WASHINGTON -- Tax regulators' efforts to redefine political subdivisions that can issue tax-exempt bonds are overreaching, ignore congressional intent, run counter to decades of practice, and could cast doubt on many legitimate entities that currently issue municipal bonds, lawyers told the Treasury Department and Internal Revenue Service.
The new rules that have been proposed to redefine political subdivisions should be abandoned and the agencies should instead consider making narrow revisions to the private activity bond rules to address their concerns about any possible abuses, the American Bar Association's Taxation Section said in a 24-page letter to the agencies.
The ABA Taxation Section joins roughly 133 groups and individuals, almost all of which strongly opposed the proposed rules in comment letters sent to tax regulators since February 2016.
The federal tax law permits a political subdivision to issue tax-exempt bonds and defines the term "political subdivision" to mean an entity that has the ability to exercise a substantial amount of at least one of three sovereign powers – taxation, eminent domain and policing. The definition hasn’t been changed since 1936, other than a court case ruling in 1994 that specified the three sovereign powers.
Districts and other political subdivisions have been set up all across the country under that definition of political subdivision. Many community development districts in Florida, metropolitan districts in Colorado, and rural utility districts in California and other states have been set up as political subdivisions to issue tax-exempt bonds to finance public infrastructure such as roads, sewer and water systems for a variety of development projects. Initially the districts are controlled by developers. But as homes, business parks, shopping areas and irrigation systems are developed, that control is passed onto to users such as homeowners, businesses or farmers.
In January 2008, the IRS began auditing the Village Center Community Development District, 166 acres in the Town of Lady Lake, Fla., that is part of a retirement community. The IRS became concerned that the CDD, which had issued millions of dollars of tax-exempt bonds, was controlled by a private developer and always would be. The district contained utilities and other facilities for the community, but no homeowners.
In 2013, the IRS Office of Chief Counsel issued a technical advice memorandum (TAM) in connection with the audit that concluded the Village Center CDD was not a political subdivision, and therefore could not have issued millions of dollars of tax-exempt bonds as it did from 1993 to 2004, because its board was and will always be controlled by the developer rather than publicly elected officials.
Lawyers and other muni market participants blasted the TAM, charging the Treasury and IRS were trying to change the longstanding definition of political subdivision through its enforcement program instead of through a public rulemaking that would allow for public input.
In February 2016, the Treasury and IRS proposed rules that would redefine a political subdivision that issues tax-exempt bonds to encompass the earlier definition and add two additional requirements. The proposed rules said it would have to: be delegated a substantial amount of at least one of three sovereign powers – taxation, eminent domain and police power; be governmentally controlled; and serve a governmental purpose “with no more than an incidental private benefit.”
Bond lawyers and other market participants blasted the proposed rules.
The letter written by the ABA Taxation Section’s tax-exempt financing committee said the proposed rules are “overreaching in many specific areas” as well as “an overreaction to a highly unusual factual situation that discounts the many benefits provided by development districts.”
“The committee is concerned that the broad sweep of the proposed regulations will cast doubt on many existing political subdivisions that, for a variety of legitimate reasons, have governance structures and purposes that do not align with the proposed rules,” it said.
“Treasury should not change the existing test for political subdivision status, which is an issue that extends beyond the regulatory realm,” the group wrote, adding, “A narrow revision to the private activity bond rules would be sufficient to address the concerns raised in the preamble to the proposed regulations.”
“As the legislative history of the Tax Reform Act of 1986 and legal precedent show, political subdivision status is a congressional matter” rather than a matter for the tax regulators, the committee said.