A. Non-Substitution Clauses in Leases
The following is an excerpt from “Common Questions about Tax-Exempt Leases” published online by Municipal Funding of Zephyrhills, Florida, available at http://municipal-funding.com/tax-exempt_leasing_faq.htm:
A non-substitution clause is a provision in a 103 lease that prevents the government from non-appropriating and then acquiring equipment to perform the same function as the previously leased equipment.
Although non-substitution clauses still appear in 103 leases, the majority view (with which the author agrees) seems to be that having a non-substitution clause in a 103 lease actually damages the lessor’s interest. Here is the rationale: If the non-substitution clause prohibits the government from performing an essential government function, such a clause may be used to show that the lessor, while purporting to recognize the unrestricted right of the government to non-appropriate, nevertheless imposed coercive sanctions on the government in the event that the government exercised such right. The right to non-appropriate becomes illusory.
The non-substitution clause becomes the basis for an argument that the 103 lease creates debt. The government still has to perform the essential government function being served by the equipment. If it is unable to acquire new equipment to perform that function subsequent to a non-appropriation, non-appropriation is not a real option and the lease is essentially a multiyear hell or high-water obligation.
Courts in several states, including Texas, Oregon, Colorado, and Florida, have already found that including a non-substitution clause turns the 103 lease into debt. In each of these cases, because the procedures for incurring debt were not complied with, the 103 lease was void.
In light of this and because experience shows the clause is rarely if ever enforced, it offers no real benefit to lessors. Limiting its reach by the phrase “to the extent permitted by law” may mitigate some of the negative consequences, but it does little to make the provision more helpful.
B. Lessor Entities
For purposes of IRS Form SS-4, Application for Employer Identification Number (EIN), does the lessor entity check the “Corporation” box or the “State/local government” box on line 9a? Does the lessor entity need to file an income tax return?
Generally, if an entity is separate from (not an “integral part” of) the government, its income will be subject to tax unless an exclusion or exemption applies. If the income is subject to income tax, the entity may need to file a return. An exclusion in I.R.C. 115, however, excludes from gross income, income (1) derived from any public utility or the exercise of any essential governmental function, and (2) accruing to a state or political subdivision (including the District of Columbia).
The IRS Exempt Organizations training material provides the following discussion:
What activities involve exercise of an “essential governmental function” is generally decided on a case-by-case basis. Factors considered include whether the activity is one traditionally considered “governmental” (as opposed to private or proprietary), whether it involves the exercise of governmental (sovereign) powers, the extent of government control over the activity, and the extent of government financial interest in the activity. Qualifying activities may include public education; investment of public funds, Rev. Rul. 77-261, 1977-2 C.B. 45; operating a municipal insurance pool; operating a public hospital or other public health facilities; or providing public recreation facilities.
Income must be derived from a qualifying activity; it is not enough that it be paid over to or benefit a qualifying activity. For example, that a university uses income derived from operating a commercial television station to conduct educational programs does not render the income excludable; the income must have been derived from educational activities. See Iowa State University of Science & Technology v. United States, 500 F.2d 508 (Ct. Cl. 1974).
The second requirement under IRC 115(1) is that income “accrue to” a state or political subdivision. Income “accrues” where the state or subdivision has an unrestricted right to a proportionate share of the income. Rev. Rul. 77-261, 1977-2 C.B. 45. The “accrual requirement” may also be met by less direct means. What is required is a substantial degree of government dominance over the enterprise. While many organizations that are “instrumentalities” for employment tax purposes (discussed below) will also have income excluded under IRC 115, the two are conceptually distinct. It is therefore conceivable that an “instrumentality” may be subject to income taxation.
If the lessor entity constitutes an entity described in I.R.C. 115, bond counsel will generally identify the lessor entity as a “State/local government” entity on the SS-4 form. It is not entirely clear whether the lessor or the governmental lessee will need to file a tax return for the lessor. The IRS Exempt Organizations training material provides the following statement:
Return Requirements. Under Rev. Rul. 78-316, 1978-2 C.B. 304, states and political subdivisions (including their “integral parts”) are generally not required to file income tax returns with respect to activities they directly conduct. Separatelyorganized instrumentalities, however, are subject to the general rule requiring taxable corporations to file returns, regardless of whether they have income or owe tax. Rev. Rul. 77-261, 1977-2 C.B. 45. Specific provisions may require a return even if an entity is an “integral part” of a state or political subdivision. For example, if an entity is an “insurance company” for federal tax purposes, it must file a return even if it is not otherwise considered a taxable corporation. See Rev. Rul. 83-132, 1983-2 C.B. 270.
C. COP Matters
PLR 200314024: Bonds are issued “as certificates of participation” in an installment sale agreement with the City in which the City agrees to make payments to purchase the Center from the Corporation. Payments will equal the interest and principal due on the COPs.
PLR 9123058: In a COP financing, the underlying lease as well as the COPs were approved under 147(f), not just the COPs.