SERVICE ISSUES TEMPORARY GUIDANCE RELATING TO STATE AND LOCAL BOND INTEREST QUALIFICATION FOR TAX-EXEMPT TREATMENT.

Notice 87-69

This notice provides guidance to issuers of state and local bonds for purposes of applying the private business tests of section 141(b) of the Internal Revenue Code of 1986. The guidance provided herein may be relied on until regulations under section 141(b) are published in the Federal Register.

BACKGROUND

Section 103(a) of the Code provides that gross income does not include interest on any state or local bond. Section 103(a) does not apply to any private activity bond that is not a qualified bond (within the meaning of section 141(d)). See section 103(b)(1) of the Code.

Section 141(a) of the Code provides that the term "private activity bond" means any bond-issued as part of an issue that meets either the private business tests of section 141(b) or the private loan financing test of section 141(c). An issue meets the private business tests of section 141(b) if the issue meets the private business use test of section 141(b)(1) and the private security or payment test of section 141(b)(2).

An issue meets the private business use test of section 141(b)(1) if more than 10 percent of the proceeds of the issue are to be used for any private business use. Section 141(b)(6) provides that 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. Use as a member of the general public is not taken into account.

An issue meets the private security or payment test of section 141(b)(2) if the payment of the principal of, or the interest on, more than 10 percent of the proceeds of the issue is (under the terms of such issue or any underlying arrangement) directly or indirectly (A) secured by any interest in property used or to be used for a private business use (or by any interest in payments in respect of such property), or (B) to be derived from payments (whether or not to the issuer) in respect of property (or borrowed money) used or to be used for a private business use.

The legislative history of section 141(b)(2) indicates that payments in respect of property (or borrowed money) financed with the proceeds of an issue need not be pledged as security for, or directly used to pay, debt service on the issue in order to be taken into account under section 141(b)(2)(B) of the Code. See H.R. Rep. No. 99- 841, 99th Cong., 2d Sess. II-688 (1986). Thus, for purposes of section 141(b)(2)(B), the payment of the principal of, or the interest on, the proceeds of an issue generally is considered (under an underlying arrangement) to be derived from such payments.

An issue that does not meet the private business tests nevertheless is treated as meeting those tests under section 141(b)(3) of the Code if such tests would be met by substituting 5 percent for 10 percent, and by applying the tests only to proceeds of the issue that are to be used for any private business use that is not related (or is disproportionate) to any government use of such proceeds (and to payments, property, and borrowed money with respect to any such private business use). For this purpose, a use is disproportionate to the extent that the proceeds of the issue to be used for the private business use exceed the proceeds of the issue to be used for the related government use.

In addition, an issue 5 percent or more of the proceeds of which are to be used with respect to any output facility (other than a facility for the furnishing of water) is treated as meeting the private business tests under section 141(b)(4) of the Code if the nonqualified amount with respect to such issue exceeds the excess of $15 million over the aggregate nonqualified amounts with respect to certain prior tax-exempt issues for the same project.

Finally, a bond that is not a private activity bond (as described above) nonetheless is treated as a private activity bond under section 141(b)(5) of the Code if the nonqualified amount with respect to the issue of which such bond is a part exceeds $15 million, and the issuer does not allocate a portion of its volume cap under section 146 to such issue in an amount equal to the excess of such nonqualified amount over $15 million.

Section 141(b)(8) of the Code provides that the "nonqualified amount" with respect to an issue is the lesser of the proceeds of the issue to be used for any private business use, or the proceeds of the issue with respect to which there are payments (or property or borrowed money) described in section 141(b)(2).

GUIDANCE

Until regulations under section 141(b) of the Internal Revenue Code are published in the Federal Register, issuers may rely on the rules set forth below for the purposes specified.

(a) PRIVATE PAYMENT TEST. (1) IN GENERAL. An issue meets the private security or payment test of section 141(b)(2) of the Code if the issue meets the private security interest test of section 141(b)(2)(A) or the private payment test of section 141(b)(2)(B). This paragraph (a) applies only for purposes of applying the private payment test.

(2) PRESENT VALUE TEST. (i) IN GENERAL. In determining whether an issue meets the private payment test, the present value of the payments taken into account under paragraph (a)(3) below is compared to the present value of the debt service to be paid over the term of the issue. Therefore, an issue meets the private payment test if the present value of such payments is more than 10 percent of the present value of such debt service.

(ii) DEBT SERVICE. Debt service includes credit enhancement fees taken into account in computing the yield on the issue under section 148 of the Code, but does not include any amount to be paid from proceeds of the issue. For example, debt service does not include accrued or capitalized interest or other amounts to be paid with proceeds of the issue (e.g., with proceeds in a reserve fund).

(iii) PRESENT VALUE. Present values are determined by using the yield on the issue as the discount rate and by discounting all amounts to the date of issue. The yield on the issue is determined in the same manner as in section 148 of the Code.

(3) PAYMENTS TAKEN INTO ACCOUNT. (i) IN GENERAL. The following payments are taken into account in determining whether an issue meets the private payment test:

(A) Payments to be made by a person for any private business use of proceeds of the issue to the extent allocable under paragraph (a)(3)(iv) to the payment of the debt service on the proceeds used by such person,

(B) Payments of debt service on the issue to be made from proceeds of any other issue to the extent treated under paragraph (a)(3)(v) as payments taken into account under this paragraph (a)(3), and

(C) Payments taken into account under section 141(b)(2)(A)(ii) (relating to the private security interest test) with respect to the issue.

(ii) PAYMENTS IN RESPECT OF PROPERTY. Payments for a use of proceeds include payments (whether or not to the issuer) in respect of property financed (directly or indirectly) with such proceeds.

(iii) PAYMENTS FOR OPERATING EXPENSES. Payments by a person for a use of proceeds do not include the portion of any payment that is properly allocable to the payment of ordinary and necessary expenses (within the meaning of section 162 of the Code and the regulations thereunder) directly attributable to the operation and maintenance of the property financed with the proceeds used by such person. The preceding sentence shall not apply to any general overhead or administrative expense. For example, if an issuer received $5,000 rent during the year for the use of space in a facility financed with proceeds of an issue and paid $500 during the year for ordinary and necessary expenses properly allocable to the operation and maintenance of such space, $500 of the $5,000 received would not be considered a payment for the use of the proceeds allocable to such space (even if the $500 actually were used for the payment of debt service).

(iv) ALLOCATION TO DEBT SERVICE. Payments by a person for a use of proceeds are allocable to the payment of the debt service on the proceeds used by such person to the extent that the present value of such payments does not exceed the present value of the debt service on such proceeds. Thus, if 10 percent of the proceeds of an issue were used by a person, payments by such person would not be taken into account under paragraph (a)(3)(i)(A) to the extent that the present value of such payments exceeded the present value of 10 percent of the debt service on the issue.

(v) REFINANCED DEBT SERVICE. Payments of debt service on the issue to be made from proceeds of any other issue are treated as payments taken into account under this paragraph (a)(3) in the same proportion that:

(A) The present value of the payments taken into account under this paragraph (a)(3) with respect to such other issue, bears to

(B) The present value of the debt service to be paid on such other issue,

determined in the same manner as under paragraph (a)(2). For example, if all the debt service on a note were to be paid with proceeds of a refunding issue, the note would meet the 10 percent private payment test if (and to the same extent that) the refunding issue meets the 10 percent private payment test.

(vi) USE. For purposes of this paragraph (a), all uses of any proceeds of an issue by one person are treated as one use.

(b) CERTAIN INCIDENTAL USES DISREGARDED. (1) IN GENERAL. For purposes of section 141(b) of the Code, incidental uses of a facility (e.g., a building) are disregarded. The proceeds of an issue to which the preceding sentence applies may not exceed 2-1/2 percent of the proceeds of the issue.

(2) INCIDENTAL USE. A use of a facility by a person is an incidental use if:

(i) The use does not involve the transfer to the person of possession and control over space that is separated from other areas of the facility by walls, partitions, or other physical barriers (such as a night gate affixed to a structural component of a building);

(ii) The use described in paragraph (b)(2)(i) is not related to any other use of the facility by the same person that is not described in paragraph (b)(2)(i); and

(iii) All uses of the facility that are described in paragraph (b)(2)(i) and (ii) do not, in the aggregate, involve the use of more than 2-1/2 percent of the facility.

Under this paragraph (b), for example, uses of space in common areas of an office building for coin-operated telephones, advertising displays, vending machines, or a newsstand or shoeshine stand would be disregarded (i.e., the space would be allocated to other uses of the facility that are not incidental).

(c) CERTAIN BUILDING IMPROVEMENTS. (1) IN GENERAL. For purposes of section 141(b) of the Code, proceeds of an issue to be used to finance any qualified improvement are not treated as proceeds to be used for a private business use.

(2) QUALIFIED IMPROVEMENT. An improvement is a qualified improvement if:

(i) The improvement is to a building or its structural components (within the meaning of section 1.48-1(e) of the regulations) or to land functionally related and subordinate thereto (hereinafter collectively referred to as the "facility");

(ii) The facility and improvement (hereinafter collectively referred to as the "improved facility") are owned for Federal income tax purposes by a governmental unit;

(iii) No portion of the improved facility or any payments in respect thereof are taken into account under section 141(b)(2)(A) of the Code (relating to the private security interest test);

(iv) The acquisition or construction of the improvement did not begin prior to the date that is one year after the first date on which the facility was in operation at substantially the level for which it was designed;

(v) The improvement does not result in the enlargement of the facility;

(vi) No more than 15 percent of the improved facility is used for any private business use;

(vii) The increase in the fair market value of the facility resulting from all improvements financed with proceeds of the issue (and any other improvements made or to be made pursuant to a common plan) does not exceed 10 percent;

(viii) The product of (A) the percent of the improved facility used for any private business use, and (B) the percent determined under paragraph (c)(vii) with respect to the facility, does not exceed 50 (e.g., if 10 percent of the improved facility were used for a private business use, the increase in fair market value could not exceed 5 percent); and

(ix) The improvement is not made to interior space occupied exclusively for any private business use.

(d) ALLOCATION OF PROCEEDS TO EXPENDITURES. (1) IN GENERAL. For purposes of section 141(b) of the Code, proceeds of two or more related issues that are to be used to finance a single facility or related facilities may be allocated ratably to all the expenditures for such facility or facilities that are to be financed with the proceeds of all the related issues.

(2) RELATED. Issues are related if they are issued by the same issuer pursuant to a common plan of financing. Facilities are related if they are part of a single integrated project and it is reasonably expected that the facilities will be placed in service for Federal income tax purposes within 12 months of one another.

(e) NONQUALIFIED AMOUNT, ETC. If proceeds of an issue (hereinafter referred to as the "multi-project issue") are to be used with respect to more than one project, section 141(b)(4), (5), and (8) of the Code are applied by treating the portion of the proceeds of the multi-project issue to be used with respect to each project as a separate issue; provided that, if any bond issued as part of the multi-project issue is thereby treated as a private activity bond, all bonds issued as part of the multi-project issue are treated as private activity bonds.

(f) PROCEEDS. Proceeds of an issue include amounts resulting from the investment of proceeds of the issue in investment property (as defined in section 148(b)(2) of the Code, but without regard to the last sentence thereof) that is not acquired in order to carry out the governmental purpose of the issue.

(g) PERSON. All persons who are related (within the meaning of section 144(a)(3) of the Code) are treated as one person.

COMMENTS

The Internal Revenue Service solicits comments relating to the definition of private activity bond. Comments should be sent to: Internal Revenue Service, Attention: CC:LR:T (LR-87-86), Washington, D.C. 20224.