The Issue Spot: Remediating Private Business Use of Governmental Bonds
The Issue Spot PUBL I C F I NANCE I N FOCUS
Remediating Private Business Use of Governmental Bonds Issuers sometimes change the use of property financed with governmental bonds in a way that creates private business use (e.g., selling or leasing property to a private user). In these instances, the issuer should consider whether the action would have the effect of causing the bonds to have private business use and private payments in excess of the permissible levels allowed under federal tax laws (a “deliberate action”). If there is a deliberate action, the issuer can protect the tax-exempt status of its bonds if certain threshold requirements have been met and the issuer takes one of the remedial actions set forth in the Treasury Regulations.
The Threshold Requirements
Eligibility to take a remedial action requires that all the following threshold requirements be met:
• Reasonable expectations test. On the original issue date of the bonds, an issuer cannot have reasonably anticipated that it would later take the deliberate action.
• Maturity not unreasonably long. The term of the bonds must not be longer than is reasonably necessary for the purposes of the issue.
• Fair market value consideration. The deliberate action taken must be at arm’s length and for fair market value, taking into account any bona fide restrictions imposed on the property by the issuer.
• Treatment of disposition proceeds. The issuer must treat any proceeds relating to the deliberate action (the “disposition proceeds”) as “gross proceeds,” meaning that they will be subject to yield restriction and rebate.
• Proceeds expended. The bond proceeds affected must originally have been expended on a governmental purpose, unless the remedial action will be redemption or defeasance of bonds.
Types of Remedial Actions
If the issuer meets the threshold requirements, taking a remedial action can cure the impermissible use and protect the tax-exempt status of the bonds. Depending on the facts, the remedial actions available are:
Redemption or Defeasance. If the disposition proceeds are exclusively cash, the issuer may remediate by redeeming “nonqualified bonds” on the earliest call date after the deliberate action is taken. If the bonds are not currently callable, the issuer may alternately provide for a defeasance escrow within 90 days, but only if the bonds were callable within 10½ years of their issue date and the issuer provides the IRS with notice that the defeasance escrow has been established within 90 days of establishing the escrow. “Nonqualified bonds” are the portion of the outstanding bonds in an amount that, if the remaining bonds were issued on the date of deliberate action, the remaining bonds would not meet the private business tests. ◊ An issuer need only remediate for the highest amount of private business use above the permitted threshold, as measured in any one-year measurement period occurring after the deliberate action. This is different from the general measurement rules, which allow an issuer to take into account average private use over the measurement period. ◊ An issuer cannot “pick and choose” the bonds to redeem or defease. Rather the allocation of nonqualified bonds must be made either (i) on a pro rata basis or (ii) in a manner that would not extend the weighted average maturity of the bond issue. ◊ An important timing consideration is that a deliberate action occurs on the date an issuer and the private party enter into a binding contract that is not subject to material contingencies. This can sometimes cause unexpected timing hiccups, as a contract for sale with no material contingencies may be signed well before the actual closing date, meaning that the issue may not have actually received amounts needed for redemption or defeasance within the required timeframe. Alternative Use of Disposition Proceeds. If the disposition proceeds are exclusively cash, the issue may use the disposition proceeds for capital expenditures related to an alternative governmental purpose, so long as the issuer reasonably expects to expend them within two years for capital expenditures related to valid governmental purpose. Any disposition proceeds remaining after two years must be used to redeem or defease nonqualified bonds. ◊ At one time, the IRS took the informal position that this remedial action requires that all of the disposition proceeds be used for capital expenditures related to an alternative governmental purpose within the prescribed two-year period even if the amount of the disposition proceeds is in excess of the amount of bond proceeds used for the financed property. It is unclear whether the IRS continues to enforce this position.
◊ The issuer should also make sure that the alternative expenditure meets state law requirements regarding use of bond proceeds.
Alternative Use of Facility. If the deliberate action results in the property being used for a qualifying purpose for another type of tax-exempt bond (e.g., a qualified private activity bond), the nonqualified bonds may be treated as reissued, provided that the new user does not use proceeds of another issue of tax-exempt obligations to finance its interest in the property. Generally, the issuer must use the disposition proceeds to pay debt service on the reissued bonds on the next available payment date or to establish a yield-restricted escrow to pay debt service.
Example An issuer issues $5,000,000 of 20-year, tax-exempt governmental bonds with a 10-year call provision. The issuer uses proceeds in the amount of $1,000,000 to purchase land to be used for governmental purposes. After five years, $4,000,000 of principal amount of the bonds remains outstanding and the issuer determines that the land is not suitable for its intended purpose. Land values have appreciated, and the issuer enters into a noncontingent contract with a nonprofit 501(c)(3) organization on September 1, 2019, to sell the land for $2,000,000. The closing on the land occurs on October 1, 2019. All other bond proceeds have been used for governmental purposes and there is no additional private business use.
• As a result of the sale, the highest amount of private business use in any year is determined to be 20% (i.e., 1,000,000/5,000,000). The issuer may remediate the bonds by:
• Defeasing $800,000 in principal amount of the bonds by establishing a defeasance escrow by November 30, 2019 (i.e., 90 days after the date of the contract for sale) and providing notice to the IRS of the defeasance; • Using the $2,000,000 of disposition proceeds for capital expenditures for a governmental purpose authorized under state law by September 1, 2021 (i.e., two years after the date of the contract for sale); or • Treating the bonds as reissued as “qualified 501(c)(3) bonds,” provided that the 501(c)(3) purchaser will be using the land in furtherance of its exempt purpose and has agreed to comply with the rules applicable to qualified 501(c)(3) bonds.
Anticipatory Remedial Actions
For many years, it was not clear whether an issuer could take a remedial action in advance of a deliberate action. In 2015, new Treasury Regulations provided an issuer with the ability to redeem or defease nonqualified bonds in anticipation of a deliberate action if the following requirements are met: Declaration of Intent. Prior to taking the remedial action, an issuer must describe the anticipated deliberate action, identify the affected property, and declare an official intent to redeem or defease all nonqualified bonds once a deliberate action is taken. Redemption or Defeasance. Upon taking the deliberate action, the issuer must actually redeem or defease the nonqualified bonds, subject to the same restrictions that apply to a redemption or defeasance in connection with an “after the fact” remedial action, as described above. Historically, the only option to remediate “bad” use created by an issuer entering into a long-term lease with a private business user was through redemption or defeasance of nonqualified bonds. In 2018, the IRS released Revenue Procedure 2018-26, which allows issuers to remediate private use resulting from eligible long-term leases by recycling an amount equal to the present value of the payments to be received under the lease (i.e., the “disposition proceeds”) into “good” use within two years of entering into the lease. ◊ This new remedial action provides issuers with more flexibility to remediate private use associated with a bad lease, but an issuer must actually have access to amounts equal to the disposition proceeds to avail itself of this option. This could present a challenge because the issuer presumably will receive payments from the lessee over the term of the lease. Remediation of Long-Term Leases
Remedial Actions for Tax Credit Bonds
Prior the release of Revenue Procedure 2018-26, there were no specific remedial actions for tax credit bonds such as “build America bonds” and other qualified tax credit bonds (e.g., qualified school construction bonds and qualified energy conservation bonds). The provisions of Revenue Procedure 2018-26 fill this gap by providing issuers with the option to remediate by either making a downward adjustment to the federal subsidy that would otherwise be received (for direct pay bonds only), redeeming or defeasing nonqualified bonds, or making alternative “good” use of any disposition proceeds within a two-year period.
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Victoria N. Ozimek Partner Austin
Brian P. Teaff Partner Houston
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