Private activity bond provisions face elimination in House tax bill
TAX ALERT |
House Tax Reform Bill (H.R. 1), the Tax Cuts and Jobs Act, was released on Nov. 2, 2017. One suggested tax law change that may have come as a surprise is in the area of private activity bonds issued after Dec. 31, 2017, and their favorable treatment under current tax laws. The suggested change comes in the form of a full repeal of the provisions that provide for the favorable tax treatment of interest income from such investments for federal income tax purposes. Specific provisions facing repeal are set forth in the following paragraphs.
Under present law, section 103 provides gross income generally does not include interest paid on state or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds which are primarily used to finance governmental functions or that are repaid with governmental funds. Private activity bonds are bonds with respect to which the state or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals). The exclusion from income for state and local bonds only applies to private activity bonds if the bonds are issued for certain permitted purposes (qualified private activity bonds).
Present law provides three main tests for determining whether a state or local bond is in substance a private activity bond, the two-part private business test, the five percent unrelated or disproportionate use test, and the private loan test.
Private business use and private payments result in state and local bonds being private activity bonds if both parts of the two-part private business test are satisfied:
- More than 10 percent of the bond proceeds is to be used (directly or indirectly) by a private business (the private business use test); and
- More than 10 percent of the debt service on the bonds is secured by an interest in property to be used in a private business use or to be derived from payments in respect of such property (the private payment test).
Private business use generally includes any use by a business entity (including the federal government), which occurs pursuant to terms not generally available to the general public. For example, if bond-financed property is leased to a private business (other than pursuant to certain short-term leases for which safe harbors are provided under Treasury regulations), bond proceeds used to finance the property are treated as used in a private business use, and rental payments are treated as securing the payment of the bonds. Private business use also can arise when a governmental entity contracts for the operation of a governmental facility by a private business under a management contract that does not satisfy Treasury regulatory safe harbors regarding the types of payments made to the private operator and the length of the contract.
A second standard to determine whether a bond is to be treated as a private activity bond is the five percent unrelated or disproportionate business use test. Under this test the private business use and private payment test (described above) are separately applied substituting five percent for 10 percent and generally only taking into account private business use and private payments that are not related or not proportionate to the government use of the bond proceeds. For example, while a bond issue that finances a new state or local government office building may include a cafeteria, the issue may become a private activity bond if the size of the cafeteria is excessive (as determined under this rule).
The third standard for determining whether a state or local bond is a private activity bond is whether an amount exceeding the lesser of (1) 5 percent of the bond proceeds or (2) $5 million is used (directly or indirectly) to finance loans to private persons. Private loans include both business and other (e.g., personal) uses and payments by private persons; however, in the case of business uses and payments, all private loans also constitute private business uses and payments subject to the private business test. Present law provides that the substance of a transaction governs in determining whether the transaction gives rise to a private loan. In general, any transaction which transfers tax ownership of property to a private person is treated as a private loan.
As provided in section 141(b)(4), a special rule for output facilities treats bonds as private activity bonds if more than $15 million of the proceeds of the bond issue are used to finance an output facility (an output facility includes electric and gas generation, transmission and related facilities but not a facility for the furnishing of water).
Section 141(b)(5) provides for a special volume cap requirement for larger transactions and treats bonds as private activity bonds if the nonqualified amount of private business use or private payments exceeds $15 million (even if that amount is within the general 10 percent private business limitation for governmental bonds) unless the issuer obtains a private activity bond volume allocation.
As stated, interest on private activity bonds is taxable unless the bonds meet the requirements for qualified private activity bonds. Qualified private activity bonds permit state or local governments to act as conduits providing tax-exempt financing for certain private activities. The definition of qualified private activity bonds includes an exempt facility bond, or qualified mortgage, veterans’ mortgage, small issue, redevelopment, 501(c)(3) or student loan bond.
The definition of exempt facility bond as set forth in section 142(a) includes bonds issued to finance certain transportation facilities (airports, ports, mass commuting and high-speed intercity rail facilities); qualified residential rental projects; privately owned and/or operated utility facilities (sewage, water, solid waste disposal and local district heating and cooling facilities, certain private electric and gas facilities and hydroelectric dam enhancements); public/private educational facilities; qualified green building and sustainable design projects and qualified highway or surface freight transfer facilities.
In most cases, the aggregate volume of these tax-exempt private activity bonds is restricted by annual aggregate volume limits imposed on bonds issued by issuers within each state. For 2017, the state volume limit is the greater of $100 multiplied by the state population, or $305.32 million as set forth in section 3.20 of Rev. Proc. 2016-55, 2016-2 C.B. 707.