SUMMARY OF TAX-EXEMPT FINANCING COMMITTEE MEETING OF FRIDAY, FEBRUARY 17, 2012

San Diego, California

Prepared by Robert S. Price

Chairman John Swendseid opened the meeting with a number of housekeeping matters. First he noted that the meeting was being recorded and requested that speakers from the floor use the microphones so that their comments could be preserved. Second, he had Stefano Taverna disclose the time and place of our now-customary after session no host dinner, which is open to all attendees. Third, he noted that there is free wi-fi in the hotel provided by the ABA. The ABA is trying arrange free wi-fi at all of our meeting places but there will not be free wi-fi at the May meeting in Washington, because the hotel has required a fee of $179 per user. If you are registered for this meeting, the materials are available on the ABA website and can be down loaded from AMBar.org.tax.

He next reported on a major project that our Committee has been working on.

Last summer we submitted a proposal for tax reform and simplification in our area of concentration. Our submission was in response to a request made by the Section of each substantive area of practice. At the Section’s Fall meeting the Section Counsel, which is in charge of all major Section submissions, decided to change the nature of Tax Section responses from recommendations to options. The idea is to provide options rather than proposals to Congress. This will free Section Counsel from having to decide which proposals to recommend. This change meant that our entire submission had to be rewritten by January. Todd Cooper agreed to do the rewrite for our Committee. His work was completed in time and you will be glad to know that a number of the options we suggested, perhaps due to pre-submission publicity, made it into the President’s budget proposal. Rick Ballard has listed which ones were included in the budget message.

First Panel: Legislative, Treasury and Internal Revenue Service Update. Chairman Swendseid, as moderator, introduced the other panelists for the

discussion of new legislative initiatives that may affect tax-exempt financing, and new Treasury and IRS regulations and other guidance in the tax-exempt bond area. The other panelists are Committee member Perry Israel; James Polfer, Chief Branch 5, Financial Institutions and Products, Office of Chief Counsel, IRS Washington, D.C.; and Committee member Stefano Taverna. Missing is John Cross, Associate Tax Legislative Counsel, Department of the Treasury, Washington, D.C. who was unable to make this meeting but was able to provide information about some of the things that are going on in a telephone conference last week.

Taking legislative developments first, John Swendseid reported that there are two

significant initiatives. First, the Senate version of the highway transportation bill

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is called The Highway Improvement, Job Creation and Economic Growth Act of 2012. Two of the provisions in the Senate bill that would affect tax-exempt financing would be similar to two provisions in the American Recovery and Reinvestment Act (“ARRA”). They would expand the bank-qualified provisions to $30 million per borrower rather than per issuer, and would extend the AMT holiday for private activity bonds through the end of this year. Two other provisions would provide an exemption from private activity volume cap for water and sewer bonds and a new tax credit bond, called “TRIPS” for transportation projects done through State Infrastructure Banks. The Senate Finance Committee voted for the bill with those provisions in it, with some bi-partisan support, but it is unclear where it will go in the House.

The second legislative initiative is the President’s Budget which came out last

Monday. It has several tax-exempt bond provisions, some good and at least one bad. It would permanently reinstate Build America Bonds (“BABS”) at a 30% rate for two years and thereafter at a 28% rate. The Budget accepted Treasury’s recommendation on Tribal Bonds, which Perry Israel will talk about in a few minutes. A very welcome provision, that had been suggested by the Committee, is a proposal in the Budget that would generally allow refundings of any tax-credit and tax-exempt bonds, so long as the principal amount is not increased and the weighted average maturity is not extended.

The Budget, which is not yet in the form of a bill, would also simplify arbitrage

by eliminating the dual yield restriction and rebate regimes in favor solely of the rebate regime. The Budget would also increase from $5 million to $10 million the small issuer rebate exception and provide a rebate exception for bonds that meet a three year temporary period spend down, somewhat similar to that provided for some tax credit bonds. Both of these provisions were in our Committee’s tax reform proposal. He noted that it was probable that not a lot of our Committee members deal with single family mortgage bonds, but the Budget would help those bonds by repealing the purchase price limitation and permit them to be used to refinance existing mortgages. That permission would be a big help to issuers of those types of bonds.

One of the better provisions in the Budget would be the repeal of Code Section

141(a)(3), the 5% test for private business use not related or disproportionate to governmental use financed by the issue. John commented on the difficulty of understanding and applying that provision and the arcane knowledge certain firms had found themselves forced to acquire merely to comply with it. The bad provision in the budget, as we all are aware, would limit the advantage of tax-exempt interest to the advantage you would get if you paid tax at the 28%marginal tax rate. In effect, this provision may tax part of the previously tax-exempt interest. John noted that we had seen this provision before as part of last year’s Jobs Bill proposed by the President but its reappearance is troubling and not a good sign, even though the enactment of the Budget as a whole seems unlikely. John’s final comment on the Budget was to point out a tax credit

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provision that has nothing to do with bonds. It would authorize the City and State of New York to fail to remit to the Treasury moneys in the amount of $200 million a year for 10 years that they had withheld for payment to the Treasury, (other than payments for Social Security and Medicare). Those sums would be split between the City and the State and be used to finance new transportation infrastructure in the City. He wondered whether Congress might not someday use this technique to provide speedy payments for tax credit bonds that haven’t proved to be popular.

John then invited comments from other members of the panel. Perry Israel

responded with two comments. First, he recounted some of the telephone discussion that he and John Swendseid had had in preparation for this meeting with John Cross. John Swendseid asked John Cross whether those preparing the 28% limitation had talked to him about the effect that proposal would have on tax-exempt bonds. John Cross responded by saying “Are you asking whether they talked to me or whether they listened to me?” Perry found that a very informative response and typical of John.

Second, John suggested in the phone conversation that we should take heart in the

current gridlock in Washington. John Swendseid then remarked that the Budget had been described by the Speaker of the House as “dead on arrival”, though not everybody agreed with that assessment. John Swendseid felt that one other piece of legislation, not of direct concern to tax-exempt financing, was worth a brief mention. That was a bill passed with bi-partisan support that was signed by the President and became effective as of last September. It prohibits the Patent Office from granting patents on tax strategies. We had been worried about such patents and there was talk of proposed regulations but Congress stopped them for sure.

John then turned the panel over to Stefano Taverna and Jim Polfer to discuss

current IRS and Treasury projects. Before Jim responded, he made the statement that his comments should at most be understood to be expressions of his personal views. In fact they might not even be his personal views when he is acting as the devil’s advocate to elicit ideas or reactions from Committee members. They should not be understood necessarily to be his positions as Chief of Branch 5.

While no members of the Press were in the room, The Bond Buyer had notified

the Committee that it expected to listen to the recording of this meeting. Jim expressed the perception – accurate or not - of some governmental participants in these sessions that the Press might be taking their comments out of context or possibly even misquoting them. He wanted to make it clear that the participation of the governmental personnel in these sessions is for the interesting and fruitful purpose of forwarding the discussion of issues, and developing possible approaches to matters of mutual concern.

Stefano then offered to play devil’s advocate with respect to the long standing

bone of contention - the computation of issue price. He cited the numerous

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recent articles about increased IRS enforcement efforts with respect to that computation, particularly as to the Build America Bonds (“BABs”) subsidy. He noted references to the need to follow up on later trades reported on EMMA, and the submission of comments to the Treasury by SIFMA on that point. He concluded by asking about the progress that the Treasury and IRS might be making on the issue price project.

Jim responded by saying that they had been very diligently working on that

project which was now “very far along”. He alluded to the procedures that require a lot of people to sign off before a regulation or proposed regulation may be published, and his lack of control over their priorities but hoped that the arbitrage project would be released sooner rather than later. Stefano asked whether the arbitrage project would address both tax-exempt bonds and BABs. Jim replied that there is a significant possibility that any guidance that comes out could be applied to both tax-exempt bonds and BABs. Stefano asked about the form in which guidance would be provided and Jim suggested a number of possibilities, among them that portions of the guidance would be in temporary regulations form and portions in proposed form.

Stefano asked whether the guidance would be a significant departure from the

standards established for both tax-exempt bonds and BABs. Jim said that any guidance would necessarily involve some changes and clarifications but he was uncomfortable with attempting to quantify the degree of change from the past. In response to the question whether the project had been developed in concert with those concerned with the taxable bond Code provisions such as those dealing with OID, Jim replied that it absolutely had been. He stressed that BABs were taxable bonds and while some of the regime of tax exempt bonds had been carried over with them, and there were some twists and nuances peculiar to tax-exempt bonds such as in Sec. 1001, the project had been done in concert with and coordinated with them.

In response to a question from the floor about the use of the temporary regulations

format, Jim discussed, not necessary with respect to this project, the advantages and disadvantages of using that format. The main advantages are that temporary regulations have precedential value and can be applied both by the Service and practitioners and issuers. They also have an expiration date, a sunset, which puts pressure on the government to finish the project for which they were issued. He noted that, without such pressure, there are proposed regs. that have been outstanding for 15 plus years and that nothing puts on pressure for completion like an expiration date. The main disadvantage is that, although they have precedential value and can be applied, they have been issued without the protective benefits of notice and the receipt of comments from the public and without the protections of the full APA review process. He said that we try not to do that without some overriding interest in so doing

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Jim next responded to a question from Stefano asking whether there will be grandfathering of past practices in areas that will be significantly changed. Jim again took care to say that he had not specified that there would be significant changes. However he commented that, especially with respect to arbitrage, the Service usually uses a number of transitional rules to recognize existing practices that have been used with outstanding bonds. In very general terms, which Jim described as not related to what is forthcoming, he reviewed the Service’s use of effective dates to limit the retroactivity of new rules. The Service may use a specific effective date or use the date of finalization of proposed regs. sometimes with a grace period of days thereafter. Sometimes the prospective application has been signaled by the use of prospective phrases like “shall apply”. There have been nuances where the option has been given to apply some parts of a proposed regulation but not other parts, or to make an election that must cover the entire regulation. He described the TRA of 86 as having had page after page of transition rules reflecting the care needed with respect to public finance when changes are made.

Perry Israel, first acknowledging that it was not in Jim’s control, reminded Jim of

the immediacy of the need for issue price guidance. Perry cited a report published in The Bond Buyer this past week about the Nebraska Public Power District’s BABs. Someone in the IRS was reported to have made an oral comment that about $10 million of that issue did not qualify because it was sold at a premium. Perry said that, if you look at EMMA, after about one third of the Power District’s maturity in question was sold at par, approximately another one third of that maturity was sold to a dealer at par in an interdealer trade. Perry speculated, because of a similarity in size, that this second one third was apparently later resold by that dealer at 103 in a trade reported on EMMA. Perry’s comment was that it was impossible for issuers and counsel to limit BABs sales to dealers who make subsequent sales.

Stefano added that the purpose of BABs had been to broaden the market, relieving

the pressure on municipal obligations, by adding dealers and other purchasers who typically have not purchased tax-exempt bonds. He noted that, once the bonds have been sold, they are subject to a whole new set of rules, particularly with international purchasers and he hoped that this had been taken into account in preparing the new rules. Jim replied that he felt that they had been educated as to the present difficulties but that it would be more fruitful if we offered some insight into what we thought should be done.

Perry responded with a two minute description of the fair dealing rules of the

securities laws and of the MSRB. They require that an underwriter and its syndicate, which has made an offer to sell the bonds to the public at a price set forth in the offering materials, must sell the bonds at that price. Whoever comes in with the money, the bonds must be sold to him at the offering price. Unless it is a private placement or a limited offering, neither the underwriter nor the issuer has the ability to tell a purchaser who has bought the bonds at the offering price,

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to whom it may resell the bonds or at what price. In response to a question from the floor, Perry said that he did not know whether the underwriter or the syndicate had the right to ask the purchaser whether it was making the purchase with the intention to resell.

Perry continued by saying that the nub of the problem is the definition in the

regulations of the “general public”. That general public definition excludes bond houses, brokers and others acting in the capacity as underwriter or wholesaler. He gave an example of the distortion caused by this definition. He posited a situation where he buys bonds at the offering price under his own name and buys the same bonds at the offering price through a bond house that he controls, which is not part of the underwriting group. The former would be a sale to the public confirming the purchase at the offering price and the later would not be. A later sale by his bond house would be required to set the offering price.

He felt that this difference is the source of the problem. He proposed instead a

definition that distinguished between those buyers that are in privity with the underwriting group and those who are not. Perry said that it should make no difference whether he buys the bonds in his own name or through his bond house, as long as he is not part of the underwriting group. He acknowledged that this could lead to fraud. A member of the syndicate might enter agree to sell to another broker at the offering price with the purchasing broker sharing the profit from a resale at a higher price with that member of the syndicate. However, this type of agreement would be a fraudulent violation of the existing fair dealing securities laws and MSRB rules. He thought that anti-fraud enforcement should be left to them, rather than enforced by a definition in the regulations. He argued for a definition that would define when a purchaser is acting in the capacity of an underwriter or wholesaler of the issue, that would be narrow enough to exclude a purchaser who is not in privity with those underwriting the bond issue. That was his response to Jim’s request for an insight into what we thought ought to be done.

John Swendseid referred back to The Bond Buyer article that was referred to in

the start of this discussion. He noted that in the first 3 or 4 minutes after the bonds were issued the trading prices on EMMA fluctuated between 99.12 and 101, which suggested market fluctuation to him. Perry responded that you could not be sure of that. The prices reported on EMMA shortly after the bonds are issued reflect when the sales are posted, not when they were made. Bonds may trade prior to their issuance at prices to be paid when delivered. They are not posted until they are delivered. So you can’t be sure whether the trades listed on EMMA reflect pre-issuance trading or market fluctuations.

Perry noted that the price that a customer may pay may also reflect the

relationship between the customer and his particular broker. He contrasted two relationships: first, the relationship between the broker who is in privity with the underwriter ands its syndicate and second, the relationship with a broker who is not in privity with the underwriter and its syndicate. A broker who is in privity

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with the underwriter and its syndicate must offer, under the securities laws and the fair dealing rules, the same price to any body who comes in, both the large scale buyer of a block of bonds and the buyer of one bond. However, those rules do not apply to a broker who is not in privity with the underwriter and its syndicate. The ultimate purchaser who buys a bond that has been held by a bunch of intermediaries in between the issuance and his purchase will pay a price that reflects the market at that time and the broker-customer relationship. But the price that buyer pays should not affect the price at which the bonds were initially offered by those in privity with the offering. Maybe the question that should be asked is whether the issuer could have gotten a better deal, if those not in privity with the underwriter and its syndicate can resell the bonds at a higher price.

Stefano introduced the next subject by asking Jim Polfer whether than had been

any progress with the reissuance and retirement of debt regulations project. Jim replied that they are still working on that project but a lot of people have to sign off before any project can go out. We may not know whether or not extinguishment of debt will be part of that package until the ink is dry. Who is a related party for the purpose of the extinguishment of debt when you are buying your own bonds may seem simple on its face. But who is a related party has a lot of application beyond the tax-exempt bond area, and a lot of people have to sign off before regulations can be issued on that question. There is [words lost from change of discs] significant likelihood that the package will go out without one of its features being comprehensive guidance on who are related parties for the purpose of extinguishment of debt held by a related party.

Stefano mentioned Notice 2012-3, which permits the current refunding of disaster

relief bonds after the applicable period for issuing them has expired, provided that the asset life test is met, there is no increase in principal, par to par, and there is de minimis OID. The Notice does not address whether they could be refunded before the applicable period has expired and some people had wondered whether you could. But they also reasoned that you should be no worse off than you would have been if you waited for the applicable period to expire. Jim confirmed that was a reasonable assumption. He has never heard anyone object to a current refunding before the expiration of the period when a tax-exempt bond was authorized to be issued.

John then asked whether there is any chance that the Notice 2012-3’s

authorization would be expanded so that we wouldn’t need the budget proposal? Has there been any discussion in the Service or Treasury of a broader authorization to currently refund other bonds whose statutory authorization to issue had expired? Jim replied that anyone who looks at the question sees the policy benefits from permitting current refundings of tax-exempt bonds, even after the statutory authorization for the prior bonds has expired. He acknowledged that there could be some hypothetical person who feels that when Congress has not specifically dealt with every detail in its legislation and has inadvertently forgotten to authorize current refundings, there should not be an

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administrative correction. However, he felt that there were significant policy arguments to expand administrative guidance to permit current refundings for all tax-exempt bonds, even after the expiration of their statutory authorization.

He said that, if guidance is needed, it should be requested. He wholeheartedly

supported the bond community making comments requesting such guidance. That said, he recognized that there are those who feel administrative relief such not be granted absent some Congressional indication that it is appropriate. He said that it is always possible that the decision could be made that, absent statutory guidance “we won’t go there”. He said that there were situations in the past where he might have said that. However, he noted the good policy reasons for the relief and said that it is much easier to give administrative relief if the bond community has strongly indicated that it is needed. He encouraged that something be sent in if that relief is needed.

Stefano turned to the other items in the IRS’s guidance plan. He noted that the

final regulations on solid waste had been issued. He asked about the status of the final Public Approval (“TEFRA”) regulations. Jim relied that significant work had been done but, again, due to the procedures for final regulations, there were many sign-offs that had to be received before they could be issued. He hoped that their issuance would be sooner rather than later. Arbitrage and issuance price had already been talked about. At that point, Jim made a cautionary warning. He suggested that it is a possibility that in an election year, due to the nature of the governmental process, guidance projects often tend to slow down as the election nears. Finally, Stefano asked about the project to provide guidance on tax credit/direct pay bonds. Jim replied that the description of that project is vague on purpose because it is really a procedural, administrative nuts and bolts project. The guidance on direct pay procedures 2006-40 came out very fast and parallels the framework for tax-exempt bonds. Yet there are a lot of miscellaneous things, when you look closely at direct pay bonds that are different or not addressed that still need to be addressed, for example, the ability to appeal. The project should not send out any alarms.

John introduced the next topic: certain recently released private letter rulings for

Perry and Jim to discuss. Perry described the first - LTR 201145005, the management contract ruling. The first question it presented was that, in the context of Rev. Proc. 97-13, the management contract was too long, being 5 years and 2 months. The second problem was presented by the contract’s variable component called an incentive fee. The incentive fee was a fixed amount, negotiated at the beginning of each year. It was paid or not paid depending on whether a targeted amount of net operating surplus was attained and whether a target amount of total gross operating revenues was attained. If you met the targets, it was paid, if you didn’t, it wasn’t. The amount of the incentive was a fixed amount unrelated to the amount of net income. It wasn’t more if the net income was more or less if net income was less.

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The manager and certain employees had similar targets to meet to earn bonuses in amounts fixed at the beginning of each year. Their direct expenses, including their bonuses, were reimbursed in computing gross operating revenues and net operating surplus. Their bonuses too did not increase or decrease with the amount of the gross revenues and net operating surplus. They got the fixed amount of the bonus if the targets were met. Also, the manager and those employees were not owners of the management company.

The Service issued a favorable ruling, which Perry thought was correct,

concluding that the agreement did not look like the management company and its employees had an ownership interest amounting to private business use of the bond-financed project. Perry characterized the 5 years and two months as “close enough” and felt that the bonuses to non-owner employees were not a problem. He described the ruling as one of a series of favorable rulings covering management contracts outside the narrow boundaries of Rev. Proc 97-13. He expressed the hope that the same kind of analysis would be reflected in the expected updating of 97-13.

Jim Polfer picked up on Perry’s comments. He said, to a large extent, that

depended on both the ABA and NABL producing the promised comments and suggestions for updating Rev. Proc. 97-13. He repeated that they had said many times before that they were not looking towards a sea change in the guidance. The rules and the basic existing framework would pretty much remain the same. He anticipated that the guidance would be an updating and clarification of the existing guidance. The clarification would be to how to apply the rules to common practice scenarios in which the bond community had indicated the 15 year old rules of Rev. Proc. 97-13 were difficult to apply. But, in light of the comments they had received from the community as to the need for updated guidance, Jim thought that it would not be productive to go ahead without receiving the promised comments and suggestions from the bond community.

Perry returned to the private letter ruling and asked whether, if the bonus had been

set at the end of the fiscal year, when you had the year’s economic results, that would not be good. Jim responded by saying that would be one factor but described a general theme that should be taken from all of the letter rulings: 97-13 merely sets forth guide lines and safe harbors, not bright lines. First, deviations occur and they regularly bless them. Second, each situation is intensely fact sensitive and you can’t pick out one fact and say, either way, I can run with this and I am okay regardless of everything else and conversely you can’t pick out one piece and say if I change this one iota it’s bad. Third, the closer any incentive structure directly mimics profit, the worse it is. If you tie it to a fraction of profit, that’s very bad. However, when you have fixed amounts payable only when goals are met, and the fixed amount does not deviate with the degree to which the goals are exceeded, that looks like an incentive. The closer you are to fixed amounts the better; the closer you are variable amounts and mimic a share of profits, the more problematic. [The discs that recorded the next portion of the

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meeting are out of order. However, what follows appears to be what happened next at the meeting and originates on the end of disc 19 and goes on to disc 20.]

Jim concluded by saying that if you analyze the PLRs that have been published, that is how we have analyzed it.

Jim then took questions from the floor. The first question asked whether

compensation of the employees of the manager is considered. Jim responded by saying that there would be extra scrutiny if it appeared that compensation to the manager’s employees was tied to net income of the entity being managed. For example, if the management said to its employees that we are a team and we’ll give you x if net income of the entity with which we have the contract is $1 million and 2x if its net income is $2 million and so on, there would be extra scrutiny. Perry stressed this by saying flatly, don’t tie management employee compensation, say, to a percentage of the profit or other results of the entity. Jim then confirmed that it was very reasonable to conclude that the general theme of the letters that are out there is that compensation of the manager’s employees is not considered compensation to the manager.

Cliff Gerber then asked a question that referred Jim back to the earlier discussion

of BABs. He wondered whether Jim could say whether any thought had been given to using Notice 2008-41 in the reissuance situation? He noted that with the broader category of tax-advantaged bonds, such as BABs, there are certain situations in which you look to the rules that apply to tax-exempt bonds. Although Notice 2008-41 technically didn’t apply to BABs, wouldn’t it have been better to bite the bullet? Rather than apply what he felt was a strained 1001 unilateral option analysis to BABs since BABs are taxable bonds, to follow the rules that apply to tax-exempt bonds and then follow Notice 2008-41 to them?

Jim responded that, looking at the ruling, it was reasonable for someone to say

that in the context of taxable BABs we do not apply the tax-exempt bond Notices, and that the 1001 rules are applied. Whether or not that was the proper approach, it was not done out of our group and that was what another group decided to do. It was sent to them because the ruling request was for BABs and BABs are taxable bonds. Cliff noted that under either path, as we had asked for, the result was favorable. Jim added that some have said that the 1001 regulations in this area are a bit of a mess and that if BABs ever come to life again, there have been suggestions that there may be a transfer of more of the tax-exempt bond regimen to them, including the rules on reissuance and defeasance.

The next private letter ruling that Perry discussed was 201149044, which did not

come out of Jim Polfer’s office. Rather, the ruling was a denial of a 501(c)(3) determination for an applicant that wanted to be recognized as a supporting organization to a exempt entity in a New Market Tax Credit (“NMTC”) transaction. The exempt entity was trying to obtain NMTCs to finance a school. To get the credits, it proposed to enter into a partnership with a Community Development Entity (a “CDE”) which is not a tax-exempt entity. The applicant

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would not be a partner in that partnership but would support the tax-exempt entity by managing the partnership. The negative ruling turned on the fact that, while the supporting structure appeared valid, the actual operating structure was not. The applicant in its role as manager had the right to determine whether certain distributions would be made to the CDE. Since the CDE was not a tax-exempt entity there was a possibility of more than an insubstantial amount of private inurement through those distributions, a conclusion that Perry found not to be surprising. But he noted that he continues to struggle with how to make NMTC transactions work within the context of tax-exempt financing.

Perry and Jim then discussed two private letter rulings that had not been public at

the time of the last Committee meeting, and could not be discussed then. The first ruling dealt with a 501(c)(3) health system that wished to use tax –exempt bonds to pay off debt originally incurred by its for-profit subsidiary. The for-profit subsidiary had incurred debt through lines of credit to build a facility. That facility had failed economically, but the tax-exempt health system had guaranteed the subsidiary’s debt. Because of that guarantee and the subsidiary’s lack of profitability, the exempt health system had been paying the for-profit subsidiary’s debt service all along. The subsidiary eventually gave up the ghost and the health system took over the facility, assumed the debt, and is presumably operating the facility as part of its tax-exempt operation.

The health system requested a ruling that it could issue tax-exempt bonds to

refund the debt it had guaranteed. The health system’s theory was that the debt had been incurred to finance the facility, the facility was now being used for good purposes and the debt had really been the health system’s debt all along. It received a negative ruling on the grounds that, since the health system already owned the facility, the requested financing would have no effect on the operation of the facility. The bond proceeds would really be used to pay off debt incurred by the health system to bail out its for-profit subsidiary. It was inappropriate to now claim that the health system’s tax-exempt bonds would be for the purpose of financing the facility.

Perry asked Jim why the economic substance of the health system’s actions had

not been followed? The fact was that the contributions the health system made to the subsidiary were actually used for service on the debt incurred to build the facility. Perry suggested that the transaction could even have been structured as the acquisition of the facility from the subsidiary with the assumption of the subsidiary’s outstanding debt, which could then have been refunded and wouldn’t that have worked?. Jim’s response was that the Service had respected the form of the transaction, not what could have been done but wasn’t. An exchange ensued on when form would or should be followed and when economic substance should or would be followed. The conclusion was that it was dangerous to assume that, if I could have done it one way, a different way with the same economic result would be okay.

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The next private letter ruling discussed was 201149017, the BABs multi-modal non-reissuance ruling, which also was not issued by Jim’s group. The BABs in question provided that the issuer could unilaterally change the mode of the bonds with a mandatory tender, not a right to tender, by the holders. The ruling held that, under the 1001 regulations, the issuer’s unilateral right to change modes would not constitute a reissuance. Therefore, the change of modes would not cause the bonds to be issued after the expiration of the statutory authorization for the issuance of BABs. Perry felt that the ruling reached the right answer and there wasn’t anything in particular to say about it, where upon Stefano injected with the words, “thank you”. However, Perry went on to say that it suggested to him that we might be moving in the direction where we might not need special rules for tax-exempt bonds under 1001 because of the way that 1001 was being interpreted.

John then asked Perry to tell us about the Treasury’s Report on Tribal Bonds.

Perry noted that the Report was mandated by the Tribal Economic Development provisions. It is straight-forward, stating that the statutory “essential governmental function” standard that applies to Indian Tribes is difficult to define and administer and that an analogous standard in Code Sec. 115 was declared vague and unenforceable by the Court. The Report recommends that Indian Tribes be put on a parity with other governmental issuers, subject to special provisions with respect to gaming activities and location.

The Report also discusses the special rules that now apply to private activity

bonds and economic development for Indian Tribes. It recommends that the same rules that apply to other governmental issuers apply to them, as well, with their own volume cap. Again, there would be restrictions with respect to gaming. The Report recommends that to use tax-exempt bonds to pay for gaming with its proprietary nature would not be appropriate. As to location, the Report recommends some flexibility. The project need not be on the reservation but might be contiguous or reasonably proximate to, or have some substantial connection with the tribal government. The proposals have been included in the President’s budget to be published at the end of the month. In response to a telephoned question about the availability of refunds from settlements based on the existing rules, Perry pointed out that the settlements provide for no refunds.

Chairman Swendseid asked Rick Ballard to discuss what appears to be a special

enforcement effort by the Service with respect to student loan bonds, involving stricter interpretations as to allocations of program investments and purchased investments. Rick began by noting that the Service has been auditing for some years certain issuers of student loan bonds. He then acknowledged that subject of the Service’s restrictive interpretation of allocations of program investments and purchase investments by these student loan bond issuers, as a result of these audits, was of narrow interest. He went on to say that he understood through the Student Loan Trade Associations who have been dealing with Director Clifford Gannett, that the Service is now saying that it will try to put out before the end of the year, to be accepted or not by the end of the year, standards or guidelines for

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VCAP settlements with respect to these audits. The VCAP settlements would be available to those issuers that had engaged in the practice of selling or exchanging loans between their various bond issues. (The VCAP guidelines were later published in Announcement 2012-14.)

The required settlement payment would be 40% of the taxpayer exposure for open

years on those issues, going back three years and forward for some sort of assumed optional redemption schedule, shorter than final maturity since it was not possible to create new federally guaranteed student loans after 2010. The guidelines would include a credit for yield reduction payments due on gains over the permitted 2% arbitrage limit applicable to student loans. That happens all of the time in student loan financing because of the variations caused by special allowance payments made by the Department of Education to the issuers. The general industry reaction seems to be that, while the guidelines may reflect the audit experience, that audit experience may or may not be representative of the industry as a whole. It is uncertain how widely used the proposed VCAP proposal will be. Some of the audits may go to Appeal which will certainly affect the reaction to the entire situation.

Perry asked Rick whether there had been any suggestion that this might be

extended to the single family mortgage issuers. Rick replied that single family mortgages and student loans had very similar arbitrage and section 103 status. Single family mortgage loans, like the student loans, are sort of mass asset acquired purpose obligations. However, most of the reallocations of single family mortgages occur within the first few months of the bond issuance, well within the 18 months (but not later than 5 years after issuance of the bonds) permitted by section 1.148-6 of the arbitrage regulations. The permitted reallocation period was not involved in the student loan issuer audits and members of the Service have said publicly that there is no effort afoot to try to overturn by audit the final allocation rules of section 1.148-6.

Second Panel: VCAP and Other Compliance and Program Management

Initiatives. Chairman Swendseid turned the panel over to Christie Martin, who introduced her panelists. Perry Israel remained and was joined by Todd Mitchell, Group Manager, Compliance and Program Management, Tax-Exempt Bonds, IRS, El Segundo, CA, and Steve Watson, formerly of the Treasury’s Office of Tax Policy and now of Fulbright & Jaworski’s Washington office. This panel addressed the new VCAP procedures released in 2011. However, before discussing that subject, Christie reported on our Committee’s project to present comments to the Service on the Management Contract regulations. When she started this project two years ago, she expected, perhaps naively, that it would take three or four months. She reported that our comments have gone through just about all levels of ABA review. She hoped that there would be just a few edits to make after final review so that the comments could be submitted shortly. (The NABL comments on Rev. Proc. 97-13 were transmitted to Messrs. John Cross and Jim Polfer by a letter dated May 2, 2012.)

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Christie then asked Todd to discuss what CPM (Compliance & Program

Management) has been up to and what his expectations going forward are. Todd began by piggy-backing on Jim’s disclaimer by saying that, of course, he could not talk about specific examinations or specific taxpayers. He then introduced himself and described his role in the IRS’s Tax-Exempt Bond Office. He is a Group Manager in the Compliance and Program Management part of the Tax-Exempt Bond Office, with a small team of tax law specialists and revenue agents. The other part of the Office is the larger group Field Operations Division which is focused on enforcement through examinations. His group is less engaged in examinations and is more focused on promoting voluntary compliance through three programs. The first is outreach through participation in programs such as our Committee’s meeting. The second is the development of materials such as can be seen on TEB’s website. The third is participation by members of the group in teleconferences or webinars.

His group assists in the compliance process through three other programs. He

reminded us of the voluntary closing agreement program (VCAP), and updated us on two other programs: the focused examination program and the compliance questionnaire program. He first gave a quick summary of his group’s VCAP program. He described it as applying to self-identified violations by an issuer of tax-exempt, tax credit or direct pay bonds. An issuer would file a request for resolution of the violations pursuant to the pretty specific requirements of the VCAP program in the Internal Revenue Manual (I.R.M.7.2.3.1. for tax-exempt bonds and 4.81.6 for closing agreements). The request would identify the violations and seek to enter into a settlement agreement. The request would be evaluated and referred to a specialist or agent to begin negotiations with the aspiration that within 90 to 120 days from the receipt of a completed submission, the negotiations would result in a closing agreement. The advertized incentive is that the closing agreement would provide for a better deal than you’d get if the violations were uncovered on audit.

The IRM was updated in August 2011 to include resolution standards for direct

pay bonds and to expand the resolution standards for tax-exempt bonds. Growing out of the recommendation of a couple of tax committees, indicative terms of settlement were provided for specified violations. The idea is to provide some certainty to an issuer coming in to the VCAP program as to what the IRS is going to do once the issuer has disclosed its violations. The IRM’s expanded list of requirements for the submission is intended to enable us to provide with more specificity the information the Service feels it needs to evaluate the violations.

Finally, there is a larger effort to get issuers to adopt written compliance

procedures. As part of that effort, which we have also seen in focused exams and compliance check list questionnaires, preferential treatment for an issuer who has identified violations through post issuance written procedures has been imbedded in the VCAP framework.

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Todd next discussed the focused examination program which, in the Tax-Exempt

bond area as elsewhere in the Code, is a means to focus the Service’s audit resources on the narrow segments of the market where there is the highest risk of noncompliance. The program enhances the classification process. It may focus on particular types of issuers, particular types of bonds or on other more narrowly defined parts of the municipal market. He said that in recent years the Service has focused on current refunding transactions, multifamily housing issues, Form 8038GC filings and tax and revenue anticipation notes. He expects this year to focus on different kinds of governmental issues where there are management contracts and the like; areas where there is concern that there may be excessive private use. These will be part of the Service’s program on an on-going basis. Todd later mentioned that, during a focused examination, if a violation is identified by the issuer in the process of responding to the examination letter, the letter should be read carefully. It will typically contain an offer to settle a self-identified violation on terms similar to those that would be available under the VCAP program discussed below. He expressed concern that the offer contained in the letter, because of the way it is presented, might be missed.

Todd contrasted the compliance questionnaires, which are not the start of an

examination, with the questionnaires that may start a focused examination. A questionnaire for a focused examination may not ask for a transcript or any documents but may start with any where from 5 to 50 or more questions. The questions are designed to elicit information to enable his group, CPM, to develop a noncompliance risk profile. For those responses that give his group a sense that there may be compliance issues, the matter may be referred to the Service’s field operations. The matter may be referred just for the matters that have been identified as having potential for noncompliance or expanded to a full scope audit. He said that the idea is to try to develop the cases that have the highest risk of noncompliance while sparing the Service’s resources, and the more compliant part of the municipal community, from having to go through a full exam.

In response to a question from the floor, Todd said that CPM’s advance refunding

questionnaire was a compliance check questionnaire. The questions can seem similar to the questions that would start a focused examination. However, Todd emphasized that, despite confusion among the recipients, these are not examination questionnaires. The main difference with the compliance questionnaires, unlike examination questionnaires, is that they do not focus on, or ask questions about, specific bond issues. Rather they ask the issuers (or conduit borrowers in the case of the 501(c)(3) questionnaire) questions about their procedures generally. Of course, the other difference is that in the examination questionnaires the answers are evaluated for referral for field examination. In contrast, in a compliance questionnaire, the Service is looking for information for which it has no other source, although potential audit targets may be identified.

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Todd reported that the Service had completed four compliance questionnaires: for qualified 501(c)(3) bonds, for governmental tax-exempt bond issuers, for direct pay (BABs) bond issuers and for issuers and borrowers benefiting from advance refunding bonds. He said that, through those projects, the Service had gathered compliance information it would not otherwise have had access to, to enable it to guide its operating priorities and focus its compliance efforts.

A questioner from the floor asked Todd how many of the responses to questions

in a compliance questionnaire have expanded the number of types of focused audits? Todd replied that the number would vary. He said that the Service had already conducted focused audits on multiple different types of bonds. The number of newly identified areas of compliance concern generated from the answers to a compliance questionnaire could vary from very low, as a percentage of the questions, to perhaps a quarter to a third, depending on the complexity of the subject matter.

He reiterated the premise of the compliance questionnaires. The information they

gather enables the Service to better set its priorities and to better use its field resources than is permitted by random audit picks. He also thought that the compliance questionnaires had other benefits. He said that they are a pretty effective way to promote public awareness of compliance needs, not just among the professionals but among the issuers, through the media and the Service’s website. Thus, they are part of the Service’s outreach effort. They might even contribute to the Service’s understanding of the areas where guidance is needed.

Todd noted that the highlights prepared for the panel had a number of questions

about the compliance questionnaires and eight numbered questions about the VCAP procedures that he was willing to address. The highlights also had a very useful summary of the August 5, 2011 update of the I.R.M. provisions. It was noted from the floor that the two excerpts from the I.R.M. were in unusually fine print. Todd admitted that he had been forced to reprint them in a larger print so that he himself could review them. Perry suggested that the website display such such materials in larger print and Todd said that he may be able to have that change made.

Perry asked the first question. He noted that the I.R.M. now provides that in a

conduit bond situation, the Service may negotiate with the conduit borrower. He asked for confirmation that the issuer must still be involved and Todd confirmed that was correct. Todd noted that, even before the updated I.R.M., conduit borrowers were parties to closing agreements from time to time but it wasn’t clarified. The need to have the issuer remain a party to the audit is based on the Service’s disclosure limitations. It is unable to discuss a tax audit of the issuer of the bonds with a third party, even though the third party is the ultimate borrower of the bond proceeds, without the issuer’s involvement. Christie added that Form 8821 must be filed.

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A questioner from the floor asked how about a Trustee? Todd replied that the protection of confidentiality of taxpayer’s information is one the Service’s highest priorities and convenience must be balanced with the need to preserve confidentiality. He thought confidentiality would outweigh convenience in that situation. That said, Trustees have sometimes been parties to closing agreements.

Todd next fielded a question that flagged for him the difference between the

resolution standards provided for direct pay bonds (BABs) in I.R.M.7.2.3.4.3. and the general VCAP resolution standards. He spoke to the difference between the TEB VCAP (“Streamlined”) resolution standards that were added to the I.R.M. in 2008 as a result of recommendations by the Advisory Committee, and the general VCAP resolution standards. The streamlined resolution standards were designed to give bond lawyers and issuers some certainty. If you came in with a covered violation, a specific factual scenario, you would pretty well know what you were going to get. Possibly in part because of the novelty of direct pay bonds, there was some reluctance to say, come in and we’ll work out for you a reduced payment. The formula was the result.

In contrast, the general VCAP resolution standards permit different types of

resolutions for different types of violations. A questioner asked whether under the language of I.R.M 7.2.3.4.3, the Service could entertain an alternative to paying the I.R.M.’s formula that produced a credit maintenance amount. Might the issuer pay a reduced amount and receive a reduced credit going forward? Todd said yes, the I.R.M’s language preserves that option and the Service would entertain that alternative as a possible settlement. Steve asked whether the Service is indifferent to settling for the credit maintenance amount or reduced future credit payments? Todd answered that it was too early to say. The preference will probably depend on the Service’s experience over the next couple of years.

Todd was asked whether there had been any VCAP requests for BABs since last

August or September? He said that he thinks there have been but was not sure he could answer that. In response to a further question, he thought that they have not received a VCAP request with regard to an issue price violation. He added that there might be heightened concerns about direct pay bond compliance, in contrast with tax-exempt bonds compliance due to the ongoing filing of Form 8038CPs.

This led to a discussion about compliance procedures. Todd said that the

Service’s experience suggests that there is probably not a one-size-fits-all set of procedures that will work for every issuer. The responses to the compliance questionnaires’ question about the existence of a written compliance procedure in place indicated that there was a very high level of compliance. However, on a closer look at the supporting documents, the Service found that there was a lower percentage level of compliance than reported. He attributed this to the fact that many bond documents require the making of certain periodic certifications. Those required certifications, which vary widely, may or may not have been

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intended to provide a road map for compliance. However, they often were misperceived to provide a road map for compliance that would permit a “yes” answer to the question whether there were written compliance procedures in place.

Todd was asked whether, if an issuer answers in a compliance questionnaire that

there are no written compliance procedures in place, does that automatically send them into an audit? There is a gap in the recording but from Cliff Gerber’s comments a few moments later, it appears that Todd answered no. Todd went on to add that there will be a big difference between those that adopt a written procedure and put it into a drawer and those who adopt a procedure and implement it.

Cliff Gerber emphasized to Todd that the existence of written compliance

procedures is a big issue for issuers, bond counsel and those who sign as paid preparers of Form 8038s. The bond documents may only “sort of” provide the necessary written procedures. Many of the check offs to the question have an asterisk explaining that the issuer is in the process of preparing written procedures or working with counsel, or is otherwise candid about where the process is. Cliff said it was good to hear what he had hoped for, that a failure to check the box yes would not automatically flag the issue for an audit.

In response to a question from the floor addressed to Cliff about why he used the

asterisk and an attachment, Cliff explained that the asterisk and attachment showed the issuer’s good faith or intent to comply. A flat no might cause someone on the other end to wonder why. In a situation that is evolving, where counsel are uncertain whether the procedure should be a page or two or 20 pages and where it is unclear what the procedure should say, he felt there was no harm in using the asterisk, although it was acknowledged that one could not be sure what would happen to the attachment.

Christie made the important point that we should recognize that a given written

compliance procedure may be unique to that issue and may show up in the resolution or other bond document that is a part of the transcript. However, it would make no sense to have a very general compliance procedure be part of a given transcript and there is nothing evil if it is not. Todd agreed, adding that he hoped that nothing he had said gave the impression that the written procedure could not be adopted after the bonds were issued or not be part of the bond documents. Indeed a general procedure applicable to many issues might be a cost effective way to assure compliance.

Perry asked Todd whether he had seen people coming in to ask for VCAPs,

streamlined or not, about questions he knows people are interested in, namely extinguishment and merger, and pension plans. Todd replied that he had not seen those questions but that he couldn’t say whether they had since he didn’t see all of the VCAP requests. He was only one of three Group Managers and the others

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may have. This reply prompted John Swenseid to ask Todd to tell us about the organization of the groups. He said that the other two group managers are Bob Griffith and Alma Dripps. The groups are geographically dispersed. He is in El Segundo, CA and the others are in St. Louis and Washington, D.C. The groups report to Steve Chamberlain who is the Program Manager and he reports to Cliff Gannett, the Director. Since Cliff is on temporary detail as Director of Governmental Entities, Bob Henn is filling in as Acting Director.

Perry’s last question related to post issuance/ pre-action conferences. He posited

the situation where an action is contemplated with respect to bond-financed facilities and the issuer wants to explore with the VCAP personnel what the VCAP settlement cost would be before the action is taken. Perry asked Todd whether he was reading the IRM correctly when he concluded that the proposed action actually has to be taken before the VCAP can be entered into. Todd confirmed that this reading is correct and that he has been surprised with the frequency that the pre-action situation has been presented to his group, perhaps as a result of the unusual or unexpected financial situations that arise in this day and age. He noted that these situations take a lot of time to complete but the program has been tailored to provide an issuer with enough time to take the action and get the VCAP relief while meeting the Service’s requirement to take action within a certain time after determining that a violation has occurred.

Third Panel: Tax Implications of On-Behalf-Of Financings. Nancy Lashnits, the moderator of this panel, introduced her three other panelists,

Jim Polfer, who served on the first panel, Carol Lew and Cliff Gerber. She announced that the panel would discuss obligations issued by a nonprofit corporation that are considered to be obligations issued on behalf of a governmental entity. A discussion outline was available in the back of the room.

Nancy began by summarizing the history of the rules applicable to nonprofit

corporations issuing tax-exempt bonds on-behalf-of governmental entities. They are currently set forth in Rev. Proc. 82-26, which amplified Rev. Rul. 63-20. Rev. Rul. 63-20 was a negative ruling but it set forth in very basic but somewhat flexible fashion, the on-behalf-of rules as then applied by the Service. In the nearly 20 years that followed, bond counsel was faced with many situations not covered by Rev. Rul. 63-20, and Rev. Proc. 82-26 was intended to provide specific, detailed rules reflecting that experience. Nancy said that she understood that Rev. Proc. 82-26 was issued in lieu of regulations and its detailed format seems to reflect such planning.

Nancy and Cliff Gerber speculated on why there seems to be renewed interest in

this technique and why use of this technique seems to occur in sporadic clusters. Nancy said that her experience was that, once a big issuer starts using the technique, it seems to keep on going. Her experience is with a large governmental university which uses the technique for specific revenue projects like research facilities or student housing. It has a 63-20 nonprofit which then

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uses a separate LLC for each project to separate the bond debt service or potential law suits.

Nancy, Cliff and Carol then discussed why an on-behalf–of issuer, rather than the

governmental entity itself, is now used at all. Historically, it may have been used to avoid limitations like voter approval for bond issues. However, with the development, particularly on the West Coast of cleaner and easier techniques, such as leases with certificates of participation, the technique fell by the wayside. Now the reason seems to be that, for political or other controversial reasons, an on-behalf-of issuer may be used when there is a desire by the governmental entity to distance itself from a transaction. Even then, the rigidity of the technique presents problems – particularly with the narrow required use of the property and the required transfer of the property to the governmental entity when the bonds are retired. Also the financing of any improvements must be accomplished using the same method.

Nancy asked Carol to start the discussion by identifying the rules that may apply

to a nonprofit, on-behalf-of issuer. Carol described four sets of rules for them. Those rules are similar but different in some respects. First, Rev. Proc. 82-26’s rigid rules are designed to deal with a nonprofit bond-issuing corporation that is created under a State’s general nonprofit corporation statute. Second, where the nonprofit, on-behalf-of corporation is created under a special State statute, “similar but different” but still fairly rigid and narrow rules may apply as set forth in several helpful revenue rulings. Third, where the nonprofit, on-behalf-of corporation rises to the level of a governmental instrumentality under Code section 141 and some other provisions of the Code, a similar but slightly different set of rules may apply. A fourth, sister set of rules under Code sec. 115 may apply to determine the taxability of the income of a nonprofit, on-behalf-of issuer. Cliff added that, when the nonprofit corporation is an integral part of a government, a fifth set of rules will apply.

Carol asked Jim Polfer to comment on why the rules are crafted as they are. She

wondered whether there might not be a better way to do this than with so many rules with so many slightly different requirements. Jim responded that the many rules are the result of the many different fact situations that have confronted the Service. They have generated a large number of letter rulings and procedures in this area, going back many years. The most difficult question to answer is whether a given nonprofit on-behalf-of corporation is an integral part of a governmental entity. He noted that a guidance project has been on the business plan for some time on what constitutes an integral part of a government. The obstacle to completion of this project is that many more parts of the Code other than the tax-exempt bond provisions are impacted. It is extremely difficult, with growing complexity, to bring cohesion to the area. Any time that you try to provide guidance you have to “rent out the auditorium in our building” because it affects almost every body. It would be very good to have clarification of these

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rules but it is not on this year’s business plan and we don’t expect it to come out soon.

Cliff then described the difficulties of applying these overlapping rules to any

given set of facts. One set of facts might be susceptible of analysis under several different approaches. He referred to PLR 200112028 cited in Nancy’s outline, which dealt with whether a nonprofit corporation was subject to income taxation under section 115. He said that those facts could be analyzed under both Rev. Rul. 63-20 or the integral part of a governmental entity paradigm. Jim responded that the “brass ring” or “gold standard” is to be able to find that an on-behalf-of issuer is a political subdivision that is an integral part of a government. If you can do that you can issue bonds, there is no taxable income and there is no need to file a tax return.

That observation triggered a discussion as to how difficult it is to determine what

is a political subdivision. The practice in Arizona was discussed. There, a city can organize a municipal corporation to do things for the City. However, it can do thing for the City that the City itself could not do.. For example, a City might not be able to purchase real property without a referendum but it can organize a municipal corporation that can buy the real property and lease it to the City. In response to a question from the floor as to whether this sort of municipal corporation is analyzed as an on-behalf-of issuer, the response was no. In Arizona such an entity is treated as a governmental entity, and it can issue its own bonds.

Another comment from the floor referred to the municipal corporation language

found in regulations sec. 1.103-1(b). Jim responded that there is no rule that the Service itself can point to for guidance as to what is a municipal corporation. However, in Jim’s experience, no one ever comes in for a ruling saying we are a municipal corporation but are not a governmental entity. They always identify the municipal corporation as a governmental entity. A discussion ensued as to whether, to be a municipal corporation, an entity had to have at least one of the three sovereign powers. It was concluded that it did not if it was an integral part of a governmental subdivision that had the needed sovereign powers.

Jim had earlier commented on the difficulty of crafting rules in this area: for any

given situation you may be able to find two or three private letter rulings that agree with you and two that don’t and another two or three that don’t even fit within the framework. He added that every once in a while you even have a case that adds to the confusion. (It might be noted that regulations proposed many years ago to amplify section 1.103-1 had to be withdrawn in face of criticism that they had not begun to cover the enormous variety of local governmental arrangements.)

Carol commented that a theme running through these various rules seems to be

the relationship of Board control by the governmental entity to the strictness of the requirements. She described a nonprofit corporation that is an integral part of

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a governmental subdivision under a special State statute. In that situation, presumably because of the specificity of the statute, the governmental subdivision need not control the Board of the nonprofit corporation. In contrast, when a nonprofit corporation is organized under a general nonprofit corporation statute, stricter rules seem to be required when the governmental entity doesn’t control the nonprofit’s Board.

The panel then focused on the differences in the strictness of the rules in 82-26

depending on whether or not the governmental entity’s Board is in control of the nonprofit corporation’s Board. Cliff identified that when you have governmental Board control, 3 or 4 of the more restrictive provisions in 82-26 do not or may not apply. They include the restriction on an advance refunding (which the Service will ordinarily permit by issuing a favorable ruling if there is Board control) , the defeasance requirements, the restriction on extension of maturities and the satisfaction of the 20% residual value test.

Jim described the 82-26 rules that continue to apply where the Board is not

subject to governmental control, such as the residual value test and the defeasance requirements, as being designed to protect the value of the bond-financed property to be returned to the governmental entity. Where the nonprofit corporation has the use of the property, the purpose of 82-20’s rules is to make sure that the governmental entity will get the property back free and clear when the debt is paid off or can take it back at any time by taking out the debt.

Nancy noted that any management contracts or other restrictions (other than

utility easements) to a free and clear return of the bond-financed property must terminate when the debt is retired either at maturity or upon any prior taking of the property. Unlike in Rev. Rul. 63-20, which only required that upon such an event the government get full legal title, 82-26 prohibited contractual arrangements that would not have impacted on full legal title. No other party than the government could have any interest in the bond-financed property. She pointed out that this imposed considerable risk on a manager, whose contract must terminate upon such an event, who had no legal right to be rehired, and who could not be rehired for 90 days thereafter.

Carol added that concern over whether the income of the nonprofit entity would

be subject to income tax also would enter into the choice of which of the three provisions that are described in 82-26 would be selected. Her experience has been that income taxation is avoided by structuring the transaction to make the bond issuing entity essentially a governmental instrumentality. That can be done by either of two ways: Under provision a) of 82-26, the governmental unit itself may be given exclusive beneficial use and control of the bond-financed property equal to at least 95% of the FMV of the property for the life of the bonds. Or, under provision b) of 82-26, the issuer is given the same beneficial possession and use of the bond-finance property but the governmental entity is given the power to appoint or control 80% or more of the issuer’s governing Board with the power to

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remove any member of that Board for cause. Nancy added that her experience had been primarily under provision c) of 82-26 where the Board is independent. There, the property must be turned over free and clear to the governmental entity when the debt is retired or the property is taken and the debt is paid by the governmental entity.

Cliff asked Jim about the provision in 82-26 that permits the encumbrance of the

bond-financed property by utility easements. He wondered if there were any other encumbrances that might be permitted, such as deeds of trust or mortgages, since the language in 82-26 talks about encumbrances that do not specifically interfere with the enjoyment of the property. Jim answered that he had heard anecdotally that most counsel had advised against any encumbrances in any way. He said that he would not bless any other encumbrances than the utility easements. A question was raised from the floor about a governmental condemnation of a portion of the bond-financed property for a public road. After some discussion, Jim concluded, speaking for himself and not as branch chief, that the property so condemned would have ceased to be owned by the issuer and would not therefore have been encumbered by it.

There was a discussion of deeds of trust or mortgages providing security for the

bonds, which should be permitted if they provide that they will be discharged upon payment of the bonds they secure. When Cliff asked about possible underlying liens not so discharged, Jim said that his understanding of the provision was that it was intended to refer only to physical improvements like those associated with utilities that as a result encumber the property. Carol suggested that it might apply to electric transmission lines of an investor owned utility that cross over the property and require restricted use of the property below the wires. While technically the lines are utility lines, they do not serve the property but would encumber it. Jim thought they would be permitted as part of the total public utility infrastructure. Public roads and utilities would be permitted but not underlying liens or mortgages.

There was a discussion of other interesting 82-26 provisions. Carol pointed out

that, another reason to consider carefully before proceeding down this path with a particular client is that working capital cannot be financed under it. However, there is permission to fund issuance costs and a reasonably required reserve. The panel members felt it was hard to understand the reason for the working capital restriction, which doesn’t seem to make sense. The conclusion was that it may just be that the Revenue Procedure is 30 years old and may reflect attitudes of that period.

Attention was drawn to a few other provisions, such as the availability of a $5,000

rounding provision and the ability to call bonds with unexpended funds under Rev. Proc. 79-5. The provisions that deal with the insurance proceeds from fire or other casualty destruction of the bond-financed property, require that they be used to rebuild the property even if they are insufficient. Jim felt that this reflects the

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concern of the Procedure that the governmental entity eventually receive the bond-financed property. The provision says that the obligation to rebuild will be subject to the claims of the holders of the bonds, but the usual bond holder position in this sort of a situation is that they want to be paid off rather than have the property rebuilt.

Nancy noted another provision that applies only to alternative c). Both the

nonprofit and the issue must be approved by the governmental entity within one year before or after the bonds are issued. If, for whatever reason the project is delayed, more than a year may elapse between those approvals and the bond issuance. It may be difficult or embarrassing politically to go back to the governmental entity to secure a those re-approvals. The one year requirement seems to track a similar 1983 TEFRA requirement, as does the language of the provision for an approval for the issuance of a series of obligations under a plan of finance (though not to exceed 5 years rather than TEFRA’s 3), which approval must occur within one year of the first issuance.

Nancy said that one of the reasons for doing this particular panel was some

discussion on the national 103 list about whether it was necessary for an on-behalf-of corporation to file Form 990. The conclusion appears to be that, if the nonprofit is a 501(c)(3) entity, a Form 990 filing is required. As for whether income has to be reported, if the nonprofit can be categorized as an integral part of a governmental entity, no income tax return has to be filed and no income has to be reported. If the nonprofit is a 501(c)(3)entity and not an integral part, and the income is not unrelated business income, no tax is due. If the nonprofit is neither an integral part nor a 501(c)(3) entity, the entity will have to file a Form 1120 even if there is no income. If there is income, section 115 will determine whether tax is due. Carol recommended that, with the uncertain application due to the way section 115 of the Code is written, a determination of 501(c)(3) status be obtained.

A lengthy discussion ensued as to what do when you discover one of these on-

behalf-of corporations that has had almost no activity and possibly no income but has not filed tax returns. The question may arise with a Certificate of Participation (COP) corporation even if it is almost totally inactive. If the overdue filings are belatedly filed, the result is apt to be the receipt of a letter assessing an astronomical amount of penalties, which may be removed when the auditor understands that there is little or no income.

Reference was made to a procedure applicable to “governmental counterparts”

which are corporations so closely connected to governmental entities that they are treated as integral parts for filing purposes and do not have to make filing or report income. A comment was made from the floor that, where you are both a 501(c)(3) and a governmental entity, the governmental status is probably determinative under the ’86 Act and a Form 990 may not have to be filed.

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In response to another question from the floor, the panel considered the tax consequences from instrumentality status other than the ability to issue bonds. Reference was made to FICA and FUTA tax advantages, and the ability under section 403(b) to offer employees tax-exempt annuities. It was noted that some charter schools have been seeking instrumentality status, so that when an IDA issues bonds for them, they can avoid the 2% limitation on issuance costs and the need for TEFRA hearings. Whether the attaining of instrumentality status obtains in the payroll tax advantages for them was beyond the scope of this panel. Jim also said that whenever they have determined that an entity was an instrumentality, they have almost always determined that it was both an instrumentality and met section 115.

As a final comment, reference was made to PLR 201114010 (April 8, 2011)

which was a State and political subdivision private letter ruling. It determined that the entity requesting the ruling had an insubstantial amount of all three sovereign powers to be a political subdivision. However, under all of the facts and circumstances it was close enough to a political entity that had those powers to be an integral part of a political subdivision. Yet it was not close enough to that political entity to be related to it, for purposes of section 150. This is an interesting situation - where the entity is close enough for one purpose but not another.

There being no further questions, the meeting was adjourned.