TAX-EXEMPT BOND COMPLIANCE
August 10, 2012
Peter H. Serreze
Ropes & Gray LLP
Boston, Massachusetts
I.
INTRODUCTION
This paper is a summary of basic tax law principles relating to tax-exempt bond compliance for
colleges and universities. It is adapted from the Ropes & Gray manual entitled Post-Issuance
Bond Compliance: A Guide to Practical Strategies and Procedures for 501(c)(3) Borrowers.
Like the Ropes & Gray manual, this summary focuses on 501(c)(3) bonds, not governmental
bonds, and in some respects the rules for governmental bonds and 501(c)(3) bonds are different.
Nevertheless, there are more similarities than differences between the two types of bonds, and a
majority of the summary should be relevant for public institutions whose bonds are of the
governmental rather than 501(c)(3) variety.
The following briefly outlines the most important differences between governmental and
501(c)(3) bonds from a post-issuance compliance standpoint:

Use by a 501(c)(3) institution. For 501(c)(3) bonds, private business use does not arise
from the use of bond-financed property by a 501(c)(3) institution (unless that use is
considered an unrelated trade or business for the institution). For governmental bonds,
however, use of bond-financed property by a 501(c)(3) institution, whether or not an
unrelated trade or business, is considered private business use.

Limit on amount of private business use. For 501(c)(3) bonds, in general, there is a 5%
limit on private business use in a given bond issue. For governmental bonds, in general,
the limit is 10% of the bond issue, although a 5% limit applies to use that is considered
unrelated to any government use of bond proceeds, and use that is considered
disproportionate to governmental use of bond proceeds, as described more specifically in
I.R.C. section 141(b)(3). (As with 501(c)(3) bonds, a 25% limit on private business use
and the $15 million effective cap on private business use can apply in some
circumstances, as explained in the summary.)

Costs of issuance. For 501(c)(3) bonds, bond proceeds spent on issuance costs (including
underwriter's discount) are treated as subject to 100% private business use. For
governmental bonds, they are treated as common costs, and therefore generally have a
private business use percentage equal to the weighted average private business use
percentage of the projects financed by the issue.

Reserve fund. For 501(c)(3) bonds, bond proceeds deposited into a reserve fund for the
issue are excluded from the calculation of private business use; that is, they are not taken
into account in either the numerator or denominator of the private business use fraction.
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For governmental bonds, bond proceeds deposited into a reserve fund are treated as a
common cost, and therefore generally have a private business use percentage equal to the
weighted average private business use percentage of the projects financed by the issue.

100% ownership rule. For 501(c)(3) bonds, 100% of the property financed by the bond
issue is required to be owned by a 501(c)(3) institution (or state or local governmental
entity) at all times while the issue is outstanding. There is no such requirement for
governmental bonds.

Form 990, Schedule K. Many 501(c)(3) bonds must be reported to the IRS annually on
Schedule K to the redesigned Form 990. There is no such requirement for governmental
bonds.

Structure of bond issues. More generally, the structures that are used to finance a public
institution's facilities on a tax-exempt basis can take forms that are not available to
private institutions. For example, in some states, bonds can be issued at the state level to
finance a variety of purposes, including to benefit a state university. Structures like these
can raise different post-issuance compliance considerations than in the 501(c)(3) bond
context.1
In many cases, however, issuances of governmental bonds for public universities are
structured in a way that resembles 501(c)(3) financing structures. For example, an
issuing authority may issue bonds for the exclusive benefit of one or more campuses of
the state university system. The post-issuance compliance considerations for
governmental bonds issued through such structures would be similar to those for
501(c)(3) bonds.
II.
BASIC TAX LAW PRINCIPLES
To maintain a bond issue’s tax-exempt status following the issue date, the borrower must comply
with the rules relating to private business use and arbitrage provided by the Internal Revenue
Code and Treasury Regulations. The following first summarizes the rules relating to private
business use, and then summarizes the rules relating to arbitrage. Again, this summary focuses
on 501(c)(3) bonds; please see the Introduction for a description of the differences between
501(c)(3) and governmental bonds.
1
For example, in these circumstances, private business use tracking may not be required at all, if (i) the issue
qualifies for the special exception available to certain governmental bonds that finance at least 25 separate purposes
and where private business use is not expected, as of the issuance date, to exceed the applicable limit (see Treas.
Reg. section 1.141-2(d)(5)), or (ii) the payment of debt service on the bonds is not derived from the public
institution, and the public institution's property and revenues are not security for the bonds, in which case there may
be no "private payment or security" with respect to the bond proceeds benefiting the public institution within the
meaning of I.R.C. section 141(b)(2).
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A.
Private business use2
1.
Basic rules
(a)
501(c)(3) bonds are generally not entitled to tax-exempt status if the
limit on "private business use" is exceeded.3
(b)
"Private business use" generally means:
(c)
(i)
use of bond-financed property in a trade or business by any person
or entity other than the borrower, a 501(c)(3) affiliate of the
borrower, or a state or local government entity, and
(ii)
use by the borrower (or any other 501(c)(3) organization) in an
"unrelated trade or business."
The limit on private business use is typically 3% to 5% of net proceeds.
(i)
Technically, the limit is 5% of net proceeds in most cases, but
proceeds used for costs of issuance – separately capped at 2% – are
counted as private business use, reducing the remaining limit to as
low as 3%.4
(ii)
In certain cases, refunding issues that refunded, directly or
indirectly, certain pre-1987 issues are entitled to a private business
use limit of 25%. It should be apparent from the tax certificate or
tax regulatory agreement whether a refunding issue qualifies for
the higher limit.5
(iii) For issues larger than $300 million, the full 5% private business
use allowance may not be available.6 Borrowers should consult
with tax-exempt bond counsel regarding any such issues.
2
See I.R.C. §§ 141, 145; Treas. Reg. §§ 1.141-2, 1.141-3, 1.145-2.
3
Technically, bonds that fail to satisfy the private business use test are not ineligible for tax-exempt status unless
they also fail the "private payment or security" test. The private payment or security test is failed if, very generally,
more than 5% of the debt service on the bonds is derived from payments in respect of property subject to private
business use, or is secured by property subject to private business use. The private payment or security test can be
very difficult to measure and apply and should only be considered in consultation with tax-exempt bond counsel.
4
See Treas. Reg. § 1.145-2(c)(2).
5
The tax certificate/tax regulatory agreement for a refunding issue that is subject to a 5% limit would likely recite
that fact. By contrast, the tax certificate/tax regulatory agreement for a refunding issue that is subject to a 25% limit
would likely indicate that the bonds are being issued pursuant to Section 1313(a) of the Tax Reform Act of 1986,
and would require that the borrower not use a "major portion" of the proceeds of the issue for private business use.
6
This is because the amount of private business use is generally capped in dollar terms at $15 million. See I.R.C. §
141(b)(5). Mathematically, this means that any issue larger than $300 million (which is $15 million divided by 5%)
may not be entitled to the full 5% private business use allowance. But in some cases the full 5% limit may still be
available – either if "volume cap" was obtained for the bonds before being issued, or if a "multipurpose allocation"
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(iv) For this purpose, "net proceeds" means the total sale proceeds of
the issue, plus any investment earnings on proceeds allocable to
the projects (including earnings on proceeds for capitalized interest
and costs of issuance), minus sale proceeds of the issue held in a
"reasonably required" reserve fund.7
(d)
2.
The amount of private business use is determined on a bond-issue-bybond-issue basis. That is, the amount of private business use is
calculated separately with respect to each bond issue8, even if multiple
bond issues financed different portions of the same project, and even if a
single bond issue financed many different projects.
Types of private business use9
(a)
Transfer of ownership.10 A transfer of ownership of bond-financed
property to a private business user results in private business use (as well
as potentially a violation of the "100% ownership" requirement – see
Section II.A.4 (p. 12).
(b)
Leases and rentals11
(i)
General rule. A lease or rental of bond-financed property by a
private business user constitutes private business use, unless an
exception is satisfied. For example, in a bond-financed hospital,
leases for private physician offices or leases to private business
users operating gift shops, cafes, or pharmacies give rise to private
business use.
(ii)
Exceptions. The following leases and rentals do not give rise to
private business use:
(1)
Rental to another 501(c)(3) entity mutually in furtherance of
exempt purposes. A rental by the borrower to another
501(c)(3) entity should not give rise to private business use if
(i) the other entity will use the property solely in furtherance
can be made which would effectively break the issue into smaller components for certain tax purposes. Borrowers
in this situation should discuss the issue with tax-exempt bond counsel.
7
Most bond-funded reserve funds are structured to qualify as a "reasonably required" reserve fund. The tax
certificate or tax regulatory agreement should contain a recital of this fact.
8
Typically, although not always, bonds issued on the same date constitute a single "issue" for private business use
purposes even if divided into separate series. If more than one bond series are being issued on or around the same
date, the borrower should refer to the tax certificate/tax regulatory agreement to determine whether the bonds consist
of a single "issue."
9
See Treas. Reg. § 1.141-3(b).
10
See Treas. Reg. § 1.141-3(b)(2).
11
See Treas. Reg. § 1.141-3(b)((3).
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of its tax-exempt purposes, and (ii) the rental itself
substantially contributes to the borrower's own tax-exempt
purposes. Example: university leases space in a research
building to an affiliated 501(c)(3) organization, or to an
unrelated 501(c)(3) organization for the purpose of
facilitating collaborative research.
12
(2)
Rental to unrelated 501(c)(3) entity for no compensation (or
compensation not to exceed actual costs). A rental of
property to an unrelated 501(c)(3) entity should not give rise
to private business use if the borrower receives no payments,
from the other 501(c)(3) entity or otherwise, in respect of
such rental, or if any payments do not exceed the borrower's
actual expenses attributable to the operation and maintenance
(but excluding general administrative or overhead expenses)
of the rented property. (Further, the other 501(c)(3) entity
must use the property solely in furtherance of its exempt
purposes). Example: university allows unrelated 501(c)(3)
entity to use conference rooms for no charge.
(3)
Generally available use – 100 day limit.12 A rental of
property that is made generally available to third parties
(though not necessarily individuals) should not give rise to
private business use if (i) the term of use under the
arrangement, including renewal options, does not exceed 100
days, (ii) the property is not financed for a principal purpose
of providing it to an outside user, (iii) to the extent the
property is not generally available to individuals, the reason
is because "generally applicable and uniformly applied rates
are not reasonably available to natural persons not engaged
in a trade or business," and (iv) the rental itself does not
constitute an unrelated trade or business for the borrower.13
For example, a university rents classroom space in the
evening to a for-profit company to hold classes that further
the borrower’s educational mission, pursuant to a firstcome-first-served policy and established rate schedule.
See Treas. Reg. § 1.141-3(d)(3)(i).
13
Because of an ambiguity in the language of the regulations, the borrower could reasonably take the position that
the “generally available use – 100 day limit” and "non-public use – 50 day limit" exceptions can be satisfied even if
clause (iv) above is not satisfied – i.e., even if the rental does constitute an unrelated trade or business for the
borrower. There is no IRS guidance on this issue, which has been the subject of discussion within the bond
community. The more conservative approach is to assume that the presence of an unrelated trade or business indeed
prevents the borrower from satisfying these exceptions.
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(c)
(4)
Non-public use – 50 day limit.14 A rental of property should
not give rise to private business use if (i) the arrangement "is
a negotiated arm's-length arrangement, and compensation
under the arrangement is at fair market value," (ii) the term
of use under the arrangement, including renewal options,
does not exceed 50 days, (iii) the property is not financed for
a principal purpose of providing it to a user other than the
borrower, and (iv) the rental itself does not constitute an
unrelated trade or business for the borrower.15 For example,
a university rents classroom space in the evening to a forprofit company to hold classes that further the borrower’s
educational mission, pursuant to a separately negotiated,
fair market value agreement.
(5)
Non-possessory uses.16 A use of a facility by a third party
(whether or not described as a "rental") should not give rise
to private business use if (i) the user does not have
possession and control of space that is physically separated
from other parts of the facility (e.g., by walls) except in the
case of vending machines, pay phones, kiosks and the like,
(ii) the non-possessory use is not functionally related to any
other use of the facility by the same party, and (iii) all nonpossessory uses of the facility do not, in the aggregate,
involve the use of more than 2.5% of the facility. This
exception may cover, for example, a rental of roof space for
a mobile telecommunications tower.
Management or service contracts17
(i)
Basic rule. A management or service contract with respect to
bond-financed property may give rise to private business use,
based on all the facts and circumstances. As a practical matter, this
means that if a contract is considered a "management or service
contract" and does not satisfy the requirements of IRS Rev. Proc.
97-13 (see below), the borrower should typically treat the contract
as giving rise to private business use.
(ii)
What is a management or service contract? In general, a
"management or service contract" is an agreement with a private
business user under which the user provides services with respect
14
See Treas. Reg. § 1.141-3(d)(3)(ii).
15
See footnote 13.
16
See Treas. Reg. § 1.141-3(d)(5).
17
See Treas. Reg. § 1.141-3(b)(4); Rev. Proc. 97-13.
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to bond-financed property. Examples of management or service
contracts include:
(1)
Contracts under which physician groups (or individual nonemployee physicians) undertake responsibility for the
delivery of a hospital's medical services (for example,
contracts for radiology or anesthesia department services).
(2)
Food service contracts (for example, contracts with Sodexo
or Aramark).
(3)
Parking garage management agreements.
(4)
Contracts under which a private business user performs a
broad range of operational services with respect to a
particular building (e.g., a single company providing
maintenance, loading dock, security, mailroom, and other
services).
(iii) What is not considered to be a management or service contract?
Arrangements that are "incidental" to the exempt uses of the
facility are not treated as management or service contracts and
should not give rise to private business use. The regulations
indicate that contracts for janitorial, office equipment repair, and
hospital billing services are "incidental." By analogy, contracts
for pest control, elevator maintenance, routine IT "tech support,"18
and security services likely qualify for this exception.
(iv) How do we determine whether a given management or service
contract gives rise to private business use? In most circumstances,
to be comfortable that a management or service contract does not
give rise to private business use, the contract will need to qualify
for the "safe harbor" of Rev. Proc. 97-13. To qualify for the safe
harbor, very generally:
(1)
The agreement must not provide the service provider with a
share of net profits from the bond-financed property;
(2)
The agreement must be limited with respect to the length of
the term and the amount of variable compensation payable to
the service provider; as a broad generalization, the shorter
the agreement term, the greater the variable portion of
compensation that may be paid; and
18
By contrast, if a private business user located in bond-financed space performs sophisticated, non-routine
information technology services for the borrower (e.g., customizing the borrower's IT platform), the services
probably do not qualify as "incidental."
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(3)
The service provider must not have any role or relationship
with the borrower (for example, overlapping boards of
directors) that limits the borrower's ability to exercise its
rights under the contract.
Analyzing a contract under Rev. Proc. 97-13 can be deceptively
tricky, and except for very straightforward arrangements, I
recommend that this task be performed by counsel familiar with
the nuances of Rev. Proc. 97-13. A copy of Rev. Proc. 97-13 is
attached to this paper.
(d)
Research agreements.19 A research agreement that is performed in bondfinanced space may give rise to private business use, depending on the
nature of the agreement, the identity of the parties, and other factors.
This discussion only addresses typical sponsored research arrangements
– i.e., where a third party agrees to sponsor research performed solely by
the borrower in bond-financed space – as well as clinical trial
agreements. Other private business use issues may arise from other
types of research arrangements, including where the sponsor's employees
participate in the research in bond-financed space, or where the research
agreement is structured as a joint venture or other separate vehicle.
(i)
Commercially sponsored agreements – basic rule. A research
agreement (other than clinical trial agreements, discussed below)
sponsored by a commercial entity under which the sponsor may
obtain rights to resulting technology generally will give rise to
private business use unless the agreement qualifies for the "safe
harbor" provided by IRS Rev. Proc. 2007-47, which requires the
following:
(1)
The activity consists of "basic research";
(2)
The transfer of any resulting technology to the sponsor is
priced at fair market value; and
(3)
Fair market value is determined at the time the technology is
available for use, not earlier.
Thus, an agreement giving the sponsor an option to acquire an
exclusive license to any resulting technology in exchange for a
price specified in the contract would not satisfy Rev. Proc. 200747. Indeed, even if the price is to be negotiated at the time the
technology is available for use, Rev. Proc. 2007-47 likely would
19
See Treas. Reg. § 1.141-3(b)(6); Rev. Proc. 2007-47.
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not be satisfied if the agreement provides that the price will take
into account the sponsor's financial contributions to the research.
A copy of Rev. Proc. 2007-47 is attached to this paper.
(ii)
Commercially sponsored agreements – nonexclusive, royalty-free
licenses. Agreements under which a sponsor is entitled to a
nonexclusive, royalty-free license to resulting technology (a
"NERF") arguably do not give rise to private business use in either
of the following circumstances:
(1)
Rev. Proc. 2007-47 provides a safe harbor for such
agreements if, among other requirements, the borrower
"determines the research to be performed and the manner in
which it is to be performed (for example, selection of the
personnel to perform the research)." The scope of this
exception is not clear, but it would be reasonable to take the
position that the exception is satisfied as long as the sponsor
does not control the design or performance of the research
study. Thus, the fact that a sponsor may agree with the
borrower on the subject of the research should not, under
this view, prevent the exception from being satisfied.
(2)
Also, it would be reasonable to take the position that private
business use does not arise if the borrower would make a
NERF to the technology available to any party that asked
(assuming the borrower would publicly divulge – for
example, through a statement on its website – that a NERF
would be offered to anyone).20
(iii) Research sponsored by other 501(c)(3) organizations. Even if a
transfer of technology to a 501(c)(3) research sponsor does not
qualify under the standards described above, the arrangement
should not give rise to private business use provided that the
sponsorship of the borrower's research is in furtherance of the
exempt purposes of the sponsoring 501(c)(3) organization and is
not a subaward.
If the contract with the sponsoring 501(c)(3) organization is a
subaward (i.e., the organization is acting as a conduit for a prime
sponsor), the prime sponsor would be treated as the sponsor for
purposes of the private business use analysis and the agreement
would need to be tested under the standard applicable to the prime
sponsor. For example, a subaward where the prime sponsor is a
20
It would be harder to make this argument, however, if the technology would not reasonably be expected to have
value to anyone other than the sponsor.
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corporation would need to be tested under Rev. Proc. 2007-47 even
though the immediate sponsor may be a 501(c)(3) organization.
(iv) Federally sponsored research agreements. Typical agreements of
this type (e.g., NIH grants) should not give rise to private business
use, assuming the government does not control the design or
performance of the research study (i.e., the same standard
applicable to commercially sponsored agreements where a NERF
is provided, as discussed above). Contracts with the Department of
Defense, Homeland Security or the FDA may raise special
issues.21
(v)
(e)
Clinical trial agreements. Although there is no IRS guidance
directly addressing this issue, the borrower may reasonably take
the position that private business use does not arise from such
agreements even if the contract has technology transfer provisions
that do not comply with Rev. Proc. 2007-47, if all of the following
requirements are satisfied:
(1)
The participation in the clinical trials is considered an
exempt activity (i.e., not an unrelated trade or business
activity) for the borrower, which should be the case to the
extent that administering the study drug furthers patient care.
(The position that clinical trials further an exempt activity is
weaker, however, to the extent a significant number of
patients are receiving placebos or the clinical trial involves
giving study drugs to patients who are "healthy.");
(2)
The parties are not entering into the clinical trial agreement
for the principal intent of making discoveries; rather, the
principal motivation is patient care (for the borrower) and
product validation (for the sponsor);
(3)
The likelihood of any discoveries is remote; and
(4)
There is no office, lab or other space set aside and
exclusively used for the trial; that is, the space in which the
trial is conducted is used for other exempt purposes as well
(e.g., patient rooms).
Unrelated trade or business.22 Private business use arises if the borrower
uses bond-financed property in connection with an "unrelated trade or
21
Such contracts might be classified as "Other Transaction Agreements" which are not bound by the requirements of
the Bayh-Dole Act. If so, they might not qualify for the safe harbor under Rev. Proc. 2007-47 that generally applies
to other federally sponsored contracts.
22
See I.R.C. § 145(a)(2)(A).
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business" within the meaning of the UBTI ("unrelated business taxable
income") rules. An unrelated trade or business means a trade or business
activity of the borrower that is not substantially related to its exempt
purposes.
Importantly, a given activity may give rise to private business use
even though it does not produce UBTI. For example, an unrelated
trade or business activity that is not profitable may not produce
UBTI but still would give rise to private business use.
(f)
Joint venture, partnership or LLC. Private business use arises from the
use of bond-financed property by a joint venture, partnership or LLC
between the borrower and one or more entities that are not 501(c)(3)
entities. On the other hand, a joint venture, partnership or LLC whose
partners/members consist exclusively of 501(c)(3) organizations should
not give rise to private business use, assuming the activities of the joint
venture, partnership or LLC promote the exempt purposes of all of the
partners/members. Note that a joint venture or partnership may exist for
tax purposes even though the arrangement between the parties is not
formally titled a "joint venture" or "partnership," if the parties conduct a
joint business undertaking and divide the profits and losses from the
activity.
(g)
Naming rights. An arrangement under which the borrower agrees to
name a bond-financed facility, or a portion thereof, for a for-profit
business in many cases will give rise to private business use.23 (Naming
a facility for an individual may give rise to private business use if the
individual's name is closely associated with a for-profit business, e.g.,
"Trump Hall.") In this situation, the borrower should consult with taxexempt bond counsel to determine whether private business use arises
(and if so, how much arises).
(h)
Substantial economic benefit or special legal entitlement.24 Under these
"catch-all" categories, private business use may arise to the extent bondfinanced property provides a "substantial economic benefit" to a private
business user, or a private business user has a "special legal entitlement"
to the property. For example, if a professor uses bond-financed office
space to provide outside consulting services to for-profit entities, private
business use may arise (though the amount of private business use is
likely very small – see Section II.A.5 (p. 13)).
23
By contrast, private business use generally should not arise if the borrower names a facility or portion thereof for a
for-profit business voluntarily (for example, in recognition of past support), if the business has no "special legal
entitlement" to the facility's name.
24
See Treas. Reg. § 1.141-3(b)(7).
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3.
4.
25
General exception to private business use for "qualified improvements."25 For
highly creditworthy borrowers, even if one of the categories of private business
use described above applies, bond-financed improvements to an existing
building26 will be exempted from private business use27 if all of the following
requirements are satisfied:
(a)
The project is not an "enlargement of the building or an improvement of
interior space occupied exclusively for any [private business use]."28 So,
for example, if the project consisted solely of renovations to cafeteria
space for use in a noncompliant food service agreement, or an addition
of a new wing to the building, this requirement apparently would not be
satisfied.
(b)
No portion of the improved building or any payments in respect of the
improved building serve as security for the bonds. This requirement
would typically prevent the qualified building improvement exception
from being available to hospital borrowers and smaller 501(c)(3)
borrowers, who would typically pledge their interest in the building to
secure the bonds, or would at least provide a general revenue pledge
(part of which would be allocable to the building). But borrowers who
do not provide such a pledge (most typically, large universities) would
satisfy this requirement.
(c)
No more than 15 percent of the improved building is subject to private
business use.
100% ownership rule29
(a)
In addition to, and technically separate from, the limitation on private
business use, there is also a requirement that 100% of the bond-financed
property of a given issue must be owned by a 501(c)(3) organization (or
a state or local government).
(b)
Although there are no exceptions specifically provided by the
regulations, many counsel believe that bond-financed property that is
obsolete and beyond its originally expected useful life may be disposed
See Treas. Reg. § 1.141-3(d)(6).
26
To be considered an "improvement," the regulations require that the building have been placed in service more
than one year before the improvement project began.
27
For certain technical reasons, it is less than completely clear whether the exception applies to private business use
arising from leases or unrelated trades or businesses, although in our view it does. There is little doubt that the
exception applies to other types of private business use (see Section II.A.2, p. 4).
28
I interpret this language to mean (although it is less than completely clear) that no project consisting of an
"enlargement" of a building is eligible for the exception (regardless of whether the enlargement is "occupied
exclusively for any" private business use).
29
See I.R.C. § 145(a)(1).
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of without violating this rule. Thus, for example, if bond-financed
leasehold improvements are beyond their originally expected useful lives
and obsolete at the end of the lease term, it is commonly thought that
turning over those improvements to the landlord does not violate this
rule. By contrast, leasehold improvements that continue to have
significant value should not simply be turned over to the landlord; the
borrower should either take remedial action (see Section II.A.7, p. 21) or
remove the improvements.
5.
30
(c)
If the borrower contributed equity or taxable debt to the project (see
Section II.A.6, p. 16) and would like to transfer a portion of the project,
counsel will need to consider whether the equity or taxable debt can be
allocated to the portion to be transferred; the rules regarding the
allocation of equity or taxable debt are especially unclear in this
circumstance.
(d)
The remedial action rules may cure a failure to comply with the 100%
ownership requirement, but only if the detailed time limits set forth in
those rules are satisfied; see Section II.A.7 (p. 21).
Measuring private business use – basic principles30
(a)
Bond-issue-by-bond-issue calculation. As noted above, private business
use is calculated on a bond-issue-by-bond issue basis, and the proceeds
of a particular issue are traced to the specific projects they financed or
refinanced.
(b)
Typically measured based on square footage. The most common way to
measure private business use of a facility is to compare the square
footage of the facility used for private business use (including allocable
common area) against the square footage of the entire facility. For
example, if 20% of the proceeds of a bond issue are traced to Building A,
and 5% of the square footage of Building A (including allocable common
area) is used for private business use, the proceeds traceable to Building
A would contribute 1% private business use toward the overall limit for
the issue.
(c)
Alternative measurement methodologies. In some cases, a measurement
methodology based on square footage is not appropriate, because private
business use and exempt use occurs in the same space, or because the
fair market value of the space used for private business use and the fair
market value of the space used for exempt use are not reasonably
comparable. In such cases, an alternative measurement methodology
may be appropriate. For example, private business use might be
measured based upon relative time of use, or relative revenues derived
See Treas. Reg. § 1.141-3(g).
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from such uses, or relative fair market rental values of the space used for
each use. Examples of such alternative methodologies include the
following:
(i)
With respect to a research lab where the borrower performs certain
research constituting private business use and certain research
constituting exempt use, the private business use percentage of the
lab space generally is equal to the amount of revenues for a given
year from "private business use contracts" compared to total
revenues from research performed in the lab for that year.
(ii)
With respect to an athletic facility that a university normally uses
for its own athletic events but occasionally rents to third parties,
the private business use percentage of the facility generally is equal
to the amount of time the facility is rented to third parties,
compared to the total time that the facility is actually in use.
(iii) With respect to a facility primarily used for private business use,
but where the borrower uses the basement for storing items relating
to its exempt purposes, the private business use percentage would
likely be understated by simply comparing the square footage
used for private business use to the total square footage of the
facility (including the basement), because the fair market value of
the basement space is likely significantly less than the fair market
value of the upper floors. In this situation, the private business use
percentage should be calculated based upon the relative fair market
rental value of the basement space as compared to the whole
building.
(iv) With respect to a chiller plant that serves three buildings on the
borrower's campus, the amount of private business use of the
chiller would likely be determined by first calculating the amount
of private business use of each of the three buildings, and then
calculating the weighted average amount of private business use
(using as the weighting factor perhaps the square footage of each
building, or perhaps the amount of output consumed by each
building, if known).
(d)
Private business use averaged over time. The overall private business
use percentage for the issue is generally calculated by determining the
average private business use percentage for each year during the
measurement period and then averaging those percentages.31 The
"measurement period" generally begins on the later of the issue date of
31
However, in the case of bonds issued before 1987 (and certain refundings of such bonds) that are eligible for a
25% private business use limitation (see Section II.A.1(c)(ii), p. 3), the overall private business use percentage is
equal to the highest annual percentage (rather than the average of the annual percentages).
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the bonds or the placed-in-service date of the property, and ends on the
earlier of the end of the expected useful life of the property or the
retirement of the bonds. For example, if a 30-year bond issue financed a
building with a 40-year life which was placed in service 3 years after
issuance, the “measurement period” would be 27 years (year 3 through
year 30). The annual private business use percentages for each of those
27 years would be averaged to produce the overall private business use
percentage for the issue.
(e)
32
Private business use of certain refunding issues determined based on
"combined" measurement period.32 In general, the overall private
business use percentage of a refunding issue is calculated over the same
period as in the case of a new money issue (i.e., by reference to the term
of that issue itself and not any prior issue), except in the following
circumstances:
(i)
In the case of a refunding issue that was issued on or after
February 17, 2006 and the original issue refunded by the
refunding issue was issued on or after May 16, 1997, the annual
private business use percentages for the refunding issue and the
refunded issue(s) are "blended together" to calculate the overall
private business use percentage for the refunding issue.
(ii)
In the case of a refunding issue that was issued on or after
February 17, 2006 and the original issue refunded by the
refunding issue was issued prior to May 16, 1997, in some cases
the annual private business use percentages for the refunding issue
and the annual percentages for the refunded issue(s) are "blended
together" to calculate the overall private business use percentage
for the refunding issue. Borrowers should probably assume in this
situation that the uses of bond-financed projects will in theory be
relevant for all periods since the date of issuance of the first
refunding series issued on or after May 16, 1997 (or since
December 19, 2005, if earlier), unless advised otherwise by taxexempt bond counsel.33
See Treas. Reg. § 1.141-13.
33
In this situation, "blending" is not technically required if the refunding bonds are not subject to the
comprehensive regulations issued in 1997 addressing private business use matters (the "1997 Regulations"), nor is
blending required with respect to any issue of refunded bonds which was not subject to the 1997 Regulations. The
1997 Regulations generally are not applicable, absent a borrower election, to any bond issue that was issued prior to
May 16, 1997, nor to any issue that refunded (directly or indirectly) pre-May 16, 1997 bonds if the weighted average
maturity of the refunding bonds did not exceed that of the refunded bonds. As a practical matter, to calculate private
business use in the case of a post-February 16, 2006 issue that refunded (directly or indirectly) pre-May 16, 1997
bonds, borrowers should probably assume that the uses of bond-financed projects will be relevant for all periods
since the date of issuance of the first refunding series issued on or after May 16, 1997 (or since December 19, 2005,
if earlier) unless advised otherwise by tax-exempt bond counsel.
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6.
Allocations of equity or taxable debt. If a project financed by a tax-exempt
bond issue is also partly financed by equity contributions or taxable debt of the
borrower, it may be possible to allocate the equity or taxable debt to the portion
of the project used for private business use, thereby minimizing the private
business use of the bonds.34
The law in this area is highly unsettled, and I recommend that borrowers
consult with tax-exempt bond counsel before making an allocation of equity to
private business use, and before assuming that a prior allocation of equity was
effective in reducing the borrower's private business use percentage.
Nevertheless, general guidance on this issue appears below. The analysis
differs somewhat depending on whether the related new money bond issue is a
future or recent bond issue, or whether the bond issue is older. The discussion
below first addresses future or recent bond issues (by which I mean issues that
are still within the Permitted Allocation Period), then addresses older issues.
For this purpose, the Permitted Allocation Period begins on the issue date and
ends 18 months following the later of the placed-in-service date of the project
or the date of the expenditure in question, provided that it cannot extend more
than five years (plus 60 days) from the issue date (or, if earlier, 60 days from
retirement of the bonds).
(a)
Future or recent new money bond issues
(i)
Introduction
(1)
The IRS has issued proposed regulations that attempt, for the
first time, to set forth a comprehensive set of rules governing
such allocations.35
(2)
The regulations are only in proposed form and will only be
effective for bonds sold at least 60 days after publication of
final regulations, and accordingly may not currently be relied
upon by borrowers. Given the lack of other guidance
addressing allocations of equity and taxable debt, the
proposed regulations provide important insight into the IRS's
current thinking. As a "best practice," I generally
recommend that borrowers follow the principles36 set forth in
34
In addition, it may be possible to allocate the equity or taxable debt to the portion of the project that has been, or
will be, transferred to a third party in violation of the "100% ownership rule," although the circumstances in which
this is permitted are particularly unclear. If relevant for a borrower, this issue should be discussed with tax-exempt
bond counsel.
35
See Prop. Treas. Reg. § 1.141-6.
36
The overview below focuses on the general principles of the proposed regulations. Certain of the literal rules in
the proposed regulations are not well thought out and are likely to change in the final regulations. I believe the most
practical course of action, given the current unsettled state of the law, is to focus on complying with these general
principles.
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the proposed regulations to the extent possible with respect
to future or recent bond issues (i.e., those that financed
projects that are within the Permitted Allocation Period).
Borrowers should recognize, however, that this area of the
law is very much unsettled and modifications to these
procedures may need to be made in the future.
(ii)
37
"Undivided portion" methodology – in general
(1)
The proposed regulations provide that a borrower can elect
to allocate equity or taxable debt to a project using the socalled "undivided portion" methodology. Under the
undivided portion methodology, the equity or taxable debt is
generally allocated to the private business uses of the project
on a "floating" basis, that is, wherever and whenever they
may arise (subject to certain limitations).37
(2)
If the undivided portion methodology is not elected, the
borrower will default into a "pro rata" methodology, under
which every use of the facility is treated as financed by both
bond proceeds and equity/taxable debt on a pro rata basis.
This essentially eliminates any potential advantage from a
private business use standpoint provided by the use of equity
or taxable debt to finance the facility.
(3)
I recommend that borrowers elect the "undivided portion
methodology" for projects financed in part by a recent new
The ability of equity or taxable debt to "float" is subject to certain limitations, including the following:

Equity or taxable debt may only be allocated to private business use on a project-by-project basis; that is,
equity that has been applied to one project financed by an issue may not "float" to private business use
within another project financed by the issue. For example, if a given issue financed two separate buildings,
Building A and Building B, and equity was applied to Building A but not Building B, the equity may be
treated as allocable to private business use within Building A, but not to private business use within
Building B. (Note that the definition of "project" in the proposed regulations has certain technical problems
and is likely to change in the final regulations. Until the regulations are finalized, I recommend that
borrowers apply a common-sense notion of "project" – thus, for example, contemporaneous renovations to
various floors in a single building would be considered part of the same "project," but renovations to two
separate buildings located on different parts of the borrower's campus, or renovations of various floors in
the same building that are not performed around the same time, would not be part of the same "project.")

Equity may only be allocated to private business use that is discrete rather than pervasive (or, in the words
of the proposed regulations, the private business use must be "on the same basis" as the exempt use). For
example, a borrower constructs a facility (financed with both bond proceeds and equity) that is managed
by a service provider, who provides comprehensive operational services including maintenance, janitorial,
mailroom, security, IT and other services, under a contract that does not comply with Rev. Proc. 97-13 (see
Section II.A.2(c), p. 6). The IRS could take the position that the equity applied to the facility cannot be
allocated to this management agreement, and the private business use percentage of the facility would be
100%, since the private business use is not discrete but rather pervades the entire facility.
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money issue and in part with equity or taxable debt, except
in the following limited situations:
a.
Where the borrower has already specifically allocated
equity or taxable debt to the project in some other
manner; or
b.
Where the borrower knows that a certain discrete
portion of the facility will be used for private business
use for the entire term of the bonds; in that situation,
the borrower could simply allocate the equity or
taxable debt to that discrete portion.38
(iii) Timing and manner of election. The undivided portion
methodology should be elected before the start of the
"measurement period," meaning generally the later of (i) the issue
date of the bonds, or (ii) the placed-in-service date of the project.
This means that the undivided portion methodology should
typically be elected in the tax certificate or tax regulatory
agreement at the time of issuing the bonds. To make the
election, the proposed regulations require the borrower to note the
"preliminary amounts and sources of funds it expects to allocate"
to the portion of the project allocable to private business use. If
these amounts are not known at the time of issuance, I would
recommend making a preliminary election in the tax certificate or
tax regulatory agreement anyway, and making a "final" election
once the amounts are known (and before the placed-in-service-date
of the project).
Even if the deadline has passed for a particular project, I
recommend that borrowers elect this methodology anyway
(assuming the issue is recent, i.e., still within the Permitted
Allocation Period).39
38
To make such an allocation, the borrower should keep good records that enable the equity or taxable debt to be
traced to the expenditures they financed, and the borrower should identify and describe, in the tax certificate or tax
regulatory agreement for the issue, as well as in the allocation certificate for the issue, the discrete portion of the
facility to which the equity or taxable debt is being allocated. Note that this methodology is contemplated by the
proposed regulations (which describe it as the "discrete physical portion" methodology).
39
The reason I recommend electing the "undivided portion" methodology for projects financed by recent issues even
if the deadline has passed is that the deadline appears only in proposed regulations which are not yet in effect. If an
election is made after the deadline in the proposed regulations, the borrower may still reasonably take the position
(at least until final regulations are issued that may clarify the issue) that an allocation methodology equivalent to the
undivided portion methodology (i.e., permitting equity or taxable debt to "float" within a project) is applicable. This
assumes, however, that the election is at least made within the Permitted Allocation Period; if it is not, see Section
II.A.6(b) (p. 19).
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(iv) The examples below illustrate the effect of electing the "undivided
portion" methodology.
(b)
(1)
Lease. A hospital leases 20,000 square feet of space
(including allocable common area) in a 200,000 square foot
building to private physicians. The original cost of the
facility was $50 million, of which $45 million consists of
bond proceeds and $5 million of equity. The borrower elects
the "undivided portion" methodology in the tax certificate.
The equity is allocated to the lease to the physicians, and no
private business use arises from the lease (assuming the persquare-foot rental value of the space leased by the physicians
is not significantly greater than the per-square-foot rental
value of the remainder of the facility). Furthermore, no
private business use arises in the future if the physicians
move to a different set of offices within the same facility
constituting 20,000 square feet.
(2)
Research lab. A university renovates a research lab for $2
million, using $1.8 million of bond proceeds and $200,000
of taxable debt. Approximately 10% of the annual revenues
from research performed in the building are attributable to
agreements that give rise to private business use (see Section
II.A.2(d), p. 8). The borrower elects the "undivided portion"
methodology in the tax certificate. The taxable debt is
allocated to the "private business use" research agreements,
and the bonds are treated as not subject to private business
use. Furthermore, no private business use arises in the future
as the existing agreements expire and are replaced by new
agreements (so long as not more than 10% of the research
revenues in any year are attributable to the "private business
use" contracts).
Older new money bond issues
(i)
Application of proposed regulations and "undivided portion"
methodology to older issues. For an older issue (meaning any
issue that financed projects with respect to which the Permitted
Allocation Period has already passed), I also generally recommend
that borrowers elect the "undivided portion" methodology if the
issue financed projects with respect to which the borrower also
contributed taxable debt or equity, unless the borrower (i) has
already allocated the taxable debt or equity to the project in some
other manner, or (ii) knows that a certain discrete portion of the
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facility will be used for private business use for the entire term of
the bonds.40
For an older issue, however, it is questionable whether such an
election would be respected by the IRS. I therefore recommend
that borrowers elect the "undivided portion" methodology in this
situation for protective purposes only (i.e., to provide another
argument in the event of an IRS audit), but not rely on it for future
planning purposes (i.e., the borrower should calculate its annual
private business use percentages without regard to the election).
(ii)
Applicable law in absence of "undivided portion" methodology. If
borrowers should not rely, for older issues, on an election of the
"undivided portion" methodology, how should they determine
whether equity or taxable debt is allocable to private business use?
Prior to the proposed regulations, there was little IRS guidance on
the circumstances in which equity or taxable debt could be treated
as allocable to private business use. Some particularly cautious
counsel believed that, in order for a borrower to allocate equity
within a project to certain private business uses, the borrower must
have made a specific, formal allocation of equity or taxable debt
to discrete portions of the bond-financed facility within the
Permitted Allocation Period. For example, in a facility where
certain ground-floor space is leased to retail stores, these counsel
would only treat equity or taxable debt as allocable to the leased
space if the borrower can produce an allocation certificate or
similar writing, dated within the Permitted Allocation Period,
documenting an allocation of equity or taxable debt to that specific
leased space.
At the other end of the spectrum, some counsel believed that equity
or taxable debt need not be specifically allocated to private
business uses within a given project; these counsel would treat any
equity within a bond-financed project as having been "implicitly"
allocated to private business use on a "floating" basis. For
example, if a borrower can show that a given building was
financed with 50% equity and 50% bond proceeds, these counsel
would treat the equity as allocable to any private business use on a
"floating" basis, even if the borrower did not make any formal, or
even informal, allocation of equity to private business uses.
Given the absence of applicable IRS authority on this issue, for
older issues, I suggest a position that is intermediate to these
40
See footnote 38.
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narrow and flexible extremes41: Borrowers may reasonably treat
equity or taxable debt as allocable to private business use
within a given bond-financed facility if the borrower can show
both of the following:
7.

Records that show that equity or taxable debt was indeed
used, in part, to pay capital expenses of the facility; and

Records that demonstrate the borrower's intent, within the
Permitted Allocation Period, for the equity to be allocable
to private business uses within the facility. Such an
expression of intent may have been made in a formal allocation
certificate, in the tax certificate or tax regulatory agreement for
the issue, in responses to bond counsel's due diligence
inquiries, or in emails or other correspondence.
Change of use of bond-financed facilities – remedial action.42 In the event the
borrower enters into an arrangement after the issue date that causes the private
business use percentage of a given bond issue to exceed the permitted amount,
it may be possible to take, within specified deadlines, "remedial action" to
correct the noncompliance.43 I recommend that borrowers undertake these
steps only in consultation with tax-exempt bond counsel. Nevertheless, the
general requirements applicable to remedial actions are summarized below,
followed by an overview of the two most common types of remedial action:
redemption or defeasance of bonds and alternative use of disposition proceeds.
(a)
Key requirements applicable to all remedial actions. The borrower must
satisfy all of the following key requirements44 to be eligible for remedial
action:
(i)
The borrower cannot have expected, on the issue date, that the
private business use limitation would be exceeded during the term
of the bonds (i.e., the excess private business use must have been
unexpected).
(ii)
The terms of any arrangement that result in the excess private
business use must be bona fide and arm's-length, and the new user
must pay fair market value for the use of the financed property.
41
This is not to suggest, however, that the "flexible" approach is unreasonable. Some borrowers do rely on this
approach, and I understand that there is no established IRS practice of challenging it.
42
See Treas. Reg. § 1.141-12.
In addition, the remedial action rules apply for purposes of the "100% ownership requirement" – see Section
II.A.4 (p. 12).
43
44
Certain other requirements apply, although they are less likely to be relevant as a practical matter.
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(iii) The borrower must treat the disposition proceeds as subject to
arbitrage restrictions (i.e., may not be invested at a yield above the
bond yield).
(b)
Redemption of bonds; key requirements
(i)
One type of authorized remedial action is to redeem the bonds
allocable to the private business use resulting from the
arrangement.45
(ii)
If the bonds are not redeemable within 90 days of the date of the
"deliberate action" giving rise to private business use, a defeasance
escrow must be established for those bonds within that 90-day
period, and a notice must be sent to the IRS (technically from the
issuer, not the borrower) within 90 days of establishing the escrow.
The escrow must not be invested at a yield in excess of the bond
yield.
(iii) Note that the "deliberate action" is deemed to occur on the date the
borrower enters into a binding agreement that is not subject to any
material contingencies (which may occur, for example, on the date
of the signing of the P&S rather than the closing date). The 90day period for redeeming or defeasing bonds starts running on
this date. This may require the borrower to redeem bonds
before the closing date of the transaction. In order to avoid such
a requirement in the context of a large redemption, it may be
advisable to ensure the pre-closing period is less than 90 days or
that there are material contingencies prior to closing.
(iv) Bonds must be redeemed on a pro rata basis (i.e., a so-called strip
call) or a "longest bonds first" basis.
(c)
Alternative qualifying use of disposition proceeds; key requirements
(i)
Another type of remedial action is to use the proceeds resulting
from the disposition for an alternative qualifying use.
(ii)
The deliberate action must be a disposition for which the
consideration is exclusively cash paid up-front (thus, this
requirement would not be satisfied if the borrower receives a
below-market-value leaseback).
45
If the deliberate action is a disposition for which the consideration is exclusively cash paid up-front, and if the
borrower uses all of the cash to redeem a pro rata portion of the outstanding bonds, the borrower will be treated as
having redeemed the portion of the bonds allocable to the private business use. This exception is potentially
valuable if the property has depreciated in value, because it allows the borrower to take remedial action by paying
down a smaller portion of the bonds than the portion otherwise allocable to the private business use.
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(iii) The borrower must reasonably expect to spend the disposition
proceeds within two years of the date of the deliberate action for
purposes that are eligible for 501(c)(3) bond financing (i.e., must
be capital projects without excessive private business use), and any
proceeds that are not so spent must be used to redeem or defease
bonds.
(iv) The borrower must treat the portion of the bonds allocable to the
private business use as being reissued for certain tax purposes,
which may require a new TEFRA notice and hearing, compliance
with the 120% useful life test, and filing a new Form 8038, among
other things.
(d)
B.
In connection with any remedial action, the borrower should prepare a
certificate for its records that documents its compliance with each of the
remedial action requirements.
Arbitrage
1.
Yield restriction46
(a)
The arbitrage rules generally prohibit, in the absence of an applicable
exception, proceeds of a bond issue from being invested at a yield in
excess of the bond yield. This is known as the requirement of "yield
restriction."
(b)
There are certain exceptions to "yield restriction." One key exception
relates to proceeds in a construction or project fund, which may
generally be invested without regard to yield during a three-year
"temporary period," if the borrower reasonably expects the following as
of the issue date:
(i)
at least 85% of the net sale proceeds of the bonds will be spent on
expenditures for the capital projects within three years of the issue
date;
(ii)
within six months of the issue date, the borrower will incur a
binding obligation to spend at least 5% of the net sale proceeds of
the issue on the capital projects; and
(iii) completion of the projects and expenditure of the bond proceeds on
the projects will proceed with due diligence.
Any proceeds (including investment earnings) remaining in the
construction or project fund after the expiration of the three-year
temporary period are subject to yield restriction.
46
See Treas. Reg. § 1.148-2.
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(c)
If no exception to yield restriction is applicable, yield restriction may be
accomplished by:
(i)
investing the proceeds at a yield not in excess of the yield on the
bonds (provided that the rules for establishing the fair market value
of investments are satisfied – for example, by investing in State
and Local Government Series Securities (so-called SLGS) or by
complying with the "three-bid" safe harbor);
(ii)
investing any such amounts in tax-exempt obligations that are not
subject to the alternative minimum tax, or
(iii) in certain permitted circumstances, by making "yield reduction
payments" to the IRS.
These requirements are very detailed, and the borrower's compliance will
be scrutinized by the IRS if the bonds are audited. If any amounts
become subject to yield restriction, the borrower should consult with taxexempt bond counsel on the appropriate manner of satisfying these
requirements.
2.
Rebate47
(a)
In general. Even if an exception to yield restriction applies, the borrower
will generally be required to remit to the Treasury any earnings in excess
of the bond yield, unless an exception is satisfied. This is known as
"rebate."
(b)
Exceptions to rebate. There are certain exceptions to rebate, including
most importantly the "spending exceptions." Calculating whether a
spending exception has been satisfied can be complex, and it is generally
advisable for the borrower to engage a rebate computation firm to
perform this function (as well as to calculate the amount of rebate owed,
if no exception applies). Still, it is worthwhile for the borrower to itself
keep track of its compliance with these exceptions.
(i)
2-year spending exception. One key exception, known as the "2year spending exception," relates generally to proceeds of an issue
that primarily will be used for constructing or renovating property.
More specifically, the "available construction proceeds," as
defined below, of the issue will not be subject to rebate if, in
general, the following requirements are satisfied:
(1)
47
As of the issue date, the borrower must expect that the issue
will be a "construction issue." A "construction issue" means
See Treas. Reg. §§ 1.148-3, 1.148-7.
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an issue where at least 75% of the "available construction
proceeds" of the issue are to be used for "construction
expenditures." "Available construction proceeds" means, in
general, the sale and investment proceeds of the bonds
excluding any sale proceeds used to fund a reserve fund or
pay costs of issuance, but including any earnings on a
reserve fund during the two-year period following issuance
(or during the construction period, if shorter)48, and
including any earnings on proceeds used to pay costs of
issuance. "Construction expenditures" means, in general,
capital expenditures allocable to the cost of real property or
constructed personal property, including costs of
construction, reconstruction, or rehabilitation of such
property (but not including the cost of acquiring any interest
in land or other existing real property).
(2)
The expenditure of the "available construction proceeds"
must equal or exceed the minimum percentages at the end of
each spending period (measured from the issue date) set
forth below:49
Spending Period
6 months
12 months
18 months
24 months
Minimum Percentage
10%
45%
75%
100%
Certain exceptions to the final spending requirement are
noted in the footnote.50
(ii)
18-month spending exception. Another exception to rebate is the
"18-month spending exception," which relates generally to
proceeds of an issue that are not eligible for the 2-year spending
48
The borrower may elect, on or before the issue date, to exclude reserve fund earnings from "available construction
proceeds"; if so, rebate would need to be calculated on these earnings. Such an election is not typically made.
49
For purposes of the first three spending requirements, the amount of total investment earnings (which is taken into
account in the denominator of the percentage) is based on the borrower's reasonable expectations as of the issue
date, unless the borrower has made an election on or before the issue date (typically in the tax certificate or tax
regulatory agreement) to apply "actual facts" for this purpose.
50
A failure to meet the final spending requirement is excused if either (i) the borrower exercises due diligence to
complete the projects and the amount of the failure does not exceed the lesser of 3% of the issue price of the issue or
$250,000, or (ii) the failure results from "reasonable retainage" which is spent within three years of the issue date.
"Reasonable retainage" means an amount not to exceed 5% of the available construction proceeds of the bonds that
is retained for reasonable business purposes relating to the project.
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exception because an insufficient portion of the proceeds will be
spent on "construction expenditures."
For such proceeds to qualify for the 18-month spending exception,
the sale and investment proceeds of the bonds (excluding amounts
in a reserve fund for the bonds) must be spent at least as rapidly as
under the following schedule:51
(1)
15% within the first 6 months;
(2)
60% within 12 months; and
(3)
100% within 18 months.
Certain exceptions to the final spending requirement are noted in
the footnote.52
(iii) Exception for certain debt service funds. Another exception to
rebate applies to amounts in a debt service fund that qualifies as a
"bona fide debt service fund."53 The debt service fund for a given
issue will be exempt from rebate for all years if average annual
debt service on that issue is not greater than $2,500,000. If
average annual debt service on that issue exceeds $2,500,000, the
debt service fund for the issue will not be subject to rebate for a
particular year, if the earnings on the debt service fund for that
year were not greater than $100,000.
(c)
Payment of rebate. Within 60 days after each "computation date" prior
to the final computation date, a rebate installment must be paid in an
amount equal, in general, to at least 90% of the rebate amount as of such
date. Within 60 days after the final computation date, 100% of the
remaining rebate amount must be paid. "Computation dates" occur no
less frequently than every five years during the term of the bonds, and
51
For purposes of the first two spending requirements, the amount of total investment earnings (which is taken into
account in the denominator of the percentage) is based on the borrower's reasonable expectations as of the issue
date.
52
A failure to meet the final spending requirement is excused if either (i) the borrower exercises due diligence to
complete the projects financed by bond proceeds and the amount of the failure does not exceed the lesser of 3% of
the issue price of the issue or $250,000, or (ii) the failure results from "reasonable retainage" which is spent within
30 months of the issue date. "Reasonable retainage" means an amount not to exceed five percent of net sale
proceeds of the bonds that is retained for reasonable business purposes relating to the project.
53
A "bona fide debt service fund" is a fund that "(1) is used primarily to achieve a proper matching of revenues with
principal and interest payments within each bond year; and (2) is depleted at least once each bond year, except for a
reasonable carryover amount not to exceed the greater of: (i) the earnings on the fund for the immediately preceding
bond year or (ii) one-twelfth of the principal and interest payments on the issue for the immediately preceding bond
year." Generally the tax certificate/tax regulatory agreement will recite that the debt service fund was intended to so
qualify.
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the final computation date is generally the date the issue is retired. Each
rebate payment to the IRS must be accompanied by Form 8038-T, which
is executed by the issuer (not the borrower).
3.
Sinking funds54
(a)
Definition. A "sinking fund" is defined by the Treasury Regulations as a
"debt service fund, redemption fund, reserve fund, replacement fund, or
any similar fund, to the extent reasonably expected to be used directly or
indirectly to pay principal or interest on the issue." Note the breadth of
the "sinking fund" definition: sinking funds include not only funds that
are formally designated as debt service funds, but any fund that is
expected to be used (even indirectly) to pay debt service on a tax-exempt
debt issue.
(b)
Consequence of having a sinking fund. It is important to avoid the
inadvertent creation of a sinking fund, because amounts in a sinking fund
are treated as "proceeds" of the applicable bond issue and are therefore
subject to the arbitrage rules of the Code (i.e., such amounts generally
may not be invested at a yield in excess of the bond yield). Thus, if a
portion of the borrower's endowment were treated as a "sinking fund,"
the borrower could be in violation of the arbitrage rules with respect to
its outstanding tax-exempt bonds, if the return on the endowment
exceeded the yield on the bonds.
(c)
Factors in determining whether a sinking fund exists. In determining
whether a fund is considered to be indirectly used to pay debt service, a
key issue is whether the borrower's current revenues are expected to be
sufficient to meet debt service obligations. In certain situations where a
borrower's revenues were not expected to exceed debt service, the IRS
has held that a sinking fund arose.55
Even if revenues are expected to exceed debt service, a sinking fund can
still arise if there is a sufficient "nexus" between a fund and a bond issue.
For example, in one ruling, the IRS held that a sinking fund was created
even though revenues were expected to exceed debt service requirements
in every year. The securities held by the issuer were scheduled to mature
in the same year as the bonds, which apparently gave rise to a "nexus" in
the IRS's view.56
54
See Treas. Reg. § 1.148-1(c)(2).
55
See Rev. Rul. 78-349; Rev. Rul. 82-101; IRS FSA 1995 WL 1918350.
56
See Rev. Rul. 78-302.
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(d)
Examples of sinking funds
(i)
The endowment would constitute a sinking fund if the borrower
draws directly from the endowment to pay debt service.
(ii)
Even if debt service payments are not directly drawn from the
endowment, the endowment likely would still constitute a sinking
fund if the borrower's revenues are insufficient to support the
payment of debt service (since the endowment would have served
as the indirect source of payment of debt service).
(iii) An endowment may constitute a sinking fund if the borrower
makes public statements (or non-public statements that are
discoverable in the event of an audit – for example, minutes of
board of trustee meetings) to the effect that the borrower will issue
tax-exempt debt and indirectly derive the debt service payments
from the endowment.
(iv) A sinking fund is potentially created if the borrower acquires
securities with a principal amount and payment terms that closely
match those of one or more bond issues, in circumstances that
suggest the borrower intends to indirectly derive the payment of
debt service from the securities.
(v)
(e)
4.
A sinking fund is potentially created if the borrower holds a fund
that would be used to pay debt service in the event the variable rate
on the borrower's bonds exceeds a certain level in the future.57
Discuss with tax-exempt bond counsel. If the borrower believes that a
sinking fund has been established, or is unsure, the borrower should
discuss the issue with tax-exempt bond counsel.
Fundraising
(a)
What is the issue? An arbitrage issue is raised if donated funds bear too
close a relationship (i.e., a "nexus") to the capital costs of a project that
was financed with tax-exempt bonds. Such funds are treated as proceeds
of the bond issue58 and are subject to yield restriction, meaning they
generally cannot be invested at a yield in excess of the yield on the bond
issue. To avoid having to yield-restrict the donated funds, the borrower's
fundraising campaigns, and in particular the written materials used in
57
In such a case, the borrower may be able to argue that no sinking fund was created because it is unlikely that such
a level would be exceeded and accordingly, in the language of the sinking fund definition, it is not "reasonably
expected" that the fund would be used for the payment of debt service.
58
See Treas. Reg. § 1.148-1(c)(1).
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such campaigns, should be designed carefully to prevent such a "nexus"
from arising.
Unfortunately, the tax law does not clearly define the circumstances in
which a "nexus" between donated funds and bond-financed projects
arises. Given the absence of clear guidance, all the facts and
circumstances must be considered, including the borrower's fundraising
materials (e.g., brochures and pledge cards), the borrower's internal
accounting and fund designations, and restrictions imposed by donors.
(b)
What types of fundraising materials are problematic? A "nexus" to
bond-financed facilities may arise if the borrower's fundraising materials
solicit donations specifically for the "bricks and mortar" of bondfinanced facilities or for the payment of debt service on such facilities.59
A "nexus" may also arise if the bond-financed project is the principal
focus of the fundraising materials, even if the materials do not restrict the
donated funds to the costs of that project.
(c)
What types of fundraising materials should be acceptable? By contrast,
if the fundraising materials solicit contributions for the borrower's
general fund, or for a particular department or program of the borrower,
and if the bond-financed project is not the principal focus of the
fundraising materials, no "nexus" to bond-financed property should arise.
Although the fundraising materials need not omit all reference to the
bond-financed project, it is important that the project not be the principal
focus of the materials.
(d)
What issues are raised by naming rights? In many cases, a substantial
donor will want his or her name placed on a particular building or room.
This tangible connection to the project makes it particularly important
that the gift made in exchange for the naming right be structured to avoid
a "nexus" to the construction or debt service expenses of the project.
To avoid such a nexus, the gift should be clear that it can be used to fund
maintenance expenses, a depreciation reserve, or the programs conducted
in the facility, rather than being restricted to "construct" or "build" or
"establish" the bond-financed facility. In short, the gift should be clear
that it can be allocated to items that are not directly related to the cost of
constructing the bond-financed project.60
59
No nexus arises to the bond-financed portion of the project, however, to the extent the gifts are received in
accordance with the plan of finance for the project. For example, if the borrower intends to finance half of a $100
million building with gifts and half with bond proceeds, up to $50 million of gifts may be received for the building
without creating an arbitrage issue.
60
In addition, if the name placed on the building or room is that of a business (rather than an individual or family
name), private business use may arise. See Section II.A.2(g) (p. 11).
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(e)
What if we receive a gift that does have a "nexus" to a bond-financed
facility? Even if the borrower generally follows the recommendations
above, gifts may still be received that bear a "nexus" to capital costs or
debt service with respect to a bond-financed facility (for example, a
donor may only be willing to make a significant gift for project costs, not
operating expenses, of a facility).61 In this situation, the borrower should
take one of the following steps (generally in consultation with taxexempt bond counsel):
(i)
Use the gift to pay capital costs of the facility not funded by bond
proceeds, or, if permitted under the terms of the gift, other capital
costs of the borrower within 30 days of being received;62
(ii)
If permitted under the terms of the gift, use the gift to pay debt
service on the bonds. Prior to such use, the gift generally will be
subject to yield restriction (see Section II.B.1(c), p. 24), unless the
gift (1) is deposited into the debt service fund for the issue within
30 days of being received,63 (2) is spent on debt service within 13
months of receipt, and (3) does not prevent the debt service fund
from qualifying as a "bona fide debt service fund" (see footnote
53); or
(iii) If permitted under the terms of the gift, use the gift to pay down
the outstanding principal amount of the bonds. Yield restriction
should not be required in this situation if the gift is entirely used
for this purpose within 30 days of receipt.64
61
Although outside the scope of this summary, the bond issue should be structured and sized prior to issuance to
take into account any gifts that are expected to be received.
If the borrower’s procedures call for it to decide whether or not to accept the gift, and if this step is not a mere
formality (i.e., from time to time some restricted gifts are in fact declined), the borrower could reasonably take the
position that the 30-day period does not begin until the borrower has actually accepted the gift.
62
63
See footnote 62.
64
See footnote 62.
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