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Taxation

Treasury, IRS May Re-Propose Political Subdivision Rules

CHICAGO -- The Treasury Department and Internal Revenue Service may rethink and re-propose controversial political subdivision rules, but will wait until next year to see what the next administration wants to do with them, a tax regulator told lawyers meeting here.

Speaking on panels at the National Association of Bond Lawyers' Bond Attorneys' Workshop here, Treasury associate tax legislative counsel John Cross noted that the rules, which were proposed in February, received more than 100 public comments from groups and individuals who opposed them.

"We may consider re-proposing the project after receiving over 100 comment letters," Cross said. "We expect to see the incoming leadership of administration to decide how to move forward or consider that project."

Historically, the determination of whether an entity was a political subdivision that could issue tax-exempt bonds was based on whether it had the right to exercise a substantial amount of at least one of three sovereign powers: eminent domain, taxation, and policing.

But IRS officials, through audits, learned some developers had created political subdivisions and were in complete control of them, issuing tax-exempt bonds partly for their own benefit.

After an unsuccessful attempt to change the definition through the audit process, the Treasury and IRS proposed new rules in February that would add two new additional requirements to the definition of political subdivisions. Besides being able to exercise sovereign powers, they also would have to serve a government purpose "with no more than an incidental private benefit" and they would have to be governmentally controlled.

Market participants said the proposed rules were overly restrictive and could cause some tax-exempt bonds to become taxable, even though they would be prospectively effective.

In a further update of the 2016-17 guidance plan, Cross said the next project expected to be completed is final issue price regulations. He said the agencies are "actively working on" them, but did not give an estimated timeframe for their release.

He also said IRS and Treasury are looking carefully at the need for a special rule or safe harbor for competitive sales, a request from many of those who commented on the proposed rules.

Issue price helps determine the yield on bonds and whether an issuer is complying with arbitrage rebate or yield restriction requirements, as well as whether subsidy payments for direct-pay bonds are appropriate.

Under the proposed rules, the issue price of a maturity would generally be the price at which the first 10% of the bonds are actually sold to the public. If 10% of a maturity hasn't been sold by the sale date, the issue price would be the initial offering price of the bonds sold to the public as long as the lead or sole underwriter certifies to the issuer that no underwriter filled an order from the public after the sale date and before the issue date at a higher price. An exception can be made for market movements justifying a higher price.

Cross said the IRS and Treasury are also working on finalizing public approval requirements for private activity bonds under the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), which was released in temporary form in 1983 and as proposed regulations 25 years later.

The TEFRA regulations are a priority for Cliff Gerber, the new NABL president who was formally elected at BAW on Wednesday.

But much of the discussion at the BAW centered on Revenue Procedure 2016-44, which contains safe harbors for management contracts and was released in August.

Cross also said the Treasury and IRS will consider "amplifications" or "clarifications" of certain provisions of the revenue procedure, in response to concerns that have been raised about them.

Cross said one of the goals of the Rev. Proc. was to make the safe harbors more flexible by getting away from the previous formulaic percentages for compensation, without changing the core standard of no net profits. There was no intent to change any law under the safe harbors, he said.

A major concern Cross said he has heard from lawyers is how the new procedure deals with reimbursed expenses, or when the service provider pays expenses in connection with the management contract.

"We intended continuity with the old safe harbors," Cross said. "We are receptive to looking at whether we need an amplification or two to provide more continuity to Rev. Proc. 97-13."

Rev. Proc. 2016-44 supersedes Rev. Proc. 97-13, which had stated contracts of up to 10 years required at least 80% of the manager's compensation to be based on a fixed fee, while 15-year contracts required at least 95% compensation to be based on a fixed fee.

The new procedure extends the terms of long-term management contracts to up to 30 years from the previous 15 years and also removes the formulaic fixed fee requirements for manager compensation.

The new, more liberal safe harbors were meant to encourage infrastructure projects and public-private partnerships as well as allow for more incentive compensation.

Cross said that other amendments could be made.

"We're at least considering some kind of handholding clarification that would address capitation fees and per unit fees," Cross said. "They weren't net profits before and they aren't net profits now regardless of what you do."

Michela Daliana, a partner with Hawkins Delafield & Wood in New York, said deferrals and net profits are the "major points of concern," but also addressed questions regarding compensation arrangements.

"We're always thinking about how you fit a compensation arrangement into a situation where you want to incentivize a private entity to do a good job and use the facility in an appropriate way and still fit within rigid guidelines," Daliana said. "This new Rev. Proc. puts those principles we're operating under on their head a little bit. We're not focusing on what kinds of compensation are permitted."

The language of the notice also created some confusion that was mentioned at the NABL conference.

"What people are tripping over is whose net profits or net profits of what," said Lauren Mack, a partner with Reyes Kurson in Chicago. "I think the language here created confusion over who or what that didn't exist in 97-13. I think that contributed to the problem."

The new safe harbors apply to management contracts entered into on or after August 22 of this year, but issuers may also use Rev Proc. 97-13 safe harbors for contracts entered into before August 18, 2017. Matthias Edrich, an attorney with Kutak Rock in Denver, questioned why Rev. Proc. 97-13 cannot live on past next August, while Perry Israel, who has a private practice in Sacramento, also expressed support for the 97-13 safe harbors.

"We're putting out rules, not revoking them," said Johanna Som de Cerff, senior technician reviewer in the IRS' office of chief counsel. "We try not to have multiple pieces in the reissuance area. In general, we push to incorporate everything into one document. At some point we want to put it all in one place."

"Our basic intent was to build on the foundation and look at private letter rulings and comments and try to broaden the safe harbors," she said.

Bond attorneys largely lauded the less restrictive safe harbors, but expressed questions regarding separate billing arrangements, the re-testing of an economic life of a contract and whether certain contracts under Rev. Proc. 97-13 will continue to be within the safe harbors of Rev. Proc. 2016-44.

The procedure includes three new requirements ensuring no private ownership or leases. A state or local government "must exercise a significant degree of control of the use of the managed property" and "must bear the risk of loss upon damage or destruction of the managed property," while the private party cannot take any depreciation or amortization, investment tax credit, or deduction for any rent payment for the property.

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