WASHINGTON — An arrangement in which an authority issued bonds to finance facilities that are leased to the state will not cause the bonds to be private-activity bonds, according to a recent Internal Revenue Service private-letter ruling.

The IRS cautioned that the ruling should only be applied to this particular issuer and financing, neither of which were identified. The favorable letter-ruling, was dated Aug. 14 but not made available to the public until Nov. 15. It was signed by Johanna Som de Cerff, an IRS senior technician reviewer in the office of chief counsel for financial institutions and products.

The issuer is an authority that acquires, constructs and maintains facilities on behalf of a state.  The authority issued bonds to finance the construction and/or renovation of buildings, including one referred to in the letter as "the facility." The state leased the facility from the authority, and was planning to enter into management contracts with private parties, which would perform services at the facility.

The bonds are backed by the state's payments on the lease for the facility as well as payments from the rentals of other buildings financed by the bonds. "The bondholders do not have a mortgage on, or other security agreement creating a security interest in, the facility under state law," the ruling stated.

Under federal tax law, bonds are private activity bonds if more than 10% of the project is used by private parties and more than 10% of the debt service is paid for or secured by private parties.

The authority conceded that the private business use test would be met as a result of the management contracts. It was asking the IRS to rule that the lease arrangement would not cause the bonds to meet the private security or payment test when the management contracts began.

The IRS said in its ruling that the state's rental payments backing the bonds would not constitute private payments or private security because they would be made by a government.

While the bondholders don't have an agreement that creates a security interest in the facility under state law, the authority was concerned that it had given bondholders rights in the facility that could be considered interest in the property under the private security test.

If bondholders do not receive debt service payments, they can obtain a money judgment against the state for the rental payments or they can file suit to compel the authority or state to make payments.

The authority has generally covenanted not to sell, lease or mortgage the facility outside of the lease with the state as long as the bonds are outstanding. While there are a few exceptions, the authority, but not the bondholders, can initiate actions like selling the facility to benefit the bondholders in those cases, the ruling said.

The IRS concluded that "the terms of the lease and the covenants contained in the indenture merely provide some assurance to bondholders." As a result, the terms don't create a security interest in the facility that would mean the bonds satisfied the private security test and were private activity bonds.

Bond lawyers thought the ruling was the correct one.

But David Caprera, a lawyer at Kutak Rock LLP, also said that the atypical set of details in this case enabled the IRS to reach the conclusion that it did.

"This is a unique and unusual fact pattern," Caprera said.

In this case, the bondholders cannot compel the authority to sell the property when the lease is terminated, but in a more typical lease purchase agreement, the bondholders or a trustee on behalf of the bondholders can compel the sale of a building, Caprera said. He added that he's concerned that someone may run into trouble with the IRS if they try to rely on this ruling in a financing with a different fact pattern.

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