Issuers Redeeming Bonds Used to Finance Jail Facilities

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WASHINGTON — At least two issuers recently redeemed or said they are planning to redeem bonds issued to finance detention facilities because of excessive private use. One redemption was required under a settlement between the issuer and the Internal Revenue Service and the other was triggered by provisions in the offering document.

The Industrial Development Authority of the County of La Paz, Ariz., is planning to redeem bonds it issued in 2013 to finance a detention facility near Holtville, Calif. because the city recently entered into an agreement with U.S. Immigration and Customs Enforcement to house federal detainees or inmates at the facility. The city agreed to serve as a contracting agent for the county because California law does not permit counties to enter into intergovernmental agreements involving privately operated facilities.

Additionally, the West Texas Detention Facility Corporation earlier this month refunded bonds it issued in 2003 to finance a jail and paid $1.08 million to settle a tax-law dispute with the Internal Revenue Service.

The refunding and planned refunding were disclosed in event and offering documents posted on the Municipal Securities Rulemaking Boards' EMMA system.

The IRS has been concerned about jail bond issues and has argued that those bonds may be taxable private-activity bonds if the facilities house a sizable number of federal inmates or the owners contract with private parties to run the jails.

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 paid or secured by private parties. PABs are only tax-exempt if they fall within certain "qualified" categories, which don't include jails. And the federal government is considered a private party by the IRS for purposes of the PAB rules.

The industrial development authority, a political subdivision of Arizona that can issue bonds for projects in multiple states, issued $88.93 million of tax-exempt bonds and $2.25 million of taxable bonds last year and loaned the proceeds to Imperial Valley Gateway Center LLC, a California company whose sole member is the 501(c)(3) organization Brawley Community Foundation, according to the official statement.

The borrower then used the proceeds to finance a detention facility in Imperial County, California, near the city of Holtville, according to the official statement. The facility opened on Sept. 22, according to a document provided the operator.

At the time of issuance, the facility was expected to be used for state and local inmates. The official statement said that, in order to preserve the bonds' tax-exempt status, the city and the operator intended to give preference to state and local governments for bed space even if federal agencies paid a higher per diem amount for each inmate.

The feasibility analysis for the facility said that there was a need for secure beds by state and county governments, which suggested that all the beds in the facility could be used for state and local inmates. However, the analysis acknowledged that the owner determined it has to be flexible over time because many factors can influence a change in demand.

But last month, Holtville entered into an agreement with ICE to have at least 640 detainees held at the facility for up to five years. The number of federal inmates to be housed at the facility under the agreement "is reasonably likely to have a material negative impact on the exclusion of interest on the bonds from gross income of the recipient," the county authority said in an event notice. As a result, the use of the facility under the agreement with ICE is a "negative tax event" under the indenture for the bonds, it said.

Tax regulations provide that a deliberate action that results in private business use does not cause bonds to be taxable if the issuer did not expect at the time of issuance that the bonds would meet the PAB tests and the bonds are redeemed within 90 days of the deliberate action.

Under the special extraordinary optional redemption provision in the official statement, the bonds can be redeemed in whole following a negative tax event. The notice of full conditional redemption states that the tax-exempt and taxable bonds will be redeemed at par on Nov. 20.

Aegis Capital Corp. and Municipal Capital Markets Group, Inc. were the underwriters, Kutak Rock LLP was bond counsel, and Dorsey & Whitney LLP was special tax counsel to the underwriters.

The West Texas Detention Facility Corp. issued $23.48 million of senior lien project revenue bonds in 2003 to finance the West Texas Detention Facility. The jail, located about 88 miles east of El Paso, houses ICE and U.S. Marshals Service inmates, according to a web page about the facility from Emerald Correctional Management, which operates the jail.

The IRS began auditing the bonds in 2012, and the following year it issued a notice preliminarily finding that the bonds are taxable private activity bonds because of "the asserted private business use of the detention facility financed with proceeds of the bonds by the operator of the facility and by federal agencies whose detainees have been incarcerated therein," according to an event notice about the audit.

To settle the dispute over the bonds, the issuer agreed to refund the outstanding 2003 bonds and pay the federal government $1.08 million. The facility corporation issued $19.36 million of taxable bonds earlier this month and used the proceeds to redeem the 2003 bonds and make the settlement payment, according to the official statement for the taxable bonds.

Herbert J. Sims & Co, Inc. and Municipal Capital Markets Group were the underwriters of the 2003 bonds, and Jenkins & Gilchrist was bond counsel. Aegis Capital and Municipal Capital Markets Group were underwriters of the 2014 bonds, and Hunton & Williams LLP was bond counsel. Dorsey & Whitney represented the issuer in the audit and was counsel to Municipal Capital Markets for the taxable deal.

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