Private Use Generally

September 16, 2010

A.  General Private Use Discussion:

In the case of qualified 501(c)(3) bonds, section 145 of the Code requires that 95% of the proceeds of tax-exempt bonds must be used in the exempt activities of the 501(c)(3) organization. Private use is measured over the entire term of the bond issue, rather than on an annual basis.

Frequent private use issues that arise in connection with qualified 501(c)(3) financings include: (1) unrelated trade or business; (2) leases and management contracts; (3) research agreements; (4) agents and employees; (5) short-term uses; (6) changes in use.  Certain of these matters are discussed below.

B.  Agents and Employees:

Use of a facility by an agent of the 501(c)(3) organization does not give rise to private use. The regulations are silent with respect to use by employees of the 501(c)(3) organization.  For instance, the regulations are not clear on how to evaluate employment contracts with senior management or other professional employees, which may not satisfy safe harbors.  According to texts published on this matter, IRS representatives have indicated that employees should generally be considered agents.  Employment contracts should therefore not need to satisfy the service contract provider provisions.

C.  Change in Use:

A change in use of bond financed facilities can cause private use problems endangering the exempt status of interest on bonds.  Remedies include redeeming bonds, using disposition proceeds for an alternate qualified use, using the bond financed facilities for an alternate qualified use, or paying the IRS an amount equivalent to the lost tax revenues (income or alternative minimum) under Rev. Proc. 97-15.  Financial penalties may apply under section 150(b) of the Code in the event of a change in use of bond financed facilities.

D.  Questions and Answers:

Issue: Private use when seller retains interest in property?

See IRS Private Letter Ruling 200502012.  This letter ruling addresses various types of interests purchased by a governmental entity.  One interest is a future interest in fee simple with the seller retaining a life estate.  The IRS finds that (1) the entitiy’s future interest in fee simple is the “bond-financed property” for private use purposes, (2) the entity and the seller will have distinct property interests that occur at different times and (3) the use of the property by the seller during the retained life interest will not impinge on the use by the entity during the Authority’s future interest.  Based on these findings, the IRS concludes that the seller’s use of the parcel will end at the end of the life estate, the seller will therefore not use the bond-financed property  and the Authority’s acquisition of the future interest in fee simple therefore does not give rise to a private business use of the bond proceeds.

Issue: Private corporation has a contract for broadcast, advertising and vending rights relating to bond-financed stadium. Does the contract cause private use?

See IRS Private Letter Ruling 201049003 (July 6, 2010). University will issue tax-exempt bonds to refinance improvements to its stadiums for which private corporation has a contract for broadcast, advertising, and vending rights. The agreement will not cause the private business use test of sec. 141(b)(1) to be met. “We think that the airing, distribution, and syndication of the Productions and the sale of the advertisements to be aired during the Productions are too remote to be considered use of the Bond-Financed Improvements.” And the corporation’s tangible uses of the stadiums are incidental uses within the meaning of sec. 1.141-3(d)(5).

Federal Home Loan Bank (FHLB) Confirming Letters of Credit

September 10, 2010

(This post relates to FHLB Confirming Letters of Credit and the prohibition of federal guaranties under the Code.)

General Information:

The Housing and Economic Recovery Act of 2008 (the “Act”), signed into law by President Bush on July 30, 2008, permits a regional Federal Home Loan Bank (“FHLB”) to extend its existing guarantee programs (each, a “Program”) to a wide array of tax-exempt bonds.   The ability to “wrap” bond transactions improves credit ratings and reduces interest costs to borrowers.

Statutory Authority:

Pursuant to Section 3023 of the Act, bonds issued after the date of enactment of the Act, and before January 1, 2011 (the “Issuance Period”) by states and local governments and guaranteed by a regional FLHB are eligible for treatment as tax-exempt bonds.  Prior to the enactment of the Act, the tax-exempt status of interest on bonds (other than bonds issued to finance housing programs) that were guaranteed by a regional FHLB was questioned by the Internal Revenue Service in various audits and generally prohibited under the Internal Revenue Code of 1986, as amended.

In accordance with the Act, the FHLB guarantee must be made in connection with the original issuance of bonds and includes a renewal or extension of the original guarantee.  Consequently, the protection of the Act does not apply to a FHLB guarantee that is added after the original issuance of tax-exempt bonds even if those bonds were issued during the Issuance Period.  The Act also requires that any guarantee by a FHLB must meet safety and soundness requirements similar to those in effect under regulations applicable to FHLBs as of April 9, 2008.  Eligible issuances could include new money and refunding issues that are issued during the Issuance Period.  (See Notice 2008-79 for the refunding discussion.)  A recent example of a refunding issue utilizing an FHLB Boston confirming letter of credit is the $5,800,000 Massachusetts Development Finance Agency Variable Rate Demand Revenue Bonds Family Service Association of Greater Boston Issue, Series 2009 (available via EMMA).

The typical guarantee extended by a FHLB is either in the form of a LOC (direct-pay or standby) or in the form of a confirmation of a LOC issued by a Member Bank.  The need for the FHLB LOC or confirmation of a LOC issued by a Member Bank arises in the case of either a low credit rating or the lack of a credit rating altogether of a Member Bank.  A LOC extended by a Member Bank with a low or nonexistent credit rating will result in unfavorable rates for the bonds guaranteed by the LOC, whereas a LOC issued or confirmed by a FHLB, which boasts a “AAA” rating, will result in favorable rates on bonds and lead to interest savings for borrowers.

An issuance or confirmation of a LOC by a FHLB can be obtained via request of a Member Bank to the FLHB of which it is a member.  A FHLB will not deal directly with the issuer of bonds.  In a representative transaction, if a FHLB issues a direct-pay LOC to a bond trustee on behalf of a Member Bank, the related reimbursement agreement is executed between such FHLB and the Member Banks, and not between such FHLB and the issuer of bonds.  In turn, the issuer of bonds is responsible for providing the funds required by the Member Bank to reimburse the FHLB.