The Issue Spot: Identifying Private Business Use
The Issue Spot PUBL I C F I NANCE I N FOCUS
Identifying Private Business Use As discussed in Bracewell’s Issue Spot on “ Governmental Bonds: Private Benefit Limitations ,” interest on state and local government bonds generally will be taxable if the bond proceeds provide a special benefit to private entities in excess of certain limits, unless the bonds fit within one of the special subcategories of “qualified private activity bonds.” As a result, an issuer of “governmental bonds” must monitor the amount of private business use associated with the bond-financed property to protect the bonds’ tax-exempt status. Federal tax law allows for a limited amount of private business use before obligations lose their status as governmental bonds, and there are exceptions for some arrangements that might otherwise result in private business use. ◊ Remember that private business use is one part of a two-part test – the other part is the “private payment or security test” – and that bonds will be taxable private activity bonds only if both parts of the test are met. In other words, if the issue of bonds 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.
Private Business Use Test (aka the “10 percent Test”)
Subject to certain exceptions, an issue of bonds meets the private business use test if more than 10 percent of the proceeds of the issue are to be used for any private business use. In certain (but fairly rare) instances, the 10 percent percent threshold is reduced to 5 percent if the private business use is “unrelated and disproportionate” to the governmental use of the bond-financed property. Moreover, for bond issues in excess of $150 million, if the amount of private business use stays beneath the threshold percentage but nonetheless exceeds $15 million, the bonds will be private activity bonds unless the issuer receives an allocation of the “state volume cap” for private activity bonds for the amount that exceeds the $15 million threshold.
◊ In certain (but fairly rare) instances, the percent threshold is reduced to 5 percent if the private business use is “unrelated and disproportionate” to the governmental use of the bond-financed property.
Identifying Private Users
Generally, private business use occurs when the proceeds of the bonds or the property financed by the bonds is used, directly or indirectly, by any private person in that person’s trade or business. A “private person” is any person or organization other than a state or local government or an instrumentality thereof. Any activity carried on by a private person who is not a natural person is considered to be a “trade or business.”
◊ For purposes of the private business use test, both the federal government and nonprofit organizations are considered to be private persons.
Types of Private Business Use Arrangements
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. Common examples of actual or beneficial use include:
Ownership . Subject to certain limited exceptions, a private user’s ownership of a bond-financed asset results in private business use.
Leases. Subject to certain limited exceptions, a lease of bond-financed property to a private user results in private business use. Determining whether an arrangement constitutes a lease is based on all of the facts and circumstances, including the degree of private business control over the financed property and whether the private business bears risk of loss on the financed property. Management/Service Contracts. Contracts under which a private user provides management or certain other services (but not incidental services such as janitorial support) with respect to a bond-financed facility are analyzed for private business use based on a facts-and-circumstances standard. Under the general rule, a management/ service contract creates private business use if the contract provides for compensation based, in whole or in part, on net profits from the operation of the facility. There are IRS safe harbors that, if met, provide comfort that the management/service contract will not be seen as creating private business use. For more information, please refer to The Issue Spot on “ Qualified Management Contracts .” Research Agreements. Most common in university and hospital settings, certain contractual arrangements pursuant to which a private user agrees to sponsor scientific research to be conducted at a bond-financed facility can result in private business use. In many cases, however, a research agreement can be negotiated such that it complies with safe harbors that, if met, provide that the research agreement does not create private business use. Output Contracts. In the case of bond-financed property used for (or related to) electric and gas generation, transmission, distribution or water collection, storage and distribution, certain contractual arrangements – such as take-or-pay contracts – can convey the benefits and burdens of ownership to a private use and, therefore, result in private business use. Other Special Legal Entitlements. There is a “catch all” for arrangements that might not fit within the categories above, but the facts and circumstances of which nonetheless result in private business use. One example of a special legal entitlement that may (but may not, depending upon the particular facts) give rise to private business use is a naming rights agreement in which a private business user pays a governmental user for the right to have a facility referred to by a certain name. Special Economic Benefit. If bond-financed property is not available for use by the general public, private business use can arise out of facts and circumstances that result in a private user deriving some special economic benefit from the property, even if there is no contractual use with respect to the property. The IRS will look at factors such as proximity of the bond-financed property to the private user’s property and the total number of users benefitted from the bond-financed property.
◊ The more an arrangement transfers the benefits/burdens of ownership or other control to a private user, the more likely that it might be characterized as private business use.
Exceptions to Private Business Use
In addition to the safe harbors for management/service contracts and research agreements mentioned above, there are a number of “short-term use” exceptions providing that certain arrangements will not be treated as private business use if certain facts and circumstances are present. These exceptions set forth varying requirements based on the type of use, the length of the arrangement, and the circumstances of the financing. In general, the more a private user is treated on the same basis as a member of the general public and the more likely the facility is to be used by the general public, the longer the term of the arrangement may be without creating private use. There are also, for example, exceptions available regarding certain routine dispositions of personal property.
Identifying potential private business use is just a first step, with measuring and allocating private business use being another step in the process. It is also important to remember that a small amount of private use is permitted, and that even higher amounts of private use may not affect the tax status of a bond issue if the private payments test is not also met. In circumstances where both the private business use and private payment tests will be met 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 private business use to contact bond counsel to discuss these concerns and the options that may be available to protect the tax status of the bond issue. Example A city uses proceeds of an issue of bonds to build a downtown parking garage close to city hall. After a few years, the city determines that it would like to contract with a private third-party to manage the parking facility. Additionally, to increase poor hourly revenues, the city would also like to lease a portion of the spaces in the facility. The city expects that many of the monthly leases will be to area residents, but believes that there may be some businesses that might also enter into contracts to ensure that there is dedicated parking available for visiting customers. The city’s finance director is worried that these arrangements will create problems for the bond issue, which also financed a number of other city projects.
There are a number of ways that the tax status of the bonds might be protected, including:
• Ensuring that, based on the facts and after applying measurement rules, the 10 percent private use threshold for the bond issue as a whole will not be met;
• Ensuring that, even if the 10 percent test for private use is met, based on the facts and after applying measurement rules, the private payments to be received will not cause the 10 percent private payments threshold to be met;
• Negotiating the terms of the management agreement to meet the requirements of a “qualified management agreement” that does not create private business use; and/or
• Structuring the monthly leases to meet the requirements of a short-term use exception.
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. Attorney advertising.
Victoria N. Ozimek Partner Austin
Brian P. Teaff Partner Houston
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