WASHINGTON — The Internal Revenue Service issued a favorable private-letter ruling to an issuer who plans to issue governmental and private-activity bonds to finance improvements to water facilities.
The IRS concluded in the ruling that the proceeds of the governmental bonds would not be used for excessive private business use, and the improvements to be financed with the PABs would be "facilities for the furnishing of water" that can be financed with exempt facility bonds.
The ruling, which did not name the issuer, was dated Oct. 28 but was not made public until Feb. 13. It was signed by Johanna Som de Cerff, a senior technician reviewer in the tax-exempt bond branch of the IRS chief counsel's office.
The issuer that requested the ruling is a political subdivision and governmental agency of a state. It collects, stores and distributes raw water from "Supply X" and "Supply Y," according to the ruling.
The issuer has entered into, and expects to enter into, contracts with customers for the delivery of raw water. The contracts are "take or pay" contracts, which means they are output contracts under which the purchaser agrees to pay for the output, regardless of whether the facility is able to provide it.
The Supply X customers are an industrial user and municipal water districts. The issuer expects, based on actual and anticipated agreements, that less than 10% of the supply will go to the industrial user. The Supply Y customers are industrial and irrigation users and municipal water districts. The contracts with industrial and irrigation users consist of more than 10% of the supply. At least 25% of the supply is expected to be available to residential users and municipal water districts, according to the ruling.
Supply Y is downstream from Supply X. The issuer has the right to move excess supply from Supply X to Supply Y. But the issuer does not expect to move any significant amount of water to Supply Y and its customers don't have any rights to the water stored in Supply X. The Supply X customers also have no rights to the water stored in Supply Y, the ruling said.
The issuer plans to issue governmental bonds to finance capital improvements to Supply X facilities and private-activity bonds to finance capital improvements to Supply Y facilities.
It also plans to use bond proceeds to finance services and equipment relating to the facilities. Services and equipment that pertain solely to specific water supplies will have their costs allocated to the specific supplies. Services that pertain to both supplies will have their costs allocated to them based on the relative costs of the improvements to Supply X and Supply Y. Equipment pertaining to both supplies will have their costs allocated to the two supplies based on the relative water supply. Proceeds of the governmental bonds will be used to finance services and equipment allocable to Supply X, and proceeds of the PABs will be used to finance services and equipment allocable to Supply Y.
The IRS concluded that no more than 10% of the proceeds of the governmental bonds will be used by private parties.
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 secured from, or paid by, private parties. Under regulations, an issuer entering into a take or pay contract with a private user gives rise to private business use. The amount of private business use is generally the amount of output purchased. Whether output sold under a contract is allocated to the seller's entire system or just to a part of the system is based on the facts and circumstances.
Since the issuer doesn't expect to release significant amounts of Supply X water to Supply Y, Supply X customers don't have rights to water from Supply Y, and Supply Y customers don't have rights to water from Supply X, "the contracts between issuer and Supply X customers are allocable to improved Supply X facilities and the contracts between issuer and Supply Y customers are allocable to improved Supply Y facilities," the IRS said. And since the issuer expects less than 10% of private business use of Supply X based on its actual and expected contracts for water, the contracts will not result in the bond proceeds being used for excessive private business use, the agency added.
Bond lawyers said the IRS' conclusion is well-reasoned.
"I think it is a good illustration of how to determine whether output sold pursuant to an output contract is treated as output from a bond-financed facility," said Matthias Edrich, a shareholder at Greenberg Traurig.
"It was nice to see the IRS treat the two water supplies as separate even though they were in some sense connected," said Johnny Hutchinson, a senior associate at Squire Patton Boggs. He added that it would have been unfortunate if the IRS told the issuer that the Supply X facilities had be financed with PABs just because the issuer had the right and physical ability to deliver excess water from Supply X to the private use customers.
The IRS also concluded that the improvements, services and equipment for Supply Y are "facilities for the furnishing of water" that can be financed with exempt facility bonds, a type of tax-exempt PAB.
Under federal tax law, PABs are only tax-exempt if they are used for certain purposes, one of which is "facilities for the furnishing of water." These facilities are defined as those that have water that is made available to the general public and that are owned by governmental units or have their rates set by governments or their public utility commissions.
Because the issuer intends to make at least 25% of Supply Y available to residential users and municipal water districts throughout the life of the bonds, the IRS determined that water would be available to the general public. The ruling cites a Senate report from when water PABs were created in 1978 that said a facility will have a substantial portion of its capacity available to the general public if 25% of capacity is made available for those purposes. Additionally, facilities are operated by the issuer, which is political subdivision and governmental agency, the IRS said.
Bond lawyers pointed out that there hasn't been much guidance on water PABs. Nearly all water projects are financed with governmental bonds, rather than PABs, they said.
But Rich Moore, a partner at Orrick, Herrington and Sutcliffe, said that water projects that use PABs tend to be large in dollar amount. Carol Lew, a shareholder at Stradling Yocca Carlson & Rauth, said she recently worked on a deal involving a refunding of water bonds where refunding involved both governmental bonds and PABs.
Legislation has been introduced in Congress to exempt PABs for water and sewer projects from state volume caps. President Obama's fiscal 2016 budget proposed creating PABs called qualified public infrastructure bonds, which would not subject to volume caps or the alternative minimum tax, and could be used for water projects that are governmentally owned and available to the public.
Allowing projects like the "Supply Y" facilities to be financed with QPIBs "would allow those bonds to be issued without getting volume cap, and interest on those bonds would be non-AMT," Hutchinson said.
