On October 27, 2015, the Treasury Department published final regulations on the allocation of tax-exempt bond proceeds to mixed use projects and related topics (the “Allocation Regulations”). The Allocation Regulations finalize proposed regulations that were issued in 2006 and 2003. Click here for a copy of the Allocation Regulations, and read below for a high-level summary of them. We will in subsequent posts be publishing more detailed analyses of specific provisions of the Allocation Regulations.
To start with the basics, the interest on a state or local governmental bond is excludable from gross income for federal income tax purposes if the bond is not a private activity bond (other than a qualified private activity bond). A state or local governmental bond is a private activity bond if: (1) more than 5%/10% (depending on the circumstances) of the proceeds of the bond is used for a private business use (i.e., use by any person other than a state or local governmental unit – this includes use by 501(c)(3) organizations and the federal government); and (2) the payment of debt service on more than 5%/10% of the proceeds of the bond is secured by property used in a private business (or payments in respect of such property) or is derived from payments in respect of private business use property. The former test is the “private business use test,” the latter is the “private payment/security test,” and they are collectively known as the “private business tests.”
The private business tests also apply to determine whether a state or local governmental bond is a “qualified 501(c)(3) bond,” a type of tax-exempt qualified private activity bond. The private business tests are in this instance modified such that: (1) 501(c)(3) organizations are treated as state or local governmental units (except to the extent of their unrelated trades or businesses); and (2) a bond is not a qualified 501(c)(3) bond if (i) more than 5% of the net proceeds of the bond is used for a private business use and (ii) the debt service on more than 5% of the net proceeds of the bond is secured by property used in a private business (or payments in respect of such property) or is derived from payments in respect of such property. References in this summary to “governmental use” of a project include use by a 501(c)(3) organization of a project financed in part by qualified 501(c)(3) bonds.
Where a project will be used for both governmental purposes and private business uses and will be financed with the proceeds of state or local governmental bonds and other sources of funding, a nettlesome question has long been how to make an allocation of the state or local governmental bond proceeds and the other sources of funding to the costs of the mixed-use project. The Allocation Regulations provide definitive guidance on this and related issues.
Allocations to Separate Purposes of a Mixed-Use Project
The Allocation Regulations provide as a general rule that where two or more sources of funding (including two or more issues of tax-exempt bonds) are allocated to the capital expenditures for a project, those sources of funds are allocated on a pro rata basis throughout the project to the governmental use and private business use of the project. In the case of an eligible mixed-use project, however, the Allocation Regulations provide that the sources of funding for the project’s capital expenditures are allocated to the project such that: (1) sources of funding comprising “qualified equity” are first allocated to the private business use of the eligible mixed-use project with the balance, if any, of the qualified equity then allocated to the governmental use of the project; and (2) the proceeds of tax-exempt bonds are first allocated to the governmental use of the eligible mixed-use project, with any proceeds not absorbed by the governmental use then allocated to the private business use of the project.
These allocations of tax-exempt bond proceeds and qualified equity are made on annual basis for each year during the private business use measurement period. If the private business use percentage of the eligible mixed-use project in a given annual period during the private business use measurement period is less than the percentage of the sources of funding that constitutes qualified equity, all of the private business use of the project for that annual period will be allocable to the qualified equity and none of the private business use for that period will be allocable to the proceeds of the tax-exempt bonds. Conversely, if the private business use percentage of the eligible mixed-use project in a given annual period during the private business use measurement period exceeds the percentage of qualified equity funding the project, the excess private business use not absorbed by the qualified equity will be allocated to the tax-exempt bonds.
For purposes of allocating sources of funds to the capital expenditures of an eligible mixed-use project, the following terms have the following meanings. “Project” means one or more capital projects, including land, buildings, equipment, or other property, where the cost of the project is financed completely or partially with the proceeds of a tax-exempt bond issue. An “eligible mixed-use project” means a project financed with state or local governmental bonds and qualified equity pursuant to the same plan of financing. “Qualified equity” means proceeds of taxable bonds that are not tax-advantaged bonds (such as Build America Bonds, Qualified School Construction Bonds, Qualified Energy Conservation Bonds, etc.) and amounts that are obtained from sources other than borrowing, where these amounts are spent as part of the same plan of financing with proceeds of tax-exempt bonds on the eligible mixed-use project.
Qualified equity and tax-exempt bonds finance an eligible mixed-use project under the same plan of financing if the qualified equity finances capital expenditures of the project on a date: (1) no earlier than one on which the capital expenditures would be eligible for reimbursement by proceeds of tax-exempt bonds, regardless of whether the tax-exempt bonds are reimbursement bonds under Treasury Regulation §1.150-2; and (2) no later than the date on which the private business use measurement period for the project begins.
A pre-issuance capital expenditure can be reimbursed with proceeds of a tax-exempt bond issue if the expenditure is reimbursed by the later of 18 months after the expenditure is paid or 18 months after the project financed by the expenditure is placed in service, but in no case can a pre-issuance capital expenditure be reimbursed more than three years after it is paid. Thus, under the “same plan of financing” rules, qualified equity will be treated as used pursuant to the same plan of financing with tax-exempt bond proceeds where the qualified equity pays a pre-issuance capital expenditure of the eligible mixed-use project during the foregoing reimbursement period for pre-issuance capital expenditures. The private business use measurement period begins on the later of the issue date of the tax-exempt bonds or the project’s placed-in-service date. Accordingly, to be part of the “same plan of financing,” qualified equity cannot be used to pay capital expenditures for eligible mixed-use project after this date.
The allocation rules for eligible mixed-use projects set forth in the Allocation Regulations are quite favorable in that they do not provide for an allocation to discrete physical portions of the project and, thus, allow qualified equity to be allocated to private business use on an undivided, or “floating,” basis throughout the project. These rules are also a significant improvement over the undivided portion allocation method that was contained in the 2006 proposed regulations. The eligible mixed-use project allocation method provided in the Allocation Regulations applies automatically; by unfavorable contrast, the undivided portion allocation method in the 2006 proposed regulations would have applied only if cumbersome election provisions were satisfied. Moreover, the eligible mixed-use project allocation method applies to any eligible mixed-use project. The undivided portion method in the 2006 proposed regulations was limited to those projects where the governmental use and private business use would occur on the same basis. Consequently, the undivided portion allocation method in the 2006 proposed regulations would have been unavailable for private business use resulting from special legal entitlements, such as naming rights, to a governmentally owned sports or convention facility, because this type of private business use would not be on the same basis as the governmental use of the subject facility.
In a related matter to the allocation of sources of funding to a mixed-use project, the Allocation Regulations provide that a partnership is an aggregate of its partners, rather than a separate entity, for purposes of applying the private business tests. This is a favorable change from the 2006 proposed regulations, and it was made in recognition of, and to accommodate, the development and use of public-private partnerships and other financing and management structures that involve private businesses acting in concert with state or local governmental units or 501(c)(3) organizations. As noted in the preamble to the Allocation Regulations, the treatment of partnerships as an aggregate of the partners, rather than as a separate entity, removes barriers that otherwise would exist to the tax-exempt financing of a governmental unit’s, or 501(c)(3) organization’s, portion of the property used in partnership or joint venture arrangements with private businesses. This is particularly true for qualified 501(c)(3) bonds, which require that either a 501(c)(3) organization or state or local governmental unit own all of the property financed by such bonds. If a partnership were treated as a separate entity, rather than as the aggregation of the partners, it would be impossible to use qualified 501(c)(3) bonds to finance the portion of the partnership’s assets attributable to the 501(c)(3) organization’s interest in the partnership. Under an aggregation construct, the 501(c)(3) organization is treated as directly owning the partnership assets attributable to the 501(c)(3) organization’s partnership interest; accordingly, qualified 501(c)(3) bonds could be used to finance the 501(c)(3) organization’s interest in those assets.
The Allocation Regulations provide that in measuring the private business use that results from a nongovernmental person’s interest in the assets used by the partnership, such private business use is the nongovernmental partner’s share of the partnership’s use of the property. For this purpose, the nongovernmental partner’s share of the partnership’s use of the assets equals the nongovernmental partner’s greatest percentage share under Section 704(b) of the Internal Revenue Code of any partnership item of income, gain, loss, deduction, or credit attributable to the annual period in which the partnership uses the property during the private business use measurement period. To the extent that the Internal Revenue Service provides alternate guidance in the Internal Revenue Bulletin regarding the determination of a nongovernmental partner’s share of the partnership’s use of property, the Allocation Regulations provide that an issuer of tax-exempt bonds may follow that alternate guidance.
Anticipatory Remedial Actions
A final, favorable provision afforded by the Allocation Regulations is the ability of an issuer of tax-exempt bonds to effect a remedial action through the redemption or defeasance of the nonqualified bonds of the issue in anticipation of a potential deliberate action that will cause the private business tests to be satisfied and, thus, the bonds to become taxable private activity bonds. Prior to this amendment of the remedial action regulations, a remedial action could be taken in respect of the affected bond issue only after the deliberate action that caused satisfaction of the private business tests had occurred. If an issuer undertook a timely remedial action after the incidence of the deliberate action, the private business use test would be treated as not having been satisfied and the bonds would therefore not be private activity bonds. The liberalization of the remedial action rules to allow certain remedial actions in anticipation of events that could cause the bonds to become taxable private activity bonds is a welcome change.
Under the Allocation Regulations, an issuer can undertake the anticipatory redemption or defeasance of the nonqualified bonds if it: (1) declares prior to the deliberate action its official intent to redeem or defease the nonqualified bonds in the case of a subsequent deliberate action that triggers satisfaction of the private business tests; and (2) redeems or defeases the nonqualified bonds prior to the deliberate action. The nonqualified bonds of the issue are the portion of the outstanding bonds that, if the bonds that remain outstanding after the redemption or defeasance were treated as issued on the same date as the deliberate action, those remaining outstanding bonds would not satisfy the private business use test. In measuring private business use for this purpose, the amount of private business use is the greatest private business use percentage in any annual period during the private business use measurement period, commencing with the annual period in which the deliberate action takes place. As a general rule, the nonqualified bonds must be allocated on a pro rata basis to the outstanding bonds of the issue. Alternatively, an issuer may allocate the nonqualified bonds to any outstanding bonds of the issue, as long as the redemption or defeasance of the bonds to which the nonqualified bonds are allocated does not increase the remaining weighted average maturity of the bonds that remain outstanding after the redemption or defeasance.
The Allocation Regulations generally apply to bonds sold on or after January 25, 2016 and to remedial actions that occur on or after that date. An issuer can elect, however, to apply the Allocation Regulations in whole, but not in part, to bonds sold before January 25, 2016 if the private business use regulations promulgated in 1997 apply to those bonds.