California Issuer Can Sell Prepay Bonds Without Arbitrage Fears

A district in California can issue tax-exempt bonds to prepay for electricity that it plans to provide to an authority made up of a group of municipalities without triggering certain arbitrage restrictions, the Internal Revenue Service concluded in a recently published private-letter ruling.

The ruling, which was dated April 2 but not publicly released until Monday, does not identify the parties involved. But Carol Lew, a shareholder at Stradling Yocca Carlson & Rauth in Newport Beach, Calif., who serves as bond counsel for the Kings River Conservation District in Fresno, said the ruling applies to the district and the San Joaquin Valley Power Authority, and is important because it may encourage other municipalities in California to follow suit.

Lew said that by determining that the authority qualified as a "utility," the IRS provided some much-needed guidance on the term, which currently is not defined in the tax code as it pertains to arbitrage.

"It shines some light in an area where there hasn't been much guidance," she said yesterday. "It was helpful for the IRS to clarify the meaning of utility and service area to assist issuers in utilizing this exception."

The ruling stems from a request that the district and the authority made to the IRS for a ruling on a project they planned to undertake.

Under the plans, the authority is to take over power production for its members: 11 cities and one county. The power would be available to all residents within the municipalities' borders, and the authority would be responsible for setting the rates.

A California state law - the 2002 Community Choice Act - permits local governments to purchase electricity for their residents, in an attempt to increase competition and potentially lower rates.

Power is currently provided by two private facilities. But under the new system, the district, which already has a hydroelectric power plant, would construct a natural gas plant and provide the power from that plant. The private facilities would simply transmit and distribute the power to residents, who could opt out of the public program and continue to receive power from the private facilities.

Currently, the district does not have sufficient facilities to provide the power, so it plans to prepay for electricity from other sources, and to finance those payments with tax-exempt bonds. The district also is in the process of developing a larger power plant, which it eventually hopes will allow it to purchase electricity on a supplemental basis.

Tax regulations stipulate that unless a prepayment is made by, or for, electrical or natural gas utilities, it is considered investment property and therefore is subject to arbitrage regulations. However, if the prepayment is made on behalf of an electrical or natural gas utility run by a municipal entity, then the payments are considered expended and are not part of arbitrage calculations.

Furthermore, a prepayment is only eligible for the utility exception if it provides power to a "service area."

The IRS agreed with the claim that the district and authority together qualify as a utility with a service area, since they will offer the electricity to all residents and assume responsibility to provide the power and set the rates.

Lew said that while the arrangement between the authority and the district to provide power is unique thus far, other California municipalities interested in providing more power options to their residents could follow suit in the future thanks in part to the favorable ruling.

"It is my understanding that we are the first ones," she said. "This is an important area for California law to help our consumers have a choice [in power providers]."

In a supplemental matter, the IRS also determined in the ruling that the usage of the two private facilities to transmit and distribute the electricity does not constitute private business use.

Under the plans, the private facilities would only receive payments for the transmission and distribution of the power, while the authority would receive payments for supplying the power. Also, since the private facilities do not stand to gain from the new arrangement because the new authority would serve as a new competitor, the IRS determined that the transmission of electricity purchased with tax-exempt bond proceeds would not constitute private business use in this case.

"They were not gaining anything from the bond proceeds - their business of distributing and transmitting stayed the same before and after," Lew said.

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