The Issue Spot PUBL I C F I NANCE I N FOCUS
Governmental Bonds: Private Benefit Limitations Current tax law distinguishes between (i) bonds that finance property and activities that primarily support state and local governments and the general public ( “governmental bonds”) and (ii) bonds that are issued predominantly for private purposes (“private activity bond”). In the mid-20th Century, the federal government began to scrutinize the use of tax-exempt bonds by state and local governments to finance private projects that did not serve a traditional public purpose. While certain categories of tax- exempt “qualified private activity bonds” can be used to finance various specific projects (e.g., affordable housing) despite significant private benefit, interest on private activity bonds that purport to be governmental bonds generally is taxable. Thus, an issuer of governmental bonds must guard against running afoul of the limits placed on private benefit. This Issue Spot focuses on the private use limitations placed on governmental bonds. These limitations are separated generally into what are known as the “private business test” and the “private loan financing test.” If either the private business test or the private loan financing test is met, interest on the bonds will be taxable. As a result, issuers of governmental bonds must understand these tests to avoid an unintended (and potentially costly!) mistake.
The Private Business Test
The Private Business Test has two parts – (i) the “private business use test” and (ii) the “private payment or security test.” If both of these tests are met with respect to an issue of governmental bonds, the bonds will be declared to be private activity bonds and, therefore, will lose their tax-exempt status. Conversely, if the issue meets the private business use test but fails the private payment or security test (or vice versa), then the bonds will not lose their tax exempt status (i.e., this is an instance where failing a test is a good thing).
The Private Business Use Test
Generally, the private business use test will be met if more than 10 percent (and in certain limited circumstances, 5 percent) of the proceeds of the issue or the property to be financed by the issue is used, directly or indirectly, by
any private user (including, for this purpose, the federal government and nonprofit organizations) in that person’s trade or business. In general, private business use can arise from either actual or beneficial use by a private user that results is a special legal entitlement to use bond-financed property. As discussed in Bracewell’s Issue Spot on “Identifying Private Business Use,” examples of private business use arrangements include ownership, leases, management/service contracts, research agreements, output contracts, and a catch all for other types of special legal entitlements. ◊ The 10 percent limitation applies to the entire issue and not just a particular project financed by the issue. For example, in the case of a $100 million bond issue, it may be possible to lease an entire $9 million building to a private user because the issue has less than 10 percent private business use. ◊ Subject to certain limitations, favorable Treasury Regulations allow an issuer to manage private business use for projects financed with multiple sources by allocating the private use to those other sources, but only so long as the project is financed pursuant to the same plan of financing. An issue of bonds will meet the private payment or security test if the payment of the principal of or the interest on more than 10 percent (and in certain limited circumstances, 5 percent) of the proceeds of such issue is directly or indirectly (i) secured by any interest in property to be used for a private business use or payments in respect of such property or (ii) to be derived from payments (whether or not to the issuer) in respect of property, or borrowed money, used or to be used for a private business use. ◊ The private payment or security test can be met even if the private payments are not used for, or directly pledged to, the payment of the bonds. Thus, general obligation bonds may meet the private payment test even if debt service on the bonds will be paid from tax collections and not from the private payments relating to the bond-financed property. Both direct and indirect payments made by a private user treated as using proceeds of the issue are taken into account as private payments during the time that the property is privately used. Further, such private payments are only taken into account to the extent allocable to proceeds used by that person. Thus, for example, if a private user is determined to use 5 percent of a bond-financed facility, the payments made by such person are taken into account only to the extent that the present value of such payments are equal to 5 percent of the present value of the debt service on the bond issue. In measuring private payments, the federal tax rules also allow issuers to exclude certain amounts, such as some operating and maintenance expenses. The Private Payment or Security Test
Private Loan Financing Test
A governmental bond meets the private loan financing test if the amount of its proceeds used (directly or indirectly) to make or finance loans to private users exceeds the lesser of (i) 5 percent of the proceeds or (ii) $5 million. The federal tax rules look to the substance of the transaction to determine whether an arrangement is the economic equivalent of a loan. Therefore, any arrangement that shifts the benefits and burdens of ownership of a bond financed asset to a private user should be reviewed by a tax attorney. Furthermore, there are specific tax rules regarding tax assessments and prepayments for property and services.
◊ Subject to a facts-and-circumstances test, a grant of proceeds to a nongovernmental user will not be treated as a private loan.
Remediating Excess Private Benefit Occurring after Issuance of the Bonds
In circumstances where both the bonds would be private activity bonds if a certain action is taken, there are several options that can help issuers achieve compliance with federal tax laws, including contract renegotiation to meet safe harbors or taking a remedial action (see Bracewell’s Issue Spot on “Remediating Private Business Use of Governmental Bonds ”). With this in mind, we encourage issuers that have identified potential noncompliance to contact bond counsel to discuss these concerns and the options that may be available to protect the tax status of the bond issue.
Bracewell LLP makes this information available for educational purposes. This information does not offer specific legal advice or create an attorney client relationship with the firm. Do not use this information as a substitute for specific legal advice. © 2023 Bracewell LLP. Attorney advertising.
Victoria N. Ozimek Partner Austin
Brian P. Teaff Partner Houston
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