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

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. 7.2.3.1.2.

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.  (http://www.irs.gov/publications/p334/ch03.html)  “Lease of property should not be a disposition, provided it qualified as a ‘true lease.'” (https://www.vtbar.org/UserFiles/Files/EventAds/022812.pdf)  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.

Resources:

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.

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