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We have used our best efforts to compile and provide only the most accurate information available in the subject matter areas which are covered herein. However, we make no warranty or representation as to the accuracy or completeness thereof. The reader is encouraged to conduct his or her own independent research on any topic dealt with herein before relying upon such information.

INTRODUCTION. Set forth below are comments regarding selected provisions of the proposed regulations relating to private activity bonds (FI-72-88). The comments for each identified section consist of parts entitled (i) Comment, (ii) Selected Regulatory Language, and (iii) Reason. In the parts entitled "Selected Regulatory Language," bold italicized words indicate additions to, and strike out indicate deletions from, the language in the proposed regulations.

All section (§) references are to the proposed regulations unless indicated otherwise. In addition, the following words have the following meanings: "Code" means the Internal Revenue Code of 1986; "1986 Tax Act" means the Tax Reform Act of 1986 (Pub. Law 99-514); "House Report" means House Report No. 99-426; "Senate Report" means Senate Report No. 99-313; "Conference Report" means Conference Report No. 99-841; "General Explanation" means General Explanation of the Tax Reform Act of 1986 Prepared by the Staff of the Joint Committee on Taxation; "1984 Tax Act" means the Deficit Reduction Act of 1984 (Pub. Law 98-369).

A. §1.141-1(a) Delete Reference to Definitions of Unused Terms

Comment. A number of terms are referenced in this subsection that are not used in §§1.141-1 through 1.141-16. We suggest that, except where otherwise appropriate, the definitions contained in §§1.150-1 and in 1.148-1 generally should apply for purposes of the private activity bond tests regulations.

Suggested Regulatory Language. Modify §1.141-1(a) as follows:

(a) In general. For purposes of §§1.141-1 through 1.141-16, the definitions and rules in this section, the definitions in §1.150-1 and, except as otherwise provided in subsection (b) or elsewhere in §§1.141-1 through 1.141-16, the following definitions under in §1.148-1, apply: bond year, commingled fund, higher yielding investment, investment proceeds, investments, investment-type property, issue price, nonpurpose investment, qualified guarantee, qualified hedge, reasonable expectations, reasonably required reserve or replacement fund, rebate amount, replacement proceeds, reserve or replacement fund, sale proceeds, and yield.

Reason. The reference to definitions of terms not in fact used in the regulations is confusing. Is it intended that concepts relating to the referenced terms apply to the regulations even though those terms are not used in the regulations? If so, we suggest that the above language will adequately reflect that notion. If not, we suggest that the enumeration of specific terms in subsection (a) that are not otherwise used may be misleading.

B. §1.141-1(b) Modify Definition of "Project Period" to Include Definition of "Substantial Completion"

Comment. In the §1.141-1(b) definition of "project period," we suggest that the term "substantially complete" be defined to refer to the general concept of §1.148-7(e)(3)(iii). (For reference, §1.148-7(e)(3)(iii) provides, "Construction may be treated as substantially completed when the issuer abandons construction or when at least 90 percent of the total costs of the construction reasonably expected, as of that date, to be financed with the available construction proceeds have been allocated to expenditures.")

Suggested Regulatory Language. Modify the definition of "project period" in §1.141-1(b) as follows:

Project period means the period beginning on the issue date and ending on the date that the construction, reconstruction, or acquisition of the project financed is substantially complete. Construction, reconstruction or acquisition of a project is substantially complete when 90 percent of the total costs of construction, reconstruction and acquisition to be financed with the proceeds of an issue have been allocated to expenditures or, if earlier, when the project has been abandoned. 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 §1.148-2(e)(2) or the end of the fifth bond year after the issue date.

Reasons. The term "project period" is used only in the definition of "investment proceeds" and "replaced amounts." The importance of the term, therefore, is for measuring the amount of proceeds used for private business use or for private loans. The date of "substantial completion" is one aspect of this measurement and, therefore, determination of that date becomes important in determining compliance with the private activity bond tests. A definition of the term is required in order to add predictability to application of the tests and thereby ease administration of the tests.

Similar concerns arose regarding application of the 2-year construction project expenditure exemption to the rebate requirement in the context of the term "substantially completed." We suggest that an approach parallel to that taken in §1.148-7(e)(3)(iii) be taken with respect to the term "substantially complete" in the definition of "project period." We do not suggest, however, a mere cross-reference to §1.148-7(e)(3)(iii) because that section employs the term "may" in the context of a rule beneficial to issuers, while the private activity bond rules require a limitation in the context of a rule detrimental to issuers.

C. §1.141-1(b) Make Technical Changes to Definition of "Output Facility" (See Alternative Substantive Expansion Concept in Next Comment)

Comment--Technical Change. If the concept of the existing reference to "output facility" is retained in the final regulations, technical modifications to the reference in §1.141-1(b) are needed to enhance clarity; for example (i) the reference to the term is not a definition in that the reference uses the word "includes" rather than the word "means"; (ii) the reference to "water collection, storage, or distribution facilities" may be an internal definition of the word "water facilities" in §1.141-7(a) and either "water facilities" should be separately defined or the reference in §1.141-7(a) to "water facilities" should be conformed to the phraseology of §1.141-1(b); and (iii) since all of §1.141-7, other than subsection (a), applies only to electric and gas facilities, the definition of the term "output facility" in §1.141-1(b) should be limited to electric and gas facilities except for purposes of §1.141-7(a) and for that purpose should be expanded to include water facilities.

Suggested Regulatory Language--Technical Change. Modify the definition of "output facility" in §1.141-1(b) as follows:

Output facility, except as otherwise provided in for purposes of §1.141-7(a), includes means electric and gas generation, transmission, and related facilities, but not (1) Sewage or solid waste disposal facilities, or (2) and water collection, storage and distribution facilities, and for all other purposes of §§1.141-1 through 1.141-16 means electric and gas generation, transmission and related facilities.

As modified, the definition of "output facility" in §1.141-1(b) would read as follows:

Output facility, for purposes of §1.141-7(a), means electric and gas generation, transmission, and related facilities and water collection, storage and distribution facilities, and for purposes of §§1.141-1 through 1.141-16, means electric and gas generation, transmission and related facilities.

Reasons--Technical Change. A definition which uses the word "includes" rather than the word "means" creates the idea that the defined term means more than what is included. If facilities, other than the listed facilities, are to be encompassed by the phrase "output facility," then guidance should be provided regarding what other facilities are intended to be included. This guidance is best provided through use of a generic description. (See discussion below regarding alternative substantive changes.)

Also, interpretative difficulties will be raised by the use of the phrase "water collection, storage and distribution facilities" in the definition of "output facility" because the only area of the regulations where the term "output facility" is substantively described (i.e., §1.141-7) is entirely limited to electric and gas facilities except in §1.141-7(a), and there the broad phrase "water facility" without clarification is used. For example, if water facilities other than "collection storage and distribution" facilities are included in §1.141-7(a) (e.g., water treatment facilities), why is the reference in §1.141-1(b) limited to collection, storage and distribution facilities?

In addition, since the primary substantive rules for "output facility" are set forth in §1.141-7 and since all of that section, other than subsection (a), relates only to gas and electric facilities, the definition should be modified to conform to the rule.

In sum, the above technical changes are needed so as to add clarity and avoid controversy.

D. §1.141-1(b) Alternative Comment to Above: Expand Concept of Output Facility

Alternative Comment--Substantive Change. As an alternative approach, we suggest that the term "output facility" be deleted in favor of a broader, generic term such as "energy or communication facility" or that separate rules be developed for application of the private business tests to specific types of energy and communication facilities, not simply electric and gas facilities.

Alternative Suggested Regulatory Language--Substantive Change. Modify the definition of "output facility" in §1.141-1(b) as follows:

Output facility, except as otherwise provided in §1.141-7(a), includes electric and gas generation, transmission, and related facilities, but not (1) Sewage or solid waste disposal facilities, or (2) water collection, storage and distribution facilities. means a facility for the production, generation, transmission, distribution or conveyance of water, energy or analog, digital or other form of data, including but not limited to electricity, gas, radio waves, television waves, electronic information and telephone communications.

Reasons--Alternative Substantive Change. We suggest that the application of the private business tests to output facilities has provoked unnecessary controversy and caused administrative difficulty for the Service. There has been much discussion regarding the application of the output rules of §1.103-(b)(5) to various facilities, including non-utility facilities (such as laundries, as referenced in private letter ruling 7408190340A, dated August 19, 1974) and facilities that receive input rather than provide output (such as sewage and solid waste facilities, as referenced in §1.141-1(b)). We also suggest that further controversies regarding application of the private business use tests will arise with participation by State and local government in facilities reflecting technological advances in communication and energy conveyance. We point, for example, to the reference to "fiber optics" in the definition of "mixed use facilities" in §1.141-6(b)(2) (as well as in private letter ruling 9311010, dated December 15, 1992) as evidence of the potential controversies. We also note that the Service has been asked to rule on several occasions regarding cable television (see, for example, private letter ruling 8125027, dated March 24, 1981, supplementing private letter ruling 8015079, dated January 16, 1980, relating to an "on behalf of" issue for cable television managed under a 1-year contract, and private letter ruling 8305018, dated October 29, 1987, relating to an "on behalf of" issue for cable television structured as an under $1 million industrial development bond). In these rulings franchise users of cable television were not in question or were overlooked as private business users. In addition, on one occasion (private letter ruling 9124025, dated March 15, 1991), a technologically advanced off-track wagering system was considered by the Service but, because the private security or payment test was not satisfied, the application of the private business use test was disregarded.

We believe that the Service should take advantage of the opportunity provided by the proposed regulations to put existing and potential controversies to rest and to provide guidance regarding potential disputes relating to newly-developed utility-like systems.

As is true with electric energy, we expect that States and political subdivisions will wish to develop local utilities for interactive information communication. Thus, the concept of exchange of electric energy through wheeling over governmental lines may apply equally to the concept of exchange of information through wheeling over governmental fiber optic systems; the concept of use of governmental gas lines by gas utility companies may apply equally to use of governmentally owned television and telephone networks as well as governmentally owned "PCS" and microwave communication systems by private enterprise; and use by franchisees and advertisers may or may not constitute short-term use or use by members of the general public. Regulatory guidance regarding the application of the private business use tests to all of these activities is required. We suggest that some guidance could possibly be provided in the context of "management contracts" (e.g., 10-year franchising contracts considered as in the nature of service contracts), but that the more appropriate location may be in the context of "output facilities". If the latter approach is selected, then the definition of output facility in §1.141-1(b) will require modification.

E. §1.141-1(b) Add Definition of "Qualified Bond"

Comment. The term "qualified bond" requires specific definition.

Suggested Regulatory Language. Modify §1.141-1(b) to add a definition of "qualified bond" to read as follows:

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

Reason. It is implied that terms used in §§1.141-1 through 1.141-16 have the meanings (if any) ascribed to them in Code section 141. To avoid any question, however, it is suggested that the term "qualified bond" be defined by cross-reference to the Code. This will prevent the assertion, for example, that a qualified bond is any bond that is not a nonqualified bond within the meaning of 1.141-13(g)(1). (Compare, for example, the definition in §1.141-1(b) of "nongovernmental person" as meaning a person other than a governmental person.)

F. §1.141-1(b) Add Definition of "Ownership"

Comment. The term "ownership" requires specific definition.

Suggested Regulatory Language. Modify §1.141-1(b) to add a definition of "ownership" to read as follows:

Ownership means ownership as defined for general federal income tax purposes.

Reason. The above definition will clarify questions that will arise regarding ownership for State law purposes (i.e., "bare" legal title). Federal income tax law has long ignored the form of a transaction (such as putative ownership) and has instead determined ownership on the basis of substance (i.e., whoever bears the benefits and burdens of ownership is the tax owner). The holding of bare legal title without the accompanying benefits and burdens of ownership should not be treated as use for purposes of the private business use test.

Also, since "loan" has been defined (in §1.141-5(b)(1)) by reference to general federal income tax principles, we believe a similar definition of "ownership" is appropriate.

Ownership means ownership as defined for general federal income tax purposes. As a safe harbor, property leased by a governmental unit shall be treated as owned by such governmental unit if the conditions of section 142(b)(1)(B) are satisfied.

In addition to the above, we would appreciate the addition of a "safe harbor" for determination of governmental ownership in the context of a "true lease." As referenced in the suggested regulatory language, we suggest that Code section 142(b)(1) provides an appropriate safe harbor. Whether there is governmental ownership arises particularly in the case of the application of the private loan financing test. Thus, if the use of bond-financed property is pursuant to the terms of an installment sale arrangement, then ordinarily there is a "loan" for purposes of Code section 141(c). If, however, the use of bond-financed property is pursuant to the terms of a true lease arrangement, then ordinarily there is not a "loan" for purposes of Code section 141(c). In certain financings, therefore, controversy arises regarding whether the arrangement in question is an installment sale or whether it is a true lease. For example, in the case of "rent-to-own" programs where the proceeds of bonds are used to acquire single-family residences that are rented to natural persons who, in turn, are provided an option to purchase, one issue is whether the option must be at fair market value as of the time of exercise of the option as contrasted with fair market value at the time of execution of the rental agreement.

To prevent controversy, therefore, we suggest that "ownership" be defined and that a safe harbor be added.

G. §1.141-1(b) Add Definition of "Fair Market Value"

Comment. The term "fair market value", as used with respect to the transfer of property, requires specific definition.

Suggested Regulatory Language. Modify §1.141-1(b) to add a definition of "fair market value" to read as follows:

Fair market value means the price a willing buyer would pay a willing seller in an arm's length transaction. The determination of fair market value takes into account covenants and restrictions imposed on future use of property.

Reason. The concept of fair market value is of great importance in the regulations, particularly in the context of remedial action and abuse. The concept of fair market value is also of importance in the context of qualified redevelopment private activity bonds under Code section 144(c) where it is required (in Code section 144(c)(2)(C)) that property, if transferred, be transferred for fair market value. In that context, extensive discussions arose during the passage of the 1986 Tax Act regarding whether the transfer by California redevelopment agencies of property for little or no cash constituted a fair market value transfer taking into account covenants and restrictions imposed on the future use of property. This question was answered in the affirmative in the General Explanation as follows:

Real property acquired by a governmental unit . . . need not be transferred to a nongovernmental person; however, if it is so transferred, the transfer must be for fair market value. The determination of fair market value for this purpose takes into account covenants and restrictions imposed on the future use of the relevant real property by the issuer of the bonds. (General Explanation at page 1191)

Because the value of land is often greater when covenants and restrictions on future use are disregarded that it is when they are taken into account and because the correct value of land is an issue of great importance to local government units (particularly redevelopment agencies) in applying State law, as well as in complying with regulatory provisions relating to fair market value transfer we suggest that the term fair market value be defined as set forth above.

The Service may also wish to consider the inclusion of an integrated definition in regulations section 1.150-1(b) taking into account the fair market value of property, as well as of investments (as referenced in regulations section 1.148-5(d)(6)).

H. §1.141-1(c)(1) Apply Rule of Disposition Proceeds to Private Business Use Test Only

Comment. The rule that disposition proceeds allocable to transferred property cease to be treated as proceeds of the issue should apply only for purposes of the private business use test and not for purposes of the private security or payment test or the private loan financing test.

Suggested Regulatory Language. Modify the §1.141-1(c)(1) as follows:

(1) Definition. Disposition proceeds are any amounts (including property) derived from the sale, exchange, or other disposition (transfer) of property (other than investments) financed with the proceeds of an issue. Except as provided in paragraph (c)(4) of this section, for purposes of the private business use test, if there are disposition proceeds, any proceeds of the issue allocable to the transferred property cease to be treated as proceeds of the issue.

Reason. The general rule of the above provision is to follow the proceeds, rather than the property, in the case of transfer of bond-financed property.

In California, there are two similar programs (herein referenced as the "Land Bank School Program" and the "Redevelopment Property Program"). Both programs involve the issuance of bonds payable from (and secured by) generally applicable taxes. In the Land Bank School Program, because student population growth areas are not definitely predictable and because it is more economic for school districts to acquire land for future schools at values lower than those values that will occur after population growth, a school district may issue bonds, use the bond proceeds to buy land with the expectation (based upon studies and projections) that a school will be constructed on that land but, when student population growth density occurs in another area, will sell that land to private persons and use the disposition proceeds to buy other land upon which the school will be constructed. The intended ultimate use of the proceeds, therefore, is always the acquisition of property to be used by a governmental person, namely, by the school district for the construction of a governmentally-owned school.

In the Redevelopment Property Program, because redevelopment by private entrepreneurs of a blighted area is the public purpose to be achieved, a redevelopment agency may issue bonds, use the bond proceeds to buy land, sell that land to a private entrepreneur for commercial development, use the disposition proceeds to acquire other land for sale to another private entrepreneur for other commercial development, etc., until ultimately the last parcel of land is deeded as a gift. The intended ultimate use of the proceeds, therefore, is always the acquisition of property to be used by nongovernmental persons for private business use.

We believe that the correct application of the private business tests in the case of the School Land Bank Program is that the private business use test is not satisfied because, by "following the proceeds rather than the property," the proceeds are ultimately used for the land upon which the school is constructed. The private security or payment test, however, is always satisfied because there has been a payment in respect of property that has been bond-financed (i.e., the proceeds of the first sale of land to a nongovernmental person). Since only the private security or payment test has been satisfied, and the private business use test has not been satisfied, the bonds are not private activity bonds.

In the case of the Redevelopment Property Program, however, we believe that the correct application of the private business tests is that the private business use test is satisfied because the ultimate use of the property (i.e., the last parcel sold) is to be used for private business use. The private security or payment test is also satisfied because there has been a payment in respect of property that has been bond-financed (i.e., the proceeds of the first sale of land to a nongovernmental person). Since both tests are satisfied, the bonds are private activity bonds.

If the "follow the proceeds" rule is applied for the private security or payment test, then one would disregard the payment made for the first sale of the land for purposes of the test; i.e., the two programs would each be analyzed for purposes of that test as if no payment was made in respect of bond-financed privately-used property, that is originally acquired. Disregarding the payment for purposes of the School Land Bank Program will not change the result, i.e., the bonds will not be private activity bonds because the private business use test is not satisfied. Disregarding the payment for purposes of the Redevelopment Property Program, however, will change the result, i.e., although the private business use test will be satisfied by reason of the ultimate use of the proceeds for land to be used for a private business use purpose, the bonds will not be private activity bonds because the amounts paid for the various sales of land will be disregarded and because there is no payment for the last transfer of land.

Although there may be another appropriate approach, we suggest that limitation of the "follow the proceeds" rule to the private business use test will achieve the intended result. (Parenthetically, we do recognize that if land is transferred as a grant or gift to a private business user, bonds secured by generally applicable taxes will not be private activity bonds because the private security or payment test is not satisfied.)

We also note that such limitation should avoid questions regarding the private loan financing test. If bond-financed property is sold on an installment payment basis, this constitutes a use of bond proceeds to make a loan within the meaning of the private loan financing test. In this case, the disposition proceeds constitute loan repayments and the fact of the loan remains. If the rule of "follow the proceeds" is limited to the private business use test, then one cannot argue that the repayments are effectively to be disregarded and that therefore a loan was not made in the first place from the proceeds of the bonds by reason of the acquisition of land sold on an installment sale basis. This argument would, we believe, be incorrect.

We also believe that an example should be added that reflects the above two types of programs and their distinction.

I. §1.141-1(c)(2) Clarify Description of Amount of Disposition Proceeds

Comment. In describing the amount of disposition proceeds, §1.141-1(c)(2) provides that "regardless of the amount received in connection with a transfer," the amount of disposition proceeds is the amount "that had been allocable to the transferred property immediately prior to the transfer." It is not clear from this language how the amount allocable to the property immediately prior to the transfer is determined and what the disposition proceeds should be when an issuer transfers the property at a loss.

Suggested Regulatory Language. Modify §1.141-1(c)(2) as follows:

(2) Amount of disposition proceeds. Regardless of the amount received in connection with the transfer, the The amount of disposition proceeds is treated as equal to the lesser of the amount received in connection with the transfer or the proceeds of the issue that had been allocable to the transferred property immediately prior to the transfer under §1.141-6(a). See §1.141-13(h), Example 1.

Reason. Section 1.141-6(a) requires that allocations of expenditures under Code section 141 follow the provisions of §1.148-6(d) (excluding §1.141-6(d)(6)); and therefore, such allocations must be consistent with the allocations made under §1.148-6(d) for purposes of Code section 148. Therefore, the definition of disposition proceeds should not employ accounting methods different than those used for purposes of §§1.141-6(a) and 1.148-6(d). This means that disposition proceeds should not exceed the amount of bond proceeds allocated to a transferred facility. When a facility is sold, the sale price should be treated as a return of bond proceeds to the extent that the sale price equals or exceeds the amount of bond proceeds allocated to the facility. The actual sale price of the facility should not determine the amount of bond proceeds allocated to the facility; such allocation should be determined by the allocation method used for purposes of §1.141-6(a).

The allocation and accounting problem created by the language in §1.141-1(c)(2) is demonstrated by the following example. An issuer issues $100 of bonds and uses all of the proceeds to build a building. The issuer then sells the building at an arm's- length market price of $90. Assuming that the issuer used a gross-proceeds-spent-first or specific tracing accounting method under §1.141-6(a), the amount of proceeds of the bonds allocable to the building immediately prior to the sale thereof would be $100 since all $100 was actually spent on the building prior to the date of sale thereof. Because the pre-transfer allocation amount was $100, the regulation appears to determine the amount of disposition proceeds as a result of this transfer as $100 instead of the $90 actually realized from the transfer. It is unclear whether this provision regarding disposition proceeds requires the allocation of proceeds of the bonds to the building in the amount of $90 regardless of the fact that, under §1.141-6(a), $100 should be allocated to the building (i.e., does this rule "override" any allocation made purpose pursuant to §1.141-6(a)?). Since the issuer only has $90, treating the amount of disposition proceeds as $100 will require the issuer to come up with $10 out of its own pocket to comply with the remedial actions contained in §1.141-13. Even though $100 of bond proceeds was actually allocated to the building, $10 was "lost" on the sale (at fair market value) and therefore need not be accounted for.

Applying the suggested regulatory change to the above-referenced example, the $90 received from the sale of the building would be treated as a return of bond proceeds and as disposition proceeds (the lesser of $90 received from the sale or $100 allocable to the building). Treating the amount of proceeds allocable (for purposes of §1.141-6(a) and §1.148-6(b)) to the building immediately prior to the transfer as $90 could result in $10 of bond proceeds being deemed to be "unspent" with possible negative arbitrage, rebate and private activity consequences. For example, if, for purposes of rebate, prior to the sale, $100 of bond proceeds was allocated to expenditures for the building, then subsequently allocating $90 of bond proceeds to the building (under Code section 141) upon the sale thereof would violate the consistency requirement of §1.141-6(a) and of §1.148-6(d)(1)(i) (i.e., allocations should be consistent between Code section 141 and Code section 148).

The result would be similar if the property were sold at a gain. Assume that the $100 building was sold for $110. The return of bond proceeds and disposition proceeds should be $100 (the lesser of the $100 allocated to the building and the $110 received from the sale). The extra $10 of gain from the sale is not bond proceeds and no remedial action should be required with respect thereto.

J. §1.141-1(c)(3) Modify De Minimis Exception to Disposition Proceeds to Apply to All Issuers

Comment. The addition of a de minimis exception for large issuers and for general obligation bonds ignores the problems of other issues that also need a de minimis exception to allow for day-to-day operational needs.

Suggested Regulatory Language. Modify the title and introductory paragraph of §1.141-1(c)(3) as follows:

(3) Exception for general obligation programs. De minimis exception. Unless the issuer elects otherwise, disposition proceeds do not arise on the transfer of property financed with the proceeds of a general obligation program an issue if the requirements of this paragraph (c)(3) are satisfied. A general obligation program is an issue of general obligation bonds issued by a general purpose governmental unit that finances more than 75 discrete facilities or projects. The requirements of this paragraph (c)(3) are satisfied if--

Reasons. Circumstances arise in the day-to-day operations of any governmental unit, not merely large governmental units, that may result in the disposition of a portion of the property financed with the proceeds of the bonds. We believe that there is no justification for providing de minimis relief only to large issuers of general obligation bonds, and that any de minimis rule should apply to small issuers. For example, small issuers who finance enterprise improvements operated by departments of the issuer separate from general city administrative departments will have as difficult a time maintaining separate records as will large issuers. We also see no real justification for adding a de minimis exception for one type of bond issue (general obligation bonds) and not for other types of bond issues (e.g., revenue bonds). Large issuers of revenue bonds will have as difficult a time maintaining separate records as will large or small issuers of general obligation bonds.

We suggest that the restrictions of paragraph (3) of §1.141-1(c)(3) are entirely appropriate, but that the general rule should apply equally to all issuers and all types of issues.

§1.141-2 Move Provisions Relating to Certification and Add Examples of Compliance Procedure or Delete Requirement

Comment. To provide comprehensive direction to issuers of tax-exempt governmental bonds, the procedural matters referenced in §1.141-13(a)(1) and (3) should be moved to §1.141-2, conformed in language to §1.148-2(b)(2), and reorganized.

Suggested Regulatory Language. Modify §1.141-2 by adding a new paragraph (e) to read as follows:

(e) Procedure. (1) Certification of expectations. An officer of the issuer responsible for issuing the bonds must, in good faith, certify in the bond documents the issuer's expectations as of the issue date, regarding the use of proceeds of the issue. The certification must state the facts and estimates that form the basis for the issuer's expectations. The certification is evidence of the issuer's expectations, but does not establish any conclusions of law or any presumptions regarding either the issuer's expectations or their reasonableness. An issuer is not required to make a certification for an issue under this paragraph (e) (1) if the issue price of the issue does not exceed $1,000,000.

(2) Required covenant. The issuer must covenant on the issue date in the bond documents for the issue that it will take no action that would cause the bonds to be private activity bonds and that it will not fail to take any action that would prevent the bonds from being private activity bonds.

(3) Compliance procedures. The issue must establish reasonable procedures to ensure compliance with the covenant referenced in paragraph (e)(2). An example of such a procedure is the preparation of a certification to be retained in the records for the issue regarding the use of proceeds of the issue and of the property (if any) financed with the proceeds of the issue for each bond year during the term of the issue.

Reasons. The concepts of reasonable expectations and deliberate actions and evidence of compliance therewith are concepts that relate not only to whether a remedial action is appropriate, as referenced in §1.141-13(a), but also to whether there is compliance with all of the provisions of §§1.141-1 through 1.141-16. We suggest that the procedures for compliance should be covered in the section of the regulations that describes scope and general rules, similar to the inclusion in §1.148-2 (general arbitrage yield restriction rules) of procedures for compliance with arbitrage yield restriction regulations.

We also suggest that the wording of the certification requirement should substantially conform to the wording of the arbitrage certification requirement so as to prevent controversy regarding the (unspecified) reasons for differences in wording.

Although, for purposes of illustration, we have included the covenant requirement and the compliance procedure requirement in the suggested regulatory language above, we generally believe that it is inappropriate to include in the regulations a specified covenant or a requirement for establishment of a compliance procedure. We inquire regarding the enforcement of those requirements. (This concern is also raised by §§1.148-13(a)(1) and (a)(3), because those provisions imply that even if proper remedial action is taken, the action will not prevent taxability if there has not been satisfaction of the covenant requirement and compliance procedure requirement.)

We are also concerned that the necessity for establishment of a compliance procedure will create unnecessary costs for an issuer and may lead to the establishment of a "cottage industry" relating to compliance. We note particularly that, even though the rebate requirement requires ongoing procedures, the arbitrage yield restriction requirements do not require formal compliance procedures. We believe, similarly, that the private activity bond tests should not require the implementation of formal compliance procedures.

Based upon the above, we suggest that the requirement for establishment of a compliance procedure be deleted. As is true with arbitrage yield restriction requirements, we believe that issuers are able to establish any needed procedures without being required by regulations to establish those procedures.

If the requirement for establishment of compliance procedures is not deleted, we suggest that one or more examples (such as the one referenced in the suggested regulatory language above) of appropriate compliance procedures be added to the regulations to provide guidance to the issuers. This is a new concept and direction is needed.

A. §1.141-3(a)(3) Delete Sublease Example of Intermediate Use

Comment. To permit the continuance of customary lease financing of governmental facilities, the reference to subleasing as an intermediate use should be deleted.

Suggested Regulatory Language. Modify §1.141-3(a)(3) to read as follows:

(3) Ultimate and intermediate use. In determining whether an issue meets the private business use test, both the ultimate and intermediate uses of proceeds are taken into account. For example, a facility is treated as being used for a private business use if it is leased to a governmental person and then subleased to a nongovernmental person or if it is leased to a nongovernmental person and subleased to a governmental person, provided in each case that the non-governmental person's use is in a trade or business.

Reason. California governmental units often employ lease financing in order to finance public facilities. This type of financing entails a financing lease between a lessor and a governmental unit. The lessor may be another governmental unit (such as a joint powers authority) or it may be a nonprofit corporation or another entity (such as a leasing corporation). The structure of the financing may entail a sublease or a sub-sublease, but the use of a sublease arrangement with a non-governmental unit is not intended to convert the financing from a governmental financing to a private activity financing.

For example, if a City wished to use lease financing with certificates of participation to construct improvements to a City Hall, the City would lease the existing City Hall owned by the City to a lessor (which, as noted, could be a nonprofit corporation or a leasing company, as well as a governmental unit) and the lessor would sublease the City Hall, as improved, to the City. Certificates of participation in the sublease would be sold and the proceeds would be used to pay the costs of the improvements to the City Hall. In this case, the participation in the financing by the lessor is, at most, an intermediate use and that participation should be disregarded for purposes of the private business use test.

The need to apply the above structure is dictated by State law and, although it may be preferable to use as a lessor a governmental unit, rather than a private entity, this is not always possible under State law. (In the case of lease financings by California counties, for example, it is ordinarily not possible to identify a governmental unit that is able to act as lessor.) It should also be noted that, particularly in the context of refinancings, there may be a "string" of subleases that are necessary to assure the State law basis for the certificate of participation arrangement.

B. §1.141-3(b)(8) Delete "Discharge of Primary Legal Obligation" as Private Business Use

Comment. Discharge of primary legal obligation is not a business use of a governmental facility and should be deleted.

Suggested Regulatory Language. Delete §1.141-3(b)(8) in whole.

Reason. We suggest that the concept of "discharge of primary legal obligation" as expressed in §1.141-3(b)(8) is not appropriate because (i) it is imprecise and therefore cannot be meaningfully applied, (ii) it inappropriately characterizes development agreements, (iii) it will eliminate or adversely affect a substantial volume of traditional governmental bonds, and (iv) it can be avoided through modifications of form (although the result is the same). These reasons are each discussed below.

(i) Imprecise Rule. The phrase "discharge of primary legal obligation" is not sufficiently meaningful so as to provide guidance for its application.

The legal obligation of a nongovernmental person relating to public facilities may be created by local government in many ways and may be viewed as discharged by bonds in an equally unlimited number of ways. Through the exercise of each of its sovereign powers (taxation, police and eminent domain), a municipality may impose a legal obligation on a nongovernmental person. For example, in exercising the power of taxation, a municipality imposes a legal obligation to pay taxes; in exercising the power of eminent domain, a municipality imposes a legal obligation to convey property; in exercising the police power, a municipality imposes a legal obligation to comply with regulations imposed for public health and safety. Through the issuance of bonds, legal obligations imposed through the exercise of these powers can be discharged. For example, the legal obligation to pay taxes in a specified amount can be discharged through the issuance of refunding bonds that lessens the obligation to pay taxes in a higher amount; the legal obligation to convey land for park purposes can be discharged through the issuance of bonds to acquire the land for park purposes; and the legal obligation to discontinue the use of septic tanks can be discharged through the issuance of bonds to provide sewage facilities. The language of the concept, therefore, is so broad as to fail to provide guidance when applied to the customary activities of local governments.

The exception for "laws of general application" does not overcome the difficulties of application arising from the imprecise concept. Suppose, for example, that under the facts of the example set forth in §1.141-3(b)(8)(ii), the city had adopted an ordinance that required all property owners to dedicate streets and sidewalks in a configuration to be approved by the city as a condition to land improvement. Would that constitute an ordinance of general application? Does it matter whether the streets and sidewalks are ultimately provided by the city using one of its sovereign powers rather than another?

See, for example, the recent United States Supreme Court case of Dolan v. City of Tigard, 114 S.Ct. 2309 (1994). In that case a plumbing supply store owner wished to extend her store area and add parking. The city imposed, as a condition of approval, the obligation on the owner to dedicate property to the city for flood control improvements and a bicycle pathway. The case addresses the issue of whether that condition was a proper exercise of the police power and concludes that it was not an improper taking. Had the city exercised its power of eminent domain, issued bonds and acquired the flood control and bicycle pathway property, would said property be deemed to be used for the private business use of the plumbing supply store owner under the discharge of legal obligation concept? If the city did not threaten the exercise of the power of eminent domain but instead exercised the police power and issued the same bonds to acquire the property for the flood control improvements and bicycle pathway, would the improvements be deemed to be used for the private business use of the property owner? If the city instead exercised its taxing power and used a combination of tax revenues and proceeds of bonds payable from tax revenues to acquire different flood control improvements and a bicycle pathway, thereby alleviating the necessity for the property owner to dedicate the flood control improvements and pathway as originally designed, would those bonds cause the alternative flood control improvements and bicycle pathway to be used for a private business use?

Assume in all of the cases that the city had adopted an ordinance that required property owners to dedicate or install city-owned flood control improvements and bicycle pathways. Would that make a difference? As an alternative, assume in all of the cases that the State legislature had adopted a law requiring property owners to dedicate or install State-owned flood control improvements and bicycle pathways? Would that make a difference?

Can any real distinction be made regarding when a law of general application creates an exception to "discharge of unconditional primary legal obligation" and when it does not in the context of the above facts or otherwise? We think that those distinctions are not possible and that the provision itself, as well as the exception, will cause controversy, uncertainty and needless administrative difficulty.

In sum, we believe that the concept of "discharge of a legal obligation" as set forth in §1.141-3(b)(8) is too imprecise to enable practical implementation and that the exception for laws of general application does not eliminate the interpretive problems caused by the general rule.

(ii) Inappropriate Characterization of Development Agreements. The example set forth in §1.141-3(b)(8)(ii), in our view, inappropriately characterizes development agreements (especially those customarily used in California) as imposing unconditional legal obligations on developers to provide public facilities.

The requirement to install public improvements in California is the primary legal obligation of cities and other local government units in the jurisdiction where the public improvements are needed. These local government units frequently coordinate that installation with developers and other private property owners so as to cause the improvements to be installed in a location, and of a quality, appropriate to the community. In the context of bonds, this coordination takes one of three forms which we label, generally, acquisition, construction or refunding.

The most common approach is acquisition. With this approach, the developer installs public improvements using its own funds and title to the improvements vests in the developer. Upon completion of the improvements, or phases of the improvements, the local government unit issues bonds and acquires the public improvements from the developer. Thereafter, the acquired public improvements remain the property of the local government unit and are maintained and replaced, when necessary, by the local government unit.

The second approach is construction. With this approach, the local governmental unit hires the developer to construct the public improvements. Bonds are issued to fund the costs of the improvements and, as with a general contractor, bond proceeds are used to make progress payments. Upon completion of the improvements, title thereto vests in the local government unit.

The third approach is refunding. With this approach, the developer loans funds to the governmental unit for purposes of construction of the public improvements. Upon completion of the improvements, title vests in the local government unit. The local government unit then issues bonds and uses the proceeds to refund (i.e., repay) the loan made to it by the developer.

All three approaches are often in the context of a developer agreement designed to coordinate public and private land uses.

In California, development agreements are the primary tool by which local governments provide for public improvements in areas of new growth and in areas of urban blight. These agreements are entered into as a part of a comprehensive scheme for land use controls of Statewide importance and represent one step in overall planning for ultimate use of property in local communities. Thus, if a developer or other property owner proposes to use property, that use will be controlled for the benefit of the community as a whole, that control may be achieved through the issuance of a number of permits and approvals, and those permits and approvals will be conditioned upon the installation of public improvements. To achieve orderly implementation of the proposed land use and coordination of the various requirements of overlapping local governmental units, the lead governmental unit (at least) will ordinarily enter into a development agreement with a developer or other property owner. That agreement will define the limits of desired use, will establish procedures for issuance of conditional and final permits and approvals and will provide for payment of costs of public improvements using one of the three approaches described above.

The need for public improvements and the requirement for payment of costs of those public improvements are facets of the goal of orderly growth. To view these as constituting a primary obligation of the developer or property owner is to compress inappropriately the land use planning efforts of California communities to the single act of a nongovernmental person.

The statutory scheme of land use planning in California is intricate and relates to any new use of property. This scheme includes, but is not limited to, the following:

(i) The requirement that each city adopt a general plan (Government Code §65300);

(ii) The requirement that each general plan include, among other matters, specified "elements," each of which elements necessitates public improvements (Government Code §65302);

(iii) The requirement that the planning agency in each city recommend means for implementation of the elements of the general plan so as to assure orderly growth and development and the efficient expenditures of public funds (Government Code §65400);

(iv) The permissive ability for the planning agency to adopt a "specific plan" for all or any part of the general plan area (Government Code §65450), including diagrams specifying in detail public improvements and a program of implementation including financing measures (Government Code §65451);

(v) The requirement that tentative and final "subdivision maps" be approved (including conditional approvals subject to completion of enumerated improvements) for division of property into five or more parcels for sale, lease or financing (Government Code §§66410 et seq.);

(vi) Requirements imposed under, or in connection with, the subdivision map act by local ordinance for (A) dedication of parks (Government Code §66477), (B) schools (Government Code §§65970 et seq.), (C) reservations for recreational facilities, fire stations, libraries and other public uses (Government Code §§66479 et seq.), (D) dedication for streets, alleys, drainage, public utilities and other public easements (Government Code §66475.2), (E) fees to defray costs of construction of drainage and sanitary sewage facilities (Government Code §66483), (F) fees to defray costs of construction of bridges, railways, freeways, major thoroughfares and canyons (Government Code §66484), (G) fees or other consideration for ground water recharge (Government Code §66484.5, and similar provisions for public improvements, all of which may be financed with bond issues;

(vii) The requirement for special development permits in certain environmentally sensitive areas (e.g., Public Resources Code §§ 30600 et seq. relating to coastal zones);

(vii) The requirement for environmental impact reports for discretionary actions taken by a city including the installation of public improvements as "mitigation measures" for avoidance of significant environmental effects (Public Resources Code §§ 21000 et seq.); and

(viii) The requirement for redevelopment areas to have a redevelopment plan including streets and open spaces (Health and Safety Code §§ 33330 et seq.).

The development agreement law (Government Code §§65864-65869) specifically provides for development agreements implementing some of the above provisions. These agreements customarily include provisions for public facilities. Government Code §65864(c), for example, provides:

(c) The lack of public facilities, including, but not limited to, streets, sewerage, transportation, drinking water, school and utility facilities, is a serious impediment to the development of new housing. Whenever possible, applicants and local governments may include provisions in agreements whereby applicants are reimbursed over time for financing public facilities.

(We understand that similar development agreement statutes have been enacted in other States, e.g., Ariz. Rev. Stat. Ann. § 9-500.05 (1990); Colo. Rev. Stat. §§ 24-68-101 to 24-68-106 (1988); Fla. Stat. Ann. §§ 163.3220-163.3243 (1990); Haw. Rev. Stat. §§ 46-121 to 46-132 (1985); Nev. Rev. Stat. Ann. § 278.0201; N.J. Stat. Ann. § 40:55D-45.2 (1990).)

In addition to enactment by State statute, California cities and counties enact individual land use planning controls. According to one article (Growth Control by the Ballot Box: California's Experience, Daniel J. Curtin, Jr. and M. Thomas Jacobson, 24 Loyola of Los Angles Law Review 1073), 71 percent of California's cities and 75 percent of California's counties have enacted some type of growth restrictions. Between 1971 and 1990, 202 growth control measures were placed on local ballots and, of these, 136 were placed on local ballots between 1986 and 1990. It is apparent that orderly growth is a public concern of California citizens beyond private business use, and that public improvements are an essential part of that public concern.

In sum, development agreements are one tool by which growth is controlled and managed. The installation of public improvements is central to orderly growth and the financing of those improvements through the issuance of governmental bonds is one alternative for payment of costs. It is simply not a question of using the development agreement to impose legal obligations on developers or other property owners to install improvements; rather, it is a question of using development agreements to accomplish an overall Statewide public policy. Moreover, as indicated above, the ultimate legal responsibility for providing public improvements rests with the governmental unit. We therefore believe that the characterization, in §1.141-3(b)(8)(ii), of a development agreement as imposing a primary unconditional legal obligation upon a developer to install public improvements as a condition to issuance of a building permit is inappropriate.

(iii) Adverse Effect Upon the Ability to Finance Public Improvements. We do not believe that Congress intended to eliminate bond financing for public improvements in new growth or blighted areas by the enactment of Code section 141(b). The fact that special tax assessment bonds for essential governmental functions is specifically retained as an exception to the private loan financing test is evidence of our conclusion regarding Congressional intent. Yet, the retention of the concept of private business use arising by reason of discharge of a primary unconditional legal obligation imposed pursuant to a development agreement will have the effect of eliminating or significantly curtailing issuance of public infrastructure bonds, particularly assessment and special tax bond issues in California as referenced below.

In California, although a variety of types of bonds are issued to finance public improvements, including tax increment bonds, the primary types of bonds issued to finance public improvements necessitated by population growth are improvement bonds secured by special assessments ("Special Assessment Bonds") and issued under the Improvement Bond Act of 1911 (Streets & Highways Code §§ 6400 et seq.), the Improvement Bond Act of 1915 (Streets & Highways Code §§ 8500 et seq.) and charter city bond ordinances, and community facilities district bonds secured by special taxes ("Special Tax Bonds") issued under the Mello-Roos Community Facilities Act of 1982 (Government Code §§53311 et seq.) and under charter city bond ordinances. Setting aside consideration of the private loan financing test of §1.141-5 (as discussed below), and assuming (i) that §1.141-3(b)(8) is applied in its broadest sense, namely, as characterizing bonds issued for public improvements installed pursuant to the terms of development agreements as being issued for a private business use, and (ii) that the private security or payment test is satisfied for Special Assessment Bonds and Special Tax Bonds, then substantially all of the Special Assessment Bonds and Special Tax Bonds issued in California will not be able to be issued on a tax-exempt basis. This result would occur because substantially all of the Special Assessment Bonds and Special Tax Bonds now issued in California are issued to finance public improvements referenced as conditions in development agreements.

The exception of §1.141-3(f)(2) for "temporary use by developers" is likely to be of little assistance. (Indeed, it seems an odd exception to apply for such an unequivocal declaration of private business use as is represented by "discharge of an obligation.") This exception requires, among other things, that the developer reasonably expect on the issue date that the related property will be sold to members of the general public within three years of the issue date. In our view, the three-year reference does not reflect the modern context for property development in California and contains a "catch-22". Developers cannot begin to sell properties in a development until public improvements are completed. Even the smallest, least environmentally-sensitive development, may require three years for installation of pubic improvements (assuming good weather), three years for home construction (assuming good weather) and three years for home sales (not taking into account the extended periods required for plan approvals and home design).

Small developments in California, however, are the exception not the rule. In the context of the Statewide concern for coordinated growth as discussed above, many new developments in California are "planned development units" that are self-sustaining whole communities with not only local public improvements, such as streets and sidewalks, but also large general public improvements, such as fire stations, police substations, schools and parks. The private properties in these communities contain residential, commercial and, sometimes, industrial facilities appropriate for the new community. These are coordinated, regional, planned developments that require many years for completion, where land sales are often made by developers to merchant builders, not to members of the public directly. These are areas where costs and responsibilities are shared by the local government units and private developers. Local government units pay for the costs of the governmentally-owned public improvements with Special Assessment Bonds and Special Tax Bonds and developers pay the costs of the homes, stores and other improvements to be privately-owned. The three-year limitation is largely impractical.

We also note technical difficulties with the exception. The burden upon issuers to have reasonable expectations regarding private land sales is improperly placed or will have little meaning since the speed with which private land is sold is a function of the economic environment and the developer control. We also inquire as to the proper identification of "related property" in the context of a development. Exactly which parcels are to be identified as being required to be sold in three years? Also, who is a developer? What about the parcels that are not to be sold in the near-term or at all? How should sale to merchant builders be handled? We expect that similar questions will arise in the context of actual implementation of the rule. If the rule of §1.141-3(b)(8) and the exception of §1.141-3(f)(2) are retained, we request that guidance be provided regarding these questions and the application of the exception to the general rule.

(We also note, based upon our involvement in the legislative history of the Tax Reform Act of 1986 and our close consultation, on behalf of the National Association of Bond Lawyers, in the development of that history that the concept of use by developers of public improvements in a subdivision, and the concept of proceeding with all reasonable speed to develop and sell land in the development, as referenced in the House Report on page 523, was deliberately and intentionally omitted from the Senate Report because of the great controversy that arose following the release of the House Report containing those provisions. The Conference Report adopted the Senate Report. The inclusion of the requirement for "sale" in the General Explanation overreached and, in our view, was incorrect.)

(iv) Technical Avoidance of Constraint. Five or more approaches could be taken to avoid the application of §1.141-3(b)(8). We are reluctant to apply these approaches in the context of rendition of an unqualified opinion without further guidance in the regulations. If it is believed that any one of these approaches is acceptable, we would suggest that guidance approving these approaches be provided in the regulations.

The first approach for avoidance of §1.141-3(b)(8) is to apply the exception for "laws of general application." Under this approach, it is argued that the land use planning scheme, including the statutory provisions for developer agreements referenced above, constitutes a law of general application. Therefore, even though a developer may agree in a development agreement to install public improvements, the issuance of bonds to finance those improvements does not discharge a primary legal obligation of the developer since a primary legal obligation does not include a law of general application.

The second approach for avoidance of §1.141-3(b)(8) is to assure that the obligation of a developer in a development agreement to install public improvements is not unconditional. The issuance of Special Assessment Bonds is subject to detailed proceedings, including a public hearing, and the issuance of Special Tax Bonds is subject to an election within the designated community facilities district boundaries and, moreover, it is always possible to insert a condition in development agreements.

The third approach for avoidance of §1.141-3(b)(8) is to distinguish the example contained in §1.141-3(b)(8)(ii) on its facts. In that example, "District, a political subdivision" is created. Although California Special Assessment Bonds entail the creation of an "assessment district," the same is a benefit district with no independent existence; and although California Special Tax Bonds entail the creation of a community facilities district, stated in Government Code §53312 to be a "governmental entity established for the purpose of carrying out specific activities within definitely defined boundaries," a community facilities district is not a political subdivision in that it does not possess the sovereign power of eminent domain. Therefore, the example does not apply. (We believe, in fact, that the Service may have intended that the example in §1.141-3(b)(8)(ii) be similar to the facts of private letter ruling 8630027, dated April 25, 1986, where a single landowner road district possessing the powers of taxation and eminent domain, but not the police power, was held not to be a political subdivision, and therefore bonds issued by the road district were not tax-exempt. The example in §1.141-3(b)(8)(ii) essentially reverses this ruling by finding that the District is a political subdivision, but nevertheless states that the bonds are not tax-exempt for other reasons, notwithstanding the use of proceeds for governmentally-owned streets and sidewalks. We disagree with both results.)

The fourth approach for avoidance of §1.141-3(b)(8) is to distinguish the example contained in §1.141-3(b)(8)(ii) by the fact that it relates to a building permit, while the installation of public improvements is ordinarily first a condition of a land use permit or subdivision map approval.

The fifth approach for avoidance of §1.141-3(b)(8) is to require cities and counties in development agreements to state that installation of public improvements for the area in question is the primary legal obligation of the city or county and either to eliminate reference to the developer in the portion of the agreement relating to public improvements or to delete all reference to public improvements from the agreement.

In sum, because the provision regarding discharge of primary unconditional legal obligation (i) is imprecise, (ii) inappropriately characterizes development agreements, (iii) will eliminate a substantial number of traditional bond issues, and (iv) is easily avoided through technical interpretations, we suggest that §1.141-3(b)(8) be deleted.

C. §1.141-3(b)(10) Modify Concept of Actual or Beneficial Use to Refer to "Arrangements"

Comment. We suggest that the expression of private business use as meaning "any" actual or beneficial use other than use as a member of the general public exceeds the scope of the private business use test in that it does not refer to use "pursuant to an arrangement."

Suggested Regulatory Language. Modify §1.141-3(b)(10) as follows:

(10) Other actual or beneficial use. For purposes of the private business use test, use includes any other actual or beneficial use of a financed facility pursuant to a direct or underlying arrangement between a governmental unit and a nongovernmental person, other than use as a member of the general public (as defined in paragraph (e) of this section).

Reason. We suggest that the insertion of the concept of an "arrangement" for use in §1.141-3(b)(10) is appropriate for the following reasons: (i) without the insertion of the concept of an arrangement, §1.141-3(b)(10) expands the basic rule of §1.141-3(b)(2); (ii) without insertion of the concept of an arrangement, §1.141-3(b)(10) inappropriately applies Code section 141(b)(6) (definition of private business use); and (iii) Congress intended that use be predicated upon the existence of a direct or underlying arrangement for use. These reasons are each discussed below.

(i) The Specific Rule of §1.141-3(b)(10) Inappropriately Expands the General Rule of §1.141-3(b)(2). Section 1.141-3(b)(2) correctly defines the scope of the private business use test by stating that a nongovernmental person uses proceeds of an issue for the purposes of the private business use test if it owns or leases financed property, is loaned the proceeds of an issue, or has actual or beneficial use of the financed property under a management or incentive payment or contract, output contract "or other arrangement." Section 1.141-3(b)(10), however, enlarges the concept of §1.141-3(b)(2) by referring to "any actual or beneficial" use of a financed facility (other than general public use as discussed below). Thus, under §1.141-3(b)(10), a facility is deemed to be used for a private business use in all cases unless an exception applies and, under §1.141-3(e), an exception applies for general public use. We suggest that the opposite approach is appropriate; namely, a facility is not deemed to be used by a nongovernmental person in all cases unless an arrangement (direct or underlying) indicates otherwise.

(ii) The Rule of §1.141-3(b)(10) Inappropriately Expands the Rule of Code Section 141(b)(6). Although not stated, we believe that the Service is concerned regarding the correct application of Code section 141(b)(6) in the context of Code section 141(b)(1) (private business use test). For reference, Code section 141(b)(6) reads as follows:

(6) PRIVATE BUSINESS USE DEFINED.--

(A) IN GENERAL.--For purposes of this subsection, the term "private business use" means use (directly or indirectly) in a trade or business carried on by any person other than a governmental unit. For purposes of the preceding sentence, use as a member of the general public shall not be taken into account.

(B) CLARIFICATION OF TRADE OR BUSINESS.--For purpose of the 1st sentence of subparagraph (A), any activity carried on by a person other than a natural person shall be treated as a trade or business. (Emphasis added.)

We think it probable that the Service has approached the relationship of Code section 141(d)(6) (private business use defined) and Code section 141(b)(1) (private business use test) by applying the following inappropriate reasoning:

(i) all activities of a non-natural person constitute private business use; and

(ii) the exception is general public use.

We believe, however, that the correct approach to the relationship of Code sections 141(b)(1) and 141(b)(6) is as follows:

(i) all activities of a non-natural person constitute private business;

(ii) use for a private business is private business use; and

bond proceeds for a private business use on the same basis as members of the general public is the exception.

In other words, we do not believe that all activity is private business use and that such use is permissible only under an exception for public use; rather we believe, there first must be a determination that a particular activity is a "use" within the meaning of Code section 141(b)(1) and, having so determined, only then must one consider whether that use is general public use. Thus, there is an interim step between finding the existence of an "activity" and making an exception for general public use. That interim step is finding that the activity is a use. (And, as discussed below, a finding that an activity is a use is only permitted if there is an "arrangement" for such use.)

If what we believe is the Service's reasoning did apply, then there would be no need for the many provisions of the regulations regarding specific types of use, such as leases, management contracts, research contracts, output contracts and the like (for all use would constitute private business use). It would only be necessary to identify the exceptions to use such as qualified management contracts, use as an agent, and the like. The proposed regulations, however, do contain multiple provisions regarding leases, management contracts, research contracts, output contracts, and other types of use. The proposed regulations therefore recognize that all use is not private business use; i.e., that there is an interim step between the "activity" of a nongovernmental person and the characterization of that activity as excepted general public use.

Based upon our close involvement in the enactment of the Tax Reform Act of 1986, we recognize that Code section 141(b)(6) was included in Code section 141(b) in order to forestall arguments that a particular activity of a non-natural person was not a "trade or business." For example, some had asserted that if a profit did not arise from an activity it was not a trade or business or that if the activity led to a deduction from trade or business income, the undertaking of that activity was not itself a trade or business. To prevent these difficult distinctions, section 141(b)(6) was added to the Code. Effectively, therefore, the purpose of Code section 141(b)(6) was to assure that the focus of the private business use test was on whether there was a use of financed improvements, rather than whether a trade or business was involved.

The intent of the addition of paragraph (6) was not to change the fundamental application of Code section 141(b). This is clear from the legislative history references that the Code section was to be applied using existing interpretations. For example, the Conference Report states:

The conferees intend that, to the extent not amended, all principles of present law continue to apply under the reorganized provisions. (H. Conf. Rep. No. 99-841, page II-686.)

The fact that use is to be defined more narrowly than meaning "any actual or beneficial" use, is also required by the wording of paragraph (6) itself. Subparagraph (B) of paragraph (6) states that the rule that any activity of a non-natural person is a private business use is for "purposes of the 1st sentence of subparagraph (A)." The first sentence of subparagraph (A) provides that the term "private business use" means use in a trade or business carried on by any person other than a governmental unit. It is necessary first to determine, therefore, what is "use". As guidance, the second (and only other sentence) of subparagraph (A) provides that use as a member of the general public is not taken into account as use. The second sentence does not however define use; it merely sets for an exception to use once found.

(iii) Congress Intended to Limit the Application of the Private Business Use Test to Use Arising from an Arrangement. We believe that Congress intended that the private business use test was to be applied only in the context of an "arrangement" for private business use. Actual or beneficial use alone, without an "arrangement," was not intended by Congress to constitute private business use for purposes of the private business use test. Thus, in each context in which there is private business use, there must also be an "arrangement" for that private business use with respect to the bond-financed facility. For example, arrangements resulting in private business use include (i) an arrangement by a governmental unit for ownership of a financed facility by a nongovernmental person, (ii) an agreement (arrangement) for lease of a bond-financed facility by a nongovernmental unit, (iii) a contract for management of a bond-financed facility, (iv) a take-or-pay contract relating to output of a bond-financed facility, (v) a contract under which research in a bond-financed facility is sponsored, and (vi) an arrangement for preferential or priority use of a bond-financed facility.

The last reference above, preferential use, is of particular interest in applying the concept of an "arrangement" in that preferential use may be the result of an underlying arrangement rather than an explicit arrangement. If an underlying arrangement for preferential use in fact existed or could (or should) be implied by reason of, for example, geographic isolation, then private business use of the facility would result even though there was not a written agreement for preferential use.

The concept of an arrangement as a condition precedent to a conclusion of private business use is supported by the legislative history of Code section 141(b). In describing the concept of use as contained in the H.R. 3838, the House Report indicates as follows:

The general concept of use applicable under present law is retained under the bill. Thus, as under present law, a person may be treated as a user of bond proceeds or bond-financed property as a result of (1) ownership, or (2) actual or beneficial use of the property pursuant to a lease, a management or incentive payment contract, or an arrangement such as a take-or-pay or other type of output contract. (H. Rep. No. 99-426, page 521. Emphasis added.)

The emphasis is upon "actual or beneficial use . . . pursuant to an arrangement." Moreover, the reference to "treated as a user" indicates that something less than "any" use was required for the test. Thus, the House Report also states,

In the case of most nonessential function bonds, the determination of the nongovernmental user of the facilities will be clear, since one such person or a limited group of such persons will use most or all of the facility subject to an identifiable lease, contract, or other arrangement that differentiates that person's use of the facility from the use by the public at large. Id. (Emphasis added.)

The House Report further states, when discussing the use of a school building by community groups as not constituting private business use, the following:

Use by such community groups must be incidental to the governmental function of the building and the building must be available for use on an equal basis by all such groups for the nongovernmental use involved to be disregarded. Similarly, the fact that the groups are charged a de minimis fee to cover costs of custodial services provided in connection with the use is disregarded provided there are no special arrangements with any one group for use other than as a member of the general public. (Id. at page 522. Emphasis added.)

See also the Conference Report, where it is stated as follows:

As under present law, a person may be a user of bond proceeds and bond-financed property as a result of (1) ownership or (2) actual or beneficial use of property pursuant to a lease, a management or incentive payment contract, or (3) any other arrangement such as a take-or-pay or other output-type contract. (H. Conf. Rep. No. 99-841, page II-687--II-688. Emphasis added.)

We suggest that the concept of arrangement is as important to the private business use test as it is to the security or payment test discussed below and that the concept of a direct or underlying arrangement for use will satisfy the Service's concern that a bond-financed facility is designed for a specific private business use even though there is not a specific contract relating to that private business use.

We also believe that if this approach (i.e., private business use arising by reason of an "arrangement" for that use) is taken in the regulations, the administration of the regulations by the Service and the application of the regulations by the public issuers will be eased.

D. §1.141-3(c)(2) Clarify Net Profits Concept in Context of Loan by Manager under Qualified Management Contract

Comment. Clarify whether compensation is based on a share of net profits where the manager under a qualified management contract defers management fees with interest.

Suggested Regulatory Language. Amend §1.141-3(c)(2) by adding new clause (iii) as follows:

(iii) The deferral of compensation due to the service provider does not cause the compensation to be based on a share of net profits if the arrangement for deferral provides for interest at a rate that is reasonable taking into account the circumstances of the deferral.

Reasons. We would first like to compliment the Service on proposed management contract provisions which reflect, to a great extent, modern business practices and contractual arrangements.

We note, however, that the case of enterprise financings, including hospital enterprises, the compensation due to a manager or other service provider under a qualified management contract is ordinarily subordinate to debt service on issues issued to finance the enterprise. In the case of financial difficulties of the enterprise, there may be insufficient revenues to pay compensation due to the manager for services performed. In such circumstances, it is appropriate to enter into an arrangement with the manager under the qualified management contract providing for the due payment of compensation in arrears with interest.

Assuming that a management agreement is in all other respects a qualified management contract, the payment of the compensation in arrears with interest in the event of late payment should not cause the contract to be viewed as unqualified. The manager or service provider in those cases is not receiving a share of net profits that relate to the period during which the services were performed; rather the debt arose in the normal course of business and was incurred without regard to the net profits of the enterprise.

Because this matter is unclear, we suggest that the regulation be clarified, as indicated above or otherwise, to respond to the issue.

E. §1.141-3(e) Modify Definition of General Public Use

Comment. Although the concept that private business use does not include general public use should be retained, the detailed definition of general public use should be eliminated.

Suggested Regulatory Language. Modify §1.141-3(e)(1) - (4) as follows:

(e) Exception for general public use--(1) General public use--(i) In general. Private business use does not include use as a member of the general public (general public use). Use of a financed facility by nongovernmental persons in their trades or businesses is treated as general public use only if--

(A) The facility is intended for use by the general public; and

(B) The use by those nongovernmental persons is reasonably expected to be on the same basis as use by other members of the general public.

(ii) Relation to other use. Use of a financed facility by the general public does not prevent the proceeds from being used for a private business use because of other use under this section.

(2) Intended for use by the general public. (i) Number of users. A facility is not intended for use by the general public if less than 25 percent of the reasonably expected direct use of the facility is by persons that individually account for no more than 1 percent of the use of the facility.

(ii) Persons constituting the general public. Although the general public ordinarily includes natural person not engaged in trades or businesses, the general public may consist entirely of a large number of nongovernmental persons engaged in different types of trades or businesses. The general public cannot consist predominately of a large number of nongovernmental persons engaged in the same type of trade or business. For example, an electric transmission line used by a large number of electric utilities is not used by the general public. See, however, Example 6 of paragraph (h) of this section.

(3) Use on the same basis--(i) Use related to other facilities--(A) General rule. The use of a financed facility by a nongovernmental person is not on the same basis as use by the general public if the financed facility is functionally and integrally related to another facility that is used by that nongovernmental person (the primary facility) and significant economic benefits with respect to the primary facility arise from the use of the related facility that are not available to the general public. If more than 75 percent o the use of the related facility is by the general public and not use in connection with the primary facility, the benefits to the primary facility are treated as insignificant for this purpose.

(B) Functionally and integrally related. Generally, a facility is not functionally and integrally related to a primary facility for this purpose if it is not a necessary component of the primary facility. Examples of facilities that re typically functionally and integrally related to other facilities in a manner that results insignificant economic benefits are parking lots at airports, stadiums, and shopping centers, and utility and other infrastructure improvements for a new development stadium, or airport. On the other hand, a parking lot in a large urban business district where there are many separate businesses typically does not produce significant benefits to any particular person.

(ii)(2) Priority rights or other preferential benefits. Use under an arrangement that conveys priority rights or other preferential benefits is not use on the same basis as the general public. Arrangements for a term of more than one month generally convey preferential benefits. 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;

(ii) Users are permitted to reserve short-term or incidental use in advance;

(iii) Existing users, each using less than 1 percent of a financed facility, possess rights of first refusal to renew their use at generally applicable, fair market value rates that are in effect at the time of renewal; and

(iv) A specially negotiated arrangement is entered into, but only if the user is prohibited by federal law from paying the generally applicable rates, and the terms of the arrangement are as comparable as reasonably possible to the generally applicable rates.

(4) Special rules for system improvements. For improvements to existing public utility or infrastructure systems such as roads or sewers, but not discrete structures such as parking facilities (system improvements), whether the use of a system improvement is general public use may be determined by reference to the system as a whole if the system improvement is insubstantial, based either on aggregate cost or scope relative to the system as a whole within the jurisdiction of the issuer. Except in the case of improvements to roads, a system improvement is insubstantial for this purpose if the cost of the system improvement is less than 5 percent of the cost of the system as a whole. In addition, in determining whether the use of a system improvement by the general public is insubstantial, paragraph (e)(3)(i) of this section (relating to use related to other facilities) does not apply.

(Conforming changes will need to be made to the examples in §1.141-3(e)(5).)

Reasons. We suggest that use of a financed facility by nongovernmental persons in their trades or businesses should be treated as general public use only if (i) the facility is intended for use by the general public, (ii) the use by those nongovernmental persons is reasonably expected to be on the same basis as use by other members of the general public, (iii) the use by those persons is not under an arrangement that conveys priority rights or other preferential benefits, and (iv) the use of a financed facility by the general public does not prevent the proceeds from being used for a private business use by reason of an arrangement for use, as otherwise referenced in §1.141-3 (i.e., ownership, lease, management under other than a qualified management contract, research sponsorship and the like), all as otherwise referenced in §1.141-3(e).

We do not believe, however, that the legislative history, the existing rulings or other parts of the proposed regulations provide authority for paragraphs (2)(i), (2)(ii), (3)(i), (3)(ii)(C) and (4) of the proposed regulations.

Paragraphs (2)(i) and (3)(ii)(C). With respect to paragraph (2)(i) (relating to use of 25 percent by persons that use one percent or less) and paragraph (3)(ii)(C) (relating to renewal rights of one percent users), we note that there is no indication in the legislative history or otherwise that the number of members of the general public can be measured. A multiple of persons or one person can be the general public. Thus, for example, the House Report indicates as follows:

Bonds may be essential function bonds [i.e., not private activity bonds] even though one industrial customer, or a limited group of customers, indirectly receive the benefit of an amount of bond proceeds in excess of [10%] as long as the benefit it receives is not other than as a member of the general public. (H. Rep. No. 99-426, page 524. Emphasis added.)

The implication of the above statement is that persons may use a facility as members of the general public without regard to the number of total users. It therefore should not be necessary to demonstrate that 25 percent of a facility is used by users that individually use 1 percent or less, or that certain renewal rights are acceptable only for one percent users.

Additionally, qualifying and substantiating such uses in most public facilities will be impractical.

Paragraph (2)(ii). With respect to paragraph (2)(ii) (relating to exclusion of same types of business), we question the authority for the statement that the general public cannot consist predominately of a large number of nongovernmental persons engaged in the same type of trade or business, as well as the reference to the use of an electric transmission line by a large number of electric utilities as not being use by the general public. We note particularly Example 1 of §1.141-7(e) of the proposed regulations in which it is implied that no private business use arises by reason of the use of 40 percent of the output of a tenant in common interest of a financed electric generating facility by "numerous other private utilities under a prevailing rate schedule." (This example is substantially the same as Example (13) of existing regulations §1.103-7(c) where there is no indication that use by "numerous other private utilities" of a facility is anything other than general public use.) Since the Service appears to indicate in §1.141-7(e) that use by the same type of business is acceptable, the prohibition of use by the same type of business in §1.141-3(e)(2)(ii) is not appropriate and, in fact, directly conflicts with §1.141-3(e)(2)(ii).

Additionally, we note both that identifying the "same type" of use is likely to cause significant controversy and that the provision appears particularly biased against agriculture.

Paragraphs (3)(i) and (4). With respect to paragraphs (3)(i) and (4) (regarding use related to other facilities and the special rule for system improvements), we again are concerned that the concept of general public use is not appropriate for measurement. We believe that the rules of these paragraphs may derive from the public use requirement contained in regulations §1.103-8(a)(2). There it is stated (in the context of a requirement relating to private activity bonds for exempt facilities) as follows:

. . . a facility must serve or be available on a regular basis for general public use, or be part of a facility so used, as contrasted with similar types of facilities which are constructed for the exclusive use of a limited number of nonexempt persons in their trades or businesses. For example, a . . . dock or wharf . . . serving only a single manufacturing plant would not qualify as a facility for general public use, but a hangar or repair facility at a municipal airport, or a dock or a wharf, would qualify . . . provided that [it] directly services the general public. . . . However, a landing strip which, by reason of a formal or informal agreement or by reason of geographic location, will not be available for general public use does not satisfy the public use requirement.

We believe the above provisions indicate that the public use requirement (in the context of exempt facility private activity bonds) is not satisfied if there is an intent for nonpublic use and, in addition, an arrangement for nonpublic use. Thus, if there is an arrangement for nonpublic use (see discussion above) of, for example, a dock serving a manufacturing facility or a landing strip that will not be used by the general public due to its location, for example, as adjacent to a private business facility, then that facility does not service the general public.

In our view, the concept of §1.103-8(a)(2) should be applied to the concept of general public use as referenced in §1.141-3(e). Thus, (i) if the financed facility is available on a regular basis for general public use or is a part of a facility so used, (ii) if the financed facility directly serves the general public, (iii) if there is no formal or informal arrangement for use by a specified private business user, and (iv) if by reason of geographic location it cannot be concluded that the facility is not available for general public use, then the facility should be deemed to be used by private business users on the same basis as the general public.

We also note that the legislative history stresses the concept of financing "activities." If a private activity is being financed, the bonds should be characterized as private activity bonds. If, however, there is merely a negation of general public use, it does not follow that a private "activity" is being financed and the bonds should not be characterized as private activity bonds.

The House Report states, for example, as follows:

In determining whether interest on a particular obligation of a qualified governmental unit is tax-exempt, a three-part inquiry is made. First, the activity being financed and thereby the type of bond being issued, must be determined. (The type of bond is generally determined by the use of bond proceeds.) Second, the authority of the issuer to issue the tax-exempt debt must be established. Finally, compliance with Internal Revenue Code rules governing tax-exempt bonds for the activity being financed must be established. (H. Rep. No. 99-426, page 492. Emphasis added.)

Qualified governmental units may issue tax-exempt bonds to finance general governmental operations and services, such as schools, courthouses, roads, and governmentally-owned and operated water, sewer and electric facilities, without regard to most of the restrictions (including volume limitations) that apply to bonds used to finance activities of nongovernmental persons (other than section 501(c)(3) organizations). (Id. at pages 492-493. Emphasis added.)

Thus even if it is conceded that a governmental facility, for example, a courthouse, is "used" by nongovernmental persons (e.g., lawyers), it was the Congressional intent that the private business use test only be satisfied if "activities" of nongovernmental persons were financed. In the case of traditional governmental facilities, such as those listed in the statement, governmental activities, rather than private activities, are being financed.

Present law does not contain a definition of when bond proceeds are used for governmental activities. Rather bonds are treated as governmental and the interest thereon is tax-exempt unless a prescribed amount of the bond proceeds is used for activities of nonexempt persons (i.e., persons other than qualified governmental units or section 501(c)(3) organizations). (Id. at page 493. Emphasis added.)

In sum, the general public use provisions should be modified to delete the detailed definition of "general public," because (i) measurement of general public use is not required by the Code or legislative history, (ii) no prohibition of the same type of business is included in the output contract rules or otherwise and (iii) only the financing of affirmative private "activities" is restricted by the Code, not the financing for general public use.

F. §1.141-3(e) If the Detailed Definition of General Public Use is Retained, Add Definitions of New Terms

Comment. A number of new terms are used in §1.141-3(e). If this section is retained as written, it cannot be effectively implemented by the issuers or the Service unless those terms are defined. In particular the following terms require definition: "predominantly" (for the purpose of measuring compliance with §1.141-3(e)(2)(ii)); "same type of trade or business" (for the purpose of measuring compliance with §1.141-3(e)(2)(ii)); and "cost" (for the purpose of measuring compliance with §1.141-3(e)(4)).

Suggested Regulatory Language.

(i) Modify §1.141-3(e)(2)(ii) as follows:

(ii) Persons constituting the general public. Although the general public ordinarily includes natural person not engaged in trades or businesses, the general public may consist entirely of a large number of nongovernmental persons engaged in different types of trades or businesses. The general public cannot consist predominately of a large number of nongovernmental persons engaged in the same type of trade or business. For example, an electric transmission line used by a large number of electric utilities is not used by the general public. See, however, Example 6 of paragraph (h) of this section. For purpose of this clause (ii), the term "predominantly" means 95 percent or more, when measured against the total use of the bond-financed facility, measured in accordance with §1.141-3(i); and the term "same type of trade or business" means having the same standard industrial classification ("SIC" Code) determined under the Standard Industrial Classification System authorized by the Regulatory and Statistical Analysis Division, Office of Information and Regulatory Affairs, Office of Management and Budget.

(ii) Modify §1.141-3(e)(4) as follows:

(4) Special rules for system improvements. For improvements to existing public utility or infrastructure systems such as roads or sewers, but not discrete structures such as parking facilities (system improvements), whether the use of a system improvement is general public use may be determined by reference to the system as a whole if the system improvement is insubstantial, based either on aggregate cost or scope relative to the system as a whole within the jurisdiction of the issuer. Except in the case of improvements to roads, a system improvement is insubstantial for this purpose if the cost of the system improvement is less than 5 percent of the cost of the system as a whole. In addition, in determining whether the use of a system improvement by the general public is insubstantial, paragraph (e)(3)(i) of this section (relating to use related to other facilities) does not apply. For purpose of this paragraph (4), the term "cost" means, in the context of the cost of the system as a whole, replacement cost and, in the context of the cost of a system improvement means actual cost paid from the proceeds of the issue financing that improvement.

Reason. Many of the concepts in §1.141-3(e) are new. The application of these concepts to specific facts will be particularly difficult if terms used in the concepts are not defined. Such difficulty could produce unnecessary administrative burdens for the Service and for issuers. We particularly recommend that the terms "predominantly," "same type of trade or business " and "cost" be defined.

With respect to the term "predominantly," we suggest that a parallel between the term "predominantly" and "substantially all" (as used in the private activity bond context) is appropriate for accomplishing the result intended by the concept. We therefore suggest that the term "predominantly" be defined as 95 percent.

With respect to the concept of "same type of trade or business," we are aware that questions will frequently arise regarding, for example, whether retail business is itself the same type of business or whether retail clothing stores (for example) are different from retail pharmacies. We suggest that the concept of the SIC Code as used on Form 8038 may be an appropriate reference for dealing with the questions that will arise. We therefore suggest that the term "same type" refer to the same SIC Code category.

Finally, we suggest that "cost" can relate to "original cost," "replacement cost," "value" (i.e., appraised cost) or other terms. We suggest that a comparison of the replacement cost of an existing system with the actual cost of a system improvement is proper in that it relates to the same time frame. We therefore suggest that "cost" be defined as "replacement cost."

We are more concerned at this time, however, that there is a specific definition than as to the content of the definition. If, of course, the Service believes that definitions different than those set forth above are appropriate, those definitions would be more helpful than would leaving the specified terms not defined.

G. §1.141-3(i)(2) Modify Determination of Average Use to Take into Account Periods When a Facility is Available to the General Public

Comment. In determining average use of a facility during a year, the period during which a facility is available for governmental or general public use should be taken into account as governmental or general public use even though the facility is not actually used during that period.

Suggested Regulatory Language. Modify §1.141-3(i)(2) as follows:

(2) Determining average of use. The average of the private business use of a facility is determined by comparing the amount of private business use and government use during that year. In determining the total amount of government use, periods during which the facility is not in use are disregarded, unless (1) the facility is available on reasonable terms for public or governmental use during such periods, and (2) the issuer reasonably expected (as of the date of issue of the bonds) that governmental and public users could actually use the facility during such periods. In determining the average amount of private business use, the following rules apply:

Reason. Use of a facility does not always involve actual physical use of a facility. For example, a nongovernmental person who has leased a parking space on a long-term basis is deemed to use the parking space during the entire period of the lease regardless of whether a car is actually parked in the space. Not taking into account periods during which a facility is not in actual physical use (but is available for use) may result in allocations of governmental use to a facility in amounts much lower than the actual governmental benefit provided by a facility. A facility that is available to be used by the public (or otherwise used for a governmental use) may provide public benefits even when not in actual, physical use. For example, a multipurpose arena that is leased part of the time to a private user and is available the remainder of the time for public and governmental use is used for a governmental use during the period that it is available for such public and governmental use.

From an issuer's viewpoint, public availability of a facility is a type of use. A city, for example, may derive significant benefit from having a large facility available for public and governmental use in the form of an improved business climate through availability of a large meeting area on an as-needed basis. Thus, arenas, convention centers and other large public meeting facilities may not always be "booked solid" for years in advance and actual use by the public (or the local government) may depend on economic and other uncontrollable conditions. For this matter, a municipality may want a large meeting facility to have a minimum amount of open time so that it can make the facility available with relatively short notice of unanticipated events that may be beneficial to the public.

In addition, the legislative history of the Tax Act indicates that availability for use was to be considered as general public use. For example, in describing the concept of use, the House Report states as follows:

Use on the same basis by all members of the general public may be determined by reason to reasonable availability of use, rather than actual use in certain cases. (H. Rep. No. 99-426, page 493. Emphasis added.)

The example provided in the context of the above statement relates to a hospital servicing only sick persons and concludes that the sick persons are members of the general public even though they are sick. We suggest that the concept of the above statement also must apply in determining the average of use. An empty hospital, for example, is as available for general public use as a hospital full of sick or injured individuals. That availability for use should be considered as government use under the averaging test of §1.141-3(i)(2).

H. §§1.141-3(i)(3) and 1.141-6(b) Modify Allocation Rules for Private Business Use Test to Conform to Allocation Rules for Private Security or Payment Test

Comment. The private business use test rules relating to allocation of use of a portion of a facility should be conformed to the allocation rules for payment relating to multiple issues for a facility and the amount of proceeds used for a private business use should be permitted to be allocated in accordance with any reasonable method of allocation selected by the issuer. The rules regarding mixed-use facilities and discrete portions of mixed-use facilities should be deleted.

Suggested Regulatory Language.

A. Modify §1.141-3(i)(3) as follows:

(3) Use of a portion of a facility--(i) Discrete portion. For purposes of this paragraph (i), measurement of the use of proceeds allocated to a discrete portion of a mixed use facility is determined by treating that discrete portion as a separate facility. Allocation among issues of tax-exempt bonds. If a facility is financed with two or more issues of tax-exempt bonds, the private business use of the facility must be allocated among those issues according to the relative amounts of proceeds of each of those issues that are allocated to that facility. If a facility is financed with the proceeds of one or more issues of tax-exempt bonds and with one or more issues of taxable bonds or with an equity investment of the issuer or a nongovernmental person, the private business use of the facility may be allocated first to the issues of taxable bonds and the equity investment.

(ii) Allocation among uses. In the case of a facility having both private business use and use that is not private business use, the proceeds of an issue of tax-exempt bonds must be allocated among the uses in accordance with a reasonable allocation method selected by the issuer. Reasonable allocation methods include, but are not limited to, allocation on the basis of actual expenditure of proceeds, allocation on the basis of square footage or other measure of area of each use, allocation on the basis of total revenues from each use, and allocation on the basis of fair market value of area of each use.

(ii) (iii) Common areas. The amount of private business use of common areas within a mixed use facility is based on the average amount of private business use of the remainder of the entire facility.

B. Delete §1.141-6(b).

Reasons. For purposes of the private business use tests, §1.141-3(i)(3) provides that measurement of the use of proceeds allocated to a discrete portion of a mixed use facility is determined by treating the discrete portion as a separate facility; and §1.141-6(b)(2)(i) provides that a mixed use facility is a facility containing two or more discrete portions and that a discrete portion of a mixed use facility is, in the case of a building, a physically-separate portion of the building and, in the case of a utility facility, an undivided ownership interest.

For purposes of the private security or payment test, §1.141-4(c)(3)(i) provides that if a payment is made for a facility financed with two or more issues, that payment must be allocated among those issues in accordance with relative amounts of proceeds, and §1.141-4(c)(3)(ii) provides that a payment from a private business user of property may be allocated first to repay the issuer for an equity investment.

The private business use test, therefore, states that private business use is to be allocated on the basis of discrete portions of a facility, while the private security or payment test may be allocated on the basis of an entire facility, without regard to discrete portions. We suggest that this treatment is inconsistent, that this inconsistency will lead to troublesome administrative issues for the Service and for issuers and that the inherent conflict between the two provisions should be solved by modification of the private business use test references (rather than by modification of the private security or payment test references, other than the technical modification referenced below).

The restrictions of Code section 141 relate only to tax-exempt bonds; that is, the private business tests were designed to restrict the private business use of facilities if private business pays for that use or if the private business use secures the bonds. If private business does not pay (or secure) bonds, then the private business tests do not apply; and to the contrary, if private business use is not financed with the proceeds of tax-exempt bonds, but rather is financed with the proceeds of taxable bonds or with equity contributions by private business or by the issuer, then even though private business pays (or secures) debt service on the bonds, the restrictions of Code section 141 do not apply. In a nutshell, because the private business tests consists of two tests, if one of the tests is not satisfied, then the bonds are not private activity bonds. From this it should follow that, in the context of partial business use, or partial business payment of debt service, if partial business use is not paid with the proceeds of tax-exempt bonds, then the restrictions of Code section 141 do not apply or, as an alternative, if debt service is not partially paid (or secured) by private business use, then the restrictions of Code section 141 do not apply. In §1.141-4(c)(3), the Service has provided for this concept; but in §1.141-3(i)(3) the Service has limited this concept beyond what, in our view, was intended by Congress and beyond that the Service has set forth in §1.141-4(c)(3). Thus, the application of the two sections is inconsistent.

Moreover, in §1.141-6(b) (regarding mixed-use facilities), the Service recognizes that a portion of a single facility may be financed as a governmental facility and that private use of a portion of a single facility does not disqualify governmental financing for the remaining portion of the facility. In §1.141-6(b), however, the portion permitted to be financed is arbitrarily limited to a portion separated by physical barriers or, in the case of output facilities, by separate ownership interests. Because Code section 141(b) does not differentiate between types of governmental facilities (those with and without physical barriers or separate ownership interests), it is not appropriate for the proposed regulations to force such differentiation.

The question then is solely one of allocation, that is, solely a question of determining whether tax-exempt bond proceeds are, or are not, used for private business use. We suggest that any reasonable, consistent allocation method selected by the issuer should suffice. To the extent that the Service has concerns regarding certain allocations, then it should provide guidance regarding prohibiting or otherwise restricting such methods. We do not believe, however, that an allocation method limited solely to buildings with separate physical areas and utility facilities with separate ownership interests is appropriate.

In private letter rulings relating to whether a user of a facility is a principal user for purposes of the capital expenditure limitation for small issue industrial development bonds, the Service has approved a variety of allocation methods, including percentage use of space of a facility and percentage of gross revenue of a facility (private letter ruling 8042033, July 22, 1980), fair rental value (private letter ruling 8112071, December 29, 1980), total space and rentals (private letter ruling 8124126, March 23, 1981), value paid (private letter ruling 8130105, April xx, 1981), fair rental value (private letter ruling 8129084, April 23, 1981), space rented (private letter ruling 8133044, May 19, 1981), fair rental value and square footage (private letter ruling 8136098, June 15, 1981), usable square footage (private letter ruling 8137041, June 22, 1981), percentage of space and percentage of value (private letter ruling 8149049, September 10, 1981), a percentage of total revenue (private letter ruling 8233018, May 18, 1982), a percentage of fair market value (private letter ruling 8252028, September 23, 1982), purchaser's requirements relative to production of facility (private letter ruling 8463039, November 7, 1983), square feet of rentable space and number of parking spaces (private letter ruling 8433091, May 17, 1984), fair rental value (private letter ruling 8612045, December 23, 1985), and percent of area (private letter ruling 8639042, June 27, 1986). We suggest that these methods should be equally acceptable, along with other methods, in the case of the private business use test itself.

We believe that the method of allocation in the proposed regulations for the private business use test, in its reference to discrete portions of mixed use facilities and its definition of discrete portions, is too narrow; it not only limits the amount of proceeds that may be used for a private business use, but also defines the required physical or, in the alternative, the legal ownership, characteristics of the private business use. We suggest that, in the context of an allocation rule for the private business use test, the more appropriate approach is to limit the amount of the expenditures for private business use, but not to limit the physical characteristics of the facility. The private business use test would then parallel the private security or payment test, where the allocation rule limits the amount of private business payments, but does not specify the physical location to which those payments may pertain.

We also suggest that the concept of separate physical barriers associated with (only) buildings and of separate ownership interest associated with (only) utility systems is over simplified. Many acceptable governmental facilities do not consist of buildings or utility systems. Modern educational and recreational facilities, for example, tend to limit physical barriers and emphasize open areas; and park and open space uses are troublesome as well. Consider, for example, the best method for allocating a multiple-acre park with open tennis courts (operated in part by a private tennis organization). Consider also the high school swimming pool to be used part-time by private sports organizations as well as by the school for physical education; or the new baseball field at the elementary school also to be used by the Little League sports organization; or the local parents nonprofit organization that will contribute money to the school in exchange for long-term meeting rights. We suggest that the concept of physical barriers in these circumstances is too narrow and that allocation on a dollar amount of use basis, measured with a reasonable allocation method, is appropriate and in keeping with the intent of Congress.

In addition, with respect to §1.141-6(b), although we do not favor the concept of "undivided ownership interests" unless selected as the allocation method by the issuer, as discussed above, we suggest that if the concept is employed, it is not appropriate to limit the concept to utility systems. This connotes a favoritism that is not appropriate for governmental regulations. If private business use may be measured by undivided ownership interests, there appears no satisfactory reason for permitting undivided ownership interests in utility facilities but excluding undivided ownership interest in other governmental facilities.

A. §1.141-4(c)(2) Emphasize Private Business Use As Required Component of the Private Payment Portion of the Private Security or Payment Test

Comment. The second sentence of section 1.141-4(a)(1) refers to property or borrowed money "used or to be used for a private business use." In conformity with this sentence and with Code section 141(b)(2)(B), section 1.141-4(c)(2) should be modified throughout to add references to the private business use concept.

Suggested Regulatory Language. Modify §1.141-4(c)(2) as follows:

(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 for a private business use are taken into account as private payments to the extent allocable to the proceeds used by that person. Payments for a use of proceeds for a private business use include payments (whether or not to the issuer) in respect of property that is used for a private business use financed (directly or indirectly) with those proceeds, even if not made by a private business user. Payments are not made in respect of property financed with proceeds if those payments are directly allocable to other property being directly used by the person making the payment, but only to the extent that those payments are reasonable compensation for that other use. See Example 4 and Example 5 of paragraph (g) of this section.

(B) Payments not to exceed use. Payments by a person for a use of proceeds for a private business use are allocable to the payment of the debt service on the proceeds used by that person (or with respect to property used by that person) to the extent that the present value of those payments does not exceed the present value of the debt service on those proceeds. Thus, if 7 percent of the proceeds of an issue is used by a person for a private business use, payments by that person 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.

(C) Payments of operating expenses. Payments by a person for a use of proceeds for a private business use 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 a private business use. 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 a private business use of space in a financed facility and pays $500 during the year for ordinary and necessary expenses properly allocable to the operation and maintenance of that space, $500 of the $5,000 received would not be considered a payment of that use of the proceeds allocable to that space (regardless of the manner in which that $500 is actually used).

(ii) Refinanced debt service. (A) Payments of debt service on an issue to be made from proceeds of a refunding issue are taken into account as private payments for a private business use in the same proportion that

(1) the present value of the payments taken into account as private payments for a private business use for the refunding issue, bears to

(2) the present value of the debt service to be paid on the refunding issue.

(B) 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 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 §1.150-1(d)(2)(i) (relating to certain payments of interest).

(iii) Use. For purpose of determining the amount of private payments used for a private business use, all related private business uses of proceeds of an issue by one person are treated as one use. For example, proceeds used to make a grant and a loan to the same person to construct a facility to be used for a private business use are aggregated in determining the portion of the loan repayments taken into account as private payments.

Reason. Code section 141(a)(2)(B) relates to payment of debt service derived from payments in respect of property or borrowed money "used or to be used for a private business use." This basic rule is set forth in section 1.141-4(a)(1), but the concept of private business use is omitted entirely from section 1.141-4(c) (setting forth the details of the private payment portion of the private security or payment test), except for a small reference in the second sentence of 1.141-4(d)(i) (relating to "payments . . . even if not made by a private business user"). (Emphasis added.) The omission from the detailed explanation of a concept that is integral to the basic rule will create unnecessary controversy. The inclusion of the concept in the detailed discussion of the private payment portion of the private security or payment test will avoid this controversy and will conform the concept of that portion of the private security or payment test to the requirement of Code section 141(b)(2)(B).

B. §1.141-4(c)(3) Make Technical Modifications to Clarify Application to Taxable Bonds

Comment. The allocation rule for application of payments under the private security or payment test among issues should be clarified to permit allocation of private business payments to taxable bonds.

Suggested Regulatory Language. Modify §1.141-4(c)(3) by inserting the bold underlined language below:

(3) Allocation of payments--(i) Allocations among issues. If a payment is made for a facility financed with two or more issues of tax-exempt bonds, that payment must be allocated among those issues according to the relative amounts of proceeds of each of those issues that are allocated to that property.

(ii) Repayments of equity. A payment from a private business user of property may be allocated first to pay taxable bonds and to repay the issuer for any equity investment in that property (that is, amounts invested by the issuer or otherwise that do not, directly or indirectly, involve an expenditure of amounts borrowed).

Reasons. Issuers may issue taxable bonds to provide financing for the private business use portion of facilities or improvements. Because of the higher cost of taxable bonds, issuers may provide for private business use payments in an amount sufficient to amortize the taxable bonds. To enable the issuer to administer the cash flow requirements for financing programs so as to adjust for the higher costs associated with those bonds, we suggest that issuers be permitted to allocate private payments first to taxable bonds and equity whether or not contributed by the issuer. We also note that, since the definition of "issue" in regulations section 1.150-1(c) is not limited to tax-exempt bonds, modification of §1.141-4(c)(3) is necessary in order to enable the issuer to assign private use payments to taxable bonds.

Without the suggested modification, §1.141-4(c)(3)(i) would require that private business use payments be allocated to tax-exempt bonds issued to finance a facility in a context where both taxable and tax-exempt bonds were issued for the facility, and §1.141-4(c)(3)(ii) would permit allocation of private payments to issuer equity but not to equity contributed by another government unit or another nongovernmental person. We suggest that Congress did not intend to limit the ability of issuers to receive private business use payments with respect to financing provided by taxable bonds, or any source other than tax-exempt bonds.

C. §1.141-4(d) Add Use of Bond Proceeds or Bond-Financed Property As Required Component of the Private Security Portion of the Private Security or Payment Test

Comment. The private payment portion of the private security or payment test relates to the use of proceeds of the issue in that it refers to payments by nongovernmental persons that are treated as using the proceeds of issue or bond-financed property. The private security portion of the private security or payment test should also relate to the use of proceeds of the issue or bond-financed property.

Suggested Regulatory Language. Modify §§1.141-4(d)(2), 1.141-4(d)(4) and 1.141-4(d)(5) as follows:

Section 1.141-4(d)(2)

(2) Security taken into account. The property that is the security for, or the source of, the payment of debt service on a bond need not be is the property financed with proceeds of the bond or property used for a private business use by a nongovernmental person that is treated as using proceeds of the bond. For example, unimproved land or investment securities, directly or indirectly financed with proceeds of a bond and used, directly or indirectly, in a private business use that secures a bond provides private security.

Section 1.141-4(d)(4)

(4) Secured by any interest in property or payments. Property, directly or indirectly financed with the proceeds of the bonds, used or to be used for a private business use by a nongovernmental person that is treated as using the proceeds of the bonds 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 to be taken into account as private security, that interest must secure the payment of debt service on the bonds.

Section 1.141-4(d)(5)

The payments taken into account as private security are payments in respect of property directly or indirectly financed with the proceeds of the bonds and used or to be used for a private business use by a nongovernmental person that is treated as using the proceeds of the bonds. Thus, to be taken into account as private security, payments in respect of property, directly or indirectly financed with the proceeds of the bonds, need not be made by the private business user. Therefore, payments made by members of the general public for use of a facility directly or indirectly financed with the proceeds of the bonds and used for a private business use by a nongovernmental person that is treated as using the proceeds of the bonds may be taken into account as private security (for example, payments by persons using a facility that is the subject of a management contract that results in private business use, other than a qualified management contract). Except as otherwise provided in this paragraph (d)(5) and paragraph (d)(6) of this section, the rules in paragraph (c) of this section apply to determine the amount of payments treated as payments in respect of property directly or indirectly financed with the proceeds of the bonds or used or to be used for a private business use by a nongovernmental person that is treated as using the proceeds of the bonds.

Reason. In the context of the proposed regulations, the Service has recognized that the private payment portion of the private security or payment tests relates only to payments made by nongovernmental persons "treated as using the proceeds of the issue." There is no statutory basis for distinguishing the private payment portion of the private security or payment test from the private security portion of the private security or payment test. Congress may have intended that neither portion of the test be linked to the use of bond proceeds or it may have intended that both portions of the test be linked to the use of bond proceeds. It could not reasonably, however, have intended that one portion of the test be linked to the use of bond proceeds and that the other portion of the test not be linked to the use of bond proceeds.

We believe that Congress intended to link both portions of the private payment or security test to the use of bond proceeds. H.R. 3838 (ultimately enacted as the Tax Reform Act of 1986) was introduced without the security interest test for the purpose of the basic definition of private activity bonds. The security interest test was added by the Senate amendment to H.R. 3838. The Senate Report, in describing the addition of the security interest test, states as follows:

The bill clarifies that both direct and indirect payments to an issuer of bonds made by a private user of bond-financed facilities are considered when determining whether the security interest test, described above, is satisfied. Thus, payments by such private users of bond-financed facilities equal to or exceeding 25 percent of debt service result in the bonds being IDBs, whether or not the payments are formally pledged as security or are directly used to pay debt service on the bonds.

This clarification applies only to payments from persons who are treated as using the bond-financed facility under the use test, described above. . . . (Sen. Rep. No. 99-313, page 831. Emphasis added.)

The Conference Report indicates (on page II-688) that the security interest test of the Senate bill was adopted with technical amendments. Although the above reference relates to the payment portion of the test, there is no indication whatsoever of an intent to extend the security portion of the test beyond bond-financed facilities.

If omission of the limitation to bond-financed property or use of bond proceeds is not simply an oversight, we suggest that the failure to include the limitation in §§1.141-4(d)(2), (4) and (5) may result from a concern regarding abuse by the Service. For example, Corporation A and Corporation B may agree with a City that bond proceeds will be used to finance a facility for Corporation A and that a deed of trust on facilities owned by Corporation B will secure debt service on the bonds. We suggest, however, that this type of abuse cannot occur since it relates to a prohibited underlying arrangement.

If the reason for the omission of the limitation is to prohibit an issuer from assigning private business use property controlled by the issuer to secure debt service, without an underlying arrangement, we suggest that this approach exceeds the scope of the Code provision. We also suggest that, if such is the intent of the omission of the limitation, then it seems incongruous to apply the provision to the security portion of the private security or payment test and not the payment portion of the private security or payment test, yet (as referenced above) Congress clearly limited the payment portion of the test to bond-financed property.

Based upon the above, we suggest that the security portion of the private security or payment test (as well as the payment portion of the test) should be linked to the use of bond proceeds by referring to proceeds allocable to nongovernmental private business use users and to bond-financed property.

D. 1.141-4(g) Expand Example 6 to Refer to Direct Lease in Addition to Asset Transfer Lease

Comment. Because Example 6 will become the basis for most governmental lease financing, it should be expanded to cover leases in addition to asset-transfer leases.

Suggested Regulatory Language. Modify §1.141-4(g), Example 6, as follows:

Example 6. Lease financing. (i) County W enters into a lease of a building to be constructed with the proceeds of certificates of participation representing fractionalized interests in lease payments to be made by W under the lease. W covenants to appropriate annual payments for the lease payments from its general fund. A portion of each lease payment is specified as interest. More than 10 percent of the building is to be used for private business use. If W defaults under the lease, the trustee for the holders of the certificates of participation has a limited right of repossession under which the trustee may not foreclose but may lease the property to a new tenant at fair market value. The lease payments are secured by an interest in property used for a private business use and therefore, the lease payment obligation satisfies the private security or payment test.

(ii) The facts are the same as in part (i) of this Example 6 except that, under the term of the lease, in the event of a default by W, the trustee's only rights are to sue W for any failure to make payments pursuant to the lease. Thus, the trustee has no rights to the building and no limited right of repossession. The right to receive lease payments is not an interest in the leased property, and therefore, this right does not provide private security.

(iii) The facts are the same as in part (ii) except that County W enters into a lease of a building that W owns that is not used for a private business use and the proceeds of the certificates of participation are used to acquire land that will be granted for private business use without payment to W. If W defaults under the lease, the trustee has no rights in the building and no limited right of repossession. The right to receive lease payments is not an interest in the leased property, and therefore, this right does not provide private security.

(iv) The facts are the same as in part (iii) except that the building owned by W that is the subject of the lease is used for a private business use. The result is the same as in part (iii).

(v) The facts are the same as in part (iv) except that instead of using the proceeds of the certificates of participation for land granted for private business use, the proceeds are used to construct a building that will be rented for private business use. Although if W defaults under the lease, the trustee has no rights in the leased building, the rental payments for private business use of the financed building are private payments and the private security or payment test is satisfied.

Reason. Example 6 will become the basis for most governmental lease financing that is undertaken after enactment of the regulations in their final form but relates to an "asset transfer" type of lease financing that is fairly unusual. We suggest that lease financing requires consideration in the following contexts: (i) whether the subject of the lease is or is not the asset to be financed, (ii) whether the lease payment covenant is enforceable by suit or by repossession, and (iii) whether or not the leased property is used for a private business use. In the context of a general fund lease (i.e., where lease payments are to be made from the general funds of the issuer), we concur with the general approach of Example 6(ii) in its implied conclusion that security or payment test is satisfied only if the right of repossession is included in the lease (and not if the enforcement of the lease payment obligation is limited to mandamus or other suit), but we disagree with its conclusion in the context of an asset transfer financing.

For the reasons discussed in Part IV.B. above, we are of the view that the payment portion of the security or payment test and the security portion of the security or payment test both relate only to the use of property financed with the proceeds of the bonds. If the subject of the lease, therefore, is not the financed asset, then the use of the leased asset for a private business use is not pertinent.

Thus, in the context of lease financing where the governmental lessee is able to covenant to make lease payments if it has the right to possess the leased asset (the "California Lease Covenant"), as contrasted with lease financing where the governmental lessee is not able to do more than to determine annually whether or not to make lease payments (the "Annual Appropriation Covenant"), there are alternative possibilities. If (i) the subject of the lease is the financed property, (ii) the financed property is used for a private business use, and (iii) there is the right of repossession, then the test should be satisfied. If, however, either the financed property is not used for a private business use or if it is so used but there is not a right of repossession, then the private security or payment test should not be deemed satisfied. In the context of an asset transfer type of financing (i.e., the financed property is not the leased property), whether or not the leased property (the existing asset) is or is not used for a private business use and whether there is or is not a right of repossession of the leased property (the existing asset) should not be relevant in determining compliance with the test. This is so because the existing asset is not the financed asset and therefore the link with the use of bond proceeds required by the legislative history of Code section 141(b)(2) does not exist.

The same results should apply in the case of an Annual Appropriation Covenant lease where the right of repossession is a necessary component of the Annual Appropriation Covenant. There, if the leased property is the financed property and is used for a private business use, the test should be satisfied (because the privately used property may be repossessed and thus is security for the obligation). If, however, the leased property is not the financed property, then the test should not be satisfied (because the private security or payment test should relate only to proceeds of the lease payment obligation and financed property).

The above conclusions are based on facts that assume no revenues arise from the financed property and focus only on the lease payments being made with respect to the property (recognizing in asset transfers that the transferred property is not the financed property). If revenues do arise from a private business use of the financed property then, of course, those revenues would count against the private security or payment test. This would be the case, for example, where the financed asset was a parking facility used by a private business user where payments were made by the private business user for that use or where the financed asset was a revenue-producing solid waste facility operated under a non-qualified management agreement (but not where, for example, the financed facility was a jail operated under a non-qualified management agreement, because no revenues are produced from a jail).

E. §1.141-4(e) Expand Concept of Generally Applicable Taxes to Include General Governmental Amounts

Comment. Because the limitation to generally applicable taxes, as defined, may restrict the private security or payment test more narrowly than intended by Congress, we suggest that section 1.141-4(e) be modified to include general governmental revenues.

Suggested Regulatory Language. Modify §1.141-4(e) as follows:

(e) Generally applicable taxes and other general governmental amounts. (1) General rule. For purposes of the private security or payment test, generally applicable taxes and other general governmental amounts 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 and other general governmental amounts. 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. The term "generally applicable taxes and other general governmental amounts" means the proceeds of generally applicable taxes, rates and charges and other revenues and amounts received by a governmental unit from general governmental operations, but does not include special charges or assessments levied, pursuant to the bond documents or other underlying arrangements, upon nongovernmental persons treated as using the proceeds of bonds for a private business use.

(3) Special charges. A payment for a special privilege granted or service rendered is not a generally applicable tax or other general governmental amount. Special assessments paid by property owners benefiting from financed improvements are not generally applicable taxes or other general governmental amounts. For example, a tax that is limited to property or persons benefited by an improvement is not a generally applicable tax.

(4) Manner of determination and collection Prohibition of Underlying Arrangements.--(i) In general. A tax does not have a generally applicable manner of determination and collection if one or more taxpayers make any special agreements relating to payment of those taxes. Taxes and other governmental amounts are excluded from the private security or payment test if they are derived from special agreements or other underlying arrangements with nongovernmental persons that are treated as using the proceeds of the issue for a private business use. A special agreement or other underlying arrangement relating to the payment of a tax or other governmental amount is taken into account whether or not it is reasonably expected to result in any payments that would not otherwise have been made. On the other hand, if an issuer uses proceeds to make a grant to a taxpayer nongovernmental person to improve property, agreements that impose reasonable conditions on the use of the grant do not cause a tax on, or other amount arising from, that property to fail to be a generally applicable tax or other general governmental amount. If an agreement by a taxpayer causes a tax to fail to have a generally applicable manner of determination and collection, the entire tax paid by that taxpayer is treated as a special charge, unless the agreement is limited to a specific portion of the tax. If an agreement or underlying arrangement by a nongovernmental person causes a tax or other governmental amount to satisfy the private security or payment test, the entire tax or other governmental amount paid by that nongovernmental person is treated as satisfying that test unless the agreement or underlying arrangement is limited to a specific portion of the tax or other governmental amount.

(ii) Impermissible agreements. The following are examples of agreements that cause a tax or other governmental amount to fail to have a generally applicable manner of determination and collection be excluded from the private security or payment test: an agreement to be personally liable, 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 or other governmental amount to fail to have a generally applicable manner of determination and collection be excluded from the private security or payment test: 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; and a right of a grantor to rescind the grant if property taxes are not paid; and an agreement regarding payments of past due amounts (as in the case of defaults and arrearages).

(iv) 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--

(A) The payment is measured by and equal to the amounts imposed by a regular statute for a tax of general application;

(B) The payment is imposed by a specific statute (even if another agreement, such as a lease, is used as the vehicle for collection); and

(C) The payment is designated for a public purpose rather than for a privilege, service or regulatory function, or for any other local benefit tending to increase the value of the property with respect to which the payments are made.

Reason. Paragraph (1) of §1.141-4(e) provides that generally applicable taxes are not taken into account for purposes of the private security or payment test. Paragraphs (2) through (4) of §1.141-4(e) set forth significant detail regarding the definition of generally applicable taxes. Although we concur with the statement that generally applicable taxes are not taken into account for purposes of the private security or payment test, we believe that the concept (as included in the legislative history of Code section 141(b)(2)) is merely an example of one of the various types of governmental revenues that is excluded from the private security or payment test. The Senate Report states the following:

This clarification [i.e., inclusion in the security interest test of both direct and indirect payments] applies only to payments from persons who are treated as using the bond-financed facility under the use test, described above. For example, revenues from generally applicable taxes are not payments that are considered in determining whether the security interest test is satisfied. (S. Rep. 99-313, page 831. Emphasis added.)

We also believe that some of the detail provided in paragraphs (2) through (4) of section 1.141-4(e) is needed, not for the purpose of defining generally applicable taxes, but rather for the purpose of limiting the concept of generally applicable governmental amounts.

Thus, we note and we believe from the examples contained in the regulations, that there are several types of financing mechanisms that are available to governmental entities that are secured by general governmental amounts that do not satisfy the private security or payment test. These include tax and revenue anticipation notes (secured by general governmental income, revenues, taxes and all of "the first" revenues that arise during a fiscal year); water and sewer revenue bonds that are secured by generally applicable user, connection and standby charges that are levied for a water or sewer enterprise of a governmental unit; general fund lease financings that are payable from general governmental revenues without regard to source other than an issuer's "general fund;" and traditional general obligation bonds that are secured not only by the power to levy an unlimited ad valorem tax within the jurisdiction of the issuer but also by all assets and revenues of the issuer.

The examples in §1.141-4(g) of the proposed regulations indicate that the Service agrees that obligations may not satisfy the private security or payment test although payable from other sources than generally applicable taxes as defined in section 1.141-4(e) as follows:

Example 1 does not indicate the source of bond payment and references merely the private payments. The debt service on the bonds may otherwise be payable from sources in lieu of or in addition to generally applicable taxes.

Example 2 again references the payments from users of bond proceeds (sales and lease payments). The remaining debt service may be payable from sources other than generally applicable taxes.

Example 4 refers to assessments not in respect of relocation costs and applies that the same do not satisfy the private security or payment test even though they are specifically excluded from the definition of generally applicable taxes in section 1.141-4(e)(3).

Example 6 refers, apparently, to lease payments made from the issuer's general fund.

Example 7 does not refer to the source of payment of the bonds; presumably the source is not generally applicable taxes.

Example 8 refers to bonds payable from rates, fees and charges imposed for use of university facilities.

Example 9 refers to general obligation bonds which, by law, are ordinarily secured by an unlimited levy of taxes, and also by the general funds and assets of the issuer (under the "full faith and credit" concept of state law).

Example 10, in (i) refers to a "ticket tax" which is not a generally applicable tax, but in (ii) refers to a "ticket tax" which is a generally applicable tax. The ticket tax may or may not be imposed under the taxing power of the issuer.

The general revenues of issuers are often comprised of many sources in addition to generally applicable taxes. In the case of a city, those general revenues may include revenues from rates and charges for city facilities generally, sales of city tourist products, federal and state grants, interest earnings from various reserves, welfare recoveries, litigation recoveries, insurance payments, advertising payments, license fees, rentals and similar general fund sources. These sources may or may not be derived from a private business use or from the exercise of the taxing power. Congress did not intend, and it is probable that the Treasury does not intend, that these funds be included within the private security or payment test.

We suggest that one way to reflect this concept would be to modify proposed regulation §1.141-4(e) in whole as set forth above. We note particularly that reference to the "exercise of the taxing power" and collection "for the purpose of raising revenue" are peculiar state law concepts and ought not be included among federal law restrictions in the context of §1.141-4(e). To do otherwise may be to create differences in the application of the federal tax law from State to State. The concept to be elucidated in the regulatory private security or payment test should be a distinction between amounts that arise from general governmental operations as contrasted with those that arise from the bond documents or from an underlying arrangement relating to the user of proceeds of the bonds.

A. §1.141-5(c)(2)(i) Restore Concept of Loan to Exception for Tax Assessment Loans

Comment. We suggest that §1.141-5(c)(2)(i) exceeds the scope of Code section 141(c)(1) by extending the private loan financing test to include any issue payable from assessments or special taxes without regard to whether those assessments or special taxes constitute a deemed loan in the first place.

Suggested Regulatory Language. Modify the first sentence of §1.141-5(c)(2)(i) as follows:

A tax assessment loan is a loan that arises for federal tax purposes when a government unit permits or requires its residents to pay finance a tax or assessment over a period of years.

Reasons.

In General. Code section 141(c)(1) prohibits the use of bond proceeds to make or finance loans. Code section 141(c)(2) excepts from the general rule any loan that enables a borrower "to finance any governmental tax or assessment of general application for a specific essential governmental function." (Emphasis added.) We believe that §1.141-5(c) of the proposed regulations exceeds the scope of Code section 141(c)(1) by expanding the general rule to cover any bonds payable from assessments or special taxes without regard to whether the proceeds of the bonds are deemed to make loans (i.e., without regard to whether, in the first place, the assessments or special taxes are "loans").

California Practice. As referenced in Part III.B. above, in California there are two types of issues secured by assessments or special taxes: (i) Special Assessment Bonds issued to finance improvements of local benefit, and (ii) Special Tax Bonds issued to finance both improvements of local benefit and improvements of general benefit. Although Special Assessment Bonds are to be analyzed under Code section 141(c)(1) because the proceeds are deemed to make loans, Special Tax Bonds are not ordinarily to be analyzed under Code section 141(c)(1) because the proceeds are not deemed to make loans. This distinction is based upon the State statutory and case law characteristics of "assessments for local benefit" as contrasted with special taxes.

Traditional bond law views Special Assessment Bonds as encompassing the following financing procedure: (i) following a petition from some (usually not all) owners of affected property, a city (or other issuer) determines that street improvements (for example) are required in a particular neighborhood of the city; (ii) the city employs an engineer to determine (a) the cost of the improvements, (b) the parcels of property benefited by the improvements and (c) a benefit formula by which the cost of the improvements is "spread" among the benefited parcels; (iii) following a public hearing in which owners of benefited parcels are entitled to protest the cost of the improvements, the determination of benefit and the spread of the cost, the city "confirms the assessment" and levies upon each benefited parcel a total assessment (e.g., if the cost of the street improvements is $1 million, if 10 parcels are benefited, if each of the 10 parcels has equal frontage on the street and if front footage is used as the method for spreading the cost, then the assessment levied upon each parcel is $100,000); (iv) if the owner of a benefited parcel does not pay the assessment in cash, a lien in the amount of the total assessment ($100,000 in the example) is imposed upon the parcel; (v) the city issues bonds, the proceeds of which are deemed to make a loan to the owner of each parcel that did not pay the assessment in cash; (vi) the deemed loan proceeds are deemed used by the owner of the benefited parcel to pay the amount of the amount assessed against the parcel and the amounts thus deemed paid by the owners (at that point not technically bond proceeds, but rather deemed loan proceeds) are used to pay the cost of the improvements; and (vii) in consideration of the loan made to the owners from the bond proceeds, the owners repay the amount of the loan over time by paying the amount of the assessment ($100,000 in the example) over time with interest (which interest is the amount necessary to pay interest on the bonds).

As contrasted with Special Assessment Bonds, Special Tax Bonds encompass the following financing procedure: (i) a city (or other issuer) determines that general public improvements are required in a particular area of the city, which general public improvements may consist of improvements of local benefit to identified properties (such as street improvements) and/or improvements of general benefit to the entire area (such as schools, fire stations and police facilities); (ii) the city forms a community services district (which is not a political subdivision); (iii) the district employs an engineer to determine (a) the cost of the improvements, (b) the amount of bonds necessary to pay the cost and (c) a special tax formula by which the debt service on the bonds and costs of maintaining the bond-financed facilities may be paid on an equitable basis by the parcels in the district; (iv) following an election, the bonds are issued and the proceeds of the bonds are used to pay the costs of the improvements; and (v) the special taxes are levied against parcels in the community facilities district in annual amounts without the imposition of a fixed lien in a single larger amount to be paid over a period of years.

For example, in the case of Special Assessment Bonds, California Streets and Highways Code section 5343 (relating to assessments imposed under the Improvement Act of 1911) requires that a diagram of the property benefited by proposed improvements shall be delivered to the superintendent of streets. The section then provides as follows:

. . . [The superintendent of streets shall] proceed to estimate upon the lots or parcels of land within the assessment district, as shown by the diagram, the benefits arising from such work, and to be received by each such lot or parcel of land. He shall thereupon assess upon and against the lands in the assessment district the total amount of the costs and expenses of such work, and in so doing shall assess the total sum upon the several lots or parcels of land in the assessment district, benefited thereby, in proportion to the estimated benefits to be received by each of the said several lots or parcels of land. (Emphasis added.)

However, in the case of Special Tax Bonds, there is no requirement for levy of a total sum upon assessed properties or levy of the tax based upon benefit. For example, Government Code section 53321(d) in describing the contents of the resolution of intention to establish a community facilities district provides that the resolution shall:

(d) State that, except where funds are otherwise available, a special tax sufficient to pay for all such facilities and services [i.e., the types of facilities and services specified in the resolution as to be provided in the area of the district] will be annually levied within such area. The resolution shall specify the rate and method of apportionment of the special tax in sufficient detail to allow each land owner or resident within the proposed district to estimate the annual amount that he or she will have to pay. . . . (Emphasis added.)

There are thus four primary distinctions between Special Assessment Bonds and Special Tax Bonds: (i) in the case of Special Assessment Bonds, the levy is a single lump sum levy that is "financed" by being permitted to be paid over time with interest, while in the case of Special Tax Bonds, the levy is a series of annual levies over time (with no recordation of a single lump sum levy); (ii) in the case of Special Assessment Bonds, the proceeds of deemed loans are used to pay the costs of improvement, while in the case of Special Tax Bonds, the proceeds of the bonds are used (directly) to pay the costs of the improvements; (iii) in the case of Special Assessment Bonds, only improvements of local benefit to properties may be financed, while in the case of Special Tax Bonds, both improvements of local benefit and improvements of general benefit may be financed; and (iv) in the case of Special Assessment Bonds, the formula must be based solely on the amount of benefit to each parcel benefited by the local improvements, but in the case of Special Tax Bonds, the special taxes may be based on any equitable formula without regard to special local benefit to property and without necessity for payment by all parcels in the district.

Attorneys not grounded in the fundamentals of assessments and local benefit bonds may easily overlook the differences between Special Assessment Bonds and Special Tax Bonds and simply view the difference as between bonds payable from assessments and bonds payable from special taxes. As outlined above, however, this casual view overlooks the distinction between the two types of bonds. We are of the firm view that Congress understood this distinction and carefully provided for this distinction in the enactment of Code sections 141(c)(1) and (2). We are also of the view that in order to extend Code section 141(c)(1) to any type of bond payable from special taxes or assessments, an amendment of Code section 141(c)(1) is necessary.

Why is the Distinction Important? The distinction is important because the private business use test permits the use of 10 percent of the bond proceeds for a private business use (related), while the private loan financing test permits only 5 percent of the proceeds of bonds to be used for items that are not "essential governmental functions." The distinction is also important because the private business use test is a negative test, i.e., it must be determined that no more than 10 percent of the proceeds are used for a private business use (while the remaining proceeds may be used for anything else), while the private loan financing test is a positive test, i.e., it must be determined that 95 percent of the proceeds are to be used for "an essential government function." In addition, the distinction is important because the private business tests consist of two tests (the use test and the security or payment test), while the private loan financing test consists of a single test (the loan test). Finally, the distinction is important because if §1.141-5(c)(3) and (5) are retained in their present form, the ability to issue Special Tax Bonds in California in accordance with customary procedures will be substantially eliminated as discussed below.

Thus, for example, if bonds are to be issued for parking facilities (assuming that the facilities perform an essential government function) and the type of bonds to be issued is general obligation bonds, then all of the parking facilities could be used for private use (e.g., donated to a private company), but if Special Assessment Bonds are issued, than only five percent of the parking facilities could be used for private use (because 95 percent would be required to be maintained as an essential government use). In addition, if Special Tax Bonds are issued under present law, ten percent could be used for private use (assuming a related use), but under the proposed regulations only five percent could be used for private use (because the bonds would be payable from special taxes, without regard to whether a deemed loan was involved).

Congressional Intent; Legislative History. As the Service is aware, the predecessor section to Code section 141(c) was 1954 Code section 103(o) ("consumer loan bonds") which was enacted by section 626(a) of the 1984 Tax Act. At the time of enactment of 1954 Code section 103(o), Congress was concerned with tax-exempt bonds issued for private functions and recognized that not all private function bonds fell within industrial development and mortgage subsidy limitations contained in 1954 Code sections 103 and 103A.

Thus, for example, as indicated by the legislative history of the 1984 Tax Act, Congress was concerned regarding the issuance of bonds the proceeds of which would be loaned to property owners for discretionary shoreline improvements. In addition, Congress may have been aware of discussion regarding the issuance of "car loan bonds" the proceeds of which would be loaned to low income persons for the purchase of automobiles for use for commuting to places of employment not located on public transportation lines. These types of bonds were not limited by 1954 Code sections 103 and 103A (because they did not finance facilities used in a trade or business or single family homes). The Congressional intent behind the general rule, therefore, was to prohibit the issuance of tax-exempt bonds for private functions through the financing mechanism of a loan.

Congress did not, however, intend to limit traditional bonds for governmental improvements; therefore (as discussed above), because assessment bonds entail a unique financing structure under State law, Congress added an exception to the general rule. The exception was enacted as a very precise recognition of the distinction made in State law between special assessments (called special taxes in some States) and other forms of governmental levies imposed on residents and property owners.

Thus, the General Explanation to the 1984 Tax Act provides as follows:

Loans to enable a borrower to finance any tax or governmental assessment of general application for an essential governmental function are not taken into account. For example, bonds to finance mandatory municipal water and sewer installation assessments that a local government permits residents of the jurisdiction generally to pay over a period of years are not treated as consumer loan bonds. On the other hand, bonds to finance loans that are available to the public generally, but are not used to finance a governmentally mandated activity would be consumer loan bonds. An example of such prohibited loans would be a program under which loans financed with bond proceeds are available to persons owning property adjacent to a shoreline for the purpose of building discretionary breakwaters." General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, prepared by the Staff of the Joint Committee on Taxation at page 952. (Emphasis added.)

The intent of the exception in our view was to distinguish between traditional bonds issued to finance assessments and (modern) bonds issued to finance governmental loan programs, such as the governmental programs referenced in §1.103-13(h) of the arbitrage regulations (now §§1.148-1(b)and 1.148-2(d)(2)(iii) relating to "governmental program obligations" including loans to a substantial number of members of the general public).

Similarly, the Senate Report relating to the 1986 Tax Act, in describing the 1954 Code provision, stated as follows:

Additionally, an exception is provided for loans to nonexempt persons to finance taxes or assessments of general application for specific governmental facilities (i.e., the financing technique known as tax-assessment bonds). Under this exception, the loans to nonexempt persons for this purpose are disregarded in determining whether interest on bonds is tax-exempt. . . . For example, the fact that a qualified governmental unit permits residents generally to pay mandatory assessments levied in connection with sewer, water, or similar specific governmental facilities over a period of years generally is disregarded in determining whether interest on bonds for water or sewer facilities is tax-exempt. . . . Thus, if a water or sewer system is owned and operated by a governmental unit, the bonds would be tax-exempt governmental bonds, notwithstanding the indirect loans arising from deferred payment of assessments.

Unlike the IDB use test, the private loan bond restriction applies whether bonds are used to finance personal loans or business loans. S. Rep. 99-313, p. 811. (Emphasis added.)

The House Report contains a similar reference, as follows:

An exception to this restriction is provided (as under present law) for the financing technique accomplished with obligations known as tax-assessment bonds. Indirect loans made to enable a borrower to finance a tax or governmental assessment of general application for an essential governmental function are disregarded in determining whether the interest on an issue is tax-exempt. Under this exception, the deemed loans arising from mandatory taxes or other assessments of general application for specific essential governmental functions (as opposed to installment payments of property or other taxes generally) that a qualified governmental unit permits its residents to pay over a period of years, are disregarded in determining if interest on the bonds is tax-exempt. (H. Rep. No. 99-426, page 525. Emphasis added.)

Based upon this legislative history, we are of the view that the private loan financing test was intended to restrict loans, other than loans arising by reason of assessments or taxes being "financed." We therefore believe that the omission in the proposed regulations of the concept of "financing" assessments or taxes does not reflect legislative intent.

Traditional State Law. For background purposes, we note that financing local benefit improvements through assessments is a traditional form of financing. We encourage a perusal of Volume 14 The Law of Municipal Corporations, Third Edition, by Eugene McQuillin. One of the "bibles" of municipal bond law, this volume is dedicated entirely to assessments and includes citations to literally thousands of judicial decisions relating to assessments, their unique characteristics and the manner by which they are distinguished from other forms of governmental levies. As indicated in the first section of the volume,

[l]ocal assessments prevailed in England several centuries ago, and the assessments made there by the commissioners of sewers on the lands affected by their operations was taxation of this character, and they prevailed from an early day in nearly all American states whose jurisprudence is rooted in common law. (McQuillin, vol. 14, sec. 38.01, p. 13, citing 8 cases themselves discussing the history of special assessments. Emphasis added.)

The distinction between financing through assessments and other forms of financing is a clear concern of State (and Federal) constitutional law. If an issuer intends to finance an improvement that not only is public, but also is "of local benefit," then the issuer may impose an assessment upon property owners to pay those costs without violating the Constitutional limitations against taking of property without due process of law, assuming proper notice and hearing. If an issuer intends to finance an improvement that is public but not of local benefit, then those Constitutional restraints do not come into play (for generally the issuer is exercising the taxing power to which the concepts of due process of law do not apply). Thus, the principle underlying special assessments to meet the cost of public improvements is that the property upon which they are imposed is peculiarly benefited, and therefore the owners do not, in fact, pay anything in excess of what they receive by reason of such improvements. Norwood v. Baker, 172 U.S. 269, 179, 19 S.Ct. 187, 190 (1898). (See also, White v. County of San Diego, 26 Cal.3d 897, 904, 608 P.2d 728 (1980) and cases cited therein holding that property may be specially assessed only for improvements that provide it benefits beyond those received by the public.)

Administrative Difficulty. We believe that if the private loan financing test is extended (through the exception) to apply to all bonds payable from special taxes or assessments, without regard to the element of a loan involved in the law of special assessments, the Service will be faced with a constant consideration of the difference between a tax, a special tax and an assessment. If, however, the private loan financing test is not so extended through the exception, but is limited to bonds payable from assessments levied for local benefit, i.e., bonds issued "to finance" loans, then this administrative difficulty will be eased.

For example, in the recent California case of Hoogasian Flowers, Inc. v. State Board of Equalization, 23 CA 4th 1264 (1994), the California Court of Appeals held that every tax levied by a special district or agency (including but not limited to water districts, sewer agencies, school districts and certain joint powers authorities) is a "special tax" and therefore subject to the two-thirds vote requirement imposed by Proposition 13. If §1.141-5(c) applies to all bonds payable from special taxes and if the federal agencies and courts ultimately refer to State law to determine whether the source of payment of bonds is a "special tax," then all California special district obligations payable from taxes would be subject to the constraints of the private loan financing test, while the same obligations in other States would not be subject to the constraints of the private loan financing test. As a distinction between States would not be appropriate, the Service would be required to develop on a case-by-case basis a federal law for determining the meaning of a special tax. This task would be difficult. As stated by one California court, "There can be no doubt that the term "special taxes" is ambiguous in the sense that it has been interpreted to mean different things in different contexts." City and County of San Francisco v. Farrell, 32 Cal. 3d 47, 53, 648 P.2d 935 (1982). The Service will not be faced with this difficulty, however, if the loan element of the private loan financing test is retained by modifying §1.141-5(c) to refer to bonds issued "to finance" taxes or assessments over a period of years, as contrasted with the statement that a federal loan arises when a governmental unit permits its residents "to pay" a tax or assessment over a period of years.

Code Section 164. We have given some thought to the application of Code section 164 to Code section 141(c), and we are generally of the view that special assessments are not general taxes under Code section 164 by reason of the exception in Code section 164(c)(1). Nevertheless, we do not advocate an approach to the effect that if a levy is within Code section 164(c)(1), it is automatically to be considered under the exception of Code section 141(c)(2), for the reason that Code section 141(c)(2) first entails the finding of a loan.

We believe there are instances when a levy may not be a general tax by reason of the exception under Code section 164(c)(1), but also may not entail a loan under Code section 141(c)(2). The primary instance in California involves certain (but not all) special taxes levied to pay Special Tax Bonds (discussed above). Some of those special taxes, or portions of those special taxes, may be within the exception of Code section 164(c)(1) because they are levied for local benefit improvements, but some may not as they are levied for improvements not of local benefit, but in either event the special taxes do not ordinarily entail the making of a loan. It is also clear that Code section 164 relates to general tax considerations of individual taxpayers, while Code section 141(c) relates to bond issuers (and persons paying tax by reason of receiving interest on the bonds).

B. §§1.141-5(c)(i)(A) and 1.141-5(c)(3) Eliminate Mandatory Tax or Assessment Requirement

Comment. Whether or not the omission of the loan concept in the tax assessment bond exception to the private loan financing test is remedied (see discussion in Part V.A. above), the mandatory tax or assessment requirement should be removed.

Suggested Regulatory Language. Modify §1.141-5(c) to delete paragraphs (2)(i)(A) and (3) (mandatory tax or other assessment).

Reasons. Paragraphs (2)(i)(A) and (3) of §1.141-5(c) require that special taxes and assessments be levied on all benefited residents in an amount proportionate to benefit. The concept of benefit, however, is peculiarly one of State law. It relates to property (i.e., it is an in rem concept) and to the increase in property value that results from the installation of improvements of local benefit. The State law concept does not relate, therefore, to residents as referenced in §1.141-5(c)(3) or to the benefit resulting from general public improvements financed with special taxes. If §§1.141-5(c)(2)(i)(A) and 1.141-5(c)(3) are retained, therefore, the federal tax law, will be imposing new federal concepts that have no basis in State law. This will, we believe, cause administrative difficulties for both the Service and issuers.

In addition, under California law, special taxes imposed to pay debt service on Special Tax Bonds (see discussion in Part V.A. above) are levied in accordance with a unique formula developed in each case of bond financing for a community facilities district to reflect overall economic benefit and including, in many cases, a concept of payment in accordance with affordability. Entire areas that receive services from, for example, new fire facilities, may be excluded from the special taxes levied to pay debt service on Special Tax Bonds issued to finance those facilities. The exclusion may be based, for example, on the fact that persons living in that area are elderly citizens living on a fixed income. Government Code section 53325.3 provides as follows:

A tax imposed pursuant to this chapter [i.e., the Mello-Roos Community Facilities District Act of 1982] is a special tax and not a special assessment, and there is no requirement that the tax be apportioned on the basis of benefit to any property. . . . (Emphasis added.)

Moreover, even in the context of special assessments (as contrasted with special taxes) under State law it is not necessary that all benefited property be directly assessed. Some statutes provide that where a property has made the improvement then to be financed, that property need not pay an assessment. DeHaven v. Berendes, 135 Cal. 178, 67 P. 786 (1901). Moreover, under certain statutes, a city may agree with land owners that in consideration of their conveying to it certain of their land for the improvement then to be financed, their land otherwise subject to assessment will be exempt from assessment and, therefore, the assessment need not be levied or financed. Blake v. Eureka, 201 Cal. 643, 258 Pac. 945 (1927). In addition, a governmental unit may find, in the context of spreading the assessment, that only a portion of a total assessment will be levied on property where dedication of land for a portion of improvements constitutes a contribution entitled to a credit against an assessment. White v. County of San Diego, 26 Cal. 3d 897, 608 P.2d 728 (1980). The required benefit in these cases is not present or is effectively paid with other consideration.

We also note that the formula for spreading the costs of improvements may vary considerably from circumstance to circumstance. "Proportionality" is only one consideration. Formulas for benefits include those referenced in the regulations, as well as formulas based on parcel area, distance from improvement, detriments offsetting benefits, zones of benefits and many other combinations. At issue for the governmental unit and the courts is a question of fact and law regarding the most appropriate method for determining benefit.

We are concerned regarding the language of proposed regulations §1.141-5(c)(3). We are cognizant that much of the language of the proposed regulations conforms to footnote 28 on page 830 of the Senate Report relating to the private loan financing test. This footnote reads, in part, as follows:

The committee understands that taxes or other mandatory assessments with respect to the improvements serving an essential governmental function may be levied on a property frontage basis or may be levied on an ad valorem basis. The committee intends that this exception apply whether the taxes or assessments are based on a property frontage basis, an ad valorem basis or any other comparable method that results in equivalent mandatory assessments to all residents benefiting from the improvements.

In our view, however, the above footnote was intended as an explanation or example rather than a limitation. We also note the following reference in the House Report:

The committee understands that the method of assessing residents for these improvements varies from State to State. Taxes or other mandatory assessments with respect to the improvements serving an essential governmental function may be levied on a property frontage basis or may be levied on an ad valorem basis. The committee intends that deemed loans for this purposes be disregarded in determining the tax status of bonds whether the taxes or other assessment are based on a property frontage basis, an ad valorem basis, or any other comparable method that results in equivalent mandatory assessments to all residents benefiting from the improvements. (H. Rep. No. 99-426, page 526.)

Thus, in some States, assessments may not be levied on the basis of a formula that takes into account an ad valorem basis, while in other States, ad valorem may be used as a component of benefit. Also, ad valorem is ordinarily recognized as the measure of general property taxes and there could have been a question at the time of adoption of the 1984 Tax Act regarding whether an assessment that had ad valorem as a component of the measure of benefit was included in the exception for tax-assessment bonds. We believe that the reference to "comparable method" was intended to indicate that benefit assessments generally were the subject of the exception rather than taxes generally. (See discussion in Part V.A. above.) Similarly, we believe that the reference to "equivalent" assessments was not intended to imply that certain benefited properties could not be omitted if acceptable under State law.

It must be clear at this point that assessments is a difficult technical subject regarding which there is much State law. The footnote in the Senate Report and the brief reference in the House Report could not have included all of the permitted permutations of State law and it is inappropriate for private activity bond regulations both to extend the rule to include all special taxes and assessments and narrow the exception to be limited to benefit assessments.

C. §1.141-5(c)(5) Omit Requirement for Assessments to be Levied on a Non-Discriminatory Basis

Comment. We suggest that the requirement for the amounts and rates of assessments to be levied on a non-discriminatory basis exceeds scope of the legislative history reference to a discriminatory procedure that permitted certain, but not other, properties to pay assessments in cash.

Suggested Regulatory Language. Modify §1.141-5(c)(5)(i) as follows:

(5) Equal basis requirement--(i) In general. An assessment does not satisfy the equal basis requirement if the terms for payment of the assessment are not the same for all assessed persons (for example, if certain residents are permitted to pay the assessment over a period of years while others must pay the entire assessment immediately or if the assessment is required to be prepaid when the property is sold). In addition the amounts payable and the rates used to determine those amounts must be determined on the basis of non-discriminatory criteria Thus, for example, an assessment does not satisfy the equal basis requirement if imposed on a different basis for business and non-business beneficiaries. The equal basis requirement is not, however, violated solely because an assessment varies on the basis of the relative benefit conferred.

Reason. We are aware that the source of the non-discrimination requirement is the legislative history reference that both "business and nonbusiness property are eligible to make deferred payments of such tax or assessment on an equal basis." (H. Rept No. 99-426, 526.) Assessment proceedings ordinarily involve the initial opportunity for assessed property owners to pay their assessment in cash. If the assessment is not paid in cash, then under modern practice, the assessment is financed through the issuance of assessment bonds. We understand that the rule relating to eligibility of property to make deferred payments derived from the procedure followed in the case of a specific assessment proceeding that was pending in a southern State during consideration of the 1986 Tax Act, which permitted cash payment of the levied assessment by nonbusiness property and prohibited the cash payment of assessment by business property in order to permit the issuance of bonds payable solely from assessments levied on business property.

We are doubtful that Congress intended that its concern regarding cash payment of assessments be compounded into an equal basis requirement not contemplated, indeed prohibited, in State law.

Although various constitutional questions arise in the context of the appropriateness of a particular assessment, it has been held in California and other States that the constitutional requirement of equality and uniformity of taxation has no application to assessments or special taxation for local improvements. See Emery v. San Francisco Gas Co., 28 Cal. 345 (1865) and subsequent cases. (Similarly, the requirement for local benefit has no application to general taxes levied for general public improvements.)

We note particularly that the United States Supreme Court in the Norwood case cited above, in analyzing special assessments within the Constitutional prohibition against taking property without due compensation noted the probability of less than exact levies:

In our judgment, the exaction from the owner of private property of the cost of a public improvement in substantial excess of the special benefits accruing to him is, to the extent of such excess, a taking under the guise of taxation, of private property for public use without compensation. We say "substantial excess," because exact equality of taxation is not always attainable; and for that reason the excess of cost over special benefits, unless it be of a material character, ought not to be regarded by a court of equity, when its aid is invoked to restrain the enforcement of a special assessment. Norwood v. Baker, 172 U.S. 969, 19 S.Ct. 187 (1898), at page 191.

We are particularly concerned that the non-discrimination requirement will substantially curtail or eliminate Special Tax Bonds in California as they are now issued. As referenced above, the formula for levy of the special taxes supporting Special Tax Bonds is permitted to take into account any appropriate factors that will enable the local government unit to conclude that the special taxes have been levied on an equitable basis. The formula may, and often does, take into account present uses of property, such as business or non-business uses, industrial business or commercial business uses, low-income residents or moderate-income residents, potential for a change in property use and the like. The non-discrimination requirement of §1.141-5(c)(5) will result in the need to levy the special tax supporting Special Tax Bonds in compliance with the requirements for "taxes of general applicability" or with the requirements for "special benefit assessments."

The State legislature, however, enacted the Mello-Roos Community Facilities Act of 1982 to enable the financing of public improvements using flexible tax formulas not constrained by the requirements for levy of general taxes supporting general obligation bonds or the rules for benefit assessments supporting Special Assessment Bonds. We believe that it would be inappropriate for the federal tax law to construe the private loan financing test so as to eliminate the ability to use the flexible tax formulas sanctioned in State law.

D. §1.141-5(c)(5)(ii) Eliminate Credit Enhancement Limitation Relating to Tax Assessment Bonds

Comment. The limitation upon credit enhancement to assessments and benefited property restricts marketability of certain traditional bonds and should be removed.

Suggested Regulatory Language. Modify §1.141-5(c)(5)(ii) as follows:

(ii) Additional security. The equal basis requirement is not violated as a result of one benefited party acquiring a guaranty of a third party to pay debt service on the bonds if it is not reasonably expected that payments will be made because of the additional assurances that otherwise would not have been made and the guarantor's recourse is limited to the assessments and the benefitted property.

Reason. Two fundamental issues are raised by §1.141-5(c)(5)(ii) that have been of some concern since the enactment of the 1984 Tax Act: (1) If a mandatory tax assessment is not a deemed "loan" for purposes of the private loan financing test by reason of Code section 141(c)(2)(A), is it nevertheless included as a deemed loan if the bonds payable from the tax assessment secured by credit enhancement? (2) Is the answer dependent on the security for the credit enhancement? In our view, the answer to both of these questions should be "no."

Whether a mandatory tax assessment qualifies for the exception should depend upon the nature of the mandatory tax assessment itself and not upon separate guaranty or credit enhancement arrangements. In other words, the application of the exception for mandatory tax assessments should not be dependent upon the source of the payment (e.g., the economic strength of the assessed owner), but rather should be dependent upon the character of the levy.

We believe that the Service correctly analyzed the issues in private letter ruling 8945032 (August 15, 1989). In the facts of the ruling, the bonds were payable from tax increment revenues and were to be secured by municipal bond insurance or a letter of credit in turn to be secured by the guaranty of a private company. The Service held that the bonds did not satisfy the private loan financing test since (i) the improvements were to be governmentally-owned, (ii) the property taxes were to be paid in the same amount (whether or not increment was to be captured), and (iii) the company was not expected to be required to perform under its guarantee. The Service concluded:

In this case we do not believe that either the company or the other owners of real property within the jurisdiction of Authority 1 . . . have received the benefits that are the economic equivalent of a loan through the issuance of bonds. . . .

Although the above ruling related to generally applicable taxes and §1.141-5(c)(5)(ii) relates to special assessments or special taxes, we believe that the analysis should be the same; that is, we do not believe that the character of the levy should change merely because the bonds payable from the tax assessments are secured by municipal bond insurance or a letter of credit that is in turn secured by the guaranty of a private company even though the guarantor's recourse is not limited to the tax assessments and the benefited property. The tax assessments are levied on the land and not upon the owner of the land. The credit enhancement may relate to the owner in that it may be guaranteed by the owner, but the guaranty does not modify the nature of the levy as a tax assessment upon land and should not therefore modify the exclusion of the levy from characterization as a deemed loan under Code section 141(c)(2)(A).

The distinction is of particular importance to the marketability of California Special Assessment Bonds and Special Tax Bonds. These Bonds, sometimes referenced as "land-secured bonds," are generally not rated by the rating agencies. The addition of credit enhancement, therefore, is often necessary to obtain a rating and to improvement marketability. For the same reason that the bonds are sometimes difficult to market when secured only by tax assessments upon land, credit enhancement is often difficult to obtain when secured only by land. A broader based guaranty is ordinarily required. Under §1.141-5(c)(5)(ii), the broader based guaranty will not be permitted.

§1.141-6(b) Delete Special Rules for Mixed Use Facilities

Comment. The limitation of private business use to discrete portions of mixed use facilities and the limitation of discrete portions to portions separated by physical barriers or separate ownership portions of output facilities narrows the rule of Code section 141(b)(1) beyond that set forth or intended by Congress.

Suggested Regulatory Language. Delete §1.141-6(b). Change lettering of (c) through (d) to conform.

Reason. See reasons and discussion under Part III.H. above.

§1.141-15(b): Delete Example 1

Comment. In order to assure orderly growth, California redevelopment agencies and cities frequently coordinate debt issuance. Example 1 of §1.141-15(b) implies that such coordination is improper.

Suggested Regulatory Language. Delete Example 1 from §1.141-15(b).

Reasons. Tax increment bonds are often issued by California redevelopment agencies for the purpose of acquiring and clearing parcels of land for transfer, subject to covenants and conditions, to private entities that are willing to construct privately-owned housing and commercial and industrial buildings on that land. This procedure is in furtherance of the redevelopment purposes of those agencies and is a primary method by which those agencies exercise their powers to achieve their redevelopment purposes. Although the proceeds of the bonds are used for private business use and therefore the private business use test is satisfied, the tax increment bonds are secured by generally applicable taxes, without special taxing agreements, and do not satisfy the private security or payment test. In addition, since the land is transferred as a gift or for an amount not in excess of five percent of the present value of debt service on the tax increment bonds, the "indirect" security or payment test is not satisfied. The tax increment bonds are not, therefore, private activity bonds.

In coordination with the redevelopment agency, the city in which the agency is located will frequently issue assessment bonds or special tax bonds for the purpose of financing the costs of streets, parks, sewer and water facilities and other public improvements in redevelopment project areas. These improvements are used by the public generally. Although the assessment or special tax bonds are not secured by generally applicable governmental taxes or other revenues, and therefore may satisfy the private security or payment test, the proceeds of the bonds are not used for a private business use. The assessment or special tax bonds are not, therefore, private activity bonds.

The tax increment bonds issued by redevelopment agencies and the assessment or special tax bonds issued by the cities may be issued less than, or more than, a year apart, but are never sold at the same time nor payable from the same source of revenues. The tax increment bonds and the assessment or special tax bonds are not, therefore, treated as a single issue under regulations §1.150-1(c).

The redevelopment agency and the city may coordinate debt issuance with one or more developers or major industries who are generally identified after a selection and negotiation procedure in which the alternative plans for the redevelopment area are submitted, reviewed, modified and approved. We are concerned that Example 1 of §1.141-15(b) casts doubt on the validity of this very traditional procedure and we suggest that the Example be deleted.

We believe that the inclusion of the Example in the proposed regulations produces great uncertainty at the time of issuance of an issue. Will it be possible for the Internal Revenue Service to take the position that a subsequent issue is part of the issue then being issued? Is there any way to protect against this possibility? Under what circumstances is the transfer of benefits of tax-exempt financing to a nongovernmental person in full compliance with the provisions of section 141 to be considered inconsistent with the purposes of section 141? We suggest that the breadth of the Example could hinder a significant number of bond issues that are coordinated by redevelopment agencies and cities in California and that this uncertainty was not intended by Congress.

We suggest the deletion of Example 1 of §1.141-15(b).

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