Bonds issued by a State or political subdivision that are considered "private activity bonds" under section 141 of the Internal Revenue Code of 1986, as amended (the Code) cannot qualify for tax-exemption under section 103(a) of the Code, with the exception of certain types of "qualified bonds," such as exempt-facility bonds (e.g., for airports, multifamily rental housing, solid waste disposal facilities), qualified mortgage bonds, student loan bonds, qualified small issue bonds, or 501(c)(3) bonds. Thus, if a particular facility does not meet the requirements of any of these types of qualified bonds, then in order for a financing for such a project to qualify for tax-exemption, it would have to avoid being considered an issue of private activity bonds.

Under Section 141 of the Code, an issue will generally be treated as consisting of private activity bonds if either (i) the private loan financing test is met, or (ii) the private business tests are met. An issue generally meets the private loan financing test if an amount of bond proceeds exceeding the lesser of 5 percent of proceeds or $5 million is used to make or finance loans to nongovernmental persons. A financing meets the private business tests if both (i) more than 10 percent of the proceeds are considered used, directly or indirectly, in a private trade or business (the "private use test"), and (ii) more then 10 percent of the debt service on the bonds is secured by or derived from property used in a private trade or business (the "private security or payment test").

Under these rules, an issue is typically characterized as consisting of private activity bonds as a result of the financed facility being used in a private trade or business (meeting the private business use test) and the debt service on the bonds being paid from amounts received by the issuer from the private business user of the financed facility (meeting the private security or payment test). The treasury regulations provide, however, that payments of generally applicable taxes are not taken into account for purposes of the private security or payment test. Thus, if the only payments made to the issuer by the private business user of the financed facility are generally applicable taxes, the bonds may avoid private activity bond status despite the fact that the facility is used in a private trade or business.

The current treasury regulations further provide that certain payments in lieu of taxes (PILOTs) are treated as generally applicable taxes for purposes of the private security or payment test. On October 19, 2006, the Internal Revenue Service (IRS) issued proposed regulations concerning the standards for treating PILOTs as generally applicable taxes (the Proposed Regulations). The IRS received a number of written comments to the Proposed Regulations, and after consideration of such comments has adopted final regulations (the Final Regulations).

The Final Regulations.

Under the current treasury regulations, PILOTs are treated as generally applicable taxes if (i) the payments are commensurate with and not greater than the amount imposed by statute for a tax of general application, and (ii) the payments are designated for a public purpose and are not "special charges," such as charges for the use of specific property.

The Proposed Regulations proposed to clarify the "commensurate" standard for PILOTs by providing generally that an eligible PILOT payment must represent a fixed percentage of, or reflect a fixed adjustment to, the amount of generally applicable taxes in each year, based on comparable current valuation assessments. Written comments on the Proposed Regulations suggested that the proposed standard was too restrictive because it did not allow for "fixed-payment" PILOTs, i.e., where the amounts of the PILOTs to be made by the project owner are fixed at the time the bonds are issued in order to allow better matching between the amounts of the PILOTs and the debt service on the bonds. The IRS did not adopt these comments in the Final Regulations, generally retaining the approach in the Proposed Regulations. The Final Regulations do, however, allow some greater flexibility by permitting multiple phased adjustments to PILOTs during the development, construction, or initial start-up period of the project.

The Final Regulations also make several other clarifications in response to the written comments received by the IRS. The Final Regulations clarify that the terms "public purpose" and "governmental purpose" as used in the PILOT rules and the rules on generally applicable taxes are intended to refer to the same standard by adopting consistent terminology to state this uniform standard. The Final Regulations also eliminate the requirement that the PILOTs be "designated" for public purposes, instead simply requiring that the PILOTs be used for governmental or public purposes for which the underlying generally applicable tax on which it is based may be used.

The Final Regulations also clarify the circumstances under which payments to a governmental entity will be considered "special charges" rather than generally applicable taxes for purposes of the private security or payment test. The Final Regulations provide that a special charge includes a payment for a special privilege granted or regulatory function (such as a license fee), a use of property (such as rent), or a payment in the nature of a special assessment to finance capital improvements that is imposed on a limited class of persons based on benefits received from the capital improvements financed with the assessment.

Effective Date.

The Final Regulations will generally apply to bonds that are sold on or after October 2, 2008. The Final Regulations also provide transition rules for certain refunding issues that do not result in an extension of weighted average maturity and for certain bonds issued on or before December 31, 2009 that finance certain projects substantially in progress at the time the Proposed Regulations were issued.