Thursday, October 19, 2006

By Alison L. McConnell

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The Internal Revenue Service’s proposed regulations for payments in lieu of taxes, or PILOTs, could restrict future tax-exempt economic development bond deals, market participants said yesterday.

The regulations, which will not be finalized until after a Feb. 13 public hearing, would tighten tax code rules for PILOTs by requiring the payments to represent a fixed percentage of generally applicable taxes. The regulations signify a new restriction and narrow the interpretation taken by the IRS Office of Chief Counsel in recent private letter rulings issued for the New York City Industrial Development Authority’s financing of two new baseball stadiums for the New York Yankees and the New York Mets.

Cities often use PILOT deals, where payments from a private entity are used to pay debt service on tax-exempt bonds, in economic development projects. In a typical transaction a city will take title to a parcel of land, thereby removing the property from tax rolls, and permit a private business to use the exempt property in exchange for payment under the terms of a fixed PILOT contract.

In order to meet private activity restrictions for tax-exempt bonds, those payments must be less than and commensurate with the taxes that would have been collected on the property otherwise. In tax code language, they cannot be “special charges” — imposed on a limited group of people for benefits to be received only by that group — but instead must qualify for treatment as “generally applicable taxes,” which apply equally to all taxpayers.

The rules proposed yesterday would require PILOT contracts to specify that the payments represent “a fixed percentage of, or reflect a fixed adjustment to, the amount of generally applicable taxes in each year, based on comparable current valuation assessments.”

That will “better assure a reasonably close relationship between eligible PILOT payments and generally applicable taxes,” the IRS said in the regulations.

The rules would also delete a sentence from the current tax code definition of “special charge” as it pertains to PILOTs because the agency felt an existing definition in another code section was sufficient.

A public hearing on the proposed rules is scheduled for Feb. 17 at 10 a.m. Eastern Standard Time in Washington. The IRS will accept comments until Jan. 16 on the topic of whether any special rules are needed to address PILOTs based on taxes other than property taxes, which are most typically used in the deals.

Market participants reacting to the proposed regulations yesterday said the IRS is taking a narrower approach than it did in two recent private letter rulings issued for the New York City IDA. Those PLRs green-lighted the sale of almost $1.5 billion in tax-exempt bonds for new baseball stadiums for the Yankees and Mets.

The IDA had sought IRS approval of the two transactions — one for each team — because no formal PILOT rulings had been issued at that point, according to Nixon Peabody LLP, the firm acting as bond counsel on the deals. The IRS’ response approved the structure of the two deals, which involved PILOTs paid by the two teams and contracted to be the amount of debt service on the tax-exempt bonds, rather than a set percentage of generally applicable taxes.

Sources said yesterday that the PLRs’ approval of tax-exempt bonds backed by a PILOT contract that looked “too much like a private loan” might have pushed Treasury Department and IRS officials to clamp down in the regulations. But the proposed rules are inconsistent with the way PILOTs are commonly used, one attorney noted.

“The IRS’ proposal would reduce the intended financial benefit the governmental entity is intending to provide for the designated project,” said Richard Chirls of Orrick Herrington & Sutcliffe LLP in New York. “Tax-exempt bonds will be issued, but at a higher cost, [and] that is not good for the IRS, the municipality, or the developer.”

And issuers considering PILOT deals are not likely to rush to market before the regulations are finalized, sources noted.

“Bringing a deal to market in the current legal environment would face the challenge of balancing the ambiguities in the current regulations, as interpreted by the recent private letter rulings for the Yankees and Mets, against the IRS’ views as indicated by the requirements set forth in the proposed regulations,” according to Chirls. “Prompt resolution by the issuance of final regulations is very important.”

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