MUNICIPAL WATER COMPANIES have been writing the US Treasury and IRS asking them to make it easier for municipalities to enter into long-term contracts with private companies to manage their water systems without jeopardizing the tax-exempt bonds used to finance such systems.

Private companies operate more than 2,000 municipal water and wastewater facilities. The contracts can run as long as 30 to 40 years. They may take the form of a concession, a lease of the water system or a contract merely operate the system. The water companies call these arrangements a form of public-private partnership or P3.

The interest on bonds used to finance a municipal water system will become taxable if there is more than 10% “private business use” of the system. The IRS has rules in Rev. Proc. 97-13 for when a contract with a private operator goes too far. The typical P3 contract signed by a municipal water company strays outside the IRS guidelines.

A municipal water company that allows too much private business use after bonds have already been issued must take one of several permitted remedial actions or the bondholders will have to pay taxes on the interest they receive.

There are three possible remedial actions in the context of a water system, but none of them works, according to the water companies.

One is to redeem the bonds on the first possible call date and to defease them in the meantime by setting aside enough money in an account to pay the future debt service and redemption price. The water companies say this is too expensive. 

Another remedial action is to leave the bonds outstanding, but basically treat them as a new bond issue and make sure they meet all the requirements for a new tax-exempt bond today. Bonds with more than 10% private business use are considered “private activity bonds.” Each state is limited in the number of such bonds it can issue each year. The water companies say it is too hard to get a share of the scarce state volume cap.

The other remedial action applies in cases where there has been a cash sale or other “disposition” of the facilities financed with the tax-exempt bonds. The bonds will retain the tax exemption as long as the municipality uses the cash received from the sale or other disposition within two years for another governmental purpose.

The water companies are asking for “clarifications” of this last option. They want to treat the long-term P3 contracts signed with private operators as “dispositions” of the water systems so that this remedial method is available even though the contracts are not treated as a sale of the systems for other tax purposes. They also want to modify the two-year window to require that the municipal water company expect to spend the cash within three years after execution of the P3 contract or, if later, within one year after receipt of the cash. Finally, they want an acknowledgement that the cash can be used to pay debt service on other debt of the municipality or to make contributions to public pension funds.

Guidance of the sort the municipalities want can take a year or more to be issued.