WASHINGTON — The tax-exempt financing committee of the American Bar Association's taxation section is working on a paper that will identify for tax regulators modifications to tax rules that could facilitate public-private partnerships.
Bond lawyers discussed the project at the committee's meeting here on Friday, as Treasury Department associate tax legislative counsel John Cross asked lawyers to closely consider two proposed new types of bonds that would incentivize private investment in infrastructure.
The ABA committee project on tax rule modifications was formed as a result of a panel on P3s at the committee's meeting in January. During that panel, committee members discussed common types of P3 transactions and the problems that can arise when integrating tax-exempt bond financing into these transactions, said Carol Lew, a shareholder at Stradling Yocca Carlson & Rauth in Newport Beach, Calif.
The hope is that the group's suggestions will not just be helpful for P3s, but will have a broader application, said Lew, who is on the working group that is preparing the paper. Other working group members are: Chas Cardall, a partner at Orrick in San Francisco; Michela Daliana, a partner at Hawkins, Delafield and Wood in New York; Michael Thomas, a partner at Kutak Rock in Denver; and Sarah Breitmeyer, an associate at Chapman and Culter in Chicago.
The paper will address two issues: expanding the safe harbors under which management contracts wouldn't give rise to private business use and finding ways to avoid tax problems when P3s involve revenue or profit sharing.
Under federal tax law, bonds are private-activity bonds if more than 10% of the proceeds are used by private parties and more than 10% of the debt service is paid from or secured by private business use. Infrastructure projects can be financed using tax-exempt PABs, but those bonds are subject to the alternative minimum tax and other restrictions.
Management contracts can give rise to private business use, but the Internal Revenue Service has provided some safe harbors so that this will not happen under certain circumstances. However, the current safe harbors apply for short-term contracts and the working group wants the IRS to create safe harbors for longer-term contracts.
It's important to incentivize long-term private involvement "because the theory is, they'll provide a better product," Lew said.
One concern with long-term management contracts is that governments must avoid transferring ownership of the project to a private entity when the transfer would threaten bonds' tax exemption. So the working group may suggest that a management contract not give rise to private business use if its length is not more than 80% of the life of the project, members said.
The other issue the paper will address is reconciling tax rules with P3s that involve revenue or profit sharing. Under tax rules, contracts where compensation is based on net profits give rise to private business use. As a result, adjusting the safe harbors may not be the right approach here.
Instead, the working group may suggest an approach to allow tax-exempt financing of the portion of a project that is equal to the public entity's share. The group may propose something that is similar to the IRS' safe harbor for when certain accountable care organizations — health-care entities that can be made up of public and private parties — don't give rise to private business use, Lew said.
Bond Proposals
During another panel at the committee meeting, Cross recommended that bond lawyers compare the Obama administration's budget proposal for qualified public infrastructure bonds with the bill recently introduced by Sen. Ron Wyden, D-Ore., that would create Move America Bonds.
QPIBs would be a type of private-activity bonds that could be used to finance certain types of infrastructure projects. The projects would have to be governmentally owned and meet a public use requirement, but would not be subject to volume caps. Also, interest on the bonds would not be subject to the alternative minimum tax.
Move America Bonds could be used to finance some of the same projects, but also different types, of infrastructure projects as those that could be financed with QPIBs. Move America Bonds would not be subject to the AMT and could finance projects that are privately owned, but they would be subject to volume caps, which could be converted into tax-credit allocations.
Cross said that Wyden's bill would be more costly than QPIBs, but "in the bond area, we like when there's interest in the topic."
Ed Oswald, a partner at Orrick, Herrington and Sutcliffe in Washington, noted that the proposals for new types of infrastructure bonds are for tax-exempt bonds rather than tax-credit bonds. In the last decade, tax-credit bond proposals were popular, so Oswald asked Cross if the "fever" for tax-credit bonds is subsiding.
Cross said, "That question is really, 'What's the best mousetrap for delivering the borrowing subsidy?'" Tax-exempt bonds have been around for a long time, but the exemption is seen to be inefficient. A market for traditional tax-credit bonds never developed. Build America Bonds were successful in that there was a broad market for them, but market participants have uncertainty about the subsidy payments, he said.
Cross said Treasury is encouraging the use of bonds as one potential piece of a bigger infrastructure-financing solution. He urged the lawyers at the meeting to raise awareness about QPIBs and other bond proposals.
Cross and other Treasury officials recently met with the Senate Finance Committee's tax-reform working group on community development and infrastructure and touched upon bond proposals in Obama's fiscal 2016 budget.
Besides QPIBs, those proposals include the creation of America Fast Forward bonds, which would be similar to BABs but would have a 28% rather than a 35% subsidy rate. AFF bonds also could be used to finance projects that could be financed with governmental and private-activity bonds. Unlike BABs, AFF bond subsidy payments would not be subject to federal spending cuts known as sequestration.
Cross said that AFF bonds would help get more institutional investors investing in state and local debt.
Another proposal in Obama's budget designed to encourage institutional investment is one that would increase the bank-qualified debt limit to $30 million from $10 million and allow financial institutions to deduct 80% for their interest expenses for any type of tax-exempt bonds, to the extent the bonds were no more than 2% of their total assets. Cross said that this proposal would encourage local banks to buy the local small issuers' bonds.
While the bank-qualified bond limit is not indexed for inflation in the budget proposal, making inflation adjustments could be considered, Cross said.
Guidance Plan
Cross also discussed items on the Treasury and Internal Revenue Service priority guidance plan with the ABA committee.
He said that he hopes new proposed issue price rules will be released "soon." Treasury and the IRS had proposed rules on the definition of issue price in September 2013 that market groups consider to be unworkable. Cross said that, in the new release, the regulators hope to provide more certainty about who is an underwriter in their new proposal.
Another project, on allocation and accounting rules for private-activity bond purposes, is "currently our most active priority," Cross said. This project will look at allocation rules for projects that have part governmental use and part private-business use, and it affects P3s, he said.
Proposed allocation and accounting rules were released in 2006. Cross said he was unsure if the current allocation and accounting project would be released as final regulations or take another form.
Guidance on the definition of a political subdivision is also on the regulators' plan, and Cross said they are considering how much and what type of governmental control would be needed to decide an entity was a political subdivision. The regulators also will consider a House Appropriations Committee report that urged guidance on political subdivisions to be prospective, he said.
A few days before the meeting, the tax-exempt financing committee submitted comments about the definition of a political subdivision. The committee recommended that the IRS not make control by another governmental unit or a general electorate a requirement for political subdivision. But it also said that to the extent there is a control requirement, it should be flexible. The committee also wants changes to the definition of a political subdivision to be prospective.
Additionally, the guidance plan includes a project to update the safe harbors for when management contracts don't give rise to private business use. Treasury and the IRS will explore allowing more flexibility with the terms and compensation under management contracts as long as compensation is not based on net profits and there are no leases, Cross said.
Cross said that Treasury and the IRS are considering adding a new project to the guidance plan about remedial actions when there's a change in the use of bond-financed projects, such as a facility that becomes subject to a long-term lease, Cross said. The regulators have received a number of comments on this topic, he said.
Last year, the National Association of Water Companies sent Treasury a letter asking for the remedial action rules to be clarified so that state and local governments can ensure that the tax-exempt bonds they used to finance water projects will not become taxable if they enter into public-private partnerships. Other groups have sent Treasury similar letters.
Daliana said it would be useful to have a way to deal with projects financed with direct-pay bonds that no longer qualify for subsidy payments because of changes in use. Cross said that change in use issues present themselves differently for tax-credit and direct-pay bonds. There could be more user-friendly remedies for addressing changes in use for tax-credit bond financed projects, such as simply turning off the subsidy payments.
Friday's meeting was the last meeting of the tax-exempt financing committee with Nancy Lashnits as the committee's chair. Lashnits, a former IRS official who is of counsel at Steptoe & Johnson PLLC in Phoenix, is finishing up a two-year term as chair.
Starting July 1, Stefano Taverna, a partner at McCall, Parkhurst & Horton LLP in Dallas, will be the committee's chair. Todd Cooper, a partner at Squire Patton Boggs in Cincinnati, and Mark Norell, counsel at Sidley Austin in New York, will be vice chairs. Cooper is expected to succeed Taverna.
"I'm very excited to become the chair," Taverna said. He noted that the work on the P3 project is very active, and he would like for work on a committee project on ACOs to be just as active.
