July 7, 2017 witnessed a once-in-a-career moment for any tax practitioner. On that date, the Treasury Department released Notice 2017-38, which acknowledged that eight regulatory projects are unduly burdensome and should be reconsidered for modification or repeal – a rare display of administrative modesty. Included in the list of burdensome regulations are the proposed regulations that would re-define the term “political subdivision” for purposes of which entities can issue tax-exempt bonds under Section 103 of the Internal Revenue Code (the “Political Subdivision Proposed Regulations,” which we have previously analyzed here, here, here, here, here, and here).
The Political Subdivision Proposed Regulations are indeed unduly burdensome and therefore merited inclusion in Notice 2017-38. As discussed below, the Political Subdivision Proposed Regulations are also of dubious constitutionality.
President Trump issued Executive Order 13789 on April 21, 2017, which directed the Treasury Secretary to issue a 60-day interim report that identifies “significant regulations” promulgated on or after January 1, 2016 “that (i) impose an undue financial burden on U.S. taxpayers; (ii) add undue complexity to the Federal tax laws; or (iii) exceed the statutory authority of the Internal Revenue Service (IRS).” Executive Order 13789 further directs the Treasury Secretary to issue a final report by September 18, 2017 that recommends “specific actions to mitigate the burden imposed by regulations identified in the interim report.” As set forth in Notice 2017-38, these “specific actions” can range from “streamlining the problematic rule provisions to full repeal.”
Notice 2017-38 is the interim report required by Executive Order 13789, and it identifies eight “burdensome regulations,” including the Political Subdivision Proposed Regulations. The Political Subdivision Proposed Regulations without doubt add unwarranted complexity of the federal tax laws, but they also exceed the statutory authority of the IRS. Article I, Section 8 of, and the 16th Amendment to, the United States Constitution grant to Congress the power to pass federal income tax laws. Pursuant to this power, the Congress has enacted Section 103(a) of the Internal Revenue Code of 1986, as amended, which provides that, with certain exceptions, “gross income does not include interest on any State or local bond.” Section 103(c)(1) defines “State or local bond” to mean “an obligation of a State or political subdivision thereof.”
Article II, Section 5, Clause 3 of the U.S. Constitution requires that the President “take care that the laws be faithfully executed.” In accordance with this mandate to administer federal law faithfully, the Treasury Department and the IRS promulgated Treas. Reg. § 1.103-1(b), which provides that for purposes of Section 103 of the Internal Revenue Code a political subdivision is “any division of any State or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit.” Thus, any municipal corporation may issue tax-exempt bonds (which is entirely sensible, because every municipal corporation is a general purpose governmental entity that possesses all sovereign powers of self-government), and any entity that holds a substantial amount of the sovereign police, taxation, or eminent domain power may also issue tax-exempt bonds.
The Political Subdivision Proposed Regulations would redefine a “political subdivision” for purposes of Section 103 of the Internal Revenue Code such that, regardless of whether an entity is a municipal corporation or other general purpose governmental entity, the entity is a “political subdivision” only if it meets the sovereign powers, governmental purpose, and governmental control tests set forth in the Political Subdivision Proposed Regulations. An entity would satisfy the governmental purpose test of the Political Subdivision Proposed Regulations only if it “operates in a manner that provides a significant public benefit with no more than incidental private benefit.”
Every general purpose governmental entity (whether incorporated or not) provides some benefit to private persons, whether in the form of tax increment financing, tax credits, tax abatements, tax holidays, grants, loans, zoning variances, or other inducements to locate and/or maintain business operations in the boundaries of the general purpose governmental entity. The Political Subdivision Proposed Regulations do not define what constitutes “no more than incidental private benefit.” In the absence of such a definition, can anyone conclude with any certainty whether any general purpose governmental entity would be a “political subdivision” under the Political Subdivision Proposed Regulations? The effect of this ambiguity would be to amend Section 103 of the Internal Revenue Code such that only a State could issue a tax-exempt bond, because no subdivision of a State could ever know whether it satisfied the “governmental purpose” test of the Political Subdivision Proposed Regulations.
Therein lay the Constitutional infirmity of these Propose Regulations. They are not merely an effort to discharge the mandate of Article II, Section 5, Clause 3 of the U.S. Constitution, they are instead an effort to exercise legislative power, which Article I of the Constitution vests exclusively in the Congress. The Political Subdivision Proposed Regulations exceed the power conferred to the IRS by statute (or the Constitution) and therefore have a well-earned place in Notice 2017-38’s list of burdensome regulations. The repeal of the Political Subdivision Proposed Regulations cannot come soon enough, and interested parties can help to ensure the repeal of these Proposed Regulations by accepting Notice 2017-38’s invitation to provide comments by August 7, 2017 and urging in those comments that these Proposed Regulations be scuttled.
It’s also worth noting that the Trump Administration has indicated its support for the preservation of tax-exempt bonds as part any change to the federal income tax laws. The coming repeal of the Political Subdivision Proposed Regulations, which, if issued as final regulations, would have eviscerated the ability of any local governmental unit to issue tax-exempt bonds, is further evidence of that support.