceeds of the financing must be used to finance depreciable property which is owned by the tribe and is part of a manufacturing facility, and (b) the facility must be located on land which, during the five-year period ending on the date of the financing, was held in trust for the tribe by the United States, and (c) beginning two years after the date of issue, for each $20 in principal amount of tax-exempt borrowing outstanding at the end of the calendar year, at least $1 in FICA wages must be paid during that year to enrolled tribal members, or their spouses, for services rendered at the facility. REQUIREMENT OF AN OBLIGATION As noted above, Section 103(a) of the Tax Code provides that only obligations issued by or on behalf of a state or any of its political subdivisions may qualify for an exemption from federal income taxation. In traditional municipal finance, the question of whether an obligation is present is often not an issue. Obligations include general obligation bonds, revenue bonds, tax increment bonds and all similar forms of bonds, notes, or promises to pay which evidence the exercise of the borrowing power by a political subdivision. In order for a governmental or municipal lease to qualify for tax-exemption, it too must constitute an obligation within the meaning of the Tax Code. In the leasing context, the question of whether a proposed financing results in the creation of an obligation is oftentimes more complex than in traditional governmental finance. Not all leases are necessarily obligations within the meaning of the Tax Code, and not all leases therefore may qualify for tax-exempt treatment. If a political subdivision were to rent space in a building using a lease obligation, that rental agreement very likely is not an obligation which qualifies for tax-exempt treatment. In the typical commercial lease arrangement, a political subdivision acquires the right to use a facility in exchange for the payment of rent to the landlord. Because such lease transactions do not involve a borrowing by the political subdivision, nor the acquisition of an ownership interest in the underlying asset, they are not tax-exempt obligations within the meaning of the Tax Code. Capital Leases. In order for a lease to constitute an obligation, it must be a financing transaction. Typically, this means that the lease is treated as a capital lease for tax purposes, rather than an operating lease. Often leases are asset purchase or acquisition vehicles for a governmental agency that is acting as the lessee. These types of leases are most often treated as capital leases and therefore potentially qualify as tax-exempt obligations. Capital leases allow 5

9 a political subdivision to acquire an asset through the exercise of the borrowing power. The benefits and burdens of ownership to the financed property transfer to the political subdivision under a capital lease immediately upon execution of the lease document. Under a capital lease, a political subdivision is typically required to pay rental as a condition to the acquisition of the asset. While technical title may remain in the lessor entity for the duration of the lease, a capital lease provides that upon payment of the lease obligation in full, title to the financed asset transfers to the political subdivision at the termination of the lease obligation. During the life of the lease obligation, a political subdivision has all of the benefits and burdens of ownership of the property. Unless the lease obligation with a governmental unit is structured in this manner, with the result that is deemed to be a capital lease, the obligation will not qualify for taxexempt financing. Nonappropriation Clauses. As noted above, some political subdivisions use lease financing as a mechanism for avoiding the creation of debt for state law purposes. A common element of such leases is a nonappropriation clause as described above. A nonappropriation clause allows the political subdivision to terminate the lease on an annual basis. With a nonappropriation clause, the decision to renew the lease each year rests with the political subdivision, and the political subdivision may terminate the lease without penalty in the event it fails to appropriate funds to renew the lease transaction. The IRS has recognized that, where the other elements of a capital lease are present, the use of a nonappropriation clause for this purpose does not prevent the lease from being treated as a capital lease and therefore an obligation for purposes of tax-exempt financing. In addition, the IRS has recognized that a transfer of the risk of nonappropriation to a third party credit enhancer, such as a bond or financial guarantee insurer or other guarantor, also does not impair the tax-exempt treatment of the lease obligation. This ruling was important because it opened the door to local governments with strong credit ratings to use lease financing for capital asset acquisition without giving up the cost benefits they have enjoyed through their access to bond insurance and other forms of credit enhancement. Mixed Asset Financings. As described above, if a lease agreement is properly structured as a purchase and other wise meets the test of an obligation under the Tax Code, it may qualify for tax-exempt treatment. Special issues sometimes arise in the context of mixed asset financings. These are lease financings where tangible and intangible assets are combined in a common financing. One example might involve combining a service contract with an item of equipment and using a single lease agreement to finance the acquisition of both items. The equipment, being a tangible asset, fits relatively easily within the parameters of a lease financing. The intangible service contract piece is less easily conceived of as an item of leased property. While the outcome will vary with the circumstances of each financing, a mixed asset financing can be viewed from a tax perspective as really two financings: 1) a capital acquisition of equipment and 2) a working capital financing used to generate cash to prepay a service contract. The Tax Code limits or regulates the ability to use tax-exempt financing for working capital purposes in some cases, as more fully described below. In addition, in lease financings that are required to have nonappropriation clauses to avoid creating debt for state law purposes, expending lease proceeds for intangible assets may create credit concerns on the part of investors. BANK QUALIFIED OBLIGATIONS COST OF CARRY DEDUCTION 6

10 Perhaps one of the most important issues in lease financing or other tax-exempt transactions is that which arises when commercial banks purchase tax-exempt obligations. Historically, the Internal Revenue Service has taken the position that interest on obligations incurred to acquire or carry tax-exempt obligations is not deductible. Thus, if a taxpayer borrows money with the intent and purpose of acquiring tax-exempt obligations, the taxpayer may not deduct the interest on that borrowing. As a result of this position, the IRS over many years attempted to argue that commercial banks that pay interest on deposits and take tax-exempt obligations into their investment portfolio should similarly be denied a deduction on a portion of the interest they pay depositors. The IRS was unsuccessful in arguing to the Tax Court and in other forums that a sufficient nexus existed between the act of accepting deposits and the act of investing in tax-exempt obligations. As a result, the IRS was not successful in arguing that it had the authority to deny the cost of carry deduction to commercial banks and other depository institutions which pay interest on deposits and purchase tax-exempt obligations for their investment portfolios. All of this changed in 1986 when Congress adopted certain amendments to the Tax Code that appear in Section 265. That section provides generally that no deduction is allowed for amounts otherwise allowable as a deduction for certain expenses and interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from federal income taxation. Moreover, in the case of a financial institution, no deduction is allowed for that portion of the taxpayer s interest expense allocated to tax-exempt interest, except for certain tax-exempt obligations for which a special exemption exists. The effect of these amendments was to substantially reduce the economic value of tax-exempt obligations for commercial banks, save only for the special exception created as part of the amendment. That exception is available for smaller issuers of tax-exempt obligations, or other tax-exempt obligations, and is very important in the marketing of leases and other smaller financing instruments to commercial banks. Tax Code Section 265(b)(3) permits partial deductibility of a financial institution s interest expense allocable to acquiring tax-exempt obligations if, among other things, the taxexempt obligation is issued by an issuer that does not reasonably anticipate issuing in excess of $10 million in tax-exempt bonds (or other tax-exempt obligations, such as lease agreements) during the calendar year in which the bank qualified obligation is issued (referred to as a qualified small issuer ). This exception applies to governmental purpose obligations and qualified 501(c)(3) obligations, and obligations issued to refund such obligations, if designated as such by a qualified small issuer. Obligations issued to current refund prior obligations are treated as qualified tax-exempt obligations, and do not count toward a $10 million determination, if the amount of the refunding issue does not exceed the prior obligations and if the average maturity date of the refunding obligation is not later than the average maturity date of the prior obligations and if the refunding obligations have a maturity date not later than 30 years after the date the original qualified tax-exempt obligation was issued. As a result of this exception, commercial banks may purchase or carry tax-exempt obligations, including tax-exempt leases, without suffering a reduction in their cost of carry 7

11 deduction, if the obligations are issued by a qualified small issuer which designates such obligations as the beneficiary of the exception, as described above. OTHER FEDERAL TAX REQUIREMENTS Prohibition of Federally Guaranteed Obligations. The Tax Code provides, with certain exceptions, that bonds (and other obligations such as lease agreements) that are federally guaranteed are not tax-exempt. This denial of tax-exemption was borne out of a Congressional concern about financing structures that combined FSLIC and FDIC deposit insurance with taxexempt obligations, thereby giving the equivalent of a federal guarantee as well as an exemption from federal tax-exemption. While critics of the structure pointed to the double dipping aspect of the federal benefits, the primary concern of the Congress and the IRS related to the substantial increase in tax-exempt obligation issuance (and resulting drains on the federal Treasury) that resulted from this financing structure. In the aftermath of this legislation, if there is a direct or indirect federal guarantee of payment under a lease obligation, it will be important to ascertain whether any of the available exceptions to the prohibition on tax-exemption are available. If no exemption is available, the financing may have to forego the federal guarantee or risk loss of federal income tax-exemption. Prohibition on Advance Refundings. The Tax Code now prohibits the issuance of bonds (or other obligations such as lease agreements) to advance refund a private activity obligation (other than a qualified 501(c)(3) obligation). A obligation is treated as issued to advance refund another obligation if it s issued more than 90 days before the redemption date of the prior obligation. What this means is that, in a refinancing context, if a prior obligation is not subject to current redemption, it may be the subject of an advance refunding. Under this structure, proceeds of the refunding issue are invested until used to retire the prior obligations. Governmental obligations and qualified 501(c)(3) bonds (or lease obligations which meet the requirements of such obligations) are the only tax-exempt obligations which may be advanced refunded on a tax-exempt basis, and they may be only advanced refunded once. Information Reporting Requirements. Whenever tax-exempt obligations are issued, the Tax Code requires that an information return be filed with the Internal Revenue Service. Form 8038 is used for private activity obligations and Form 8038-G is used for governmental purpose obligations. Thus, one of the procedural steps that is an absolute requirement in any lease financing which is intended to be structured on a tax-exempt basis is the filing of the appropriate form (8038 or 8038-G, depending on the type of financing) with the IRS. That filing is required to occur by the 45 th day of the calendar quarter after the quarter in which the financing occurred. A failure to meet the deadline will mean a complete denial of tax-exemption unless the IRS grants a special extension, which typically occurs only in unusual circumstances. Registration. The Tax Code requires that all tax-exempt obligations (including leases) be issued in fully registered form. While obligations historically were issued in bearer form, meaning that ownership transferred by delivery, such obligations may not be issued on a taxexempt basis under current tax law. Each tax-exempt obligation (including lease agreements) must be issued in a form such that a record of ownership of the instrument is maintained, and that transfers or exchanges of the obligation may occur only by means of a change in the written ownership records. In leasing transactions, this requirement will come into play in 8

12 circumstances where ownership of the lease instrument is fractionated by means of certificates of participation or other instruments evidencing an ownership interest in the underlying lease obligation. Prohibition on Hedge Obligations. The Tax Code provides that hedge obligations will not be tax exempt unless certain requirements are met. The issuer must reasonably expect that 85% of the spendable proceeds of the issue will be used to carry out the governmental purposes of the issue within three years after the date of issuance, and not more than 50% of the proceeds of the issue are invested in investments having a substantially guaranteed rate of return for four years or more. The statute creates exceptions for investments in tax-exempt obligations that are not subject to the alternative minimum tax, investments of monies in a bona fide debt service fund, and certain temporary investments of 30 days or less. If the issue is determined to be a hedge obligation, the issuer must reasonably expect that 10% of the spendable proceeds of the issue will be spent for the governmental purposes of the issue within a one-year period beginning on the date those obligations are issued, 30% will be spent within two years, 60% will be spent within three years, and 95% will be spent within four years. Hedge obligation issues are rare in the leasing world. A problem with hedge obligations would likely occur only in circumstances where the proceeds of the lease financing were held in an acquisition fund pending the construction or purchase of very specialized leased property with a long construction or development period, and the unspent proceeds were invested as described above during the acquisition period. CONCEPTS OF PUBLIC USE AND PRIVATE USE Over the years, Congress, the IRS and the courts have imposed many requirements and limitations on the ability of states and local governments to access tax-exempt financing. One of the most complex areas in which this has occurred involves the notion of what constitutes a public use of the financed property, as opposed to a private use. Tax-exempt financing is a substantial economic benefit that makes projects more feasible to achieve. Historically, many states and local governments attempted to use tax-exempt finance for the purpose of promoting economic development or encouraging other activities by the private sector that the governmental unit thought beneficial. Under these circumstances, a governmental unit might issue bonds or incur other obligations for the purpose of financing a project that was to be primarily used by a private sector entity. The approach was thought to be a particularly beneficial one for local government. A private entity accessed tax-exempt finance for its project, and the local governmental unit received the benefit of the project in the form of economic development, job creation or other political objectives. As a consequence of this type of deal, the volume of tax-exempt obligations grew dramatically. As tax-exempt volume increased, the U.S. Treasury saw a drain on its revenues. Projects which otherwise would have been financed on a taxable basis which produced revenues for the Treasury in the form of taxation on the interest component of the financing, now were being done on a tax-exempt basis with the resulting loss of Treasury revenues. In response to these activities, and in a desire to limit the loss of revenues to the Treasury, Congress amended the tax 9

13 laws to incorporate the concept of a prohibited private activity bonds into the Tax Code. If a bond, lease or other obligation is a private activity bond, it is not tax-exempt unless it qualifies for a special exemption. By this mechanism, Congress and the IRS substantially limited the ability of local governments to use tax-exempt financing for projects that involved the private sector. Private Activity Bonds. In general, private activity bonds are obligations (including leases) of a state or a local government used to finance improvements that are used in the trade or business of a nongovernmental entity and the payment or security for which is derived from private sources. In addition, private activity bonds also include obligations, the proceeds of which are loaned by the governmental entity to a private entity. Where these circumstances are present, the obligation constitutes a private activity bond and is taxable, unless a specific exemption is otherwise available. The threshold for private use and private payment or security is 10%. Where more than 10% of the proceeds of the bond issue (or 10% of the proceeds of the lease financing) is used directly or indirectly in the trade or business of a nongovernmental person, and more than 10% of the debt service on the obligation is paid or secured from private sources, the obligation is a private activity bond. If the facilities in question are used for a purpose that is unrelated to a governmental purpose, that 10% threshold becomes 5%. In addition, if 5% or more of the proceeds is lent by a political subdivision to a nongovernmental person, that fact alone makes the obligations private activity bonds. As a result of these amendments to the tax laws, political subdivisions generally are prohibited from extending the benefits of tax-exempt finance to nongovernmental persons unless one or more specific exemptions to that treatment is available. As described below, there are various categories of qualified private activity bonds which have been specifically recognized by Congress in amendments to the Tax Code as types of private activity bonds, which will nonetheless qualify for tax-exemption. The first step, however, is to determine whether an obligation is to be treated as a private activity bond (as opposed to a governmental purpose bond) because of private use or benefit of the financed property and private payment or security for the obligation. General Public Use. Private business use does not include use as a member of the general public. Thus, if one or more private entities use financed property in the same manner as members of the general public, such use does not necessarily result in prohibited private use. However, use of financed property by nongovernmental persons in their trades or businesses is treated as general public use only if the property is intended to be available and in fact is reasonably available for use by natural persons not engaged in a trade or business. Use of the financed facility under an arrangement that conveys priority rights or other preferential benefits is not use on the same basis as the general public. Rights that are generally applicable and uniformly applied do not convey priority rights. Rights may be treated as generally applicably and uniformly applied even if (a) different rights apply to different classes of users, if the differences in rights are customary and reasonable; and (b) a specially negotiated arrangement is entered into, but only if the user is prohibited by federal law from paying generally applicable rates and the terms of the arrangement are as comparable as reasonably possible to generally applicable rates. 10

14 For these reasons, private use is always closely examined in the tax-exempt finance context to determine whether the use is on terms different from that which the general public may access. Certain Short-Term Use Arrangements. The Tax Code and the regulations issued thereunder create certain safe harbor exceptions for short-term usages. For instance, temporary exclusive use for up to 200 days under certain circumstances, as well as other exceptions for use under 150-day arrangements, are created which allow private use of financed property for short periods of time without adversely affecting the tax-exempt nature of the financing. Measurement of Private Business Use. Under the Tax Code, all private business uses are aggregated for purposes of determining whether the prohibited threshold of private business use has been crossed. The amount of private business use of financed property is calculated according to the average percentage of private business use during the measurement period. That period begins on the later of the date the obligations are issued or the date the property is placed in service, and ends on the earlier of the last date of reasonably expected economic life or the last maturity date of any obligations issued to finance the property. Average percentage of private business use equals the average of the percentages of private business use during the various one-year calculation periods within the measurement period. The regulations provide guidance for calculating the level of private use in the case of property used for both private businesses and governmental use. If such use occurs at different times, the average amount of private business use generally is based on the amount of time that the property is used for private business use as a percentage of total time for all actual use. Equipment down time, or time under which there are no uses of the financed property, is time that is disregarded for purposes of this calculation. If property is used for governmental use and private business use simultaneously, the entire facility is treated as having private business use. If the governmental use and business use, however, is on the same basis, the average amount of private business use may be determined on a reasonable basis that reflects the proportionate benefit to be derived by the various users of the facility. Discrete portions of a financed facility are treated as separate facilities for purposes of calculating the level of private business use of such property. The amount of private business use of common areas is based on a reasonable method that properly reflects the proportionate benefit to be derived by the users of the financed facility. Neutral costs must be allocated ratably among the other purposes for which the proceeds are used. Private business use commences on the first date on which there is a right to actual use by the nongovernmental person. However, if ownership or other long-term use is involved, and the issuer enters into a arrangement for private business use a substantial period (10% of the measurement period) before the right to actual use commences, private business use commences on the date of the arrangement. If private business use is reasonably expected as of the issue date to have a significantly greater fair market value than the governmental use of the obligation financed facilities, the 11

15 average amount of private business use must be determined according to the relative reasonably expected fair market values of use. This determination of relative fair market value may be made as of the date the property is acquired or as of the date it is placed in service if this determination is not reasonably possible on the issue date. Relative reasonable expected fair market value must be determined by taking into account the amount of reasonably expected payments for private business use in a manner that properly reflects the proportionate benefit to be derived from the private business use. Qualified Management Contracts. Political subdivisions often desire to access the resources of the private sector in the management or operation of their public facilities. Cities and other units of local government hire management companies to operate and maintain their facilities and pay such companies fees in exchange for those services. Under the very restrictive requirements for private activity obligations described above, the use of a private manager of a governmental facility could impair the ability of the political subdivision to use tax-exempt finance for the acquisition of the project. States and local governments were concerned about this potential result, and as a result, the IRS has adopted regulations that describe the circumstances under which a management or operations arrangement with a private entity will not adversely affect the ability of the project to qualify for tax-exempt financing. Where the requirements of these regulations are met, the management and operations agreement is deemed to be a qualified management contract. Qualified management contracts do not produce prohibited private use and therefore will not adversely affect the tax-exemption of the financing used to acquire the facility and will not result in the creation of a prohibited private activity bond. Whenever a political subdivision seeks to engage the resources of the private sector to operate or maintain a tax-exempt financed facility, a qualified management contract is typically required in order to avoid adversely affecting the tax-exemption of the financing. Under the qualified management contract rules, which appear primarily in Revenue Procedure 97-13, the arrangement must be a managerial one. The management contract will result in prohibited private business use if the service provider is treated in substance as the lessee or owner of the mfinanced property for federal income tax purposes. Thus, management contracts cannot be used as a subterfuge for greater private use that would be the case in a normal management and operations arrangement. The qualified management contract regulations provide that a qualified management contract must not provide for compensation for services rendered based, in whole or in part, on a share of net profits from the operation of the facility. Revenue Procedure states that reimbursement of the service provider for actual and direct expenses paid by the service provider to unrelated parties is not by itself treated as compensation. The Revenue Procedure further provides that net profits compensation will not be involved if compensation is based on (a) a percentage of gross revenues (or adjusted gross revenues) of the facility or a percentage of expenses from the facility, but not both, (b) a capitation fee, or (c) a per unit fee. In addition, a productivity award equal to a stated dollar amount based on increases or decreases in gross revenues, reductions in total expenses, but not both, in any annual period during the contract term, generally does not cause the compensation to be based on a prohibited share of net profits. Revenue Procedure states five general types of arrangements that will qualify as qualified management contracts. 12

16 (a) 95% Periodic Fixed-Fee Arrangement and 15 to 20-Year Contract Duration. At least 95% of the compensation must be based on a periodic fixed fee. The terms of the contract, including all renewal options, must not exceed the lesser of 80% of the reasonably expected useful life of the financed property and 15 years (20 years for certain public utility property ). A one-time fixed dollar incentive award based on a gross revenue or expense target (but not both) is permitted. (b) 80% Periodic Fixed-Fee Arrangement and 10 to 20-Year Contracts. At least 80% of the compensation is based on a periodic fixed fee. The contract term, including all renewal options, must not exceed the lesser of 80% of the reasonably expected useful life of the financed property and 10 years (or 20 years for public utility property). A one-time fixed dollar incentive award based on gross revenues or expense target (but not both) is permitted. (c) 50% Fixed-Fee Arrangements and 5-Year Contracts. Either 50% of the compensation is based on a periodic fixed fee or 100% of the compensation is based upon a capitation fee or a combination of a capitation fee and periodic fixed fee. The contract term, including renewal options, must not exceed five years and the contract must be terminable by the qualified user (the governmental entity or certain nonprofit corporations) without penalty or cause at the end of the third year of the contract term. (d) Per Unit Fee Arrangements and Certain 3-Year Contracts. All of the compensation is based on a per unit fee or a combination of a per unit fee and a periodic fixed fee. The term of the contract, including all renewal options, must not exceed three years. The contract must be terminable by the qualified user without penalty or cause by the end of the second year. (e) Percentage of Revenue or Expense Fee Arrangements and Two-Year Contracts. All the compensation for services is based on a percentage of fees charged or a combination of per unit fee and a percentage of revenue or expense fee. The term of the contract, including renewal options, must not exceed two years and the contract must be terminable by the qualified user without penalty or cause at the end of the first year of the contract. The contract must involve services to third parties or certain startup situations. Periodic fixed fees, and capitation fees and per unit fees may be automatically increased according to a specified, objective, external standard that is not linked to the output or efficiency of a facility. Revenue Procedure states the general rule that the service provider must not have any role or relationship with the qualified user that substantially limits the qualified user s ability to exercise its rights under the contract, based on all the facts and circumstances. A safe harbor is provided if (a) not more than 20% of the voting power of the governing body of the qualified user is vested in the service provider, (b) overlapping board members do not include the chief executive officer of the service provider or its governing body or the qualified user or its governing body, and (c) the service provider and the qualified user are not related parties for purposes of the Tax Code. 13

17 Research Agreements. The IRS has adopted special rules regarding research facilities and prohibitions on private use. These circumstances will come into play where a lease financing is undertaken with a university or other research entity that is either a governmental agency or 501(c)(3) corporation. In such circumstances, care must be exercised to ensure that any private benefits associated with sponsored research at the facility do not give rise to prohibited private use. Under the regulations, an agreement by a nongovernmental person to sponsor research performed by a governmental person (such as a public university) may result in private business use of the property based upon the facts and circumstances. An arrangement that results in the sponsor of the research being treated as the lessee or owner of the financed property for federal income tax purposes will give rise to private business use of the financed property. Revenue Procedure sets forth conditions under which a research agreement between a governmental person and a nongovernmental sponsor does not result in prohibited private business use. Under that procedure, a research arrangement relating to property used for basic research is permitted if any license or other use or resulting technology by the sponsor is permitted only on the same terms as the recipient would permit use by any unrelated, nonsponsoring party. In this regard, the sponsor is typically required to pay a market price for its use of the technology at the sponsored facility. The price to be paid for the products of the research must be determined at the time the licensed property or other resulting technology is available for use. The revenue procedure does not require that persons other than the sponsor be permitted to use the technology. However, the price paid by the sponsor must be no less than the price that would be paid by a nonsponsoring party, if the nonsponsoring party were entitled to access to the products of research. The foregoing rules apply to corporate sponsored research arrangements at tax-exempt financed facilities. In the case of cooperative research agreements, Revenue Procedure provides a slightly different approach. A research arrangement relating to property used pursuant to a joint industry-governmental cooperative research arrangement is permitted if (a) multiple unrelated sponsors agree to fund governmentally-performed basic research, (b) the research to be performed and the manner in which it is performed is determined by the qualified user, (c) title to any patent or other product incidentally resulting from the basic research lies exclusively with the qualified user, and (d) sponsors are entitled to no more than a nonexclusive royalty-free license to use the product at the end of any research. As is apparent from the foregoing, the concept of use for purposes of private activity obligations is complex and subtle. Whenever a private entity has a right to use a tax-exempt financed facility on a basis that is different from that under which the general public may use the facility, a strong potential for private use exists. Lease arrangements between governmental agencies and for-profit users are a clear case of prohibited private use. As is apparent in the case of research facilities, prohibited business use can arise from far less than a lease arrangement. The ability to enjoy the fruits or benefits of a facility, or consume its output, or control its operation, are all ways in which the facility may be deemed to be used by a private entity which potentially creates a private activity bond. Generally, the Tax Code looks at the question of prohibited business use on a reasonable expectations basis. This means that whether a facility is deemed to have prohibited private 14

18 business use is generally determined on the basis of the expectations of the governmental entity at the time the facility is financed. Whenever those reasonable expectations change, the governmental agency is required to take action to address the subject of prohibited private use. Either the use must be fashioned in a way that is permitted, such as a qualified management contract or qualified research facility agreement, or the issuer must take steps to retire the debt. This has significance for leasing transactions in particular. Normally an investor in a lease obligation expects that the lease will run its course and, accordingly, the lease will be priced on that basis. If expectations concerning private use arise, and if as a result the lease must be refinanced or retired before its term, the tax-exemption of the financing may be preserved at the expense of the investor s expectations. The alternative is a serious one. Under normal circumstances, if the financing results in prohibited private use, the obligation may be taxable back to the point at which that use first began, whether or not the issuer at the time expected that the private use would be prohibited. QUALIFIED PRIVATE ACTIVITY BONDS As noted above, if a obligation is a private activity bond, it is taxable unless it qualifies for an exemption from taxability under the Tax Code. Congress has recognized a variety of exemptions for otherwise taxable private activity bond. General Types of Qualified Private Activity Bonds. The exceptions under the Tax Code for certain types of qualified private activity bonds generally relate to the type of facility which is being finance, or the type of entity that is the borrower of the proceeds of the issue. The most important exception to the requirement that private activity bonds are taxable is the exception charitable not-for-profit corporations whose charitable purpose has been recognized by the Internal Revenue Service under Section 501(c)(3) of the Tax Code. As more fully described below, a qualified 501(c)(3) obligation issue is a financing the proceeds of which are used in the charitable activities of 501(c)(3) nonprofit corporations. These financings are typically undertaken for charitable entities whose purposes are religious, educational, cultural or scientific in nature. Probably the second most important category of qualified obligations is qualified small issue obligations. As described below, this category of obligations is allowed for manufacturing facilities for certain companies with limited capital investments. Another exempt facility category exists for obligations issued to finance certain exempt facilities, such as airports, docks and wharves, mass commuting facilities, water furnishing facilities, sewage facilities, solid waste disposal facilities, qualified residential rental projects, enterprise zone facility projects, facilities for the local furnishing of electrical energy or gas, local district heating or cooling facilities, qualified hazardous waste facilities, high-speed innercity rail facilities and environmental enhancements of hydroelectric generating facilities. Less useful (at least for leasing purposes) exemptions exist for enterprise zone obligations, qualified mortgage obligations, qualified redevelopment obligations and qualified student loan obligations. 15

19 If a financing of a facility qualifies as any one of the foregoing, it has the potential to be tax-exempt notwithstanding the fact that it is a private activity bond. General Requirements Applicable to Qualified Obligations. Each of the foregoing categories of qualified private activity obligations must meet certain requirements. Some of those requirements are specific to the type of exemption and are described later in these materials. Some requirements, however, are generally applicable to all types of qualified private activity bonds and are described below. Use of Proceeds. The Tax Code requires that 95% or more of the net proceeds of the issue be used to finance exempt facilities. Net proceeds is defined as the proceeds of an issue reduced by amounts in reasonably required reserve or replacement funds. The proceeds of the issue include investment proceeds earned from the investment of proceeds during the construction period. Public Use Requirement. A facility financed with exempt facility obligations must be available on a regular basis for general public use. Volume Cap Requirement. The Tax Code requires that most private activity bonds, unless otherwise excepted, obtain an allocation of the appropriate state volume cap. The volume cap limitations under the Tax Code limit the aggregate dollar amount of private activity obligations that may be issued during any year in each state. The figure for each state is schedule to increase to $225 million, or $75 per person, by Some private activity obligations are excluded from the state volume cap limitation. The most important exclusion is that which exists for qualified 501(c)(3) obligations. In addition, obligations issued for airports, docks and wharves and environmental enhancements of hydroelectric generating facilities are exempt. A portion of any exempt facility obligation issued as part of a high-speed inner-city rail facility is also exempt from volume cap limitations. Substantial User Requirement. The Tax Code provides that a private activity bond shall not be a qualified obligation for any period during which the bond is owned by a person who is a substantial user of the facilities financed with the obligations or a related person of such substantial user. Thus, private beneficiaries of qualified private activity bonds are essentially precluded from investing in obligations issued to finance their own facilities. Maturity Limitation. The Tax Code provides that the weighted average maturity of exempt facility obligations may not exceed 120% of the weighted average reasonably expected useful life of the facilities financed. Limitation on Land Acquisition. The Tax Code provides that a private activity obligation shall not be a qualified obligation if (a) it is issued as part of an issue on 25% or more of the net proceeds of the issue are used directly or indirectly for the acquisition of land, or (b) any portion of the proceeds of the issue is to be used directly or indirectly for the acquisition of land to be used for farming purposes. Certain exceptions exist for first-time farmers from this prohibition. In addition, exceptions exist for land acquired by a governmental unit or issuing authority in connection with an airport, mass commuting facility, high-speed inner-city rail facility, dock or wharf, if acquired for noise abatement or wetland preservation or for future use 16

20 as an airport, mass commuting facility, high-speed inner-city rail facility, dock or wharf, and there is no other significant use of such land. Acquisition of Existing Improved Property. The Tax Code generally prohibits the use of net proceeds of a private activity obligation for the acquisition of existing improved property (or any interest therein) unless the first use of such property is pursuant to such acquisition. Thus, private activity obligations typically cannot be used to acquire existing facilities without expansions or improvements. In this regard, the Tax Code creates an exception to the general prohibition on acquiring used property with respect to any building if the rehabilitation expenditures with respect to such building equal or exceed 15% of the portion of the cost of acquiring such building and equipment financed with the proceeds of the issue. In the case of structures other than a building, the rehabilitation expenditures with respect to such structure must equal or exceed 100% of the cost of acquiring the structure. Certain Prohibited Uses. The Tax Code states that a private activity obligation shall not be a qualified obligation if issued as part of an issue any portion of the proceeds of which are to be used to provide any airplane, skybox or other private luxury box, health club facility, facility primarily used for gambling, or store the principal business of which is the sale of alcoholic beverages for consumption off premises. Public Approval Requirement. The Tax Code provides that a private activity bond shall not be qualified unless the public approval requirements have occurred. Generally, the approval must be obtained (a) from the governmental unit issuing such obligations or on behalf of which such obligation is issued, and (b) from each governmental unit having jurisdiction over the area in which any facility financed with the net proceeds or the obligations is located. Generally, prior published notice of a hearing must be made at least 14 days prior to the date on which the hearing is to occur. Once the hearing has occurred, the public approval requirements will be met if the highest elected official of the applicable political subdivision approves the issuance of the obligations. Restrictions on Financing Issuance Costs. The Tax Code provides that a private activity bond shall not be a qualified obligation if more than 2% of the proceeds of the issue are used to finance issuance costs. In order to meet the substantially all test applicable to private activity obligations, 95% of the proceeds of the issue must be spent on qualified facilities. Costs of issuance financed with the proceeds of the obligations are therefore also required to be financed with the 5% bad money portion of the issue, and also are capped at the 2% level as described above. Alternative Minimum Tax. Private activity bonds constitute a preference item for purposes of federal alternative minimum tax provisions. Thus, private activity bonds typically trade a slightly higher interest rate (approximately 10 basis points) above a similarly structured governmental purpose obligation. QUALIFIED 501(c)(3) OBLIGATIONS CHARITABLE BORROWERS As noted above, the most important exception from the private activity bond rule that such obligations are taxable is the exception that exists for qualified 501(c)(3) obligations. In 17

21 general, these are obligations are issued for the benefit of not-for-profit corporations that have a 501(c)(3) determination letter from the Internal Revenue Service. Even though they are private activity bonds because they meet the private business use and security or payment test as described above, they are nonetheless tax-exempt given their special status under the Tax Code. A qualified 501(c)(3) obligation must be issued for the benefit of an activity that falls within the charitable purpose of the not-for-profit entity. In addition, all property which is to be provided by the net proceeds of the issue must be owned by a 501(c)(3) not-for-profit corporation, or must be owned by a governmental unit. Questions sometimes arise concerning the financing of improvements in connection with property that is leased by a 501(c)(3) corporation from a private user. In most circumstances, if the term of the lease is longer than the expected useful life of the financed property, or if the property can be removed without damaging the leasehold and the 501(c)(3) nonprofit corporation would be allowed to do so under the terms of the lease, or if the 501(c)(3) organization is required under the terms of the lease to return the leased property independently of the financed improvement, normally such financings are treated as being tax-exempt as qualified 501(c)(3) financings. If two or more 501(c)(3) corporations form a joint venture, this arrangement could adversely affect the ability of the corporations to participate in a tax-exempt financing. This would be true if the resulting entity is treated as a partnership or other separate entity for tax purposes and has not itself qualified as charitable under Section 501(c)(3) of the Tax Code. Some charitable joint ventures have been undertaken by means of limited liability companies, all the members of which are 501(c)(3) organizations. A obligation will be treated as a qualified 501(c)(3) obligation if 95% of the proceeds of the issue is used by the 501(c)(3) entity in a recognized charitable purpose. For this purpose, the private business use and private payment and security tests, in effect, are used to determine whether there is more than 5% bad use of the obligation proceeds. The 501(c)(3) use rules are, however, more restrictive in certain respects: (a) Net proceeds for this purpose are the proceeds of the issue less amounts invested in a reasonably required reserve or replacement fund. No reduction may be made for any proceeds used to finance costs of issuance for the obligations. Thus, costs of issuance are counted against the allowable 5% bad use limit. (b) The use of obligation proceeds by a 501(c)(3) organization in an unrelated trade or business is treated as a nonqualifying use and counts against the 5% limit. As is true with private activity bonds generally, prohibited nonqualifying use for 501(c)(3) obligation purposes can arise through operating or management agreements. For this purpose, the qualified management contract rules described above are applied to determine whether a management or operating agreement generates prohibited private use in a qualified 501(c)(3) financing context. Many 501(c)(3) nonprofit corporations, particularly in the healthcare industry, are undergoing a period of substantial change. Consolidations, privatizations and other changes in the relationships between the nonprofit charitable sector and the private sector are occurring with 18

22 considerable regularity. As noted above, the normal rule is that a nonprofit corporation must reasonably expect on the date of issue that all of the proceeds financed with the obligation issue will be owned by a 501(c)(3) entity or a governmental corporation and that the 95% qualified use requirement described above will be met for the duration of the obligation issue. The tax regulations, however, allow issuers that may not be able to meet these expectations to nonetheless participate in tax-exempt financings under certain circumstances described below. If the issuer (or the nonprofit user) expects as of the date of issue that an action will occur after that date that may cause the ownership requirement or the 95% use requirement to not be met over the entire life of the financing, then that action may be disregarded if the following four conditions are satisfied: (a) The issuer (or 501(c)(3) user) reasonably expects to use the property for a substantial period of time; (b) The issuer (or 501(c)(3) user) is required to redeem all nonqualified obligations within six months of an action which results in the ownership test or the use test not being met; (c) The issuer (or the 501(c)(3) user) has no arrangement for a private use or ownership as of the date that the obligations are issued; and (d) The obligations are subject to a mandatory redemption within six months after a change of use or other event resulting in a failure to meet the ownership or 95% use test. Most private activity obligations are limited by a state cap on aggregate volume of private activity bonds to be issued within each state during a calendar year. Qualified 501(c)(3) obligations are not subject to the private activity bond volume cap. MANUFACTURING FACILITIES AND ENTERPRISE ZONE FINANCINGS Two types of private activity financings, which are potentially available for leasing transactions, are qualified small issue financings and enterprise zone financings. Both are described below. Qualified Small Issue Financings. One type of qualified private activity financing is for a qualified small issue financing. The Tax Code provides that this term means any obligation issued as part of an issue which does not exceed $1 million in principal amount and 95% or more of the net proceeds of which are to be used for the acquisition, construction, reconstruction or improvement of land or depreciable property used for manufacturing purposes. In addition to the principal amount of the financing, all prior qualified small issue obligations that finance facilities in the same municipality or county and which have the same principal user as the facilities being financed are required to be included in calculating the maximum allowable principal amount of the financing. Capital Expenditures. The Tax Code allows the issuer to elect a $10 million limitation, rather than the $1 million limitation, but requires that certain capital expenditures be included in that calculation. If the issuer elects the $10 million limit, all capital expenditures paid or 19

23 incurred during the six year period, which begins three years prior to the date of the financing and ends three years after the date of financing, must be included if they are with respect to a facility located in the same incorporated municipality or the same county and if they have the same principal user as the financed facility. Thus, a qualified small issue is allowed to exceed $1 million, but may not exceed a total of $10 million reduced by capital expenditures of all principal users during the six-year period described above. In practice, this provision of the Tax Code means that most qualified small issue financings for existing businesses of any substantial size are capped at $1 million. If a new business locates an operation within the city or county, the size of the issue can exceed $1 million, but typically will not go above $10 million reduced by anticipated capital expenditures by the user within the jurisdiction during the three years subsequent to the date of the financing. The Tax Code provides that the following are not capital expenditures for purposes of the small issue capital expenditure limitation: (i) public utility improvements for the facility, (ii) leased personal property if leased by a person in the trade or business of leasing property or by the manufacturer of that property, (iii) expenditures required by a change in law or as a result of a casualty, and (iv) expenditures up to $1 million that could not be reasonably foreseen when the obligations were issued. If the $10 million limit is exceeded, the financing will become taxable on the date the expenditure occurs, but will not become taxable retroactively back to the date of the original financing. For this reason, many exempt facility small issue financings allow for the user to exceed the $10 million limit if the user agrees to retire the principal and interest on the obligations (including in many cases a pre-payment premium) on or before the first date that the obligations become taxable. As noted above, capital expenditures of all principal users are included within the $10 million limitation. Generally, a principal user is any person who owns or leases 10% or more of, or purchases more than 10% of the output of, a facility. Short-term lessees (under a lease of less than one year) generally will not be considered a principal user. In addition, any person who is a related person to a principal user is also counted for purposes of the capital expenditure limitations. Manufacturing Facilities. As noted above, qualified small issues are available principally for the purpose of financing manufacturing facilities. The Tax Code provides that manufacturing facility means any facility which is used in the manufacture or production of tangible personal property (including the processing resulting in a change in the condition of such property). Office space cannot be financed unless the office is located on the premises of the manufacturing facility and not more than a de minimus amount of the functions to be performed at such office is not directly related to the day-to-day operations of the manufacturing facility. Enterprise Zone Facility Obligations. An additional category of exempt facility private activity obligations are those which meet the requirements for enterprise zone facility obligation. This type of obligation may be used to finance improvements in enterprise communities and empowerment zones, as designated by the federal government. The Tax Code permits the Secretary of Housing and Urban Development (in urban areas) and the Secretary of Agriculture 20

24 (in rural areas) to designate, in the aggregate, 11 areas known as empowerment zones, with eight in urban areas and three in rural areas. The Secretary is also authorized to designate 95 enterprise communities (65 in urban areas and 30 in rural areas). In addition to the foregoing, the Tax Code was amended in 1997 to allow each secretary to designate 20 additional empowerment zones (15 in urban areas and 5 in rural areas) that are subject to slightly different eligibility criteria. The availability of this type of financing is limited to certain types of improvements for qualifying businesses in one or more of the designated zones. INVESTMENT LIMITATIONS THE MEANING OF ARBITRAGE As described above, the Tax Code imposes a variety of limitations and requirements on tax-exempt financing. These limitations relate to the identity of the issuer or borrower, the nature of the project, the extent to which private parties benefit from the financing and other project or issuer-related requirements. In addition to the foregoing, the Tax Code imposes a number of very stringent limitations on the investment of proceeds of the issuance. The arbitrage rules and regulations arise out of the ability of an issuer to borrow at tax-exempt interest rates and invest the proceeds of that borrowing at a higher taxable interest rate. Without regulation or limitation, this difference between taxable and tax-exempt interest rates would allow issuers of tax-exempt obligations to generate substantial investment income or arbitrage profits from the issuance of tax-exempt obligations. It was exactly these types of profits that led Congress and the IRS in 1968 to adopt prohibitions on arbitrage obligations. Under the Tax Code, if a obligation or other obligation is an arbitrage obligation, it is not taxexempt. All types of potentially tax-exempt obligations can be treated as arbitrage obligations regardless of whether they are in fact obligations. Thus, a lease obligation that violates the arbitrage regulations is treated as an arbitrage obligation, and is therefore taxable under the Tax Code. The arbitrage rules and regulations arise out of the ability of an issuer to borrow at tax-exempt interest rates and invest the proceeds of that borrowing at a higher taxable interest rate. Without regulation or limitation, this difference between taxable and tax-exempt interest rates would allow issuers of tax-exempt obligations to generate substantial investment income or arbitrage profits from the issuance of tax-exempt obligations. It was exactly these types of profits which led the IRS in 1968 to adopt prohibitions on arbitrage obligations. Under the Tax Code, if a obligation or other obligation is an arbitrage obligation, it is not tax-exempt. All types of potentially tax-exempt obligations can be treated as arbitrage obligations regardless of whether they are in fact obligations. Thus, a lease obligation that violates the arbitrage regulations is treated as an arbitrage obligation, and is therefore taxable under the Tax Code. Under the Tax Code, an arbitrage obligation means any obligation issued as part of an issue, any portion of the proceeds of which, is reasonably expected (at the time of the issuance of the obligations) to be used directly or indirectly (a) to acquire higher yielding investments or (b) to replace funds which were used directly or indirectly to acquire higher yielding investments. Definition of Proceeds. The first step in analyzing whether a financing has an arbitrage problem, is to identify what moneys, if any, in the financing constitute unspent 21

25 proceeds of the issue. In a obligation context, proceeds are typically easy to identify. Proceeds are the money that you receive in exchange for the issuance of obligations before that money gets spent on the financed project, as well as other types of funds or moneys that are deemed to be proceeds of the issue. In a municipal leasing context, proceeds may be somewhat more difficult to identify. In general, the concept of proceeds with regard to a lease is the same as the concept of proceeds in the context of a obligation. As noted above, the arbitrage investment limitations apply to all moneys that are proceeds of a obligation issued. The tax laws define proceeds as including sale proceeds, investment proceeds, transferred proceeds and replacement proceeds. Sales proceeds are the amounts that are received, actually or constructively, from the selling of a tax-exempt obligation. These amounts include compensation to underwriters and accrued interest (other than preissuance accrued interest) and all other amounts derived by the issuer from the financing. Investment proceeds are any amounts actually or constructively received from investing other proceeds. Thus, sale proceeds which were deposited in the construction fund and which are invested pending their use generate investment proceeds that are themselves treated as proceeds of the issue. Transferred proceeds are proceeds that arise when a tax-exempt obligation is used to retire a previously outstanding tax-exempt obligation. This occurs when an issuer chooses to refinance or refund its outstanding high coupon tax-exempt interest with lower coupon newly issued tax-exempt obligations. As the prior obligations are paid or retired with the proceeds of the new obligations, unspent proceeds of the prior issue transfer and become proceeds of the new refunding issue for purposes of the arbitrage regulations. Replacement proceeds include amounts that are in a sinking fund, a pledged fund or other amounts constituting replacement proceeds to the extent that the funds are held by or derived from a substantial beneficiary of the issue. Sinking funds and pledged funds generally are moneys deposited and reasonably expected to be used to pay principal or interest on a taxexempt obligation. Thus, an obligation on the part of a lessee or other borrower in a tax-exempt financing to maintain cash balances for the purpose of securing its lease payment obligations results in the creation of a pledged or sinking fund. In such a case, the lessee will be required to yield restrict these moneys (invest them at a yield no higher than the yield on the tax exempt obligation) in order to maintain a tax exemption of the obligation. Negative Pledge Accounts. The Tax Code does allow a negative pledge by an issuer or a lessee with regard to cash balances, and has treated such a negative pledge as not creating a pledged fund or a sinking fund, if certain requirements are met. This arrangement involves a covenant by the lessee or issuer that it will maintain identified cash reserves at a particular level for the direct or indirect benefit of the investors in the financing. The tax regulations provide that such a covenant does not create a yield restricted account if (i) the issuer may grant rights that are superior to the rights of the investors or the guarantor or (ii) the following three factors are true: (a) the amount does not exceed the reasonable needs for which it is maintained; (b) the level is tested not more frequently than every six months; and (c) the amount may be spent without substantial restriction other than a requirement for replenishment by for next six-month testing date. If the foregoing three requirements are met, such funds will not create a pledged or sinking fund that is subject to yield restriction. 22

26 Reasonable Reserve Funds. The Tax Code allows a reserve fund to be created in connection with the tax-exempt obligation as a source of security for the payment of the issuer s obligations, so long as that reserve fund is reasonably required. Under the tax regulations, a reserve fund is reasonably required (and, hence, permitted to be invested in materially higher yielding obligations) if the amount in the fund is not greater than the least of (i) the maximum yield of principal and interest requirements on the issue, (ii) 10% of the stated principal amount of the issue, or (iii) 125% of average annual principal and interest requirements on the issue. Rebate. In addition to yield restrictions, the arbitrage regulations also impose requirements on issuers to rebate arbitrage earnings to the government. Under these rules, even though an issuer may be entitled to invest proceeds at an unrestricted yield (such as in a reasonable required reserve fund, or in a construction fund during the temporary period), the issuer is still required to rebate to the United State Government arbitrage in excess of the obligation yield unless certain exceptions to the rebate requirement are applicable. The most common exception to the rebate requirement concerns four different rebate exceptions based upon the timely expenditure of obligation proceeds, including (i) the sixmonth expenditure exception, (ii) the six-month exception for working capital financings, (iii) the 18-month expenditure exception, and (iv) the two-year construction expenditure exception. Other exceptions exist for (i) the $5 million small issuer exception, (ii) investments of a bona fide debt service fund, (iii) investments which are themselves made in taxexempt obligations, and (iv) certain other exceptions, including yield restriction exceptions. Reimbursement Financings. One of the arbitrage related issues that often arises in the context of tax-exempt financings concerns the prohibition on reimbursement financings. This term refers to a type of tax-exempt financing under which an issuer issues tax-exempt obligations and treats such obligations as having been spent to reimburse the issuer for expenditures incurred prior to the date of issuance. By treating the proceeds of the borrowing as spent, the proceeds then become exempt from the investment limitations and rebate requirements of the arbitrage regulations. The IRS has viewed such financings as creating the potential for abuses and has regulated their use. Under the reimbursement regulations, an issuer must adopt an official intent to reimburse an expenditure with tax-exempt proceeds not later than 60 days after the original expenditure to be reimbursed is paid, and the financing must be completed not later than 18 months after the later of (i) the date the payment is made or (ii) the date the project financed with the payment is first placed in service (but in no event later than three years after the date the payment is made). Under the Tax Code, the three-year period may be extended to five years in the case of projects qualifying for a special extension based on an architect s or engineer s certificate. The notice of official intent must contain a general description of the project and the maximum amount of obligations expected to be issued. 23

27 A prior declaration of official intent is not required for the following: (i) a small amount of proceeds equal to the lesser of (a) $100,000 or (b) 5% of the proceeds of the issue; and (ii) preliminary expenditures, up to 20% of the par amount of the issue. Such expenditures include issuance costs as well as architectural, engineering, surveying, soil testing and similar costs related to the commencement of acquisition and construction of a project, but do not include land acquisition, site preparation or similar costs incident to the commencement of construction. Summary. If in connection with a municipal lease or other tax-exempt transaction, construction funds, reserve funds, debt service funds or other funds are created, it will be important to ascertain (i) whether such funds constitute proceeds of the issue, (ii) whether the funds qualify for an exception from the prohibition on materially higher yielding investments, and (iii) whether the funds will, or portions of them, qualify for an exception from the requirement that all arbitrage be rebated to the United States. 24

28 Federal Income Tax Issues in Municipal Lease Financing Gregory V. Johnson Patton Boggs LLP 1660 Lincoln Street, Suite 1900 Denver, CO (303)

29 Introduction Benefits from Leasing Exception from Voter Approval Requirements Exception from Debt Limitations Access to Broader Revenue Base Economic Value of Tax Exemption

30 Requirement of an Issuer Definition of a Political Subdivision Taxation Power Condemnation Power Police Power

31 Issuers that are not Political Subdivisions Instrumentalities of Political Subdivisions Joint Powers Authorities

32 63-20 Nonprofit Corporations Created by Political Subdivision Obligations Authorized by Political Subdivision Solely Charitable Purposes Right of Political Subdivision to Acquire Unencumbered Title the Financed Property

33 Indian Tribes Essential Governmental Functions Current IRS Scrutiny

34 Requirement of an Obligation Capital Leases: Benefits and Burdens of Ownership with Lessee Transfer of Title to Lessee for No Consideration at end of Lease Term

35 Non-appropriation Clauses Market Risk Status of Lease as Tax-Exempt Credit Enhancement

36 Mixed Asset Financings Service Contract Example Capital Acquisition Working Capital Financing Tax Analysis

37 Bank Qualified Obligations Cost of Carry Deduction Market Opportunity: Banks and Financial Institutions $1 Million Small Issuer Exception Requirement of Designation by Issuer Available for Governmental Purpose and 501(c)(3) Bonds

38 Qualified 501(c)(3) Borrowers Charitable Purposes of the Borrower Prohibition on Unrelated Business Use Avoidance of Volume Cap Change in Use Provisions

39 Other Tax Requirements Prohibition of Federal Guarantee of Obligations Prohibition on Advance Refundings Information Reporting Requirements

40 Other Tax Requirements Continued Bond Registration Prohibition on Hedge Bonds

41 Concepts of Public Use and Private Use Private Activity Bonds Private Payment and Security Tests Private Loan Tests Exceptions General Public Use Certain Short-Term Use Arrangements

42 Concepts of Public Use and Private Use Continued Measurement of Private Business Use Qualified Management Contracts Research Agreements

43 Qualified Private Activity Bonds General Types of Qualified Private Activity Bonds General Requirements Applicable to Qualified Bonds Use of Proceeds Limitations

44 Qualified Private Activity Bonds Continued Public Use Requirement Volume Cap Requirement Substantial User Requirement Maturity Limitation

45 Qualified Private Activity Bonds Continued Limitation on Land Acquisition Prohibition on Acquisition of Existing Property

46 Qualified Private Activity Bonds Continued Certain Prohibited Uses Public Approval Requirement Restrictions on Financing Issuance Costs Alternative Minimum Tax

47 Qualified 501(c)(3) Bonds Charitable Borrowers Use in Charitable Purposes Prohibition on Unrelated Business Use Exception From Volume Cap

48 Manufacturing Facilities and Enterprise Zone Financings Qualified Small Issue Financings Capital Expenditures Limits Manufacturing Facilities Enterprise Zone Facility Obligations

49 Investment Limitations the Meaning of Arbitrage Definition of Proceeds Negative Pledge Accounts Reasonable Reserve Funds Rebate Reimbursement Financings

50 Thank You for Coming Gregory V. Johnson Patton Boggs LLP 1660 Lincoln Street, Suite 1900 Denver, CO (303)