WASHINGTON — The Internal Revenue Service should withdraw or alter a controversial 2013 memorandum relating to the definition a political subdivision, provide interim guidance, and propose new rules that apply prospectively, the tax-exempt financing committee of American Bar Association's taxation section said.
"Our concern is that the analysis used in the 2013 TAM imposes new requirements for qualifying as a political subdivision that are not supported by existing legal precedent and could call into question a variety of financing structures that have been used for many years in many states," the group said in a paper sent to the IRS on Tuesday, several days before it meets here.
Mark Norell, a member of the committee and an attorney at Sidley Austin in New York, had principal responsibility for preparing the comments. Other bond lawyers also made significant contributions.
The definition of a political subdivision has become a major issue for municipal bond market because the 2013 TAM concluded that the Village Center Community Development District in Florida is not a political subdivision because it is not accountable to a general electorate. After the TAM was issued, the Treasury Department and the IRS added a project on political subdivisions to their priority guidance plan.
The tax-exempt financing committee stressed that it is not commenting on whether the Village Center CDD is a political subdivision. However, it said the TAM creates uncertainty because accountability to an electorate has not previously been necessary for an entity to be a political subdivision. While the TAM is not precedent, the committee said it is concerned that the IRS may use it to apply a new standard in audits, which could hurt issuers and be costly for them.
Under tax rules, interest on obligations of states and territories and their political subdivisions can be tax exempt. A political subdivision is defined in regulations as a division of a state or local government which is a municipal corporation or has been delegated the right to exercise part of the government's sovereign power.
The TAM outlined a two-part test for determining whether an entity is a political subdivision that can issue tax-exempt bonds. Under the test, an entity is a political subdivision if it: 1) is a division of a state or local government and 2) has been delegated sufficient sovereign powers. The TAM found that the CDD was not a division of the state because it was not directly or indirectly answerable to a general electorate. While the CDD argued that it was sufficiently controlled by the state, the IRS disagreed because the district's board was, and always would be, controlled by a developer.
The TAM relied on a 1983 revenue ruling in determining that the CDD was not a political subdivision, but the ABA committee said that the reliance on that ruling is "misplaced."
The TAM states that the 1983 ruling found certain North Carolina electric and telephone membership corporations were not political subdivisions because they were controlled by a board of directors that was independent from the authority of any state or local government.
However, the 1983 ruling actually separately stated that the corporations do not have sufficient sovereign power to be political subdivisions and that the corporations should not qualify for an excise tax exception based on governmental control because they were not controlled directly or indirectly by a government. Also the 1983 ruling "does not provide support for the accountability to a general electorate requirement set forth in the 2013 TAM," the ABA committee said.
The committee analyzed past court cases and revenue rulings concerning the definition of a political subdivision and described several issues that Treasury and the IRS should consider when issuing guidance on the topic.
The committee recommended that the agencies rely only on case law and rulings that relate to the issuance of tax-exempt financings. The group also wants Treasury and the IRS to differentiate between political subdivision status and other legal statuses, such as entities' statuses as "on behalf of" issuers or their eligibility for excise tax exemptions.
"While control is an important consideration with respect to "on behalf of" issuer status, excise tax exemptions, and section 115 [tax-exempt] status, it is not a specific requirement applicable to political subdivision status," the committee said.
Past rulings found that entities need further a public purpose in order to be a political subdivision. The tax-exempt financing committee said the concept of public purpose needs to be flexible because governments' needs change over time. If the Treasury and the IRS intend to further explain what constitutes a public purpose, they should do so through proposed regulations and provide state and local governments with some discretion, according to the paper.
The committee said it is not aware of any other guidance or ruling outside of the TAM that suggests that an entity needs to be accountable to the general public in order to be a division of a state. It said the division language in existing regulations "is satisfied if the division is established by a proper authority of a state, acting within its constitutional power, for the purpose of carrying out governmental functions."
In past rulings, control by other governmental units or an electorate has not been considered an independent requirement for an entity to be a political subdivision, and the committee said it does not want control to become one. If the Treasury and the IRS want control to be an independent consideration when determining whether an entity is a political subdivision, they should develop these ideas in proposed regulations so that stakeholders have the opportunity to provide comments, it said.
"Further, if control is to be developed as a consideration, the Committee believes that a facts and circumstances analysis should be used because the governmental purposes to be achieved by an issuer will vary significantly across political subdivisions, and the types of sovereign powers (tax, police and eminent domain) needed to achieve the governmental purposes will vary from case-to-case," the committee said.
The ABA group thinks the Treasury and the IRS should issue interim guidance on political subdivisions "given the strong need for certainty in the tax exempt transactional practice." The notice that provides interim guidance should also state that the agencies plan to issue proposed regulations with an updated definition of a political subdivision for tax-exempt bond purposes. Also, the notice should state that any changes to the definition will be prospective, the committee said.
The paper included an appendix with a suggested outline of a notice addressing the definition of a political subdivision.