On February 22, 2016, the Internal Revenue Service (IRS) released proposed regulations (the "Proposed Regulation") providing guidance regarding the definition of "political subdivision" for purposes of the tax-exempt bond provisions of the Internal Revenue Code of 1986, as amended (the "Code"). 

Background. Section 103 of the Code provides tax-exemption for interest on bonds issued by States and political subdivisions. Under the traditional legal analysis applied by courts and practitioners for many years, the determination of whether an entity is properly considered a political subdivision for federal income tax purposes was based on whether it has been delegated the right to exercise one or more substantial sovereign powers. These sovereign powers include the power to tax, the power of eminent domain and the police power. But in 2013, the IRS issued Technical Advice Memorandum 201334038 (the "TAM"), which called into question whether certain governmental entities with a limited number of property owners, electors or taxpayers may ever qualify as a political subdivision by asserting that "an entity that is organized and operated in a manner intended to perpetuate private control, and to avoid indefinitely responsibility to a public electorate, cannot be a political subdivision of a State." The TAM was roundly criticized as being inconsistent with existing legal authority and as casting doubt on the continued viability of long-standing methods for financing infrastructure using special districts.

The Proposed Regulations. The Proposed Regulations would replace the traditional analysis described above with a new three-part test. Under the Proposed Regulations, an entity would qualify as a political subdivision only if, taking into account all of the facts and circumstances: (i) it has been delegated the right to exercise a substantial amount of at least one of the recognized sovereign powers (taxation, eminent domain, police); (ii) it serves a governmental purpose; and (iii) a State or local government exercises control over the entity.

The most significant change from existing legal authority and long-standing practice is the requirement that the entity be controlled by a State or local government. For this purpose, the Proposed Regulations define control as an ongoing right to direct significant actions of the entity, such as the power to approve and remove a majority of the governing body of the entity, the power to elect a majority of the governing body of the entity in periodic elections, or the power to approve or direct the significant uses of funds or assets of the entity in advance of that use. Procedures designed to ensure the integrity of the entity but not to direct significant actions, such as requirements for submission of audited financial statements to a higher level of State or local government, open meeting requirements, and conflict of interest limitations, are insufficient to constitute control of an entity.

The Proposed Regulations further provide that control by a State or local government may exist through control by an electorate established under applicable State or local law of general application, but only if that electorate is not a "private faction." A "private faction" is determined to exist under the Proposed Regulations if the exercise of control is determined by the votes of an unreasonably small number of private persons. The Proposed Regulations provide that whether a number of private persons is unreasonably small for this purpose is generally based on all of the facts and circumstances, but further provide that a private faction exists if any three private persons, in the aggregate, possess a majority of the votes necessary to exercise control, and that an electorate is not a private faction if the smallest number of private persons who can combine votes to establish a majority of the votes necessary to exercise control is greater than 10 persons.

Potential Impact. The Proposed Regulations, if enacted in proposed form, could have significant impact on special districts formed to finance infrastructure for new developments, where at least initially the district is often controlled by the developer and related persons as the primary landowners. In the preamble to the Proposed Regulations, the IRS has specifically requested comments with regard to such development districts. The Proposed Regulations could also have significant impact on other types of special purpose districts serving a small number of landowners, such as irrigation districts, soil conservation districts and flood control districts. Note that the Proposed Regulations generally should not have significant impact on so-called "constituted authorities" which are authorized under specific state statutes to issue bonds on behalf of a state or political subdivision.

Effective Dates. The Proposed Regulations are proposed to be effective 90 days after publication in final form, but under transition rules would not apply for purposes of determining the status of currently outstanding bonds or bonds issued to refund currently outstanding bonds where the weighted average maturity is not being extended. In addition, for existing entities, the Proposed Regulations would not apply until three years and 90 days after publication in final form, in order to give existing entities time to restructure while still being able to issue tax-exempt bonds during a transition period.

Comments and Public Hearing. A public hearing on the Proposed Regulations has been scheduled for June 6, 2016, and the IRS is accepting written comments on the Proposed Regulations.