Definition of Private Activity Bonds

Federal RegisterJan 16, 1997

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DEPARTMENT OF THE TREASURY

26 CFR Parts 1 and 602

[TD 8712]

RIN 1545-AU62

Definition of Private Activity Bonds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations on the definition of

private activity bonds applicable to tax-exempt bonds issued by state

and local governments. These final regulations reflect changes to the

applicable law that were made by the Technical and Miscellaneous

Revenue Act of 1988. These regulations affect issuers of tax-exempt

bonds and provide needed guidance for applying the private activity

bond restrictions.

DATES: These regulations are effective May 16, 1997.

For dates of applicability of these regulations, see Secs. 1.141-

15, 1.141-16, 1.148-6(a)(3) and 1.148-6(d)(1)(iii) of these

regulations.

FOR FURTHER INFORMATION CONTACT: Loretta J. Finger or Nancy M.

Lashnits, (202) 622-3980 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

have been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1451. Responses to these collections of information

are mandatory. Pursuant to comments received, the collections of

information have been amended, but the estimated annual burden per

respondent/recordkeeper has not changed.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated average annual burden hours per respondent/

recordkeeper: 3 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,

DC 20024, and to the Office of Management and Budget, Attn: Desk

Officer for the Department of the Treasury, Office of Information and

Regulatory Affairs, Washington, DC 20503.

Books or records relating to collections of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

Removal of Existing Regulations for Repealed Sections

Prior to the enactment of the Tax Reduction and Simplification Act

of 1977 (Pub. L. 95-30), sections 141 through 144 contained provisions

of the Internal Revenue Code of 1954 relating to the standard

deduction. Sections 141 (``Standard Deduction''), 142 (``Individuals

Not Eligible for Standard Deduction''), and 144 (``Election of Standard

Deduction'') were repealed by section 101(d)(1) of that act. Section

143 (''Determination of Marital Status'') was redesignated section 7703

by section 1301(j)(2) of the Tax Reform Act of 1986 (Pub. L. 99-514).

Therefore, existing regulations Secs. 1.141-1, 1.142-1, 1.142-2, 1.144-

1, 1.144-2, and 1.144-3 are being removed from the Code of Federal

Regulations (CFR), and regulation Sec. 1.143-1 is being redesignated

Sec. 1.7703-1.

Proposed Regulations

On December 30, 1994, proposed regulations (FI-72-88) were

published in the Federal Register (59 FR 67658) to provide guidance

under the Internal Revenue Code of 1986 (Code) in sections 141

(relating to private activity bonds and to qualified bonds), 142

(relating to exempt-facility bonds), 145 (relating to qualified

501(c)(3) bonds), 147 (relating to other requirements applicable to

certain private activity bonds), 148 (relating to arbitrage), 150

(relating to change of use), and 1394 (relating to enterprise zone

facility bonds). All subsequent references in this preamble to Code

sections are to the Internal Revenue Code of 1986. On June 8, 1995, the

IRS held a public hearing on the proposed regulations. Written comments

responding to the proposed regulations were received.

On May 31, 1996, final regulations (FI-72-88) were published in the

Federal Register (61 FR 106) to provide guidance under Code section

1394 to address the issues relating to enterprise zone facility bonds.

After consideration of all the comments, certain of the proposed

regulations under Code sections 141, 142, 144, 145, 147, 148, and 150

are adopted as revised by this Treasury decision. The principal

revisions to the proposed regulations are discussed below.

Explanation of Provisions

Certain commentators suggested that the proposed regulations, with

certain modifications, be published again as proposed regulations. A

number of other commentators suggested that the proposed regulations,

with certain modifications, should be promulgated as final regulations

to provide certainty at the earliest possible time. After considering

these comments, the IRS and Treasury concluded that state and local

government issuers would benefit from the adoption of the proposed

regulations, with certain modifications made in response to comments,

as final regulations.

A. Section 1.141-1 Definitions and rules of general application.

Replaced amounts. The proposed regulations provide that the

proceeds taken into account under the private activity bond tests

include certain replacement proceeds that are reasonably expected to be

available during the project period.

The final regulations treat replaced amounts also as arising to the

extent that the issuer reasonably expects that the term of the issue

will be longer than is reasonably necessary for the governmental

purposes of the issue, in the same manner as replacement proceeds arise

under the arbitrage regulations under Code section 148. Thus, replaced

amounts may arise under the private activity bond tests if an issuer

reasonably expects that there will be available amounts during the

period that the bonds remain outstanding longer than necessary for the

governmental purposes of the issue and if those amounts are used for

purposes that are inconsistent with the private activity bond tests.

B. Section 1.141-2 Private activity bond tests.

1. Clarification of reasonable expectations test. Under the

proposed regulations the private activity bond tests depend on both

reasonable expectations as of the issue date and

[[Page 2276]]

subsequent deliberate actions of the issuer.

The final regulations clarify that, in general, the reasonable

expectations test is met only if the issuer reasonably expects, as of

the issue date, that no action or event during the entire term of the

bonds will cause either the private business tests or the private loan

financing test to be met. The final regulations further provide,

however, that, if certain conditions are met, the period of expected

compliance needs to extend only to a mandatory redemption date. This

special rule is intended to accommodate issuers that reasonably expect

that bond-financed property may be used by nongovernmental persons

during the stated term of the issue, but have not entered into any

arrangement with a nongovernmental person that will use the property

and are unable to predict the timing of that nongovernmental use. This

special rule does not permit, however, reasonably expected

``recycling'' of disposition proceeds because the special rule requires

redemption of all nonqualified bonds.

2. Definition of deliberate action. The proposed regulations

generally provide that any action within the control of an issuer is

treated as a deliberate action and that, if the financed property was

designed differently than is reasonably necessary for the governmental

purposes of the issuer, an action with respect to that property is

treated as deliberate, even if it is not within the issuer's control.

Commentators suggested that deliberate action should be more narrowly

defined.

The final regulations make certain changes that narrow the scope of

the deliberate action rule to minimize administrative burden on state

and local governments. First, the special rule for property that is

``designed differently'' is deleted. The reasonable expectations test

adequately addresses the concerns of this special rule. Second, the

final regulations clarify that an action taken by a state or local

government in response to a regulatory directive of the federal

government is not a deliberate action. Finally, the final regulations

provide that, if certain conditions are met, dispositions of personal

property in the ordinary course of an established governmental program

are not treated as a deliberate action.

3. Special rule for general obligation bond programs that finance a

large number of separate purposes. The proposed regulations provide a

special exception to the definition of disposition proceeds that is

intended to minimize the administrative burden of tracing the use of

proceeds of general obligation bonds that finance a large number of

projects. Commentators suggested that this exception should be

available for other types of bonds and that fewer conditions should

apply to the exception.

The final regulations provide a similar rule that is broadly stated

as an exception to the rule that a deliberate action after the issue

date can cause an issue to meet the private activity bond tests. This

exception is intended to provide relief for ``cash flow'' general

obligation programs, where issuers use the proceeds of an issue for a

large number of projects and spend proceeds promptly. These programs

merit special treatment in part because they further the purposes of

the arbitrage rules.

4. When a deliberate action occurs. The proposed regulations

provide that a deliberate action occurs on the earlier of the date the

parties agree on the consideration for the new use or the date on which

the new use occurs. Commentators suggested that the regulations should

not treat a deliberate action as occurring before the date on which new

private business use actually commences, in part because it may not be

possible to take a remedial action with disposition proceeds before the

date on which the disposition proceeds are received.

The final regulations provide in general that a deliberate action

occurs on the date the issuer enters into a binding contract with a

nongovernmental person for use of the financed property that is not

subject to any material contingencies. In most cases, material

conditions to closing a transaction that results in private business

use will be treated as material contingencies so that this date will

not occur before the date of receipt of disposition proceeds.

C. Section 1.141-3 Definition of private business use.

1. Economic benefit as private business use. Under the proposed

regulations, economic benefit to a nongovernmental person may be

treated as private business use, even if the nongovernmental person has

no special legal rights to use the financed property.

Commentators suggested that the private business use test should

not be met unless special legal rights are provided to a

nongovernmental person pursuant to an arrangement, and that mere

economic benefit is insufficient to give rise to private business use.

The final regulations largely adopt these suggestions. The final

regulations provide, however, that, if the financed property is not

available for use by the general public, a nongovernmental person may

be treated as a private business user of the property based on all of

the facts and circumstances, even if that nongovernmental person has no

special legal entitlements to use of the property.

2. Ownership. The proposed regulations provide that ownership of

property by a nongovernmental person is private business use of that

property.

Commentators suggested that ownership for this purpose should be

defined to mean ownership for general federal income tax purposes and

that mere holding of title to property by a nongovernmental person

should not necessarily give rise to private business use. Commentators

further suggested that certain customary financing structures that

require a nongovernmental person to be a nominal owner of financed

property should be accommodated.

The final regulations adopt these suggestions.

3. Discharge of a primary legal obligation. The proposed

regulations provide that the use of bond proceeds to provide property

that discharges a primary and unconditional legal obligation of a

nongovernmental person results in private business use of that

property.

Commentators suggested that this rule be deleted from the final

regulations. Many commentators indicated that this rule would interfere

with traditional tax assessment bond financings for governmental

projects such as roads and sidewalks. Some commentators also indicated

that certain state and local governments may be required or encouraged

under state law to enter into development agreements with private

developers that could result in private business use of governmental

projects under the discharge of a primary legal obligation rule.

The final regulations adopt this comment by deleting this rule.

4. Management contracts. The proposed regulations provide that

management contracts other than qualified management contracts result

in private business use of the managed property.

Commentators suggested that the qualified management contract rules

should be safe harbors, not substantive rules, and that a management

contract should give rise to private business use only if it transfers

a proprietary interest in financed property to a manager that is a

nongovernmental person. Commentators suggested that the permissible

contract terms for qualified management contracts should be further

extended and that limitations on the contract term based on useful life

of the

[[Page 2277]]

financed property should be deleted. In addition, commentators

suggested that contracts for incidental services, such as janitorial

and equipment repair services, should never give rise to private

business use of financed property.

The final regulations provide more flexible accommodation for

management contracts that implement cost-saving ``privatization''

measures for state and local governments, but continue to reflect the

view that Congress intended that a management contract can give rise to

private business use even if it does not in substance transfer a

leasehold or ownership interest to a nongovernmental person for general

federal income tax purposes. Thus, the final regulations do not adopt

the rule that a management contract gives rise to private business use

only if it transfers a proprietary interest to a nongovernmental

service provider. The final regulations provide that the determination

of whether a management contract that does not meet the qualified

management contract safe harbors gives rise to private business use is

based on all of the facts and circumstances. In general, a management

contract gives rise to private business use if the compensation under

the contract is based on net profits. The final regulations further

provide, however, that contracts for services solely incidental to the

primary governmental function or functions of a financed facility do

not otherwise give rise to private business use under the management

contract rules. In addition, the final regulations clarify the

standards to be applied in determining whether a management contract is

properly characterized as a lease.

A separate revenue procedure establishes safe harbors which expand

the types of management contracts that do not result in private

business use. This revenue procedure in particular permits longer term

management contracts for public utility facilities and systems, relaxes

certain of the requirements for permitted compensation arrangements,

and deletes the requirement that the issuer not control the service

provider.

5. Research agreements. The proposed regulations set forth bright

line rules for determining when corporate-sponsored research agreements

and cooperative research agreements do not give rise to private

business use. These rules apply only to basic research.

The final regulations provide a facts and circumstances rule, and a

separate revenue procedure establishes safe harbors for determining

when corporate-sponsored research agreements and cooperative research

agreements do not give rise to private business use. This revenue

procedure also expands the definition of basic research, for purposes

of Code section 141, to include any original investigation for the

advancement of scientific knowledge not having a specific commercial

objective.

6. Exception for general public use. The proposed regulations

contain detailed quantitative rules for determining when use of

financed property by a nongovernmental person is disregarded because

the nongovernmental person is treated as using the property as a member

of the general public. The proposed regulations also provide that use

by a nongovernmental person of financed property is not treated as

general public use if the property provides a significant economic

benefit to the nongovernmental person because it is functionally and

integrally related to other property used by the nongovernmental

person.

Commentators suggested that the quantitative rules for defining

general public use should be deleted, because they are not sufficiently

flexible to accommodate the wide variety of state and local government

financings and because they disproportionately affect small local

governments.

The final regulations largely delete the quantitative approach in

the proposed regulations for general public use. Instead, the final

regulations adopt a more qualitative test focusing on whether financed

property is intended to be available and in fact is reasonably

available for use on the same basis by natural persons not engaged in a

trade or business. This approach is more consistent with the

requirement in Code section 141 that any activity carried on by a

person that is not a natural person is treated as a trade or business

activity. Because the final regulations generally do not treat mere

economic benefit as private business use, the rules for functionally

and integrally related property are deleted. In light of this narrower

definition of private business use, the special system improvement

rules have also been deleted. The final regulations retain the rule in

the proposed regulations that use under an arrangement that conveys

priority rights is not used on the same basis as the general public and

clarifies that an arrangement for long-term use (defined as more than

180 days) is not treated as general public use. The final regulations

provide that use of financed property by a nongovernmental person that

is not general public use is not necessarily private business use.

Under the approach taken in the final regulations, the definition of

general public use is significant for determining when economic benefit

alone can give rise to private business use and for determining the

permitted terms of short-term arrangements that are not treated as

private business use.

7. Exceptions for short-term arrangements. The proposed regulations

provide that a lease or similar arrangement that has a term of 1 year

or less and that is not renewed or renewable is generally disregarded.

Commentators suggested that longer term arrangements should be

disregarded.

The final regulations provide different exceptions for various

short-term contracts. The exceptions for short-term contracts are based

on a hierarchy depending on how broadly contracts with the same terms

are offered to other users. Under this approach, a contract that is

available to the general public may have a term up to 180 days; a

contract not treated as general public use, but offered on the basis of

generally applicable or uniformly applied rates, may have a term of up

to 90 days; and a specially negotiated contract that provides fair

market value compensation may have a term of up to 30 days. In each

case, the exception applies only if the property is not financed for a

principal purpose of providing that property for use by the

nongovernmental person entering into the contract. The final

regulations delete the 1-year exception for non-renewable short-term

contracts because the final regulations adopt a more flexible rule for

measuring private business use, as discussed below.

8. Exception for temporary use by developers. The proposed

regulations provide an exception for temporary use by a developer of an

improvement that carries out an essential governmental function during

an initial development period not exceeding 3 years.

Commentators suggested that the 3-year limitation on the exception

is too short for many developments and that a requirement that

development proceed with reasonable speed should suffice.

The final regulations largely adopt this comment. This approach

focuses more on whether financed property serving an essential

governmental function is transferred to a governmental person with

reasonable speed than on a specific time frame for development of the

property benefited by the improvement.

9. Exceptions for incidental use and qualified improvements. The

final regulations remove certain conditions to exceptions for

incidental use and qualified improvements.

[[Page 2278]]

10. Measurement of private business use. The proposed regulations

generally provide that private business use is measured on an annual

basis, except for private business use of output facilities.

Commentators suggested that private business use should be measured on

an average or cumulative basis over the term of an issue. The final

regulations largely adopt the suggestion that private business use

should be measured over the term of an issue. In general, the

percentage of private business use of financed property is determined

according to the average annual private business use of that property

over the measurement period. The measurement period begins on the later

of the issue date of the issue or the date the property is placed in

service and ends on the earlier of the last date of the reasonably

expected economic life of the property or the latest maturity date of

any bond of the issue. For certain bonds that are issued in

contemplation of refinancing, such as bond anticipation notes, the

measurement period is based on the final maturity date of any bond of

the refunding issue. Under an anti-abuse rule, however, if an issuer

extends the term of an issue for a principal purpose of increasing the

permitted amount of private business use, the Commissioner may

determine the amount of private business use according to the greatest

percentage of private business use in any 1-year period. Further, if an

issuer reasonably expects on the issue date that bonds will be redeemed

before the final maturity of the issue because of a deliberate action,

the measurement period ends on the reasonably expected date of

redemption. In addition, for arrangements that result in ownership of

financed property by a nongovernmental person, the amount of private

business use is the greatest percentage of private business use in any

1-year period.

This approach of looking to the average amount of private business

use over the expected economic life of financed property is more

consistent with the approach adopted for measuring private payments and

security, which also in effect looks over the term of an issue. This

approach also provides issuers with significantly greater flexibility

to spread out de minimis private business use over the term of an

issue.

The final regulations adopt the measurement-over-the-term rule for

private business use, however, only for purposes of determining whether

an issue has no more than the permitted amount of private business use

(that is, in most cases, the 10 percent threshold). This general

approach reflects the view that adoption of the measurement-over-the-

term rule for purposes other than the de minimis rules would be unduly

complex to administer and could distort the economic substance.

This general approach also simplifies the regulations by providing

a single rule for measuring private business use that applies to both

output facilities and other governmental facilities. The final

regulations reflect the view that all governmental facilities generally

would benefit from more flexible private business use measurement

rules.

11. Determining average use within an annual period. The proposed

regulations generally provide that the average amount of private

business use within a year is based on the amount of time financed

property is actually used for private business use as a percentage of

total time for all actual use, provided that significant differences in

fair market value of different times of use must be taken into account.

Some commentators suggested that the average amount of private

business use should be based on a comparison of time of private

business use to time the financed property is available for use, not to

time it is actually used.

The final regulations continue to determine private business use

for certain purposes as a percentage of actual use. This method more

accurately reflects economic substance. The final regulations also

clarify that, in certain cases, the determination of fair market value

of private business use must take into account the amount of private

payments for that use.

D. Section 1.141-4 Private security or payment test.

1. Payments not directly made by private business users. The

proposed regulations provide that payments made with respect to

property used for a private business use are taken into account under

the private payment test, even if not made by persons that are private

business users of proceeds. Commentators suggested that payments by

persons that are not private business users should be taken into

account only if they can be imputed to a private business user of

proceeds.

The final regulations retain the general rule in the proposed

regulations but clarify that only payments made for the period of

private business use are taken into account. The definition of private

business use in the final regulations narrows the application of this

general rule.

2. Allocation of private payments to different sources of funding.

The proposed regulations provide that a payment from a private business

user of property may be allocated first to repay any costs of the

property paid by the issuer from a source other than a borrowing

(``equity''). The proposed regulations also provide, however, that, if

a payment is made for property financed with two or more issues

(including issues that are not tax-exempt), the payment must be

allocated among those issues according to the relative amount of

proceeds of those issues used to finance the property. Commentators

generally favored the rule permitting allocations first to equity, but

suggested that the same rule should apply to costs financed with

taxable bonds.

The final regulations provide a more general facts and

circumstances test for the allocation of private payments that looks to

the nexus between the private payment and both the property financed

and the source of funding. Thus, under the approach of the final

regulations, allocations of private payments first to equity before

other sources of funding are generally permitted only to the extent

that there is a specific nexus between the payment and a prior

expenditure. The final regulations do not adopt the recommendation that

issuers also be permitted in all cases to allocate private payments

first to repayment of taxable bonds, but treat the obligation to pay

debt service in future years under the taxable debt as establishing a

nexus to future private payments. The final regulations retain the rule

that allocations of private payments among issues according to relative

amounts of those sources of funding that are expended on the property

is generally appropriate, but the final regulations provide issuers

with more flexibility to match these allocations to debt service

payments associated with various sources of funding.

3. Allocation of private security among issues. The proposed

regulations provide that, for bonds other than parity bonds, property

or payments securing more than one issue must be fully allocated to

each issue under the private security test. Commentators suggested that

the rule for allocation of private security among issues should

reasonably reflect foreclosure and default scenarios under the bond

documents. The final regulations in general adopt this comment.

4. Limitations on private security. The proposed regulations

provide that any property that is used for a private business use is

taken into account under the private security test if it secures

payment of debt service on an issue.

The final regulations provide that

[[Page 2279]]

only financed property and property that is provided directly or

indirectly by a nongovernmental person that is treated as a user of

proceeds are taken into account under the private security test.

5. Exception for generally applicable taxes. The proposed

regulations contain specific rules for when a special agreement with

respect to a generally applicable tax may cause tax payments to be

treated as private payments.

In response to comments, the final regulations are more flexible

for arrangements that reduce the amount of tax paid and permit a wider

range of tax equivalency payments. The final regulations also clarify

that an impermissible agreement entered into by one taxpayer does not

affect whether payments made by other taxpayers are treated as

generally applicable taxes.

E. Section 1.141-5 Private loan financing test.

1. Definition of proceeds for purposes of the private loan

financing test. The proposed regulations provide that the private loan

financing test is met if more than the lesser of 5 percent of the

``proceeds'' or $5 million of ``sale proceeds'' is used to make or

finance loans to nongovernmental persons. Commentators suggested that

the definition of proceeds for purposes of the test should be

consistent.

The final regulations apply the general private activity bond

definition of ``proceeds'' to both parts of the test. This approach

reflects the view that investment proceeds that are used to make or

finance loans should be taken into account in determining whether the

private loan financing test is met.

2. Requirements for the ``tax assessment loan'' exception. The

proposed regulations provide that a number of special requirements

apply to the exception in Code section 141(c)(2) from the private loan

financing test for loans that enable the borrower to finance a

governmental tax or assessment of general application for a specific

essential governmental function. Commentators suggested that these

requirements would improperly restrict traditional special tax and

assessment tax-exempt financing for governmental infrastructure in some

states.

In general, special state law restrictions (for example, state

constitutional limitations on issuing general obligation bonds) should

not necessarily foreclose state and local governments from access to

tax-exempt financing for traditional governmental infrastructure

projects. Accordingly, the final regulations relax the requirements for

the tax assessment bond exception. The requirement that a tax or

assessment of general application be proportionate to the benefit to

the taxpayer is deleted. Further, the definition of improvements that

serve essential governmental functions is expanded. Under the new

definition, all improvements to utilities and systems that are owned by

a governmental person and that are available for use by the general

public serve essential governmental functions for this purpose. In

addition, the final regulations provide that guarantees provided by

persons treated as borrowers in most cases will not cause taxes or

assessments to fail to qualify for the tax assessment bond exception.

F. Section 1.141-6 Allocation and accounting rules.

1. Allocations of proceeds to expenditures. The proposed

regulations in general provide that proceeds must be allocated to

expenditures consistently for private activity bond purposes and

arbitrage purposes. Commentators suggested that, in light of the

different purposes of the private activity bond rules and the arbitrage

rules, this consistency should not be required.

The final regulations continue the approach of the proposed

regulations. Final regulations are also adopted under Code section 148

clarifying that allocations of proceeds to expenditures for both

purposes must be made by a definite time (in no event later than the

date that rebate is, or would be, due).

2. Other allocation rules. The proposed regulations contain

detailed rules in Secs. 1.141-1 and 1.141-6 for allocations of proceeds

and bonds, including rules for mixed use facilities and partnerships.

The final regulations reserve these provisions. The IRS and

Treasury are considering more flexible rules to accommodate public/

private partnerships.

G. Section 1.141-7 Special rules for output contracts.

The proposed regulations contain detailed rules in Sec. 1.141-7 for

determining the private business use and private payments resulting

from output contracts.

Regulatory changes are dramatically affecting the electric power

industry. In order to further consider the issues raised by these

changes, the final regulations reserve this section. The final

regulations, however, otherwise apply to bonds issued to finance output

facilities.

H. Section 1.141-8 $15 million limitation for output facilities.

Clarification of computation of nonqualified amount. The proposed

regulations provide guidance on the special $15 million limitation on

output facilities of Code section 141(b)(4). The final regulations

reserve this section.

I. Section 1.141-12 Remedial actions.

1. Remedial actions generally. The proposed regulations provide

that an action that causes the private business tests or the private

loan financing test to be met is not treated as a deliberate action if

the issuer takes an appropriate remedial action.

The final regulations clarify that a remedial action affects only

compliance with the private activity bond rules relating to use of

proceeds and does not affect compliance with rules relating to security

or payment. This clarification is important for purposes of determining

the amount of ``nonqualified bonds'' with respect to which a remedial

action must be taken.

2. Relationship of disposition proceeds and remedial actions. The

proposed regulations contain separate rules for use of proceeds derived

from the disposition of bond-financed property (``disposition

proceeds'') and remedial actions. Commentators suggested that the

relationship between the disposition proceeds rules and the remedial

action rules should be clarified and that, in particular, additional

rules should be provided indicating when it is appropriate to treat an

issue as financing disposition proceeds rather than the transferred

property.

The final regulations take the view that, if an issuer disposes of

bond-financed property, it is generally appropriate under Code section

141 for the Commissioner to treat the issue as financing either the

transferred property or the disposition proceeds. This is because any

disposition of bond-financed property has the potential to transfer the

benefits of tax-exempt financing to the purchaser, and the private

activity bond rules extend to transactions that have significant

potential to transfer these benefits, as well as transactions that

actually transfer these benefits. As a matter of administrative

convenience, however, the final regulations in certain cases permit an

issuer to choose to treat an issue as financing either the transferred

property or the disposition proceeds, provided that certain conditions

are met that protect against abuse. The final regulations accordingly

treat the disposition proceeds rules as conditions to taking certain

remedial actions. For

[[Page 2280]]

example, in order for an issue to be eligible for a remedial action,

the disposition proceeds of an issue must generally be treated as

proceeds for purposes of the arbitrage regulations.

3. Conditions to taking a remedial action. The proposed regulations

provide that an issuer may take a remedial action to prevent bonds of

an issue from becoming private activity bonds only if it made certain

covenants and certifications on the issue date. Commentators suggested

that these specific requirements should be deleted because they are

unnecessary in light of standard industry practice to require similar

covenants and certifications. The final regulations adopt this comment.

4. Maturity limitations and remedial actions. The proposed

regulations provide that an issuer cannot take advantage of certain

favorable rules involving disposition proceeds if the weighted average

maturity of an issue is greater than 120 percent of the economic life

of the financed property. Commentators suggested that use of this 120

percent maturity limitation as a condition to favorable treatment in

taking remedial actions is burdensome for issuers of governmental

bonds.

The final regulations provide that an issue is eligible for the

remedial action rules only if the term of the issue is not longer than

is reasonably necessary for the governmental purposes of the issue. To

determine whether the term of an issue is unreasonably long, the final

regulations adopt the same standard that is used for purposes of

determining whether replacement proceeds arise because the term of an

issue is unreasonably long under Sec. 1.148-1(c)(4). This standard

provides that the 120 percent maturity limitation is a safe harbor,

rather than a requirement in all cases.

5. Special rules for identifying disposition proceeds. Under the

proposed regulations, many of the rules for remedial actions depend on

identification of disposition proceeds. The final regulations clarify

how disposition proceeds are to be allocated to an issue when the

transferred property has been financed with different sources of

funding. In general, the final regulations provide that disposition

proceeds should be allocated first to the outstanding bonds that

financed the property (both tax-exempt and taxable) in proportion to

the outstanding principal amounts of those outstanding bonds. Only

amounts in excess of these outstanding principal amounts may be

allocated to other sources of funding, such as equity of an issuer or

bonds that are no longer outstanding.

6. Redemption and defeasance as remedial actions. The proposed

regulations generally provide that redemption and defeasance of

nonqualified bonds are permitted remedial actions. In cases where the

disposition is exclusively for cash, only the disposition proceeds need

to be used to redeem or defease bonds; in other cases, the entire

amount of nonqualified bonds is required to be redeemed or defeased.

The proposed regulations also provide, however, that defeasance of

bonds to a date that is more than six months from the date of a

deliberate action is permitted only if the possibility of a disposition

was remote as of the issue date of the bonds. Commentators suggested

that this special limitation should be deleted because the remoteness

standard is vague and would require governmental issuers to use special

call provisions that would substantially increase borrowing costs.

The final regulations delete the ``remote possibility'' limitation

on use of defeasance as a remedial action. Instead, the final

regulations permit defeasance as a remedial action only if the first

call date of the nonqualified bonds is not greater than 10\1/2\ years

from the issue date. This limitation presents an administrable standard

that will not unduly interfere with customary financing practices of

state and local governments, while at the same time preventing improper

use of defeasance as a remedial action for bonds that cannot be called

for an extended period of time.

7. Alternative qualifying use of a facility as a remedial action.

The proposed regulations provide that alternative qualifying use of a

bond-financed facility is a permitted remedial action if the facility

is used in a manner that meets the requirements for any type of

qualified private activity bonds and the bonds are treated as reissued

as of the date of the deliberate action for purposes of the tax-exempt

bond rules concerning use of bond-financed property. Commentators

suggested that for purposes of determining whether bonds that are

treated as reissued as of the date of the deliberate action satisfy all

of the applicable requirements for qualified bonds, the rules contained

in Code section 146 relating to volume cap and the rules contained in

Code sections 55 and 57 should not apply. Commentators also suggested

that the regulations should clarify whether any limitations are placed

on an issuer's use of disposition proceeds when it chooses to use this

remedial action.

The final regulations provide that, in order to qualify for this

remedial action, an issuer must deposit any disposition proceeds that

it receives into a yield-restricted escrow to pay the nonqualified

bonds. This requirement is different than the defeasance remedial

action, because an issuer is permitted to leave bonds outstanding until

maturity (rather than the first call date) and is not subject to the

special 10 \1/2\-year call protection limitation on the defeasance

remedial action. Also, if an issuer chooses to use this rule, it may

receive compensation in installments and use any payments received

either to pay debt service or to deposit into a yield-restricted escrow

to pay debt service. This requirement is appropriate because it

establishes the necessary nexus between the new user and the

nonqualified bonds. In effect, the new user is treated, as far as is

reasonably practicable, as if it were the conduit borrower of the bond

proceeds.

The final regulations also clarify that, for purposes of

determining whether nonqualified bonds that are deemed to be reissued

meet all of the requirements for qualified private activity bonds, the

law in effect on the date of the deliberate action applies. The final

regulations do not adopt the suggestion that the rules contained in

Code section 146 relating to volume cap and the rules contained in Code

sections 55 and 57 should not apply. The IRS and Treasury are issuing a

revenue procedure (discussed in paragraph 10 below) to address the

change in status of bonds from governmental bonds to qualified private

activity bonds and the application of the alternative minimum tax

provisions. The final regulations provide that the rules contained in

Code section 147(d) relating to the acquisition of existing property do

not apply to this remedial action.

8. Nonqualified bonds. The proposed regulations permit an issuer to

take a remedial action with respect to a portion of the bonds of an

issue, rather than the entire issue. In general, the proposed

regulations require that these ``nonqualified bonds'' be a pro rata

portion (among the maturities) of the outstanding bonds of an issue.

Commentators suggested that issuers should have greater flexibility to

allocate uses of proceeds to bonds when a deliberate action occurs.

The final regulations permit an issuer to redeem or defease bonds

with longer maturities than the nonqualified bonds in a remedial

action, but in general continue to require that nonqualified bonds be

identified on a pro rata basis. Issuers have significant flexibility to

allocate bonds of an issue to separate

[[Page 2281]]

purposes on or before the issue date under Sec. 1.150-1(c)(3).

Under the final regulations, the percentage of outstanding bonds

that are nonqualified bonds is equal to the highest percentage of

private business use in any 1-year period commencing with the

deliberate action.

9. Effect of deliberate actions and remedial actions on bonds that

have been advance refunded. The proposed regulations do not

specifically address how deliberate actions and remedial actions affect

bonds that have been advance refunded. Commentators suggested that a

deliberate action should not affect the status of an advance refunded

bond under Code section 141.

The final regulations provide that a remedial action taken with

respect to advance refunding bonds proportionately ``cures'' the bonds

that have been advance refunded.

10. Remedial payment revenue procedure. The preamble to the

proposed regulations indicates that the IRS and Treasury are

considering issuance of a revenue procedure pursuant to which an issuer

may request a closing agreement with respect to outstanding bonds.

Under the closing agreement, the issuer would make a payment to the IRS

to prevent the interest on bonds from being includible in gross income

of bondholders as a result of a deliberate action that results in

satisfaction of the private activity bond test. In general, the payment

would be based on the difference between applicable federal rates for

taxable and tax-exempt obligations. The preamble to the proposed

regulations indicates that this revenue procedure is being considered

in lieu of permitting defeasance as a remedial action. Commentators

generally favored the publication of such a revenue procedure but

suggested that it should apply in addition to defeasance as a remedial

action.

Commentators also suggested that an issuer should be permitted to

make a payment to the IRS in those cases where the bonds were issued as

governmental bonds, the interest on which was not treated as an item of

tax preference for purposes of the alternative minimum tax provisions,

but the bonds become qualified private activity bonds, the interest on

which is treated as an item of tax preference for purposes of the

alternative minimum tax provisions as a consequence of a remedial

action taken by the issuer.

The IRS and Treasury are issuing a revenue procedure in addition to

permitting defeasance as a remedial action. Under this revenue

procedure the amount of the remedial payment is based on a factor that

roughly approximates revenue loss to the United States rather than the

difference between taxable and tax-exempt applicable federal rates.

While this approach may in many cases require greater remedial payments

than under the approach described in the proposed regulations, the

fluctuation in the difference between taxable and tax-exempt applicable

federal rates would result in inconsistent treatment of issuers.

Further, a more rigorous standard for determining the remedial payment

is appropriate because the revenue procedure is adopted in addition to

all of the remedial actions set forth in the final regulations.

In response to comments, this revenue procedure also provides that

an issuer may make a payment to prevent the application of the

alternative minimum tax provisions to interest payable on bonds that

were issued as governmental bonds but, as a consequence of a remedial

action taken by an issuer, are qualified private activity bonds. This

approach recognizes the difficulty state and local government issuers

may have in notifying bondholders of this change in status.

J. Section 1.141-13 Refunding issues.

The final regulations reserve on the treatment of refunding bonds

under Code section 141.

K. Section 1.141-14 Anti-abuse rules.

Application of the rule to override specific tracing. The proposed

regulations provide that if an issuer enters into a transaction or

series of transactions with a principal purpose of transferring to

nongovernmental persons (other than as members of the general public)

significant benefits of tax-exempt financing in a manner that is

inconsistent with the purposes of Code section 141, the Commissioner

may take any action to reflect the substance of the transaction or

transactions.

The final regulations adopt this rule and add examples to clarify

that it may be invoked in appropriate cases to override specific

tracing of the use of proceeds.

L. Section 1.145-1 Special rules for qualified 501(c)(3) bonds.

1. Application of private activity bond rules to Code section

145(a). The proposed regulations provide that the regulations under

Code section 141 interpreting the private activity bond tests apply for

purposes of Code section 145(a)(2).

The final regulations in general continue this approach but also

provide that certain provisions under Code section 141, which are

intended to apply only to governmental programs, do not apply to

qualified 501(c)(3) bonds. The final regulations also clarify that

regulations under Code section 141 apply in the same manner to the

ownership test of Code section 145(a)(1) and to the modified private

activity bond test of Code section 145(a)(2).

2. Application of deliberate action and remedial action rules to

other provisions of Code section 145. The proposed regulations provide

that the deliberate action rules of Sec. 1.141-2 and the remedial

action rules of Sec. 1.141-12 generally apply to Code section 145.

The final regulations do not apply to Code sections 145(b), (c), or

(d). The $150 million limitation on bonds other than hospital bonds of

Code sections 145(b) and (c) involves a number of special

considerations, which the IRS and Treasury believe would be more

appropriate to consider in a project comprehensively interpreting the

operation of the special volume cap rules. Similarly, the restrictions

on bonds used to provide residential rental housing for family units of

Code section 145(d) involve a number of special considerations, which

the IRS and Treasury believe would be more appropriate to consider in a

project comprehensively interpreting the special rules for bonds

financing residential rental housing.

M. Special rules for other qualified bonds.

1. General standard for compliance. The proposed regulations

provide that the requirements for qualified bonds (other than qualified

501(c)(3) bonds) generally must be actually met throughout the term of

an issue. Commentators suggested that this rule should be deleted

because the compliance standard for each type of qualified bond should

be separately considered. Other commentators suggested that the

compliance standard applicable to governmental bonds, looking to

reasonable expectations and deliberate actions, is generally

appropriate for qualified bonds.

The final regulations do not address the general compliance

standard for qualified bonds (other than qualified 501(c)(3) bonds).

The IRS and Treasury believe that further consideration should be given

to whether special rules apply to different types of qualified bonds.

Accordingly, the final regulations address only whether remedial

actions may be taken to prevent certain types of qualified bonds from

failing to meet requirements relating to use of proceeds. Thus, no

implication is intended that the

[[Page 2282]]

measurement-over-the-term rule for private business use under Code

sections 141 and 145 applies in any manner to other qualified bonds.

2. Remedial actions for change in use. The proposed regulations in

general provide that, if an action results in nonqualified use of

proceeds, the remedial actions that apply to governmental bonds also

apply to qualified bonds. The permitted remedial actions include

redemption and defeasance of bonds and alternative qualifying use of a

facility.

The final regulations address only whether remedial actions may be

taken for exempt facility bonds under Code section 142 and qualified

small issue bonds under Code section 144(a) and with respect to certain

provisions of 147. The final regulations continue to provide that

redemption and defeasance are permitted remedial actions for these

types of issues, under rules that are similar to the remedial action

rules that apply to governmental bonds. The requirements for these

types of qualified bonds focus on the use of a particular facility for

a particular qualifying use, and, unlike governmental bonds and

qualified 501(c)(3) bonds, do not generally focus on the status of the

borrower. For this reason, the final regulations generally do not

permit an issuer of exempt facility bonds or qualified small issue

bonds to take a remedial action based on use of disposition proceeds.

Accordingly, the final regulations clarify that the amount of bonds

required to be redeemed or defeased under a remedial action is not

limited to the amount of disposition proceeds. For administrative

convenience, however, the final regulations permit the use of

disposition proceeds from the sale of personal property that is

incidental to a qualifying facility to replace the personal property

that is sold. The final regulations do not permit alternative

qualifying use of a facility as a remedial action for exempt facility

bonds or qualified small issue bonds.

3. Remedial actions for failure to spend proceeds. The proposed

regulations provide that a remedial action may be taken to correct a

failure to spend proceeds as required under Code sections 142 and 144.

This rule replaces Rev. Proc. 79-5, 1979-1 C.B. 485, and Rev. Proc. 81-

22, 1981-1 C.B. 692, which provide guidance on how the requirement in

the predecessor to Code section 142 that substantially all of the

proceeds be spent for a qualifying purpose is met when excess bond

proceeds remain on hand after acquisition or construction has been

completed.

The final regulations clarify that the requirements for remedial

action in the case of failure to spend proceeds for a qualifying

purpose are comparable to the requirements for remedial action in the

case of change in use of a qualifying facility. Accordingly, the final

regulations require that nonqualified bonds must be redeemed at their

first call date, regardless of the amount of call premium that is

required to be paid, and that defeasance is permitted only if the first

call date is no later than 10\1/2\ years after the issue date.

4. Refundings of qualified bonds. The final regulations reserve on

the treatment of refundings of qualified bonds.

N. Section 1.150-4 Statutory change of use rules for qualified

private activity bonds.

The proposed regulations provide that the change of use provisions

of Code section 150(b) apply even if an issuer takes a remedial action

that enables an issue of qualified private activity bonds to continue

to meet use of proceeds requirements. Commentators suggested that a

remedial action that preserves the tax-exempt status of a qualified

private activity bond should also prevent application of the interest

deduction denial and imputed unrelated business income provisions of

Code section 150(b).

The final regulations more specifically address the effect of each

type of remedial action on the application of the Code section 150(b)

consequences. In general, defeasance of bonds does not prevent

application of Code section 150(b). If other remedial actions are taken

promptly after the date of the remedial action, however, Code section

150(b) does not apply.

O. Effective dates.

The final regulations generally apply to bonds issued after May 16,

1997. To promote compliance, the final regulations generally permit

elective, retroactive application of the regulations in whole, but not

in part, to outstanding issues. In addition, the final regulations

permit elective, retroactive application to outstanding issues of any

of the following sections of the regulations: Sec. 1.141-12 (the

remedial action rules); Sec. 1.141-3(b)(4) (the management contract

rules); and Sec. 1.141-3(b)(6) (the research agreement rules).

Effect on Other Documents

In part because the existing industrial development bond

regulations under Sec. 1.103-7 may continue to apply to refunding bonds

issued after the effective date of the private activity bond

regulations, Sec. 1.103-7 is not being removed from the Code of Federal

Regulations.

For bonds to which the final regulations apply, the following

publications are obsolete:

Notice 87-69, 1987-2 C.B. 378.

Notice 89-9, 1989-1 C.B. 630.

For actions that occur on or after May 16, 1997, the following

publications are obsolete:

Rev. Proc. 93-17, 1993-1 C.B. 507.

Rev. Proc. 81-22, 1981-1 C.B. 692.

Rev. Proc. 79-5, 1979-1 C.B. 485.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations, and because the notice of proposed

rulemaking preceding the regulations was issued prior to March 29,

1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not

apply. Pursuant to section 7805(f) of the Internal Revenue Code, the

notice of proposed rulemaking preceding these regulations was submitted

to the Chief Counsel for Advocacy of the Small Business Administration

for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Michael G. Bailey,

Loretta J. Finger, and Nancy M. Lashnits, Office of Assistant Chief

Counsel (Financial Institutions and Products), and Linda B. Schakel of

the Office of Tax Legislative Counsel. However, other personnel from

the IRS and Treasury Department participated in their development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding

an entry in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

[[Page 2283]]

Section 1.148-6 also issued under 26 U.S.C. 148(f), (g), and (i). *

* *

Section 1.150-4 also issued under 26 U.S.C. 150(c)(5). * * *

Par. 2. The center heading immediately preceding Sec. 1.141-1 is

revised to read as follows:

Tax Exemption Requirements for State and Local Bonds

Par. 3. Section 1.141-1 is revised.

Sec. 1.143-1 [Redesignated as Sec. 1.7703-1]

Par. 4. Section 1.143-1 is redesignated as Sec. 1.7703-1.

Sec. 1.144-3 [Removed]

Par. 5. Section 1.144-3 is removed.

Par. 6. Sections 1.141-0 and 1.141-2 through 1.141-16 are added.

The revised and added sections read as follows:

Sec. 1.141-0 Table of contents.

This section lists the captioned paragraphs contained in

Secs. 1.141-1 through 1.141-16.

Sec. 1.141-1 Definitions and rules of general application.

(a) In general.

(b) Certain general definitions.

(d) Related parties.

Sec. 1.141-2 Private activity bond tests.

(a) Overview.

(b) Scope.

(d) Reasonable expectations and deliberate actions.

(1) In general.

(2) Reasonable expectations test.

(3) Deliberate action defined.

(4) Special rule for dispositions of personal property in the

ordinary course of an established governmental program.

(5) Special rule for general obligation bond programs that

finance a large number of separate purposes.

(e) When a deliberate action occurs.

(f) Certain remedial actions.

(g) Examples.

Sec. 1.141-3 Definition of private business use.

(a) General rule.

(1) In general.

(2) Indirect use.

(3) Aggregation of private business use.

(b) Types of private business use arrangements.

(1) In general.

(2) Ownership.

(3) Leases.

(4) Management contracts.

(5) Output contracts.

(6) Research agreements.

(7) Other actual or beneficial use.

(1) In general.

(2) Use on the same basis.

(3) Long-term arrangements not treated as general public use.

(4) Relation to other use.

(d) Other exceptions.

(1) Agents.

(2) Use incidental to financing arrangements.

(3) Exceptions for arrangements other than arrangements

resulting in ownership of financed property by a nongovernmental

person.

(4) Temporary use by developers.

(5) Incidental use.

(6) Qualified improvements.

(e) Special rule for tax assessment bonds.

(f) Examples.

(g) Measurement of private business use.

(1) In general.

(2) Measurement period.

(3) Determining average percentage of private business use.

(4) Determining the average amount of private business use for a

1-year period.

(5) Common areas.

(6) Allocation of neutral costs.

(7) Commencement of measurement of private business use.

(8) Examples.

Sec. 1.141-4 Private security or payment test.

(a) General rule.

(1) Private security or payment.

(2) Aggregation of private payments and security.

(3) Underlying arrangement.

(b) Measurement of private payments and security.

(1) Scope.

(2) Present value measurement.

(1) In general.

(2) Payments taken into account.

(3) Allocation of payments.

(d) Private security.

(1) In general.

(2) Security taken into account.

(3) Pledge of unexpended proceeds.

(4) Secured by any interest in property or payments.

(5) Payments in respect of property.

(6) Allocation of security among issues.

(e) Generally applicable taxes.

(1) General rule.

(2) Definition of generally applicable taxes.

(3) Special charges.

(4) Manner of determination and collection.

(5) Payments in lieu of taxes.

(f) Certain waste remediation bonds.

(1) Scope.

(2) Persons that are not private users.

(3) Persons that are private users.

(g) Examples.

Sec. 1.141-5 Private loan financing test.

(a) In general.

(b) Measurement of test.

(1) In general.

(2) Application only to purpose investments.

(3) Grants.

(4) Hazardous waste remediation bonds.

(d) Tax assessment loan exception.

(1) General rule.

(2) Tax assessment loan defined.

(3) Mandatory tax or other assessment.

(4) Specific essential governmental function.

(5) Equal basis requirement.

(6) Coordination with private business tests.

(e) Examples.

Sec. 1.141-6 Allocation and accounting rules.

(a) Allocation of proceeds to expenditures.

(b) Allocation of proceeds to property. [Reserved]

(d) Allocation of proceeds to common areas. [Reserved]

(e) Allocation of proceeds to bonds. [Reserved]

(f) Treatment of partnerships. [Reserved]

(g) Examples. [Reserved]

Sec. 1.141-7 Special rules for output contracts.

[Reserved]

Sec. 1.141-8 $15 million limitation for output facilities.

[Reserved]

Sec. 1.141-9 Unrelated or disproportionate use test.

(a) General rules.

(1) Description of test.

(2) Application of unrelated or disproportionate use test.

(b) Unrelated use.

(1) In general.

(2) Use for the same purpose as government use.

(1) Definition of disproportionate use.

(2) Aggregation of related uses.

(3) Allocation rule.

(d) Maximum use taken into account.

(e) Examples.

Sec. 1.141-10 Coordination with volume cap.

[Reserved]

Sec. 1.141-11 Acquisition of nongovernmental output property.

[Reserved]

Sec. 1.141-12 Remedial actions.

(a) Conditions to taking remedial action.

(1) Reasonable expectations test met.

(2) Maturity not unreasonably long.

(3) Fair market value consideration.

(4) Disposition proceeds treated as gross proceeds for arbitrage

purposes.

(5) Proceeds expended on a governmental purpose.

(b) Effect of a remedial action.

(1) In general.

(2) Effect on bonds that have been advance refunded.

(1) Definition.

(2) Allocating disposition proceeds to an issue.

(3) Allocating disposition proceeds to different sources of

funding.

(d) Redemption or defeasance of nonqualified bonds.

(1) In general.

(2) Special rule for dispositions for cash.

(3) Notice of defeasance.

(4) Special limitation.

(5) Defeasance escrow defined.

(e) Alternative use of disposition proceeds.

(1) In general.

[[Page 2284]]

(2) Special rule for use by 501(c)(3) organizations.

(f) Alternative use of facility.

(g) Rules for deemed reissuance.

(h) Authority of Commissioner to provide for additional remedial

actions.

(i) Effect of remedial action on continuing compliance.

(j) Nonqualified bonds.

(1) Amount of nonqualified bonds.

(2) Allocation of nonqualified bonds.

(k) Examples.

Sec. 1.141-13 Refunding issues.

[Reserved]

Sec. 1.141-14 Anti-abuse rules.

(a) Authority of Commissioner to reflect substance of

transactions.

(b) Examples.

Sec. 1.141-15 Effective dates.

(a) Scope.

(b) Effective dates.

(d) Permissive application of regulations.

(e) Permissive retroactive application of certain sections.

Sec. 1.141-16 Effective dates for qualified private activity bond

provisions.

(a) Scope.

(b) Effective dates.

Sec. 1.141-1 Definitions and rules of general application.

(a) In general. For purposes of Secs. 1.141-0 through 1.141-16, the

following definitions and rules apply: the definitions in this section,

the definitions in Sec. 1.150-1, the definition of placed in service

under Sec. 1.150-2(c), the definition of grant under Sec. 1.148-

6(d)(4)(iii), the definition of reasonably required reserve or

replacement fund in Sec. 1.148-2(f), and the following definitions

under Sec. 1.148-1: bond year, commingled fund, fixed yield issue,

higher yielding investments, investment, investment proceeds, issue

price, issuer, nonpurpose investment, purpose investment, qualified

guarantee, qualified hedge, reasonable expectations or reasonableness,

rebate amount, replacement proceeds, sale proceeds, variable yield

issue, and yield.

(b) Certain general definitions.

Common areas means portions of a facility that are equally

available to all users of a facility on the same basis for uses that

are incidental to the primary use of the facility. For example,

hallways and elevators generally are treated as common areas if they

are used by the different lessees of a facility in connection with the

primary use of that facility.

Consistently applied means applied uniformly to account for

proceeds and other amounts.

Deliberate action is defined in Sec. 1.141-2(d)(3).

Discrete portion means a portion of a facility that consists of any

separate and discrete portion of a facility to which use is limited,

other than common areas. A floor of a building and a portion of a

building separated by walls, partitions, or other physical barriers are

examples of a discrete portion.

Disposition is defined in Sec. 1.141-12(c)(1).

Disposition proceeds is defined in Sec. 1.141-12(c)(1).

Essential governmental function is defined in Sec. 1.141-

5(d)(4)(ii).

Financed means constructed, reconstructed, or acquired with

proceeds of an issue.

Governmental bond means a bond issued as part of an issue no

portion of which consists of private activity bonds.

Governmental person means a state or local governmental unit as

defined in Sec. 1.103-1 or any instrumentality thereof. It does not

include the United States or any agency or instrumentality thereof.

Hazardous waste remediation bonds is defined in Sec. 1.141-4(f)(1).

Measurement period is defined in Sec. 1.141-3(g)(2).

Nongovernmental person means a person other than a governmental

person.

Output facility means electric and gas generation, transmission,

distribution, and related facilities, and water collection, storage,

and distribution facilities.

Private business tests means the private business use test and the

private security or payment test of section 141(b).

Proceeds means the sale proceeds of an issue (other than those sale

proceeds used to retire bonds of the issue that are not deposited in a

reasonably required reserve or replacement fund). Proceeds also include

any investment proceeds from investments that accrue during the project

period (net of rebate amounts attributable to the project period).

Disposition proceeds of an issue are treated as proceeds to the extent

provided in Sec. 1.141-12. The Commissioner may treat any replaced

amounts as proceeds.

Project period means the period beginning on the issue date and

ending on the date that the project is placed in service. In the case

of a multipurpose issue, the issuer may elect to treat the project

period for the entire issue as ending on either the expiration of the

temporary period described in Sec. 1.148-2(e)(2) or the end of the

fifth bond year after the issue date.

Public utility property means public utility property as defined in

section 168(i)(10).

Qualified bond means a qualified bond as defined in section 141(e).

Renewal option means a provision under which either party has a

legally enforceable right to renew the contract. Thus, for example, a

provision under which a contract is automatically renewed for 1-year

periods absent cancellation by either party is not a renewal option

(even if it is expected to be renewed).

Replaced amounts means replacement proceeds other than amounts that

are treated as replacement proceeds solely because they are sinking

funds or pledged funds.

Weighted average maturity is determined under section 147(b).

Weighted average reasonably expected economic life is determined

under section 147(b). The reasonably expected economic life of property

may be determined by reference to the class life of the property under

section 168.

issue date and retained as part of the bond documents, and, once made,

may not be revoked without the permission of the Commissioner.

(d) Related parties. Except as otherwise provided, all related

parties are treated as one person and any reference to ''person''

includes any related party.

Sec. 1.141-2 Private activity bond tests.

(a) Overview. Interest on a private activity bond is not excludable

from gross income under section 103(a) unless the bond is a qualified

bond. The purpose of the private activity bond tests of section 141 is

to limit the volume of tax-exempt bonds that finance the activities of

nongovernmental persons, without regard to whether a financing actually

transfers benefits of tax-exempt financing to a nongovernmental person.

The private activity bond tests serve to identify arrangements that

have the potential to transfer the benefits of tax-exempt financing, as

well as arrangements that actually transfer these benefits. The

regulations under section 141 may not be applied in a manner that is

inconsistent with these purposes.

(b) Scope. Sections 1.141-0 through 1.141-16 apply generally for

purposes of the private activity bond limitations under section 141.

bonds are private activity bonds if they meet either the private

business use test and private security or payment test of

[[Page 2285]]

section 141(b) or the private loan financing test of section 141(c).

The private business use and private security or payment tests are

described in Secs. 1.141-3 and 1.141-4. The private loan financing test

is described in Sec. 1.141-5.

(d) Reasonable expectations and deliberate actions--(1) In general.

An issue is an issue of private activity bonds if the issuer reasonably

expects, as of the issue date, that the issue will meet either the

private business tests or the private loan financing test. An issue is

also an issue of private activity bonds if the issuer takes a

deliberate action, subsequent to the issue date, that causes the

conditions of either the private business tests or the private loan

financing test to be met.

(2) Reasonable expectations test--(i) In general. In general, the

reasonable expectations test must take into account reasonable

expectations about events and actions over the entire stated term of an

issue.

(ii) Special rule for issues with mandatory redemption provisions.

An action that is reasonably expected, as of the issue date, to occur

after the issue date and to cause either the private business tests or

the private loan financing test to be met may be disregarded for

purposes of those tests if--

(A) The issuer reasonably expects, as of the issue date, that the

financed property will be used for a governmental purpose for a

substantial period before the action;

(B) The issuer is required to redeem all nonqualifying bonds

(regardless of the amount of disposition proceeds actually received)

within 6 months of the date of the action;

nongovernmental person, as of the issue date, with respect to that

specific action; and

(D) The mandatory redemption of bonds meets all of the conditions

for remedial action under Sec. 1.141-12(a).

(3) Deliberate action defined--(i) In general. Except as otherwise

provided in this paragraph (d)(3), a deliberate action is any action

taken by the issuer that is within its control. An intent to violate

the requirements of section 141 is not necessary for an action to be

deliberate.

(ii) Safe harbor exceptions. An action is not treated as a

deliberate action if--

(A) It would be treated as an involuntary or compulsory conversion

under section 1033; or

(B) It is taken in response to a regulatory directive made by the

federal government.

(4) Special rule for dispositions of personal property in the

ordinary course of an established governmental program--(i) In general.

Dispositions of personal property in the ordinary course of an

established governmental program are not treated as deliberate actions

if--

(A) The weighted average maturity of the bonds financing that

personal property is not greater than 120 percent of the reasonably

expected actual use of that property for governmental purposes;

(B) The issuer reasonably expects on the issue date that the fair

market value of that property on the date of disposition will be not

greater than 25 percent of its cost; and

purposes on the date of disposition.

(ii) Reasonable expectations test. The reasonable expectation that

a disposition described in paragraph (d)(4)(i) of this section may

occur in the ordinary course while the bonds are outstanding will not

cause the issue to meet the private activity bond tests if the issuer

is required to deposit amounts received from the disposition in a

commingled fund with substantial tax or other governmental revenues and

the issuer reasonably expects to spend the amounts on governmental

programs within 6 months from the date of commingling.

(iii) Separate issue treatment. An issuer may treat the bonds

properly allocable to the personal property eligible for this exception

as a separate issue under Sec. 1.150-1(c)(3).

(5) Special rule for general obligation bond programs that finance

a large number of separate purposes. The determination of whether bonds

of an issue are private activity bonds may be based solely on the

issuer's reasonable expectations as of the issue date if all of the

requirements of paragraphs (d)(5) (i) through (vii) of this section are

met.

(i) The issue is an issue of general obligation bonds of a general

purpose governmental unit that finances at least 25 separate purposes

(as defined in Sec. 1.150-1(c)(3)) and does not predominantly finance

fewer than 4 separate purposes.

(ii) The issuer has adopted a fund method of accounting for its

general governmental purposes that makes tracing the bond proceeds to

specific expenditures unreasonably burdensome.

(iii) The issuer reasonably expects on the issue date to allocate

all of the net proceeds of the issue to capital expenditures within 6

months of the issue date and adopts reasonable procedures to verify

that net proceeds are in fact so expended. A program to randomly spot

check that 10 percent of the net proceeds were so expended generally is

a reasonable verification procedure for this purpose.

(iv) The issuer reasonably expects on the issue date to expend all

of the net proceeds of the issue before expending proceeds of a

subsequent issue of similar general obligation bonds.

(v) The issuer reasonably expects on the issue date that it will

not make any loans to nongovernmental persons with the proceeds of the

issue.

(vi) The issuer reasonably expects on the issue date that the

capital expenditures that it could make during the 6-month period

beginning on the issue date with the net proceeds of the issue that

would not meet the private business tests are not less than 125 percent

of the capital expenditures to be financed with the net proceeds of the

issue.

(vii) The issuer reasonably expects on the issue date that the

weighted average maturity of the issue is not greater than 120 percent

of the weighted average reasonably expected economic life of the

capital expenditures financed with the issue. To determine reasonably

expected economic life for this purpose an issuer may use reasonable

estimates based on the type of expenditures made from a fund.

(e) When a deliberate action occurs. A deliberate action occurs on

the date the issuer enters into a binding contract with a

nongovernmental person for use of the financed property that is not

subject to any material contingencies.

(f) Certain remedial actions. See Sec. 1.141-12 for certain

remedial actions that prevent a deliberate action with respect to

property financed by an issue from causing that issue to meet the

private business use test or the private loan financing test.

(g) Examples. The following examples illustrate the application of

this section:

Example 1. Involuntary action. City B issues bonds to finance

the purchase of land. On the issue date, B reasonably expects that

it will be the sole user of the land for the entire term of the

bonds. Subsequently, the federal government acquires the land in a

condemnation action. B sets aside the condemnation proceeds to pay

debt service on the bonds but does not redeem them on their first

call date. The bonds are not private activity bonds because B has

not taken a deliberate action after the issue date. See, however,

Sec. 1.141-14(b), Example 2.

Example 2. Reasonable expectations test--involuntary action. The

facts are the same as in Example 1, except that, on the issue date,

B reasonably expects that the federal government will acquire the

land in a condemnation action during the term of the bonds. On the

issue date, the present value of the amount that B reasonably

expects to

[[Page 2286]]

receive from the federal government is greater than 10 percent of

the present value of the debt service on the bonds. The terms of the

bonds do not require that the bonds be redeemed within 6 months of

the acquisition by the federal government. The bonds are private

activity bonds because the issuer expects as of the issue date that

the private business tests will be met.

Example 3. Reasonable expectations test--mandatory redemption.

City C issues bonds to rehabilitate an existing hospital that it

currently owns. On the issue date of the bonds, C reasonably expects

that the hospital will be used for a governmental purpose for a

substantial period. On the issue date, C also plans to construct a

new hospital, but the placed in service date of that new hospital is

uncertain. C reasonably expects that, when the new hospital is

placed in service, it will sell or lease the rehabilitated hospital

to a private hospital corporation. The bond documents require that

the bonds must be redeemed within 6 months of the sale or lease of

the rehabilitated hospital (regardless of the amount actually

received from the sale). The bonds meet the reasonable expectations

requirement of the private activity bond tests if the mandatory

redemption of bonds meets all of the conditions for a remedial

action under Sec. 1.141-12(a).

Example 4. Dispositions in the ordinary course of an established

governmental program. City D issues bonds with a weighted average

maturity of 6 years for the acquisition of police cars. D reasonably

expects on the issue date that the police cars will be used solely

by its police department, except that, in the ordinary course of its

police operations, D sells its police cars to a taxicab corporation

after 5 years of use because they are no longer suitable for police

use. Further, D reasonably expects that the value of the police cars

when they are no longer suitable for police use will be no more than

25 percent of cost. D subsequently sells 20 percent of the police

cars after only 3 years of actual use. At that time, D deposits the

proceeds from the sale of the police cars in a commingled fund with

substantial tax revenues and reasonably expects to spend the

proceeds on governmental programs within 6 months of the date of

deposit. D does not trace the actual use of these commingled

amounts. The sale of the police cars does not cause the private

activity bond tests to be met because the requirements of paragraph

(d)(4) of this section are met.

Sec. 1.141-3 Definition of private business use.

(a) General rule--(1) In general. The private business use test

relates to the use of the proceeds of an issue. The 10 percent private

business use test of section 141(b)(1) is met if more than 10 percent

of the proceeds of an issue is used in a trade or business of a

nongovernmental person. For this purpose, the use of financed property

is treated as the direct use of proceeds. Any activity carried on by a

person other than a natural person is treated as a trade or business.

Unless the context or a provision clearly requires otherwise, this

section also applies to the private business use test under sections

141(b)(3) (unrelated or disproportionate use), 141(b)(4) ($15 million

limitation for certain output facilities), and 141(b)(5) (the

coordination with the volume cap where the nonqualified amount exceeds

$15 million).

(2) Indirect use. In determining whether an issue meets the private

business use test, it is necessary to look to both the indirect and

direct uses of proceeds. For example, a facility is treated as being

used for a private business use if it is leased to a nongovernmental

person and subleased to a governmental person or if it is leased to a

governmental person and then subleased to a nongovernmental person,

provided that in each case the nongovernmental person's use is in a

trade or business. Similarly, the issuer's use of the proceeds to

engage in a series of financing transactions for property to be used by

nongovernmental persons in their trades or businesses may cause the

private business use test to be met. In addition, proceeds are treated

as used in the trade or business of a nongovernmental person if a

nongovernmental person, as a result of a single transaction or a series

of related transactions, uses property acquired with the proceeds of an

issue.

(3) Aggregation of private business use. The use of proceeds by all

nongovernmental persons is aggregated to determine whether the private

business use test is met.

(b) Types of private business use arrangements--(1) In general.

Both actual and beneficial use by a nongovernmental person may be

treated as private business use. In most cases, the private business

use test is met only if a nongovernmental person has special legal

entitlements to use the financed property under an arrangement with the

issuer. In general, a nongovernmental person is treated as a private

business user of proceeds and financed property as a result of

ownership; actual or beneficial use of property pursuant to a lease, or

a management or incentive payment contract; or certain other

arrangements such as a take or pay or other output-type contract.

(2) Ownership. Except as provided in paragraph (d)(1) or (d)(2) of

this section, ownership by a nongovernmental person of financed

property is private business use of that property. For this purpose,

ownership refers to ownership for federal income tax purposes.

(3) Leases. Except as provided in paragraph (d) of this section,

the lease of financed property to a nongovernmental person is private

business use of that property. For this purpose, any arrangement that

is properly characterized as a lease for federal income tax purposes is

treated as a lease. In determining whether a management contract is

properly characterized as a lease, it is necessary to consider all of

the facts and circumstances, including the following factors--

(i) The degree of control over the property that is exercised by a

nongovernmental person; and

(ii) Whether a nongovernmental person bears risk of loss of the

financed property.

(4) Management contracts--(i) Facts and circumstances test. Except

as provided in paragraph (d) of this section, a management contract

(within the meaning of paragraph (b)(4)(ii) of this section) with

respect to financed property may result in private business use of that

property, based on all of the facts and circumstances. A management

contract with respect to financed property generally results in private

business use of that property if the contract provides for compensation

for services rendered with compensation based, in whole or in part, on

a share of net profits from the operation of the facility.

(ii) Management contract defined. For purposes of this section, a

management contract is a management, service, or incentive payment

contract between a governmental person and a service provider under

which the service provider provides services involving all, a portion

of, or any function of, a facility. For example, a contract for the

provision of management services for an entire hospital, a contract for

management services for a specific department of a hospital, and an

incentive payment contract for physician services to patients of a

hospital are each treated as a management contract.

(iii) Arrangements generally not treated as management contracts.

The arrangements described in paragraphs (b)(4)(iii) (A) through (D) of

this section generally are not treated as management contracts that

give rise to private business use.

(A) Contracts for services that are solely incidental to the

primary governmental function or functions of a financed facility (for

example, contracts for janitorial, office equipment repair, hospital

billing, or similar services).

(B) The mere granting of admitting privileges by a hospital to a

doctor, even if those privileges are conditioned on the provision of de

minimis services, if those privileges are available to all

[[Page 2287]]

qualified physicians in the area, consistent with the size and nature

of its facilities.

of facilities that consists predominantly of public utility property,

if the only compensation is the reimbursement of actual and direct

expenses of the service provider and reasonable administrative overhead

expenses of the service provider.

(D) A contract to provide for services, if the only compensation is

the reimbursement of the service provider for actual and direct

expenses paid by the service provider to unrelated parties.

(iv) Management contracts that are properly treated as other types

of private business use. A management contract with respect to financed

property results in private business use of that property if the

service provider is treated as the lessee or owner of financed property

for federal income tax purposes, unless an exception under paragraph

(d) of this section applies to the arrangement.

(5) Output contracts. See Sec. 1.141-7 for special rules for

contracts for the purchase of output of output facilities.

(6) Research agreements--(i) Facts and circumstances test. Except

as provided in paragraph (d) of this section, an agreement by a

nongovernmental person to sponsor research performed by a governmental

person may result in private business use of the property used for the

research, based on all of the facts and circumstances.

(ii) Research agreements that are properly treated as other types

of private business use. A research agreement with respect to financed

property results in private business use of that property if the

sponsor is treated as the lessee or owner of financed property for

federal income tax purposes, unless an exception under paragraph (d) of

this section applies to the arrangement.

(7) Other actual or beneficial use--(i) In general. Any other

arrangement that conveys special legal entitlements for beneficial use

of bond proceeds or of financed property that are comparable to special

legal entitlements described in paragraphs (b) (2), (3), (4), (5), or

(6) of this section results in private business use. For example, an

arrangement that conveys priority rights to the use or capacity of a

facility generally results in private business use.

(ii) Special rule for facilities not used by the general public. In

the case of financed property that is not available for use by the

general public (within the meaning of paragraph (c) of this section),

private business use may be established solely on the basis of a

special economic benefit to one or more nongovernmental persons, even

if those nongovernmental persons have no special legal entitlements to

use of the property. In determining whether special economic benefit

gives rise to private business use it is necessary to consider all of

the facts and circumstances, including one or more of the following

factors--

(A) Whether the financed property is functionally related or

physically proximate to property used in the trade or business of a

nongovernmental person;

(B) Whether only a small number of nongovernmental persons receive

the special economic benefit; and

depreciable by any nongovernmental person.

member of the general public (general public use) is not private

business use. Use of financed property by nongovernmental persons in

their trades or businesses is treated as general public use only if the

property is intended to be available and in fact is reasonably

available for use on the same basis by natural persons not engaged in a

trade or business.

(2) Use on the same basis. In general, use under an arrangement

that conveys priority rights or other preferential benefits is not use

on the same basis as the general public. Arrangements providing for use

that is available to the general public at no charge or on the basis of

rates that are generally applicable and uniformly applied do not convey

priority rights or other preferential benefits. For this purpose, rates

may be treated as generally applicable and uniformly applied even if--

(i) Different rates apply to different classes of users, such as

volume purchasers, if the differences in rates are customary and

reasonable; or

(ii) A specially negotiated rate arrangement is entered into, but

only if the user is prohibited by federal law from paying the generally

applicable rates, and the rates established are as comparable as

reasonably possible to the generally applicable rates.

(3) Long-term arrangements not treated as general public use. An

arrangement is not treated as general public use if the term of the use

under the arrangement, including all renewal options, is greater than

180 days. For this purpose, a right of first refusal to renew use under

the arrangement is not treated as a renewal option if--

(i) The compensation for the use under the arrangement is

redetermined at generally applicable, fair market value rates that are

in effect at the time of renewal; and

(ii) The use of the financed property under the same or similar

arrangements is predominantly by natural persons who are not engaged in

a trade or business.

(4) Relation to other use. Use of financed property by the general

public does not prevent the proceeds from being used for a private

business use because of other use under this section.

(d) Other exceptions--(1) Agents. Use of proceeds by

nongovernmental persons solely in their capacity as agents of a

governmental person is not private business use. For example, use by a

nongovernmental person that issues obligations on behalf of a

governmental person is not private business use to the extent the

nongovernmental person's use of proceeds is in its capacity as an agent

of the governmental person.

(2) Use incidental to financing arrangements. Use by a

nongovernmental person that is solely incidental to a financing

arrangement is not private business use. A use is solely incidental to

a financing arrangement only if the nongovernmental person has no

substantial rights to use bond proceeds or financed property other than

as an agent of the bondholders. For example, a nongovernmental person

that acts solely as an owner of title in a sale and leaseback financing

transaction with a city generally is not a private business user of the

property leased to the city, provided that the nongovernmental person

has assigned all of its rights to use the leased facility to the

trustee for the bondholders upon default by the city. Similarly, bond

trustees, servicers, and guarantors are generally not treated as

private business users.

(3) Exceptions for arrangements other than arrangements resulting

in ownership of financed property by a nongovernmental person--(i)

Arrangements not available for use on the same basis by natural persons

not engaged in a trade or business. Use by a nongovernmental person

pursuant to an arrangement, other than an arrangement resulting in

ownership of financed property by a nongovernmental person, is not

private business use if--

(A) The term of the use under the arrangement, including all

renewal options, is not longer than 90 days;

(B) The arrangement would be treated as general public use, except

that it is not available for use on the same basis by natural persons

not engaged in a trade or business because generally applicable and

uniformly applied rates

[[Page 2288]]

are not reasonably available to natural persons not engaged in a trade

or business; and

providing that property for use by that nongovernmental person.

(ii) Negotiated arm's-length arrangements. Use by a nongovernmental

person pursuant to an arrangement, other than an arrangement resulting

in ownership of financed property by a nongovernmental person, is not

private business use if--

(A) The term of the use under the arrangement, including all

renewal options, is not longer than 30 days;

(B) The arrangement is a negotiated arm's-length arrangement, and

compensation under the arrangement is at fair market value; and

providing that property for use by that nongovernmental person.

(4) Temporary use by developers. Use during an initial development

period by a developer of an improvement that carries out an essential

governmental function is not private business use if the issuer and the

developer reasonably expect on the issue date to proceed with all

reasonable speed to develop the improvement and property benefited by

that improvement and to transfer the improvement to a governmental

person, and if the improvement is in fact transferred to a governmental

person promptly after the property benefited by the improvement is

developed.

(5) Incidental use--(i) General rule. Incidental uses of a financed

facility are disregarded, to the extent that those uses do not exceed

2.5 percent of the proceeds of the issue used to finance the facility.

A use of a facility by a nongovernmental person is incidental if--

(A) Except for vending machines, pay telephones, kiosks, and

similar uses, the use does not involve the transfer to the

nongovernmental person of possession and control of space that is

separated from other areas of the facility by walls, partitions, or

other physical barriers, such as a night gate affixed to a structural

component of a building (a nonpossessory use);

(B) The nonpossessory use is not functionally related to any other

use of the facility by the same person (other than a different

nonpossessory use); and

aggregate, involve the use of more than 2.5 percent of the facility.

(ii) Illustrations. Incidental uses may include pay telephones,

vending machines, advertising displays, and use for television cameras,

but incidental uses may not include output purchases.

(6) Qualified improvements. Proceeds that provide a governmentally

owned improvement to a governmentally owned building (including its

structural components and land functionally related and subordinate to

the building) are not used for a private business use if--

(i) The building was placed in service more than 1 year before the

construction or acquisition of the improvement is begun;

(ii) The improvement is not an enlargement of the building or an

improvement of interior space occupied exclusively for any private

business use;

(iii) No portion of the improved building or any payments in

respect of the improved building are taken into account under section

141(b)(2)(A) (the private security test); and

(iv) No more than 15 percent of the improved building is used for a

private business use.

(e) Special rule for tax assessment bonds. In the case of a tax

assessment bond that satisfies the requirements of Sec. 1.141-5(d), the

loan (or deemed loan) of the proceeds to the borrower paying the

assessment is disregarded in determining whether the private business

use test is met. However, the use of the loan proceeds is not

disregarded in determining whether the private business use test is

met.

(f) Examples. The following examples illustrate the application of

paragraphs (a) through (e) of this section. In each example, assume

that the arrangements described are the only arrangements with

nongovernmental persons for use of the financed property.

Example 1. Nongovernmental ownership. State A issues 20-year

bonds to purchase land and equip and construct a factory. A then

enters into an arrangement with Corporation X to sell the factory to

X on an installment basis while the bonds are outstanding. The issue

meets the private business use test because a nongovernmental person

owns the financed facility. See also Sec. 1.141-2 (relating to the

private activity bond tests), and Sec. 1.141-5 (relating to the

private loan financing test).

Example 2. Lease to a nongovernmental person. (i) The facts are

the same as in Example 1, except that A enters into an arrangement

with X to lease the factory to X for 3 years rather than to sell it

to X. The lease payments will be made annually and will be based on

the tax-exempt interest rate on the bonds. The issue meets the

private business use test because a nongovernmental person leases

the financed facility. See also Sec. 1.141-14 (relating to anti-

abuse rules).

(ii) The facts are the same as in Example 2(i), except that the

annual payments made by X will equal fair rental value of the

facility and exceed the amount necessary to pay debt service on the

bonds for the 3 years of the lease. The issue meets the private

business use test because a nongovernmental person leases the

financed facility and the test does not require that the benefits of

tax-exempt financing be passed through to the nongovernmental

person.

Example 3. Management contract in substance a lease. City L

issues 30-year bonds to finance the construction of a city hospital.

L enters into a 15-year contract with M, a nongovernmental person

that operates a health maintenance organization relating to the

treatment of M's members at L's hospital. The contract provides for

reasonable fixed compensation to M for services rendered with no

compensation based, in whole or in part, on a share of net profits

from the operation of the hospital. However, the contract also

provides that 30 percent of the capacity of the hospital will be

exclusively available to M's members and M will bear the risk of

loss of that portion of the capacity of the hospital so that, under

all of the facts and circumstances, the contract is properly

characterized as a lease for federal income tax purposes. The issue

meets the private business use test because a nongovernmental person

leases the financed facility.

Example 4. Ownership of title in substance a leasehold interest.

Nonprofit corporation R issues bonds on behalf of City P to finance

the construction of a hospital. R will own legal title to the

hospital. In addition, R will operate the hospital, but R is not

treated as an agent of P in its capacity as operator of the

hospital. P has certain rights to the hospital that establish that

it is properly treated as the owner of the property for federal

income tax purposes. P does not have rights, however, to directly

control operation of the hospital while R owns legal title to it and

operates it. The issue meets the private business use test because

the arrangement provides a nongovernmental person an interest in the

financed facility that is comparable to a leasehold interest. See

paragraphs (a)(2) and (b)(7)(i) of this section.

Example 5. Rights to control use of property treated as private

business use--parking lot. Corporation C and City D enter into a

plan to finance the construction of a parking lot adjacent to C's

factory. Pursuant to the plan, C conveys the site for the parking

lot to D for a nominal amount, subject to a covenant running with

the land that the property be used only for a parking lot. In

addition, D agrees that C will have the right to approve rates

charged by D for use of the parking lot. D issues bonds to finance

construction of the parking lot on the site. The parking lot will be

available for use by the general public on the basis of rates that

are generally applicable and uniformly applied. The issue meets the

private business use test because a nongovernmental person has

special legal entitlements for beneficial use of the financed

facility that are comparable to an ownership interest. See paragraph

(b)(7)(i) of this section.

Example 6. Other actual or beneficial use--hydroelectric

enhancements. J, a political subdivision, owns and operates a

hydroelectric generation plant and related facilities. Pursuant to a

take or pay contract, J sells 15 percent of the output of the plant

[[Page 2289]]

to Corporation K, an investor-owned utility. K is treated as a

private business user of the plant. Under the license issued to J

for operation of the plant, J is required by federal regulations to

construct and operate various facilities for the preservation of

fish and for public recreation. J issues its obligations to finance

the fish preservation and public recreation facilities. K has no

special legal entitlements for beneficial use of the financed

facilities. The fish preservation facilities are functionally

related to the operation of the plant. The recreation facilities are

available to natural persons on a short-term basis according to

generally applicable and uniformly applied rates. Under paragraph

by the general public. Under paragraph (b)(7) of this section, K's

use is not treated as private business use of the recreation

facilities because K has no special legal entitlements for

beneficial use of the recreation facilities. The fish preservation

facilities are not of a type reasonably available for use on the

same basis by natural persons not engaged in a trade or business.

Under all of the facts and circumstances (including the functional

relationship of the fish preservation facilities to property used in

K's trade or business) under paragraph (b)(7)(ii) of this section, K

derives a special economic benefit from the fish preservation

facilities. Therefore, K's private business use may be established

solely on the basis of that special economic benefit, and K's use of

the fish preservation facilities is treated as private business use.

Example 7. Other actual or beneficial use--pollution control

facilities. City B issues obligations to finance construction of a

specialized pollution control facility on land that it owns adjacent

to a factory owned by Corporation N. B will own and operate the

pollution control facility, and N will have no special legal

entitlements to use the facility. B, however, reasonably expects

that N will be the only user of the facility. The facility will not

be reasonably available for use on the same basis by natural persons

not engaged in a trade or business. Under paragraph (b)(7)(ii) of

this section, because under all of the facts and circumstances the

facility is functionally related and is physically proximate to

property used in N's trade or business, N derives a special economic

benefit from the facility. Therefore, N's private business use may

be established solely on the basis of that special economic benefit,

and N's use is treated as private business use of the facility. See

paragraph (b)(7)(ii) of this section.

Example 8. General public use--airport runway. (i) City I issues

bonds and uses all of the proceeds to finance construction of a

runway at a new city-owned airport. The runway will be available for

take-off and landing by any operator of an aircraft desiring to use

the airport, including general aviation operators who are natural

persons not engaged in a trade or business. It is reasonably

expected that most of the actual use of the runway will be by

private air carriers (both charter airlines and commercial airlines)

in connection with their use of the airport terminals leased by

those carriers. These leases for the use of terminal space provide

no priority rights or other preferential benefits to the air

carriers for use of the runway. Moreover, under the leases the lease

payments are determined without taking into account the revenues

generated by runway landing fees (that is, the lease payments are

not determined on a ``residual'' basis). Although the lessee air

carriers receive a special economic benefit from the use of the

runway, this economic benefit is not sufficient to cause the air

carriers to be private business users, because the runway is

available for general public use. The issue does not meet the

private business use test. See paragraphs (b)(7)(ii) and (c) of this

section.

(ii) The facts are the same as in Example 8(i), except that the

runway will be available for use only by private air carriers. The

use by these private air carriers is not for general public use,

because the runway is not reasonably available for use on the same

basis by natural persons not engaged in a trade or business.

Depending on all of the facts and circumstances, including whether

there are only a small number of lessee private air carriers, the

issue may meet the private business use test solely because the

private air carriers receive a special economic benefit from the

runway. See paragraph (b)(7)(ii) of this section.

(iii) The facts are the same as in Example 8(i), except that the

lease payments under the leases with the private air carriers are

determined on a residual basis by taking into account the net

revenues generated by runway landing fees. These leases cause the

private business use test to be met with respect to the runway

because they are arrangements that convey special legal entitlements

to the financed facility to nongovernmental persons. See paragraph

(b)(7)(i) of this section.

Example 9. General public use--airport parking garage. City S

issues bonds and uses all of the proceeds to finance construction of

a city-owned parking garage at the city-owned airport. S reasonably

expects that more than 10 percent of the actual use of the parking

garage will be by employees of private air carriers (both charter

airlines and commercial airlines) in connection with their use of

the airport terminals leased by those carriers. The air carriers'

use of the parking garage, however, will be on the same basis as

passengers and other members of the general public using the

airport. The leases for the use of the terminal space provide no

priority rights to the air carriers for use of the parking garage,

and the lease payments are determined without taking into account

the revenues generated by the parking garage. Although the lessee

air carriers receive a special economic benefit from the use of the

parking garage, this economic benefit is not sufficient to cause the

air carriers to be private business users, because the parking

garage is available for general public use. The issue does not meet

the private business use test. See paragraphs (b)(7)(ii) and (c) of

this section.

Example 10. Long-term arrangements not treated as general public

use--insurance fund. Authority T deposits all of the proceeds of its

bonds in its insurance fund and invests all of those proceeds in

tax-exempt bonds. The insurance fund provides insurance to a large

number of businesses and natural persons not engaged in a trade or

business. Each participant receives insurance for a term of 1 year.

The use by the participants, other than participants that are

natural persons not engaged in a trade or business, is treated as

private business use of the proceeds of the bonds because the

participants have special legal entitlements to the use of bond

proceeds, even though the contractual rights are not necessarily

properly characterized as ownership, leasehold, or similar interests

listed in paragraph (b) of this section. Use of the bond proceeds is

not treated as general public use because the term of the insurance

is greater than 180 days. See paragraphs (b)(7)(i) and (c)(3) of

this section.

Example 11. General public use--port road. Highway Authority W

uses all of the proceeds of its bonds to construct a 25-mile road to

connect an industrial port owned by Corporation Y with existing

roads owned and operated by W. Other than the port, the nearest

residential or commercial development to the new road is 12 miles

away. There is no reasonable expectation that development will occur

in the area surrounding the new road. W and Y enter into no

arrangement (either by contract or ordinance) that conveys special

legal entitlements to Y for the use of the road. Use of the road

will be available without restriction to all users, including

natural persons who are not engaged in a trade or business. The

issue does not meet the private business use test because the road

is treated as used only by the general public.

Example 12. General public use of governmentally owned hotel.

State Q issues bonds to purchase land and construct a hotel for use

by the general public (that is, tourists, visitors, and business

travelers). The bond documents provide that Q will own and operate

the project for the term of the bonds. Q will not enter into a lease

or license with any user for use of rooms for a period longer than

180 days (although users may actually use rooms for consecutive

periods in excess of 180 days). Use of the hotel by hotel guests who

are travelling in connection with trades or businesses of

nongovernmental persons is not a private business use of the hotel

by these persons because the hotel is intended to be available and

in fact is reasonably available for use on the same basis by natural

persons not engaged in a trade or business. See paragraph (c)(1) of

this section.

Example 13. General public use with rights of first refusal.

Authority V uses all of the proceeds of its bonds to construct a

parking garage. At least 90 percent of the spaces in the garage will

be available to the general public on a monthly first-come, first-

served basis. V reasonably expects that the spaces will be

predominantly leased to natural persons not engaged in a trade or

business who have priority rights to renew their spaces at then

current fair market value rates. More than 10 percent of the spaces

will be leased to nongovernmental persons acting in a trade or

business. These leases are not treated as arrangements with a term

of use

[[Page 2290]]

greater than 180 days. The rights to renew are not treated as

renewal options because the compensation for the spaces is

redetermined at generally applicable, fair market value rates that

will be in effect at the time of renewal and the use of the spaces

under similar arrangements is predominantly by natural persons who

are not engaged in a trade or business. The issue does not meet the

private business use test because at least 90 percent of the use of

the parking garage is general public use. See paragraph (c)(3) of

this section.

Example 14. General public use with a specially negotiated rate

agreement with agency of United States. G, a sewage collection and

treatment district, operates facilities that were financed with its

bonds. F, an agency of the United States, has a base located within

G. Approximately 20 percent of G's facilities are used to treat

sewage produced by F under a specially negotiated rate agreement.

Under the specially negotiated rate agreement, G uses its best

efforts to charge F as closely as possible the same amount for its

use of G's services as its other customers pay for the same amount

of services, although those other customers pay for services based

on standard district charges and tax levies. F is prohibited by

federal law from paying for the services based on those standard

district charges and tax levies. The use of G's facilities by F is

on the same basis as the general public. See paragraph (c)(2)(ii) of

this section.

Example 15. Arrangements not available for use by natural

persons not engaged in a trade or business--federal use of prisons.

Authority E uses all of the proceeds of its bonds to construct a

prison. E contracts with federal agency F to house federal prisoners

on a space-available, first-come, first-served basis, pursuant to

which F will be charged approximately the same amount for each

prisoner as other persons that enter into similar transfer

agreements. It is reasonably expected that other persons will enter

into similar agreements. The term of the use under the contract is

not longer than 90 days, and F has no right to renew, although E

reasonably expects to renew the contract indefinitely. The prison is

not financed for a principal purpose of providing the prison for use

by F. It is reasonably expected that during the term of the bonds,

more than 10 percent of the prisoners at the prison will be federal

prisoners. F's use of the facility is not general public use because

this type of use (leasing space for prisoners) is not available for

use on the same basis by natural persons not engaged in a trade or

business. The issue does not meet the private business use test,

however, because the leases satisfy the exception of paragraph

(d)(3)(i) of this section.

Example 16. Negotiated arm's-length arrangements--auditorium

reserved in advance. (i) City Z issues obligations to finance the

construction of a municipal auditorium that it will own and operate.

The use of the auditorium will be open to anyone who wishes to use

it for a short period of time on a rate-scale basis. Z reasonably

expects that the auditorium will be used by schools, church groups,

sororities, and numerous commercial organizations. Corporation H, a

nongovernmental person, enters into an arm's-length arrangement with

Z to use the auditorium for 1 week for each year for a 10-year

period (a total of 70 days), pursuant to which H will be charged a

specific price reflecting fair market value. On the date the

contract is entered into, Z has not established generally applicable

rates for future years. Even though the auditorium is not financed

for a principal purpose of providing use of the auditorium to H, H

is not treated as using the auditorium as a member of the general

public because its use is not on the same basis as the general

public. Because the term of H's use of the auditorium is longer than

30 days, the arrangement does not meet the exception under paragraph

(d)(3)(ii) of this section.

(ii) The facts are the same as in Example 16(i), except that H

will enter into an arm's-length arrangement with Z to use the

auditorium for 1 week for each year for a 4-year period (a total of

28 days), pursuant to which H will be charged a specific price

reflecting fair market value. H is not treated as a private business

user of the auditorium because its contract satisfies the exception

of paragraph (d)(3)(ii) of this section for negotiated arm's-length

arrangements.

(g) Measurement of private business use--(1) In general. In

general, the private business use of proceeds is allocated to property

under Sec. 1.141-6. The amount of private business use of that property

is determined according to the average percentage of private business

use of that property during the measurement period.

(2) Measurement period--(i) General rule. Except as provided in

this paragraph (g)(2), the measurement period of property financed by

an issue begins on the later of the issue date of that issue or the

date the property is placed in service and ends on the earlier of the

last date of the reasonably expected economic life of the property or

the latest maturity date of any bond of the issue financing the

property (determined without regard to any optional redemption dates).

In general, the period of reasonably expected economic life of the

property for this purpose is based on reasonable expectations as of the

issue date.

(ii) Special rule for refundings of short-term obligations. For an

issue of short-term obligations that the issuer reasonably expects to

refund with a long-term financing (such as bond anticipation notes),

the measurement period is based on the latest maturity date of any bond

of the last refunding issue with respect to the financed property

(determined without regard to any optional redemption dates).

(iii) Special rule for reasonably expected mandatory redemptions.

If an issuer reasonably expects on the issue date that an action will

occur during the term of the bonds to cause either the private business

tests or the private loan financing test to be met and is required to

redeem bonds to meet the reasonable expectations test of Sec. 1.141-

2(d)(2), the measurement period ends on the reasonably expected

redemption date.

(iv) Special rule for ownership by a nongovernmental person. The

amount of private business use resulting from ownership by a

nongovernmental person is the greatest percentage of private business

use in any 1-year period.

(v) Anti-abuse rule. If an issuer establishes the term of an issue

for a period that is longer than is reasonably necessary for the

governmental purposes of the issue for a principal purpose of

increasing the permitted amount of private business use, the

Commissioner may determine the amount of private business use according

to the greatest percentage of private business use in any 1-year

period.

(3) Determining average percentage of private business use. The

average percentage of private business use is the average of the

percentages of private business use during the 1-year periods within

the measurement period. Appropriate adjustments must be made for

beginning and ending periods of less than 1 year.

(4) Determining the average amount of private business use for a 1-

year period--(i) In general. The percentage of private business use of

property for any 1-year period is the average private business use

during that year. This average is determined by comparing the amount of

private business use during the year to the total amount of private

business use and use that is not private business use (government use)

during that year. Paragraphs (g)(4) (ii) through (v) of this section

apply to determine the average amount of private business use for a 1-

year period.

(ii) Uses at different times. For a facility in which actual

government use and private business use occur at different times (for

example, different days), the average amount of private business use

generally is based on the amount of time that the facility is used for

private business use as a percentage of the total time for all actual

use. In determining the total amount of actual use, periods during

which the facility is not in use are disregarded.

(iii) Simultaneous use. In general, for a facility in which

government use and private business use occur simultaneously, the

entire facility is treated as having private business use. For example,

a governmentally owned facility that is leased or managed by a

nongovernmental person in a manner

[[Page 2291]]

that results in private business use is treated as entirely used for a

private business use. If, however, there is also private business use

and actual government use on the same basis, the average amount of

private business use may be determined on a reasonable basis that

properly reflects the proportionate benefit to be derived by the

various users of the facility (for example, reasonably expected fair

market value of use). For example, the average amount of private

business use of a garage with unassigned spaces that is used for

government use and private business use is generally based on the

number of spaces used for private business use as a percentage of the

total number of spaces.

(iv) Discrete portion. For purposes of this paragraph (g),

measurement of the use of proceeds allocated to a discrete portion of a

facility is determined by treating that discrete portion as a separate

facility.

(v) Relationship to fair market value. For purposes of paragraphs

(g)(4) (ii) through (iv) of this section, if private business use is

reasonably expected as of the issue date to have a significantly

greater fair market value than government use, the average amount of

private business use must be determined according to the relative

reasonably expected fair market values of use rather than another

measure, such as average time of use. This determination of relative

fair market value may be made as of the date the property is acquired

or placed in service if making this determination as of the issue date

is not reasonably possible (for example, if the financed property is

not identified on the issue date). In general, the relative reasonably

expected fair market value for a period must be determined by taking

into account the amount of reasonably expected payments for private

business use for the period in a manner that properly reflects the

proportionate benefit to be derived from the private business use.

(5) Common areas. The amount of private business use of common

areas within a facility is based on a reasonable method that properly

reflects the proportionate benefit to be derived by the users of the

facility. For example, in general, a method that is based on the

average amount of private business use of the remainder of the entire

facility reflects proportionate benefit.

(6) Allocation of neutral costs. Proceeds that are used to pay

costs of issuance, invested in a reserve or replacement fund, or paid

as fees for a qualified guarantee or a qualified hedge must be

allocated ratably among the other purposes for which the proceeds are

used.

(7) Commencement of measurement of private business use. Generally,

private business use commences on the first date on which there is a

right to actual use by the nongovernmental person. However, if an

issuer enters into an arrangement for private business use a

substantial period before the right to actual private business use

commences and the arrangement transfers ownership or is an arrangement

for other long-term use (such as a lease for a significant portion of

the remaining economic life of financed property), private business use

commences on the date the arrangement is entered into, even if the

right to actual use commences after the measurement period. For this

purpose, 10 percent of the measurement period is generally treated as a

substantial period.

(8) Examples. The following examples illustrate the application of

this paragraph (g):

Example 1. Research facility. University U, a state owned and

operated university, owns and operates a research facility. U

proposes to finance general improvements to the facility with the

proceeds of an issue of bonds. U enters into sponsored research

agreements with nongovernmental persons that result in private

business use because the sponsors will own title to any patents

resulting from the research. The governmental research conducted by

U and the research U conducts for the sponsors take place

simultaneously in all laboratories within the research facility. All

laboratory equipment is available continuously for use by workers

who perform both types of research. Because it is not possible to

predict which research projects will be successful, it is not

reasonably practicable to estimate the relative revenues expected to

result from the governmental and nongovernmental research. U

contributed 90 percent of the cost of the facility and the

nongovernmental persons contributed 10 percent of the cost. Under

this section, the nongovernmental persons are using the facility for

a private business use on the same basis as the government use of

the facility. The portions of the costs contributed by the various

users of the facility provide a reasonable basis that properly

reflects the proportionate benefit to be derived by the users of the

facility. The nongovernmental persons are treated as using 10

percent of the proceeds of the issue.

Example 2. Stadium. (i) City L issues bonds and uses all of the

proceeds to construct a stadium. L enters into a long-term contract

with a professional sports team T under which T will use the stadium

20 times during each year. These uses will occur on nights and

weekends. L reasonably expects that the stadium will be used more

than 180 other times each year, none of which will give rise to

private business use. This expectation is based on a feasibility

study and historical use of the old stadium that is being replaced

by the new stadium. There is no significant difference in the value

of T's uses when compared to the other uses of the stadium, taking

into account the payments that T is reasonably expected to make for

its use. Assuming no other private business use, the issue does not

meet the private business use test because not more than 10 percent

of the use of the facility is for a private business use.

(ii) The facts are the same as in Example 2(i), except that L

reasonably expects that the stadium will be used not more than 60

other times each year, none of which will give rise to private

business use. The issue meets the private business use test because

25 percent of the proceeds are used for a private business use.

Example 3. Airport terminal areas treated as common areas. City

N issues bonds to finance the construction of an airport terminal.

Eighty percent of the leasable space of the terminal will be leased

to private air carriers. The remaining 20 percent of the leasable

space will be used for the term of the bonds by N for its

administrative purposes. The common areas of the terminal, including

waiting areas, lobbies, and hallways are treated as 80 percent used

by the air carriers for purposes of the private business use test.

Sec. 1.141-4 Private security or payment test.

(a) General rule--(1) Private security or payment. The private

security or payment test relates to the nature of the security for, and

the source of, the payment of debt service on an issue. The private

payment portion of the test takes into account the payment of the debt

service on the issue that is directly or indirectly to be derived from

payments (whether or not to the issuer or any related party) in respect

of property, or borrowed money, used or to be used for a private

business use. The private security portion of the test takes into

account the payment of the debt service on the issue that is directly

or indirectly secured by any interest in property used or to be used

for a private business use or payments in respect of property used or

to be used for a private business use. For additional rules for output

facilities, see Sec. 1.141-7.

(2) Aggregation of private payments and security. For purposes of

the private security or payment test, payments taken into account as

private payments and payments or property taken into account as private

security are aggregated. However, the same payments are not taken into

account as both private security and private payments.

(3) Underlying arrangement. The security for, and payment of debt

service on, an issue is determined from both the terms of the bond

documents and on the basis of any underlying arrangement. An underlying

arrangement may result from separate agreements between the parties or

may

[[Page 2292]]

be determined on the basis of all of the facts and circumstances

surrounding the issuance of the bonds. For example, if the payment of

debt service on an issue is secured by both a pledge of the full faith

and credit of a state or local governmental unit and any interest in

property used or to be used in a private business use, the issue meets

the private security or payment test.

(b) Measurement of private payments and security--(1) Scope. This

paragraph (b) contains rules that apply to both private security and

private payments.

(2) Present value measurement--(i) Use of present value. In

determining whether an issue meets the private security or payment

test, the present value of the payments or property taken into account

is compared to the present value of the debt service to be paid over

the term of the issue.

(ii) Debt service--(A) Debt service paid from proceeds. Debt

service does not include any amount paid or to be paid from sale

proceeds or investment proceeds. For example, debt service does not

include payments of capitalized interest funded with proceeds.

(B) Adjustments to debt service. Debt service is adjusted to take

into account payments and receipts that adjust the yield on an issue

for purposes of section 148(f). For example, debt service includes fees

paid for qualified guarantees under Sec. 1.148-4(f) and is adjusted to

take into account payments and receipts on qualified hedges under

Sec. 1.148-4(h).

(iii) Computation of present value--(A) In general. Present values

are determined by using the yield on the issue as the discount rate and

by discounting all amounts to the issue date. See, however, Sec. 1.141-

13 for special rules for refunding bonds.

(B) Fixed yield issues. For a fixed yield issue, yield is

determined on the issue date and is not adjusted to take into account

subsequent events.

determined over the term of the issue. To determine the reasonably

expected yield as of any date, the issuer may assume that the future

interest rate on a variable yield bond will be the then-current

interest rate on the bonds determined under the formula prescribed in

the bond documents. A deliberate action requires a recomputation of the

yield on the variable yield issue to determine the present value of

payments under that arrangement. In that case, the issuer must use the

yield determined as of the date of the deliberate action for purposes

of determining the present value of payments under the arrangement

causing the deliberate action. See paragraph (g) of this section,

Example 3.

(iv) Application to private security. For purposes of determining

the present value of debt service that is secured by property, the

property is valued at fair market value as of the first date on which

the property secures bonds of the issue.

rules that apply to private payments.

(2) Payments taken into account--(i) Payments for use--(A) In

general. Both direct and indirect payments made by any nongovernmental

person that is treated as using proceeds of the issue are taken into

account as private payments to the extent allocable to the proceeds

used by that person. Payments are taken into account as private

payments only to the extent that they are made for the period of time

that proceeds are used for a private business use. Payments for a use

of proceeds include payments (whether or not to the issuer) in respect

of property financed (directly or indirectly) with those proceeds, even

if not made by a private business user. Payments are not made in

respect of financed property if those payments are directly allocable

to other property being directly used by the person making the payment

and those payments represent fair market value compensation for that

other use. See paragraph (g) of this section, Example 4 and Example 5.

See also paragraph (c)(3) of this section for rules relating to

allocation of payments to the source or sources of funding of property.

(B) Payments not to exceed use. Payments with respect to proceeds

that are used for a private business use are not taken into account to

the extent that the present value of those payments exceeds the present

value of debt service on those proceeds. Payments need not be directly

derived from a private business user, however, to be taken into

account. Thus, if 7 percent of the proceeds of an issue is used by a

person over the measurement period, payments with respect to the

property financed with those proceeds are taken into account as private

payments only to the extent that the present value of those payments

does not exceed the present value of 7 percent of the debt service on

the issue.

of proceeds do not include the portion of any payment that is properly

allocable to the payment of ordinary and necessary expenses (as defined

under section 162) directly attributable to the operation and

maintenance of the financed property used by that person. For this

purpose, general overhead and administrative expenses are not directly

attributable to those operations and maintenance. For example, if an

issuer receives $5,000 rent during the year for use of space in a

financed facility and during the year pays $500 for ordinary and

necessary expenses properly allocable to the operation and maintenance

of that space and $400 for general overhead and general administrative

expenses properly allocable to that space, $500 of the $5,000 received

would not be considered a payment for the use of the proceeds allocable

to that space (regardless of the manner in which that $500 is actually

used).

(ii) Refinanced debt service. Payments of debt service on an issue

to be made from proceeds of a refunding issue are taken into account as

private payments in the same proportion that the present value of the

payments taken into account as private payments for the refunding issue

bears to the present value of the debt service to be paid on the

refunding issue. For example, if all the debt service on a note is paid

with proceeds of a refunding issue, the note meets the private security

or payment test if (and to the same extent that) the refunding issue

meets the private security or payment test. This paragraph (c)(2)(ii)

does not apply to payments that arise from deliberate actions that

occur more than 3 years after the retirement of the prior issue that

are not reasonably expected on the issue date of the refunding issue.

For purposes of this paragraph (c)(2)(ii), whether an issue is a

refunding issue is determined without regard to Sec. 1.150-1(d)(2)(i)

(relating to certain payments of interest).

(3) Allocation of payments--(i) In general. Private payments for

the use of property are allocated to the source or different sources of

funding of property. The allocation to the source or different sources

of funding is based on all of the facts and circumstances, including

whether an allocation is consistent with the purposes of section 141.

In general, a private payment for the use of property is allocated to a

source of funding based upon the nexus between the payment and both the

financed property and the source of funding. For this purpose,

different sources of funding may include different tax-exempt issues,

taxable issues, and amounts that are not derived from a borrowing, such

as revenues of an issuer (equity).

(ii) Payments for use of discrete property. Payments for the use of

a discrete facility (or a discrete portion of a facility) are allocated

to the source or

[[Page 2293]]

different sources of funding of that discrete property.

(iii) Allocations among two or more sources of funding. In general,

except as provided in paragraphs (c)(3)(iv) and (v) of this section, if

a payment is made for the use of property financed with two or more

sources of funding (for example, equity and a tax-exempt issue), that

payment must be allocated to those sources of funding in a manner that

reasonably corresponds to the relative amounts of those sources of

funding that are expended on that property. If an issuer has not

retained records of amounts expended on the property (for example,

records of costs of a building that was built 30 years before the

allocation), an issuer may use reasonable estimates of those

expenditures. For this purpose, costs of issuance and other similar

neutral costs are allocated ratably among expenditures in the same

manner as in Sec. 1.141-3(g)(6). A payment for the use of property may

be allocated to two or more issues that finance property according to

the relative amounts of debt service (both paid and accrued) on the

issues during the annual period for which the payment is made, if that

allocation reasonably reflects the economic substance of the

arrangement. In general, allocations of payments according to relative

debt service reasonably reflect the economic substance of the

arrangement if the maturity of the bonds reasonably corresponds to the

reasonably expected economic life of the property and debt service

payments on the bonds are approximately level from year to year.

(iv) Payments made under an arrangement entered into in connection

with issuance of bonds. A private payment for the use of property made

under an arrangement that is entered into in connection with the

issuance of the issue that finances that property generally is

allocated to that issue. Whether an arrangement is entered into in

connection with the issuance of an issue is determined on the basis of

all of the facts and circumstances. An arrangement is ordinarily

treated as entered into in connection with the issuance of an issue

if--

(A) The issuer enters into the arrangement during the 3-year period

beginning 18 months before the issue date; and

(B) The amount of payments reflects all or a portion of debt

service on the issue.

(v) Allocations to equity. A private payment for the use of

property may be allocated to equity before payments are allocated to an

issue only if--

(A) Not later than 60 days after the date of the expenditure of

those amounts, the issuer adopts an official intent (in a manner

comparable to Sec. 1.150-2(e)) indicating that the issuer reasonably

expects to be repaid for the expenditure from a specific arrangement;

and

(B) The private payment is made not later than 18 months after the

later of the date the expenditure is made or the date the project is

placed in service.

(d) Private security--(1) In general. This paragraph (d) contains

rules that relate to private security.

(2) Security taken into account. The property that is the security

for, or the source of, the payment of debt service on an issue need not

be property financed with proceeds. For example, unimproved land or

investment securities used, directly or indirectly, in a private

business use that secures an issue provides private security. Private

security (other than financed property and private payments) for an

issue is taken into account under section 141(b), however, only to the

extent it is provided, directly or indirectly, by a user of proceeds of

the issue.

(3) Pledge of unexpended proceeds. Proceeds qualifying for an

initial temporary period under Sec. 1.148-2(e)(2) or (3) or deposited

in a reasonably required reserve or replacement fund (as defined in

Sec. 1.148-2(f)(2)(i)) are not taken into account under this paragraph

(d) before the date on which those amounts are either expended or

loaned by the issuer to an unrelated party.

(4) Secured by any interest in property or payments. Property used

or to be used for a private business use and payments in respect of

that property are treated as private security if any interest in that

property or payments secures the payment of debt service on the bonds.

For this purpose, the phrase any interest in is to be interpreted

broadly and includes, for example, any right, claim, title, or legal

share in property or payments.

(5) Payments in respect of property. The payments taken into

account as private security are payments in respect of property used or

to be used for a private business use. Except as otherwise provided in

this paragraph (d)(5) and paragraph (d)(6) of this section, the rules

in paragraphs (c)(2)(i)(A) and (B) and (c)(2)(ii) of this section apply

to determine the amount of payments treated as payments in respect of

property used or to be used for a private business use. Thus, payments

made by members of the general public for use of a facility used for a

private business use (for example, a facility that is the subject of a

management contract that results in private business use) are taken

into account as private security to the extent that they are made for

the period of time that property is used by a private business user.

(6) Allocation of security among issues. In general, property or

payments from the disposition of that property that are taken into

account as private security are allocated to each issue secured by the

property or payments on a reasonable basis that takes into account

bondholders' rights to the payments or property upon default.

(e) Generally applicable taxes--(1) General rule. For purposes of

the private security or payment test, generally applicable taxes are

not taken into account (that is, are not payments from a

nongovernmental person and are not payments in respect of property used

for a private business use).

(2) Definition of generally applicable taxes. A generally

applicable tax is an enforced contribution exacted pursuant to

legislative authority in the exercise of the taxing power that is

imposed and collected for the purpose of raising revenue to be used for

governmental purposes. A generally applicable tax must have a uniform

tax rate that is applied to all persons of the same classification in

the appropriate jurisdiction and a generally applicable manner of

determination and collection.

(3) Special charges. A payment for a special privilege granted or

service rendered is not a generally applicable tax. Special assessments

paid by property owners benefiting from financed improvements are not

generally applicable taxes. For example, a tax or a payment in lieu of

tax that is limited to the property or persons benefited by an

improvement is not a generally applicable tax.

(4) Manner of determination and collection--(i) In general. A tax

does not have a generally applicable manner of determination and

collection to the extent that one or more taxpayers make any

impermissible agreements relating to payment of those taxes. An

impermissible agreement relating to the payment of a tax is taken into

account whether or not it is reasonably expected to result in any

payments that would not otherwise have been made. For example, if an

issuer uses proceeds to make a grant to a taxpayer to improve property,

agreements that impose reasonable conditions on the use of the grant do

not cause a tax on that property to fail to be a generally applicable

tax. If an agreement by a taxpayer causes the tax imposed on that

taxpayer not to be treated as a generally applicable tax, the

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entire tax paid by that taxpayer is treated as a special charge, unless

the agreement is limited to a specific portion of the tax.

(ii) Impermissible agreements. The following are examples of

agreements that cause a tax to fail to have a generally applicable

manner of determination and collection: an agreement to be personally

liable on a tax that does not generally impose personal liability, to

provide additional credit support such as a third party guarantee, or

to pay unanticipated shortfalls; an agreement regarding the minimum

market value of property subject to property tax; and an agreement not

to challenge or seek deferral of the tax.

(iii) Permissible agreements. The following are examples of

agreements that do not cause a tax to fail to have a generally

applicable manner of determination and collection: an agreement to use

a grant for specified purposes (whether or not that agreement is

secured); a representation regarding the expected value of the property

following the improvement; an agreement to insure the property and, if

damaged, to restore the property; a right of a grantor to rescind the

grant if property taxes are not paid; and an agreement to reduce or

limit the amount of taxes collected to further a bona fide governmental

purpose. For example, an agreement to abate taxes to encourage a

property owner to rehabilitate property in a distressed area is a

permissible agreement.

(5) Payments in lieu of taxes. A tax equivalency payment and any

other payment in lieu of a tax is treated as a generally applicable tax

if--

(i) The payment is commensurate with and not greater than the

amounts imposed by a statute for a tax of general application; and

(ii) The payment is designated for a public purpose and is not a

special charge (as described in paragraph (e)(3) of this section). For

example, a payment in lieu of taxes made in consideration for the use

of property financed with tax-exempt bonds is treated as a special

charge.

(f) Certain waste remediation bonds--(1) Scope. This paragraph (f)

applies to bonds issued to finance hazardous waste clean-up activities

on privately owned land (hazardous waste remediation bonds).

(2) Persons that are not private users. Payments from

nongovernmental persons who are not (other than coincidentally) either

users of the site being remediated or persons potentially responsible

for disposing of hazardous waste on that site are not taken into

account as private security. This paragraph (f)(2) applies to payments

that secure (directly or indirectly) the payment of principal of, or

interest on, the bonds under the terms of the bonds. This paragraph

(f)(2) applies only if the payments are made pursuant to either a

generally applicable state or local taxing statute or a state or local

statute that regulates or restrains activities on an industry-wide

basis of persons who are engaged in generating or handling hazardous

waste, or in refining, producing, or transporting petroleum, provided

that those payments do not represent, in substance, payment for the use

of proceeds. For this purpose, a state or local statute that imposes

payments that have substantially the same character as those described

in Chapter 38 of the Code are treated as generally applicable taxes.

(3) Persons that are private users. If payments from

nongovernmental persons who are either users of the site being

remediated or persons potentially responsible for disposing of

hazardous waste on that site do not secure (directly or indirectly) the

payment of principal of, or interest on, the bonds under the terms of

the bonds, the payments are not taken into account as private payments.

This paragraph (f)(3) applies only if at the time the bonds are issued

the payments from those nongovernmental persons are not material to the

security for the bonds. For this purpose, payments are not material to

the security for the bonds if--

(i) The payments are not required for the payment of debt service

on the bonds;

(ii) The amount and timing of the payments are not structured or

designed to reflect the payment of debt service on the bonds;

(iii) The receipt or the amount of the payment is uncertain (for

example, as of the issue date, no final judgment has been entered into

against the nongovernmental person);

(iv) The payments from those nongovernmental persons, when and if

received, are used either to redeem bonds of the issuer or to pay for

costs of any hazardous waste remediation project; and

(v) In the case when a judgment (but not a final judgment) has been

entered by the issue date against a nongovernmental person, there are,

as of the issue date, costs of hazardous waste remediation other than

those financed with the bonds that may be financed with the payments.

(g) Examples. The following examples illustrate the application of

this section:

Example 1. Aggregation of payments. State B issues bonds with

proceeds of $10 million. B uses $9.7 million of the proceeds to

construct a 10-story office building. B uses the remaining $300,000

of proceeds to make a loan to Corporation Y. In addition,

Corporation X leases 1 floor of the building for the term of the

bonds. Under all of the facts and circumstances, it is reasonable to

allocate 10 percent of the proceeds to that 1 floor. As a percentage

of the present value of the debt service on the bonds, the present

value of Y's loan repayments is 3 percent and the present value of

X's lease payments is 8 percent. The bonds meet the private security

or payment test because the private payments taken into account are

more than 10 percent of the present value of the debt service on the

bonds.

Example 2. Indirect private payments. J, a political subdivision

of a state, will issue several series of bonds from time to time and

will use the proceeds to rehabilitate urban areas. Under all of the

facts and circumstances, the private business use test will be met

with respect to each issue that will be used for the rehabilitation

and construction of buildings that will be leased or sold to

nongovernmental persons for use in their trades or businesses.

Nongovernmental persons will make payments for these sales and

leases. There is no limitation either on the number of issues or the

aggregate amount of bonds that may be outstanding. No group of

bondholders has any legal claim prior to any other bondholders or

creditors with respect to specific revenues of J, and there is no

arrangement whereby revenues from a particular project are paid into

a trust or constructive trust, or sinking fund, or are otherwise

segregated or restricted for the benefit of any group of

bondholders. There is, however, an unconditional obligation by J to

pay the principal of, and the interest on, each issue. Although not

directly pledged under the terms of the bond documents, the leases

and sales are underlying arrangements. The payments relating to

these leases and sales are taken into account as private payments to

determine whether each issue of bonds meets the private security or

payment test.

Example 3. Computation of payment in variable yield issues. (i)

City M issues general obligation bonds with proceeds of $10 million

to finance a 5-story office building. The bonds bear interest at a

variable rate that is recomputed monthly according to an index that

reflects current market yields. The yield that the interest index

would produce on the issue date is 6 percent. M leases 1 floor of

the office building to Corporation T, a nongovernmental person, for

the term of the bonds. Under all of the facts and circumstances, T

is treated as using more than 10 percent of the proceeds. Using the

6 percent yield as the discount rate, M reasonably expects on the

issue date that the present value of lease payments to be made by T

will be 8 percent of the present value of the total debt service on

the bonds. After the issue date of the bonds, interest rates decline

significantly, so that the yield on the bonds over their entire term

is 4 percent. Using this actual 4 percent yield as the discount

rate, the present value of lease payments made by T is 12 percent of

the present value of the actual total debt service

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on the bonds. The bonds are not private activity bonds because M

reasonably expected on the issue date that the bonds would not meet

the private security or payment test and because M did not take any

subsequent deliberate action to meet the private security or payment

test.

(ii) The facts are the same as Example 3(i), except that 5 years

after the issue date M leases a second floor to Corporation S, a

nongovernmental person, under a long-term lease. Because M has taken

a deliberate action, the present value of the lease payments must be

computed. On the date this lease is entered into, M reasonably

expects that the yield on the bonds over their entire term will be

5.5 percent, based on actual interest rates to date and the then-

current rate on the variable yield bonds. M uses this 5.5 percent

yield as the discount rate. Using this 5.5 percent yield as the

discount rate, as a percentage of the present value of the debt

service on the bonds, the present value of the lease payments made

by S is 3 percent. The bonds are private activity bonds because the

present value of the aggregate private payments is greater than 10

percent of the present value of debt service.

Example 4. Payments not in respect of financed property. In

order to further public safety, City Y issues tax assessment bonds

the proceeds of which are used to move existing electric utility

lines underground. Although the utility lines are owned by a

nongovernmental utility company, that company is under no obligation

to move the lines. The debt service on the bonds will be paid using

assessments levied by City Y on the customers of the utility.

Although the utility lines are privately owned and the utility

customers make payments to the utility company for the use of those

lines, the assessments are payments in respect of the cost of

relocating the utility line. Thus, the assessment payments are not

made in respect of property used for a private business use. Any

direct or indirect payments to Y by the utility company for the

undergrounding are, however, taken into account as private payments.

Example 5. Payments from users of proceeds that are not private

business users taken into account. City P issues general obligation

bonds to finance the renovation of a hospital that it owns. The

hospital is operated for P by D, a nongovernmental person, under a

management contract that results in private business use under

Sec. 1.141-3. P will use the revenues from the hospital (after the

required payments to D and the payment of operation and maintenance

expenses) to pay the debt service on the bonds. The bonds meet the

private security or payment test because the revenues from the

hospital are payments in respect of property used for a private

business use.

Example 6. Limitation of amount of payments to amount of private

business use not determined annually. City Q issues bonds with a

term of 15 years and uses the proceeds to construct an office

building. The debt service on the bonds is level throughout the 15-

year term. Q enters into a 5-year lease with Corporation R under

which R is treated as a user of 11 percent of the proceeds. R will

make lease payments equal to 20 percent of the annual debt service

on the bonds for each year of the lease. The present value of R's

lease payments is equal to 12 percent of the present value of the

debt service over the entire 15-year term of the bonds. If, however,

the lease payments taken into account as private payments were

limited to 11 percent of debt service paid in each year of the

lease, the present value of these payments would be only 8 percent

of the debt service on the bonds over the entire term of the bonds.

The bonds meet the private security or payment test, because R's

lease payments are taken into account as private payments in an

amount not to exceed 11 percent of the debt service of the bonds.

Example 7. Allocation of payments to funds not derived from a

borrowing. City Z purchases property for $1,250,000 using $1,000,000

of proceeds of its tax increment bonds and $250,000 of other

revenues that are in its redevelopment fund. Within 60 days of the

date of purchase, Z declared its intent to sell the property

pursuant to a redevelopment plan and to use that amount to reimburse

its redevelopment fund. The bonds are secured only by the

incremental property taxes attributable to the increase in value of

the property from the planned redevelopment of the property. Within

18 months after the issue date, Z sells the financed property to

Developer M for $250,000, which Z uses to reimburse the

redevelopment fund. The property that M uses is financed both with

the proceeds of the bonds and Z's redevelopment fund. The payments

by M are properly allocable to the costs of property financed with

the amounts in Z's redevelopment fund. See paragraphs (c)(3) (i) and

(v) of this section.

Example 8. Allocation of payments to different sources of

funding--improvements. In 1997, City L issues bonds with proceeds of

$8 million to finance the acquisition of a building. In 2002, L

spends $2 million of its general revenues to improve the heating

system and roof of the building. At that time, L enters into a 10-

year lease with Corporation M for the building providing for annual

payments of $1 million to L. The lease payments are at fair market

value, and the lease payments do not otherwise have a significant

nexus to either the issue or to the expenditure of general revenues.

Eighty percent of each lease payment is allocated to the issue and

is taken into account under the private payment test because each

lease payment is properly allocated to the sources of funding in a

manner that reasonably corresponds to the relative amounts of the

sources of funding that are expended on the building.

Example 9. Security not provided by users of proceeds not taken

into account. County W issues certificates of participation in a

lease of a building that W owns and covenants to appropriate annual

payments for the lease. A portion of each payment is specified as

interest. More than 10 percent of the building is used for private

business use. None of the proceeds of the obligations are used with

respect to the building. W uses the proceeds

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