Rev. Rul. 80-339

ISSUE

Will the bonds issued by a political subdivision of a state to finance the construction of terminals and related airport facilities for commercial airline carriers be "industrial development bonds" within the meaning of section 103(b)(2) of the Internal Revenue Code?

FACTS

The political subdivision issued revenue bonds and used the bond proceeds to construct terminals and related facilities for several commercial airline carriers. The political subdivision also operates a toll bridge that is used by the general public. The bonds are not "arbitrage bonds" as such term is defined in section 103(c) of the Code.

The bond indenture for the bond issue provided that principal and interest on the bonds would be payable solely from a pledge of revenues derived by the political subdivision from the toll bridge. The bond indenture further provided that unpledged revenues derived by the political subdivision from the terminals and related airport facilities might be used for any purpose of the political subdivision, subject to a priority to pay operating expenses and maintenance costs relating to the airport facilities. Revenues from the terminals and related facilities were derived from long-term lease payments.

The total revenues derived from the terminals, related airport facilities, and the toll bridge in 1979 were 100x dollars, of which 60x dollars were derived from the toll bridge. The long-term lease payments to be made by the airline carriers and the debt service on the revenue bonds are approximately equal in present value.

LAW AND ANALYSIS

Section 103(a)(1) of the Code provides that gross income does not include interest on obligations of a state.

Section 103(b)(1) of the Code provides that, with certain exceptions, the interest on "industrial development bonds" is not excludable from gross income.

Section 1.103-7(b) of the Income Tax Regulations defines industrial development bonds as obligations that meet the "trade or business test" and the "security interest test." The trade or business test is satisfied if a major portion (more than 25 percent) of the bond proceeds is used in the trades or businesses of nonexempt persons. The security interest test is met if a major portion (more than 25 percent) of the payment of the principal or interest on the bonds is secured by any interest in property used in a trade or business or by payments in respect of such property, or is to be derived from payments in respect of property, or borrowed money, used or to be used in a trade or business.

Section 1.103-7(b)(3) of the regulations provides that the trade or business test relates to the use of the proceeds of a bond issue. The test is met if all or a major portion (more than 25 percent) of the proceeds of a bond issue is used in a trade or business carried on by a nonexempt person. For example, if all or a major portion of the proceeds of a bond issue is to be loaned to one or more private business users, or is to be used to acquire, construct, or reconstruct facilities to be leased or sold to such private business users, and such proceeds or facilities are to be used in trades or businesses carried on by them, such proceeds are to be used in a trade or business carried on by persons who are not exempt persons, and the debt obligations comprising the bond issue satisfy the trade or business test.

Section 1.103-7(b)(4) of the regulations provides that the security interest test relates to the nature of the security for, and the source of, the payment of either the principal or interest on a bond issue. The nature of the security for, and the source of, the payment may be determined from the terms of the bond indenture or on the basis of an underlying arrangement. An underlying arrangement can be inferred from all the facts and circumstances.

Example (14) of section 1.103-7(c) of the regulations, which illustrates the existence of an underlying arrangement, reads as follows:

J, a political subdivision of a State, will issue several series of bonds from time to time and will use the proceeds to rehabilitate urban areas. More than 25 percent of the proceeds of each issue will be used for the rehabilitation and construction of buildings which will be leased or sold to non-exempt persons for use in their trades or businesses. There is no limitation either on the number of issues or the aggregate amount of bonds which may be outstanding. No group of bondholders has any legal claim prior to any other bondholders or creditors with respect to specific revenues of J, and there is no arrangement whereby revenues from a particular project are paid into a trust or constructive trust, or sinking fund, or are otherwise segregated or restricted for the benefit of any group of bondholders. There is, however, an unconditional obligation by J to pay the principal and interest on each issue of bonds. Further, it is apparent that J requires the revenues from the lease or sale of buildings to nonexempt persons in order to pay in full the principal and interest on the bonds in question. The bonds are industrial development bonds because a major portion of the proceeds will be used in the trades or businesses of nonexempt persons and, pursuant to an underlying arrangement, payment of the principal and interest is, in major part, to be derived from payments in respect of property or borrowed money used in the trades or businesses of nonexempt persons.

An underlying arrangement will always be inferred if the payments to be made by the industrial user or users and the debt service on the bonds are approximately equal in present value. Other facts that tend to show an underlying arrangement are, first, that payments made by the industrial user or users are material to the security for the bonds, and second, that the identity of the industrial user or users can be determined with reasonable certainty at the time of issue.

In this case the bond proceeds will be used in constructing facilities that will be leased to nonexempt persons. Because more than 25 percent of the bond proceeds will be used in the trades or businesses of nonexempt persons, the bond proceeds will be considered used in the trades or businesses of nonexempt persons and the "trade or business test" described in section 1.103-7(b)(3) of the regulations will be satisfied.

For purposes of satisfying the "security interest test," the substance and not the form of the transaction is to control. See section 1.103-7(b)(4) of the regulations. In this case, in order to fail the "security interest test," the political subdivision arranged the terms of the bond indenture to provide that the bonds will be payable only from pledged revenues. Notwithstanding the formal documents, an underlying arrangement can be inferred because the payments to be made by the airline carriers and the debt service on the bonds are approximately equal in present value. Consequently, payment of a major portion of debt service on the political subdivision's bonds will be derived from payments in respect of property used or to be used in a trade or business within the meaning of section 103(b)(2)(B)(ii) of the Code. See example (14) of section 1.103-7(c). Moreover, the use of toll bridge revenues (instead of the revenues derived from the terminals and related airport facilities) to pay debt service on the bonds does not significantly alter the economic consequences of the transaction. The use of toll bridge revenues to pay debt service on the bonds "frees up" the revenues from the terminals and related facilities or uses for which the toll bridge revenues would otherwise have been available. Since the political subdivision would not have issued the bonds in this case without requiring the commercial airline carriers to pay for the use of the bond-financed facilities, the revenues derived from the use of the bond-financed facilities are the true "source" of the debt service payments. Therefore, the "security interest test" described in section 1.103-7(b)(4) will be satisfied.

HOLDING

The bonds issued by the political subdivision to finance the terminals and related airport facilities are industrial development bonds within the meaning of section 103(b)(2) of the Code.