The U.S. Treasury Department (“Treasury”) and the Internal Revenue Service (“IRS”) announced the withdrawal of proposed regulations to re-define the term “political subdivision” under § 103 of the Internal Revenue Code (“IRC”) for purposes of determining which public entities are eligible to issue tax-exempt obligations such as municipal bonds. The proposed regulations would have added significant new criteria to the definition that could eliminate the recognition of many special taxing entities created under state law and currently authorized to issue tax-exempt bonds.
§ 103(a) of the IRC provides that, subject to certain exceptions, gross income does not include interest on any state or local bond. § 103(c)(1) defines “state or local bond” as an obligation of a state or political subdivision thereof. Current Treasury Regulations define the term “political subdivision” as “any division of any state or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit.” These “sovereign powers” include: taxation, eminent domain, and police power. Under current regulations, authority for only one of the three powers was sufficient to confer status on the public entity.
The proposed regulations would have added to existing requirements various layers of supplemental tests. These include: whether the entity serves and actually carries out a governmental purpose; whether the entity is subject to oversight and control by a state or local government body; whether the entity operates in a manner that provides a significant public benefit with no more than incidental private benefit; and, if governed by electors (rather than a local governing body), whether the controlling electors are sufficiently large and diverse so as not to constitute “an unreasonably small number of private persons.” Most of these determinations would have been subject to “facts and circumstances” guidance and tests, by necessity, arrived at over time.
Current regulations recognize that various state-created political subdivisions “may or may not” satisfy existing sovereign powers criteria. Applying applicable tests, however, many Missouri and Illinois public entities including Community Improvement Districts (“CIDs”) and Transportation Development Districts (“TDDs”), as well as various road, water, drainage, and levee districts have been recognized as exercising requisite sovereign powers. Under supplemental tests contained in the proposed regulations, many of these entities could have lost the ability to issue tax exempt obligations, increasing their financing costs and potentially impairing their core missions. Under even the best circumstances, uncertainty resulting from imposition of these proposed regulations would likely have caused significant disruption in municipal finance markets.
Although originally offered in 2016, the proposed regulations were re-visited under Executive Order 13789 (Identifying and Reducing Tax Regulatory Burdens). During the review period many commenters argued that the proposed regulations would force costly and burdensome changes in entity structure to meet the new requirements and that existing requirements that a “political subdivision” possess sovereign powers were sufficient. In withdrawing the proposed regulations, Treasury and the IRS now believe that because of the far-reaching impact on existing legal structures the proposed regulations are not justified. However, Treasury and IRS continue to believe that some enhanced standards for qualifying as a political subdivision may be appropriate and may propose more targeted guidance in the future after further study.
In its opposing comments, the National Association of Bond Lawyers (“NABL”) noted that the genesis of the proposed regulations stems from a determination in an IRS examination that two community development districts in Florida, although created by state statute as political subdivisions, were not eligible to issue tax-exempt bonds. This position was solidified and its reach expanded in the subsequently released Technical Advice Memorandum 201334038 (the “2013 TAM”).
Although the proposed regulations have been withdrawn, the 2013 TAM apparently remains in effect. Thus the status as “political subdivisions” under IRC Section 103 of various entities, particularly those CIDs and TTDs which are subject to developer control, remains in question. Given the importance of this issue to the tax-exempt bond community generally and to various affected public entities specifically, community leaders in Missouri and Illinois would do well to remain vigilant to this issue, particularly to any future similar regulations or guidance Treasury or IRS may propose. For more information, feel free to contact Tom Cunningham at tom@municipalfirm.com.
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