Exempt Facility Bonds (I.R.C. § 142)

General Matters:

Exempt facility bond means any bond issued as part of an issue 95 percent or more of the net proceeds of which are to be used to provide one of the following:

  1. Airports;
  2. Docks and wharves;
  3. Mass commuting facilities;
  4. Facilities for the furnishing of water;
  5. Sewage facilities;
  6. Solid waste disposal facilities;
  7. Qualified residential rental projects;
  8. Facilities for the local furnishing of electric energy or gas;
  9. Local district heating or cooling facilities;
  10. Qualified hazardous waste facilities;
  11. High-speed intercity rail facilities;
  12. Environmental enhancements of hydro-electric generating facilities;
  13. Qualified public educational facilities;
  14. Qualified green building and sustainable design projects; or
  15. Qualified highway or surface freight transfer facilities.

Note that, with certain exceptions, the basic rules applicable to all private activity bonds apply to exempt facility bonds.  These rules include:

  1. Volume cap rules under Section 146 (not applicable to airport exempt facilities);
  2. Substantial user requirement under Section 147(a);
  3. Limitation on maturity under Section 147(b);
  4. Limitation on use of proceeds to acquire land under Section 147(c);
  5. Prohibition for acquiring existing property under Section 147(d);
  6. Prohibition of certain “bad” uses under Section 147(e);
  7. TEFRA approval requirement under Section 147(f);
  8. Restrictions on costs of issuance under Section 147(g) (2% of sale proceeds);
  9. Official action requirements (adoption of an inducement resolution, for example);
  10. Arbitrage limitations; and
  11. Special change in use penalties under Sections 150(b) and (c).

Governmental Ownership Requirement (Sec. 142(b)):

(1) Certain facilities must be governmentally owned; and

(2) Limitation on office space.

There are special exempt facility bond rules set forth in Section 142(b) of the Code.  First, for several types of exempt facility bonds, the facilities must be “governmentally owned.”  The Code states that “a facility shall be treated as described in paragraph (1) (airports), (2) (docks and wharves), (3) (mass commuting facilities) or (12)(environmental enhancements of hydro-electric generating facilities) only if all of the property to be financed by the net proceeds of the issue is to be owned by a governmental unit.”

In paragraph (b)(1)(B), the Code provides for a safe harbor for leases and management contracts.  Under this safe harbor, if the facilities are leased to a non-governmental person, the bonds can still be exempt facility bonds if certain conditions are met:

  1. the non-governmental lessee makes an irrevocable election (binding on the lessee and all successors in interest under the lease) not to claim depreciation or an investment tax credit with respect to such property;
  2. the lease term (as defined in 168(i)(3)) is not more than 80% of the reasonably expected economic life of the property (as determined under section 147(b)); and
  3. the lessee has no option to purchase the property other than at fair market value (as of the time such option was exercised).

(Note that the 80% requirement is more conservative than under I.R.C. 467(b)(4)(A), which states that a disqualified leaseback or long-term agreement means any section 467 rental agreement if such agreement is part of a leaseback transaction or such agreement is for a term in excess of 75 percent of the statutory recovery period for the property.  A “section 467 rental agreement” is a rental agreement that has increasing or decreasing rents or deferred or prepaid rents.  Treas. Reg. 1.467-1.  If an agreement is a section 467 rental agreement, the lessor and the lessee must each take into account for any taxable year the sum of (1) the section 467 rent for the taxable year and (2) the section 467 interest for the taxable year.  Section 467, in other words, may be viewed as imputing a loan in certain non-level rent payment structures.  This mismatch in timing of payments and the receipts of any benefits relates to private loan analyses.)

In applying these rules, use by a non-governmental person includes use pursuant to any arrangement that allows use on a basis different from that available to the general public, such as leases, management contracts, service contracts and preferential-use agreements.

It should be noted that “ownership” and the status of an activity as a “lease” is determined under federal tax law, not state law.  Under federal tax law, ownership is determined based on substance over form. In other words, it does not matter what the intent of the parties is or what the documents are called – what matters is whether there is evidence that an activity should be considered ownership.  This substance over form approach determines whether a lessor really has sufficient property ownership of the asset involved or whether the lessor is really just a conditional seller, an option holder or a lender.

The Internal Revenue Code does not define what a real lease is.  Instead, case law provides the relevant rules.  The bottom line, as determined in Frank Lyon Company v. United States, 435 U.S. 561 (1978), is that, in considering tax ownership, and therefor true lease status, is to determine whether the lessor, rather than the lessee, is the equipment’s/property’s tax owner, having “significant and genuine attributes of the traditional lessor status.  What those attributes are in any particular case will necessarily depend upon its facts.”  See Richard M. Contino, Esq., “Understanding Tax Leases,” available online at http://www.continopartners.com/UnderstandingTaxLeases.pdf

What this means is that a lease transaction between a bank and a city, for municipal trucks, should not necessarily be treated as a lease within the meaning of Section 142(b).  If the city actually operates the trucks and maintains them, for instance, the facts strongly suggest that federal tax law should treat this lease arrangement as actual ownership by the city.  This means, in turn, that the special rule in paragraph (b)(1) is met without the need to satisfy the safe harbor in subparagraph (b)(1)(B).

Note also that the AGL&F 50 State Survey has a good discussion of leases vs. ownership.  The publication explains that a “lease-purchase arrangement, conditional sale or purchase agreement […] is generally treated as a lease under state law, but as an installment sale and loan for federal tax purposes. […] For federal tax purposes, the city is both the buyer and new owner of the property and the borrower of a loan.”

Public Use Requirements of the Regulations:

The Code does not impose a public use requirement to qualify bonds as exempt facility bonds for airports.  However, the Regulations (Treas. Reg. 1.103-8(e)(1)) require that the facility must be available on a regular basis for general public use, or be part of a facility so used, as contrasted with similar types of facilities that are constructed for the exclusive use of a limited number of non-governmental persons in their trades or businesses.  A facility at a municipal airport, such as a terminal gate, baggage or cargo handling facility, qualifies as an exempt facility even if it is leased to or preferentially used by a non-governmental person; provided that the non-governmental person directly serves the general public as a common passenger carrier or freight carrier.  In addition, any other airport owned or operated for general public use is considered to be a facility for public use.

Airports, Docks and Wharves, Mass Commuting Facilities and High-Speed Intercity Rail Facilities (Sec. 142(c)):

Section 142(c) provides certain additional rules for airports, docks and wharves, mass  commuting facilities and high-speed intercity rail facilities.

Treas. Reg. 1.103-8(e)(2)(iv) provides that a mass commuting facility includes realty, improvements and personalty used to serve the general public commuting on a day-to-date basis by bus, subway, rail, ferry or other vehicles with prescribed routes.  Machinery, equipment, furniture and terminals are specifically mentioned in the regulations as “mass commuting facilities.”  In addition, a facility will qualify even if used by noncommuters and commuters.  Thus, a bus terminal used by a common carrier serving commuters and long-distance travelers qualifies as a mass commuting facility.

Treas. Reg. 1.103-8(e)(1) provides that the facility must be available for use by members of the general public or for use by common carriers or charter carriers who serve members of the general public.

Change in Use or Ownership:

Section 1.142-2 of the Regulations states that a change in use of a qualified facility from a qualifying to a non-qualified use will generally require that outstanding airport bonds be redeemed or defeased.

Section 150(b) of the Code states that a change in the use of a qualified facility from a qualifying to a non-qualifying use will also result in the denial of certain deductions to the users for any time the airport bonds remain outstanding until they are actually redeemed (e.g., in a defeasance situation).  For example, legislative history states that if a governmentally owned airport facility is converted to a private office building, each non-governmental tenant would be denied any rent deduction to the extent of bond interest payments allocable to that portion of the facility used by the tenant.

Section 150(c) of the Code states that change in the ownership of a facility in whole or part after issuance of the bonds will act to deny the new owner any deduction for interest paid by the new owner in connection with the facility for any time the airport bonds remain outstanding until actually redeemed.  Therefore, if the new owner assumes the bond debt, interest paid is not deductible.  In addition, if the bond debt is not assumed but remains outstanding and the owner incurs new debt in connection with the facility, deductions on the new debt may be denied to the extent of interest on the airport bonds accruing after acquisition.

Demolition is not change in use.  PLR 200928018: Bond-financed pollution control facilities sold to a new owner became subject to a consent degree and were demolished because the new owner determined the conditions imposed by the consent decree were not economical and as a result the property would not be used for anything other than scrap materials for recycling and the demolition contract provided there was no net scrap value.  PLR 201110007:  Demolition of the project facilities will not cause interest on the bonds to fail to be excludable from gross income and will not preclude the borrower from deducting interest where the facility was demolished due to an environmental law decree and uncertainty regarding the plant’s future fuel contracts and the salvage value net of decommissioning costs was negative.

Other Rules:

  1. Deep discount obligations:  The proceeds of any issue of exempt facility bonds includes any imputed proceeds of the issue.  The imputed proceeds of the issue equal the sum of the amounts of imputed proceeds for each annual period over the term of the issue.  But, there are no imputed proceeds if the obligation does not have a stated interest rate (determined on the date of issuance) that increases over the term of the obligation, and the purchase price of the obligation is at least 95% of its face amount.  See Treas. Reg. § 1.103-8(a)(6) and (a)(7).

Sewage Facilities:

PLR 8814017 (Jan. 4, 1988):  Ruling requested as to whether certain facilities proposed to be built by the company are “sewage facilities.”  Request was made under the provisions of Rev. Proc. 84-49, which provides procedures for the issuance of rulings under I.R.C. 103 when the requestor of the ruling is not the issuer of the prospective obligations.  The facilities consist of a pump station, an equalization tank and an anaerobic reactor that consists of a distribution system on the bottom of the reactor for the income effluent, a settling device to remove solids from the effluent and a methane gas collection system.  The facilities also include office space in a laboratory.  The sewage consists of process waters from rinsing and cleaning production equipment that is discharged into the sewer system and that is contaminated with soluble biochemical oxygen demand (“BOD”).

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