Rev. Rul. 77-416

City M sold several issues of municipal bonds during previous years to finance the acquisition and improvement of an electric generation, transmission, and distribution system that serves M. The current total outstanding balance of the bonds is $60,000,000. The security for the bonds is the revenue produced by the sale of electric energy generated by the facilities. The interest on the bonds is excludable from the gross incomes of the bondholders under the provisions of section 103(a)(1) of the Internal Revenue Code of 1954.

After operating the electrical system for many years, M has concluded that the recent large increases in fuel and operating costs have removed the economic basis for continued operation of the system by M, and has proposed selling the system to O, a private utility company. There have been no previous dealings between O and M. Representatives of M have made a good faith effort in bargaining for the sale of the electric system in order to receive full value for the system. At the time the outstanding bonds were issued, M fully intended to operate the system indefinitely.

Under the terms of the sale, O will pay M a fixed payment of $14,000,000 plus an additional amount that, together with investment income on such additional amount, will be sufficient to make all required interest payments on the bonds and to retire the bonds at maturity. It is currently estimated that the second amount will be $52,000,000. However, O may be required to increase the second amount at the time the sale is completed if the estimated investment income on the second amount has decreased. In no event will the second amount exceed the current outstanding face amount of the bonds. If it is determined that the investment income on the second amount will be more than estimated, O will pay a reduced amount.

M will place the estimated amount of $52,000,000 of the sale proceeds in an escrow account as substituted security for the electric system revenues originally pledged as security for the bonds. If the escrowed funds and the investment income on the escrowed funds are insufficient to pay the principal and interest to pay the principal and interest on the bonds, then M must deposit additional funds in the escrow account since M will be liable to pay the principal and interest on the bonds. If surplus funds remain in the account after the bonds are retired, the funds will be distributed to M.

Held, after the sale of the electric system by M, the interest on the outstanding bonds will continue to be excludable from the gross incomes of the bondholders under section 103(a)(1) of the Code.

Held further, since the funds were placed in the escrow account for the benefit of M, the income earned by the escrow account will not be includible in the gross incomes of O or of the bondholders. See section 1.61-13(b) of the Income Tax Regulations.