Capital Expenditures under Treas. Reg. 1.150-1(b); Capital Assets under Treas. Reg. 1.1221-1

July 21, 2010


Treas. Reg. 1.150-1(b) defines working capital expenditures as any expenditures that are not capital expenditures.  In order to avoid analysis under the special working capital rules, therefore, it is important to determine whether expenditures constitute “capital expenditures.”

What Are Capital Expenditures:

A “capital expenditure” is any cost of a type that, under general federal income tax principles, is properly chargeable to a capital account or would be so chargeable with a proper election.  Examples include costs to acquire, construct or improve land, buildings and equipment.  Whether an expenditure is a capital expenditure is determined at the time the expenditure is paid, and future changes in law do not affect that determination.  Treas. Reg. 1.150-(b).

Sections 263 and 263A of the Code and the related regulations and rulings provide some guidance as to general federal tax principles relating to capitalization of costs.  In general, a capital asset must have a useful life in excess of one year.  Often courts have also looked to whether a separate, identifiable asset is created to determine whether costs are capital costs, but in INDOPCO (503 U.S. 79 (1992)), the court specifically found that the creation or enhancement of a separate and distinct asset is not an exclusive test for identifying a capital expenditure.  The Court also stated that it is important to determine whether a taxpayer will realize benefits that are not just incidental future benefits beyond the year in which the expenditure is incurred.

Clean-up costs are capitalizable to the land (and, since the land is not depreciable, would simply add to the basis and only be recoverable on the sale of the land). See PLR 9519020.  But see Rev. Rul. 94-38 in which the IRS determined that such costs are currently deductible, and see Announcement 2002-9 in a notice of proposed rulemaking for the capitalization of specific categories of expenditures in connection with intangible assets or benefits (prepaid items, amounts paid in respect of tangible property owned by another and transaction costs).

Certain regulations under Section 263 permit costs that otherwise are deducted to be capitalized, and vice versa.  See Treas. Reg. 1.263(a)-3.  For example, under Section 266, carrying costs, including interest costs during construction, may be capitalized.  Therefore, because Sections 148 and 150 state that capitalizable costs may be treated as actual capital costs, true capitalized interest can be treated as a capital cost and not as working capital.  For purposes of the tax-exempt bond rules, “construction” ends when the facility is “placed-in-service” within the meaning of Treas. Reg. 1.150-2(c) (operating at substantially its design level).

Capitalization Examples:

  • Demolition Costs:  The following discussion was included at TaxAlmanac regarding capitalization of demolition costs:
    • The treatment of demolition costs depends on how much of the building was demolished. If a structure is demolished, the cost of the demolition is not deductible, nor can it be added to the depreciable basis of any replacement structure; it is capitalized into the cost of the land. IRC Sec. 280B.
    • Modification of a building is not treated as a demolition subject to these rules if at least 75% of the existing external walls remain in place as external or internal walls, and at least 75% of the internal structure of the building remains in place. Rev. Proc. 95-27, 1995-1 CB 704. If Sec. 280B is not applicable, then generally the demo costs would be capitalized as part of the depreciable cost of the improvements under IRC Sec. 263A (UNICAP).
  • Software:  Capitalization of software is required under Section 197(a) and Section 167(f)(1), generally.  However, capitalization is not required for off-the-shelf software.
    • Instructional software is treated as a supply expenditure in the same manner as textbooks and other instructional supplies are treated.  This should not be treated as a capital expenditure.
    • Operating (non-instructional) system software should be treated as a fixed asset that can be capitalized and depreciated over time as any other asset based on the following criteria: (1) meets any local capitalization thresholds (e.g., $1,000); (2) lasts more than one year; (3) software faults like equipment faults are more likely to be repaired than replaced; (4) the typical capitalization requirement that the equipment be an independent unit rather than being incorporated into another item does not apply in the case of software; (5) the value of software and normal licensing requirements may take the place of typical inventory tagging procedures; (6) the software does not replace or enhance textbooks or other instructional supplies.
    • The administrative guideline for the useful life of software in Rev. Proc. 62-21 set forth a five-year useful life of computer software.  In 1993, I.R.C. 167(f)(1) provided for a three-year life for depreciation purposes.
    • See PLR 200515006: “The Issuer intends to issue bonds in a maximum principal amount not to exceed $a (the “Bonds”) to finance all or a portion of the costs of certain computer software which it will use to perform administrative functions, including financial accounting, procurement, payroll, and personnel administration (the “Computer Software”). The Issuer does not request a ruling as to the average reasonably expected economic life of the Computer Software. The Issuer requests this ruling to help the Issuer determine whether the Bonds will meet the safe harbor against the creation of replacement proceeds under § 1.148-1(c)(4)(i)(B)(2) of the Income Tax Regulations and whether the Bonds will have an average maturity that is no longer than reasonably necessary for the governmental purposes of the Bonds.”
    • See also Treas. Reg. 1.148-7(g)(4), regarding the treatment of specially developed computer software as a construction expenditure for purposes of the two-year spending exception.
    • See CCA 201549024 (December 7, 2015) treating the cost of an Enterprise Resource Planning (ERP) software (including the sales tax) as a capital expenditure pursuant to I.R.C. 263(a) and under I.R.C. 167(f) was amortizable ratably over 36 months, beginning in the month the software was placed in service.  Because the taxpayer was unable to use the ERP software without the option selection and implementation of templates, the cost of the templates was capitalized as part of the ERP software.
  • Repairs:  See,,id=231440,00.html#14. Do not capitalize:
    • Improvements that keep property in efficient operating condition
    • Restorations of property to its previous condition (note that some restorations might be capitalizable, under Treas. Reg. 1.263(a)-3T(i))
    • Repairs that protect the underlying property through routine maintenance
    • Repairs that consist of incidental repairs to property
    • Unless Treas. Reg. 1.263(a)-3T(i) applies, it may be prudent not to capitalize (or treat as a capital expenditure) carpet replacements.  But, consider viewing the carpet replacement as a related working capital expenditure under the de minimis working capital rules.
  • Litigation Costs:  See, for example, 410 F.2d 313 (8th App), affirming 49 T.C. 377 (1969)
    • The cost of defending or perfecting title to property is a capital expenditure.
    • Look to the primary purpose of the litigation to determine deductibility.
    • If the litigation cost relates to acquisition of a capital assets, the cost is generally capitalizable and there is no need to review the primary purpose of the litigation.
  • Tax Credits:  See, e.g., Temple v. Commissioner, 136 T.C. 341 (April 5, 2011), on whether Colorado income tax credits are capital assets and whether the seller of a Colorado income tax credit may treat the gain on sale of the credit as a capital asset.  The court concludes that the credit is a capital asset.
  • Purchase Options:  An option to purchase land, for example, is treated as a capital asset under I.R.C. 1234(a), whether or not the option is exercised.
    • Can a lapsed option be tax-exempt financed with reimbursement bond proceeds? Probably not. One would need a valid reimbursement resolution.  However, the lapsed option would have no useful life left.  May be difficult to argue that it is still a good capital asset for tax-exempt bond purposes if the asset doesn’t have any life when it is financed.  It may be necessary to treat the cost as a related working capital cost.
    • Can an outstanding option be tax-exempt financed? Yes, but one might need to caution that the useful life will likely be short.

See Also:

Section 1.263(a)-5(a) of the Regulations concerning capitalization of facilitating payments.

Financing Energy Related Facilities; Tax Credits Generally

July 14, 2010

Solar Panel Array

Topics addressed in this posting:

  1. New Clean Renewable Energy Bonds
  2. Qualified Energy Conservation Bonds
  3. Renewable Energy Production Tax Credits (PTC)
  4. Energy Investment Tax Credits (ITC)
  5. Renewable Energy Grants
  6. Common Ownership Structures and Tax Issues
  7. Claiming Investment Credits
  8. Other Matters

1.  New Clean Renewable Energy Bonds:

[To come]

2.  Qualified Energy Conservation Bonds:

Issuers must be states, political subdivisions and entities empowered to issue bonds on behalf of any such entity.  Issuer also include conduit issuers.  QECBs must be used for one or more “qualified conservation purpose,” including the following:

  • Capital expenditures for (i) reducing energy consumption in publicly owned buildings by at least 20 percent, (ii) implementing green community programs, (iii) rural development involving the production of electricity from renewable energy sources, or (iv) facilities eligible to be funded by NCREBs (except for Indian coal and refined coal production facilities);
  • Expenditures (not limited to capital expenditures) with respect to research facilities, and research grants, to support research in (i) development of cellulosic ethanol or other nonfossil fuels, (ii) technologies for the capture and sequestration of carbon dioxide produced through the use of fossil fuels, (iii) increasing the efficiency of existing technologies for producing nonfossil fuels, (iv) automobile battery technologies and other techologies to reduce fossil fuel consumption in transportation or (v) technologies to reduce energy use in buildings; and
  • Certain mass commuting facilities, demonstration projects and public education campaigns to promote energy efficiency.

3.  Renewable Energy [Electricity] Production Tax Credit (PTC):

Section 38 of the Code (setting forth permissible business tax credits) currently expressly permits the inclusion in total tax credits the “renewable electricity production credit” (PTC) under Section 45(a) of the Code.  Here is a summary of the PTC:

Under present law, an income tax credit of 2.1 cents/kilowatt-hour is allowed for the production of electricity from utility-scale wind turbines, geothermal, solar [* See note below], hydropower, biomass and marine and hydrokinetic renewable energy plants. This incentive, the renewable energy Production Tax Credit (PTC), was created under the Energy Policy Act of 1992 (at the value of 1.5 cents/kilowatt-hour, which has since been adjusted annually for inflation)


The PTC was originally introduced in 1992 pursuant to the Energy Policy Act of 1992, referenced above.  The American Jobs Creation Act of 2004 (H.R. 4520) expanded the PTC to include additional resources, including solar energy, in addition to then existing resources permitted under the PTC.  The Energy Policy Act of 2005 (EPAct 2005), however, removed solar energy resources from the PTC’s scope.  The Wikipedia description incorrectly states that the PTC is still available for solar projects.  See Section 45(d)(4) of the Code. An election may be made to take the Energy ITC (see below) instead of the PTC.

Also note that the Energy ITC and PTC is not available with respect to property in which a Section 1603 “Renewable Energy Grant.”  See Section 48(d).  See also, generally:

Refined Coal:  PLR 201430008, 201430009 and 201430010

4.  Renewable Energy/Federal Business Energy Investment Tax Credit (ITC):

Section 38 of the Code (setting forth permissible business tax credits) currently expressly permits the inclusion in total tax credits the “investment tax credits” (ITC) under Section 46 of the Code.  ITCs include five types of credits.  The Energy credit ITC is summarized below and is more fully described in Section 48 of the Code:

This investment tax credit varies depending on the type of renewable energy project; solar, fuel cells ($1500/0.5 kW) and small wind (< 100 kW) are eligible for credit of 30% of the cost of development, with no maximum credit limit; there is a 10% credit for geothermal, microturbines (< 2 MW) and combined heat and power plants (< 50 MW). The ITC is generated at the time the qualifying facility is placed in service. Benefits are derived from the ITC, accelerated depreciation, and cash flow over a 6-8 year period.


The construction, reconstruction or erection of the property must be done by the taxpayer, or the original use must be with the taxpayer if the taxpayer acquires the property.   Property qualifies only if depreciation (or amortization) is allowable.  The credit does not apply to the portion of the basis of any property that is attributable to qualified rehabilitation expenditures (another type of ITC set forth in Section 47 of the Code).  There are a number of coordination rules with the PTC in Section 45 that need to be adhered to.

Also note that the basis of the property (upon which the credit is calculated) is reduced if the property is financed in whole or in part by (a) subsidized energy financing or (b) tax-exempt private activity bond proceeds (within the meaning of Section 141).  The reduction equals = basis of the property * (basis of the property allocable to such financing or proceeds / total basis of the property).  “Subsidized energy financing” means financing provided by federal, state or local program that aims to provide subsidized financing for projects designed to conserve or produce energy.  But see subparagraph (D) which states that this limit is not applicable to periods after December 31, 2008.

Also note that the Energy ITC and PTC is not available with respect to property in which a Section 1603 “Renewable Energy Grant.”  See Section 48(d).  See also, generally:

Currently (July 2014), I.R.C. 48(a) provides for an energy credit equal to 30% of the cost basis of qualifying energy property placed in service before January 1, 2017.

See IRS Notice 2013-29 regarding when construction begins for purposes of the limitations contained in Section 48 that construction begin by December 31, 2013.  The notice includes discussion of the 5% safe harbor for determining the begin of construction.

PLR 201426013 (Mar. 19, 2014):  Relates to a partnership in Puerto Rico and the restriction contained in I.R.C. 50(b)(1)(A).  Partnership operates solar energy facilities in Puerto Rico.  The facilities are not eligible for the PTC under I.R.C. 45.  Ruling requested that, (1) assuming that Partnership is regarded as a valid partnership for federal tax purposes and that each partner will be regarded as a valid partner, each partner will be regarded as an owner and user of the facilities to the extent of its respective share of the basis of each facility for purposes of I.R.C. 50(b)(1)(B) and, therefore, will be entitled to share of the energy credit in accordance with Treas. Reg. 1.46-3(f), and (2) to the extent each partner is so regarded, the facilities will not be ineligible for the energy credit by I.R.C. 50(b)(1)(A).

5.  Renewable Energy Grants (Section 1603 Grants):

Preliminary Caution: The Renewable Energy Grant (Section 1603 Grant) is available only to tax-paying entities. Federal, state and local government bodies, non-profits, qualified tax energy credit bond lenders and cooperative electric companies are not eligible to receive this grant. Partnerships and pass-through entities for the organizations described above are also not eligible to receive this grant, except in cases where the ineligible party only owns an indirect interest in the applicant through a taxable C corporation.

The Section 1603 Grant arises from the American Recovery and Reinvestment Act of 2009, and was extended by the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (H.R. 4853).  The grant is available to taxpayers who qualify for the Energy ITC or the PTC (each described above), and may be received in lieu of the Energy ITC or PTC (See Section 48(d) of the Code).  The grant is not included in the gross income of the taxpayer.  Certain recapture provisions apply with respect to credits taken prior to election of the grant.

For solar-related property, the grant is equal to 30% of the basis of the property.  Solar-related property includes equipment that uses solar energy to generate electricity, to heat or cool (or provide hot water for use in) a structure, or to provide solar process heat.  Passive solar systems and solar pool heating systems are not eligible.  Hybrid solar lighting systems, which use solar energy to illuminate the inside of a structure using fiber-optic distributed sunlight, are also eligible.

In order to qualify for the grant with respect to particular qualifying property, construction must begin before January 1, 2012.  Construction begins as soon as the applicant has incurred or paid at least 5% of the total cost of the property, excluding land and certain preliminary planning activities.

Grant applications must be submitted by October 1, 2012. The U.S. Treasury Department is to make determinations of grants within 60 days of the grant application date or the date the property is placed in service, whichever is later.

See also the following sources of information:

6.  Common Ownership Structures and Tax Issues

Certain of the matters discussed under this heading are based on the helpful publication by Novogradac & Company available online.

The three most common structures for renewable energy financings are:

  1. Partnership Flip Structure
  2. Master-Tenant/Lease Pass-Through Structure (Inverted Lease)
  3. Sale/Leaseback

Partnership Flip Structure.  In this structure, the developer is the GP (general partner) and the investor (e.g., a bank) is the LP (limited partner) of the property owner partnership.  The property owner owns and operates the renewable energy facility.  This structure originated with wind energy facility financings and has been used successfully in connection with other types of financings.

Master-Tenant/Lease Pass-Through Structure.  In this structure, the developer is the GP of the developer/property owner partnership. The property owner/partnership, as lessor, leases the facility to a master-tenant lessee, which is a partnership with the investor as the LP.  Pursuant to election by the lessor, the tax credits flow through to the lessee entity.  The lessee entity is a partnership in the lessor entity and contributes capital to the lessor to be used to construct the project.  This structure is said to have originated in historic tax credit transactions.

Sale/Leaseback.  In this structure, the developer constructs the facility and sells it to the investor. The investor immediately leases it back to the developer for operation. The developer makes lease payments to the investor.  The investor, as owner, taxes the tax credits and all other benefits. The structure might not be applicable for production tax credits, but apparently can be used for investment tax credits and the Section 1603 Grant.

Tax Issue: Rev. Proc. 2007-65.  This Revenue Procedure establishes the requirements (the Safe Harbor) under which the IRS will respect the allocation of sec. 45 wind energy production tax credits by partnerships in accordance with sec. 704(b).  Novogradac suggests that this Revenue Procedure applies in connection with other renewable energy financings, too, absent other guidance.  The Safe Harbor is intended to simplify the application of sec. 45 to partners and partnerships that own and produce electricity from qualified wind energy facilities.

Sec. 704(b) states that, while a partner’s distributive share of tax items may be determined by the partnership agreement under subsection (a), if either the partnership agreement does not discuss distributive shares or the distribution set forth in the agreement does not have “substantial economic effect,” the allocation must be determined in accordance with the partner’s interest in the partnership.

The Safe Harbor only applies if the Developer, Investor and Project Company satisfy each and every requirement in section 4 of the revenue procedure, addressing the following matters:

  1. Partners’ Minimum Partnership Interest:  Developer must have a minimum of 1% interest in each material item of partnership income, gain, loss, deduction and credit.
  2. Investor’s Minimum Unconditional Investment: The Investor must make a minimum unconditional investment in the Project Company and maintain the investment during the duration of its ownership of its partnership interest in the Project Company.  The Investor may not be protected against loss of any portion of the investment.
  3. Contingent Consideration
  4. Purchase Rights: Neither Developer nor Investor may have a contractual right to purchase the wind farm at any time at a price less than its FMV, and the Developer may not have a right to purchase the wind farm or an interest in the Project Company earlier than 5 years after the qualified facility is first placed in service.
  5. Sale Rights:  The Investor cannot have a right to cause any party to purchase its partnership interest in the Project Company
  6. Guarantees and Loans
  7. Allocation of Sec. 45 PTC
  8. Separate Activities for Purposes of Sec. 469

7. Claiming the Credit:

Use Form 3468 to claim the investment credit.  The investment credit consists of not only the renewable energy investment credit but also the rehabilitation, qualifying advanced coal project, qualifying gasification project, qualifying advanced energy project and qualifying therapeutic discovery project credits.

If you lease the property to someone else, you may elect to treat all or part of your investment in new property as if it were made by the person who is leasing it from you.  Once the election is made, the lessee will be entitled to an investment credit for that property for the tax year in which the property is placed in service and the lessor will generally not be entitled to such a credit.

8. Other Matters:

Depreciation and Power Purchase Agreements:  “Value of Power Purchase Agreements May Significantly Increase Tax Benefits of a Renewable Energy Facility,” May 7, 2012, available online at (reporting on PLR 201203003). “In the Letter Ruling, the IRS concluded that a taxpayer, who purchased a wind energy facility subject to a facility-specific PPA, was not required to treat the PPA as a separate asset. Accordingly, the portion of the purchase price attributable to the value of the PPA would be taken into account in determining the basis of the wind energy facility for purposes of calculating depreciation. Thus, the cost of acquiring the facility, including the PPA, could be recovered over the class lives of the facility’s depreciable property and no costs would be allocated to the PPA.”

Tolling Agreements:  A tolling agreement is an agreement whereby a “toller” agrees with an owner of raw materials to process the raw materials for a specified fee (a “toll”) into a product with the raw material and product remaining the property of the provider of the raw material.  (Tolling agreement may also be an agreement that has the effect of tolling or suspending the course of a fixed period of time.)

EP&C Agreements:  This is an acronym for “Engineering, Procurement and Construction” agreements.

Megawatt:  A watt is a unit of power.  It is defined as 1 joule per second, and measures the rate of energy conversion or transfer.  A megawatt is equal to one million watts.  A large residential or commercial building may consume several megawatts in electric power and heat.  The productive capacity of electrical generators if often measured in megawatts.  A typical wind turbine has a power capacity of 1-3 MW.  U.S. nuclear power plans have net summer capacities between 500 and 1300 MW.  A gigawatt is equal to one billion watts (or 1,000 megawatts).  The installed capacity of wind power in Germany was 25.8 GW.  If a light bulb has a power rating of 100 watt-hours, this means it consumes 100 watt in one hour.  The watt second is a unit of energy, equal to one joule.

BTU:  British Thermal Unit:  This is a traditional unit of energy equal to about 1,055 joules.  It is approximately the amount of energy needed to heat 1 pound of water.  The unit is used most often in power, steam generation, heating and air conditioning industries.  In scientific contexts, the BTU has largely been replaced by the joule, but is still used as a measure of agricultural energy production.

Notices and other IRS Publications:

Notice 2009-52: Procedure for electing energy tax credit in lieu of production tax credit. See this client alert for more background information.

Announcement 2009-69: Announcement on safe harbors and guidance concerning Rev. Proc. 2007-65.  See this client alert for more background information.

IRS Notice 2006-88: Electricity Produced from Open-Loop Biomass. Addresses what a biomass facility is and what biomass is. Also discusses sale requirement to unrelated parties and sale where steamboat commingled with non-biomass facilities, and how to distinguish between the biomass produced electricity and the non-biomass electricity.

Section 48(d) prior to the 1990 tax act: Click here.

AM2011-004: Memorandum of the Office of Chief Counsel relating to excessive payments under the Section 1603 Grant.

Selected 1603 Grant Materials by Chadbourne: Click here.

Remedial Actions (Treas. Reg. 1.141-12, and Elsewhere)

July 13, 2010

General Rule:

Under the private activity bond regulations, any deliberate act by the issuer after bond issuance that results in a satisfaction of the private business tests or the private loan test will result in private activity bond status unless one or more qualifying remedial actions is taken by the issuer.  An action is not treated as a deliberate action if (a) five conditional requirements are met and (b) one of three remedial actions is taken with respect to “nonqualified bonds.”  Tax compliance certificates will commonly refer to these requirements. A deliberate act or action means any action, occurrence or omission by the issuer that is within the control of the issuer which causes either (a) the Private Business Use Test to be satisfied with respect to the bonds (without regard to the private security or payment test of Section 141(b) of the Code), or (b) the Private Loan Financing Test to be satisfied with respect to the bonds or the proceeds thereof.  An action, occurrence or omission is not a deliberate action if (a) the action, occurrence or omission would be treated as an involuntary or compulsory conversion under Section 1033 of the Code, or (b) the action, occurrence or omission is in response to a regulatory directive made by the government of the United States.

Until alternate guidance is issued, remedial action provisions in Treas. Reg. 1.141-12 apply to build America bonds, based on conversations with the Internal Revenue Service and based on I.R.M.

Conditional Requirements:

  1. Reasonable expectations:  Issuer must have reasonably expected that it would not meet the private business tests or the private loan test;
  2. Reasonable bond maturity:  Term of the issue must not be unreasonably long.  This requirement is met if the WAM of the bond issue is not greater than 120% of the expected economic life of the bond-financed property (e.g., “The Bonds have a weighted average maturity (___ years) that does not exceed 120% of the average reasonably expected economic life of the capital improvements financed or refinanced by the Bonds (such economic life is at least ___ years).”);
  3. Fair market value consideration:  Terms of any agreement must be bona fide and on an arm’s-length basis, and the new user must pay a fair market value consideration for the use of the bond financed property;
  4. Disposition proceeds are gross proceeds:  The issuer must treat any disposition proceeds as gross proceeds subject to arbitrage/rebate restrictions. Disposition proceeds are the moneys received from the sale of bond financed property (generally, but see full definition).
  5. Proceeds spent for governmental purposes:  Prior to the deliberate action, the affected proceeds must have been spent for a governmental purpose (or, for the 501(c)(3) purpose).

Remedial Actions:

  1. Redemption or defeasance of non-qualified bonds:  Note, there is a special rule in section 1.1001-3(e)(5)(ii)(B)(1) that prevents defeasance of a tax-exempt bond from being a signficant modification in certain cases.  Also note that this remedial action is not available (i.e., that the establishment of a defeasance escrow does not satisfy the requirements of the remedial action) if the period between the issue date and the first call date of the bonds is more than 10 1/2 years (see also description under next heading).
  2. Alternative use of disposition proceeds:  Requires a disposition for which the consideration is exclusively cash.
  3. Alternative use of facility.

Note: It has been suggested that, for Build America Bonds, an additional remedy should be considered that might allow the IRS to simply disqualify subsidy payments from non-qualified bonds. The effect of a remedial action is to cure use of proceeds that causes  the private business use test or the private loan financing test to be met.  A remedial action does not affect application of the private security or payment test. Note in the case of bonds that have been advance refunded:  If proceeds of an issue were used to advance refund another bond, a remedial action taken with respect to the refunding bond proportionately reduces the amount of proceeds of the advance refunded bond that is taken into account under the private business use test or the private loan financing test.

Does a lease constitute a disposition for which the consideration is exclusively cash? Perhaps it is not a disposition at all, and the alternative use of disposition proceeds remedial action cannot be used.  (  “Lease of property should not be a disposition, provided it qualified as a ‘true lease.'” (  In Rev. Rul. 75-457, the IRS concluded that a disposition occurs when the seller’s rights are materially disposed of or altered.  See IRS Publication 544, Sales and Other Dispositions of Assets.

Reasonable Expectations Exception:

The first condition to remedial action is that the issuer must reasonably expect, on the issue date of the bonds, that the private activity bond tests will not be met during the entire term of the bonds.  “Term of the bonds” means the stated term.  However, there is an exception where the issuer in fact expects as of the issue date to take action that causes either the private activity bond tests to be met. To take advantage of this exception, the issuer must provide for redemption of the nonqualifying bonds within six months of the offending action and meet the regulatory conditions for remedial action.  The “term of the bonds” in the case of this exception will then be the term from the issuance of the bonds through the mandatory redemption date.  See Section 12:9 of White, “Private Activity Bond Tests,” 2012 Edition. Here are the regulatory requirements:

  1. The issuer must reasonably expect, as of the issue date, that the bond-financed property will be used for a governmental purpose for a substantial period before the action is taken. “Substantial period” is not defined.  One might look to the measurement period provisions relating to the private business use where, for purposes of determining the date of commencement of the private business use, 10% of the measurement period is generally treated as a substantial period.  As an overall rule, however, “Private Activity Bond Tests” in Section 10:5 suggests that facts and circumstances related to the particular matter will apply.  Some firms believe that 3 to 5 years is a substantial period.
  2. As of the issue date, the issuer may not enter into any arrangement with a nongovernmental person with respect to the specific action which is reasonably expected to cause the private activity bond tests to be met.  For example, if an issuer as of the issue date enters into an agreement to sell a bond-financed facility to an identified nongovernmental person five years after completion of the facility, such contract is an arrangement in violation of the condition, and the reasonable expectation as of the issue date will cause the bonds to be private activity bonds.  (Remedial action otherwise permitted by the regulation is not available in this case because remedial action only cures satisfaction of the private business use test caused by deliberate action after the issue date that is not reasonably expected as of the issue date.)
  3. The mandatory redemption of the bonds must meet the conditions otherwise required for remedial action under the regulations.  This includes the following:
    1. The term of the issue must not be longer than reasonably necessary for the governmental purposes of the issue;
    2. Any arrangement which causes the private activity bond tests to be met must be bona fide and arm’s length;
    3. The new user must pay a fair market value for the use of the financed property;
    4. Disposition proceeds must be treated as gross proceeds for arbitrage and rebate purposes; and
    5. The proceeds of the issue affected by the deliberate action must be spent on a governmental purpose before the date of the deliberate action.

The above discussion is taken in large part, and to certain extents verbatim from White, “Private Activity Bond Tests,” 2012 Edition, published by WEST.

The 10 1/2 Call Limitation Requirement:

This 10 1/2 call limitation requirement is set forth as a condition to satisfying the defeasance remedial action.  It is important to note (as a panelist at a recent NABL Tax and Securities Law Conference session noted) that, where a bond is changed from one interest mode to the fixed rate mode, the fixed rate investors may require a 10 1/2 call period starting on that conversion date.  However, because the 10 1/2 call limitation for remedial action purposes begins on the issue date, the bonds, upon such conversion, will not satisfy this requirement.  The result is that either the fixed rate bonds can be callable with much shorter n0-call restrictions or the bondholders forfeit call protection, which will result in increased interest costs. Otherwise, the issuer will run the risk that this defeasance remedial action is not available.  If the initial interest mode (e.g., a weekly mode) contained the ability to optionally redeem within the 10 1/2 year window, but the subsequent mode does not provide a call until more than 10.5 years after the conversion, some bond counsel have decided to disregard the initial interest mode redemption ability and find that the bonds do not meet the call limitation requirement.  Other counsel have provided for special redemption provisions that permit an early redemption in the event that a change in use situation occurs. Note that “first call date” for purposes of this limitation does not require a first call date at which no redemption penalty is paid.  A transaction will still satisfy the first call date limitation even if there is a make whole or other redemption penalty.

Proposed 2003 Regulations:

The Treasury Department on July 21, 2003, published proposed regulations (REG 132483-03) to revise various sections of Treas. Reg. 1.141-12.  See I.R.B. 2003-34.

Remedial Actions Elsewhere in the Code and Regulations:

Formal remediation provisions:

  • Private use regulations under Treas. Reg. 1.141-12 (see discussion above)
  • Expected private use under Treas. Reg. 1.141-1(d)(4)
  • Non-qualified use of exempt facility under Treas. Reg. 1.141-2
  • Private ownership prohibition for 501(c)(3) financings under Treas. Reg. 1.145-2(b)(3)
  • Small issue and redevelopment bond violations under Treas. Reg. 1.144-2
  • Prepayment under Treas. Reg. 1.148-1(e)(2)(iii)(F)
  • Long term working capital under Prop. Treas. Reg. 1.148-1(c)(4)(ii)(B)
  • Skyboxes, public approval, etc. under Treas. Reg. 1.147-2
  • Expanded service area under I.R.C. 142(f)(4)
  • Unspent proceeds of tax credit bonds under I.R.C. 54A(d)(2)(B)(i)
  • Proposed rule for substantial deviations from public approval under Prop. Treas. Reg. 1.147(f)-1(b)(6)(iii)
  • Correction of single family mortgage bond requirement failures under Treas. Reg. 6a.103A-2(c)(1)(iii) and I.R.C. 143(a)(2)(B)(iii)
  • Borrower consequences for violations under I.R.C. 150 and Treas. Reg. 1.150-4
  • Late elections option for a ruling under Treas. Reg. 301.9100-1 et seq.

Less formal remediation provisions:

  • Yield reduction payments under Treas. Reg. 1.148-5(c)
  • Late rebate payments under Treas. Reg. 1.148-3(h)
  • Reallocations under Treas. Reg. 1.148-6(d)(1)(iii)
  • Post-issuance multipurpose allocations under Treas. Reg. 1.148-9(h)(2), Treas. Reg. 1.141-13(d)(1) (but not Treas. Reg. 1.140-1(c)(3), where the election needs to be made on or before the issue date)

Other Information:

In Rev. Proc. 97-15, the IRS provides a program in which issuers which cannot meet a listed remedial action can enter into a closing agreement with the IRS to avoid private activity bond status. The final regulations also contain remedial action rules for exempt facility bonds, qualified small issue bonds, qualified 501(c)(3) bonds and bonds that violate certain of the special private bond rules of section 147 of the Code. For purposes of applying the private activity bond rules, 501(c)(3) organizations that do not engage in unrelated trades or businesses are treated as governmental units.  Thus, the general remedial action rules described above are applicable for qualified 501(c)(3) bonds.

Can bank qualification issues under I.R.C. 265(b)(3) be remediated?  LB&I has jurisdiction, and coordination between TEB and LB&I may be difficult.


See this IRS publication of May 2012 re: “Sale of Assets Financed with Tax-Exempt Bond” PLR 9345031, regarding (deliberate) actions in connection with the sale/transfer/lease by a governmental entity of its hospital facilities to a 501(c)(3) organization.  Applies concepts relating to Rev. Proc. 93-17. PLR 9522025 (Mar. 2, 1995): Application of remedial action rule under Rev. Proc. 93-17.  Sale of hotel to private operator, tender offer of bonds and defeasance of bonds. See Rev. Proc. 79-5 (Jan. 1, 1979) regarding excess bond proceeds in the context of private activity bonds.  Under the procedure, the excess bond proceeds must be used to redeem the outstanding bonds or establish an escrow for redemption.

Relevant Internal Revenue Service Publications

July 12, 2010

Rev. Proc. 2010-23: Qualified mortgage bonds; mortgage credit certificates; national median gross income.  This revenue procedure provides guidance with respect to the United States and area median gross income figures that are to be used by issuers of qualified mortgage bonds, as defined in § 143(a) of the Internal Revenue Code, and issuers of mortgage credit certificates, as defined in § 25(c), in computing the housing cost/income ratio described in § 143(f)(5).