A safe harbor that the Internal Revenue Service proposed in private-activity bond rules to make it easier for issuers to obtain public approval for projects would be "almost impossible" to comply with and inappropriate for some bonds, a bond attorney warned.

Richard A. Newman, a partner with Arent Fox LLP, issued the warning in a three-page comment letter that he sent the IRS on Oct. 1.

Newman's concerns stem from the agency' attempts to update existing private-activity bond rules that establish a process under which an issuer must obtain public approval for a bond-financed project. According to the rules, if an issuer obtains public approval for financing of a project and then there is a "substantial deviation" to the project or the transaction, the issuer must go through the approval process again.

However, market participants complained that it was unclear what "substantial deviation" meant.

The IRS tried to clarify the term in the updated rules proposed Sept. 8. The rules contained two safe harbors under which a bond-financed project would not be considered "substantially" changed if the amount of proceeds used for the project differed from the approved amount by less than 5%, or if the owner or principal user of the facility was changed to a related party.

But Newman argued that the 5% safe harbor "may unintentionally impede the legitimate use of tax-exempt bonds" by placing undue expectations on an issuer.

The attorney said there is no precedent in existing tax law to establish guidelines for variations in issue size and that issuers often address the size question by proposing an initial amount of bonds that would cover cost fluctuations.

"Frequently a public notice will specify a significantly greater expected issuance than is ultimately needed to avoid the need to repeat the approval process if additional costs arise," Newman wrote to the IRS.

"It is almost impossible for a borrower to estimate the costs to be incurred over a four-year time period within a 5% margin of error," he added. "It is often difficult to accurately estimate even one year in advance ... especially given the volatility of construction costs."

As a result, the new rules "may force borrowers to issue more bonds than are actually needed to ensure that the issue falls within 5% of the amount listed, even if the proceeds are not necessary for the completion of the project," he cautioned.

Furthermore, Newman maintained that the new safe harbor is "particularly inappropriate" for 501(c)(3) bonds. Since these bonds, unlike other private-activity bonds, are not subject to state PAB volume caps, Newman contended that these issuers should not have to exactly determine the amount of bonds they need.

"When bonds are not a scarce resource, such as where there is no volume cap, the cost of the facility is irrelevant to the public," he said.

Another attorney yesterday said it is unclear whether the 5% safe harbor would apply to an under-issuance of bonds as well as an over-issuance.

But asked about this issue, an IRS official said the safe harbor is intended to go both ways.

Treasury officials have stated they would like to finalize the regulations as soon as possible so issuers can take advantage of the changes, which have generally been praised.

Treasury is accepting public comments on the regulations until Dec. 8. A public hearing on the proposal has been scheduled for Jan. 26, 2009. o

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