Advanced Municipal Lease Financing: Equipment Leasing for Research and Development

Transcription

1 Advanced Municipal Lease Financing: Equipment Leasing for Research and Development Gregory V. Johnson Patton Boggs LLP 1660 Lincoln Street, Suite 1900 Denver, CO (303)

2 Two Structures for Equipment Financing Tax Exempt Structure Enhanced Use Leasing Structure

3 Introduction Benefits from Leasing Tax Exempt Exception from Voter Approval Requirements Exception from Debt Limitations Access to Broader Revenue Base Economic Value of Tax Exemption Benefits from Leasing Enhanced Use Lease Federal Use Equals Loss of Tax Exemption Improved Creditworthiness State/Federal Initiatives Essential Facilities

4 Tax-Exempt Leasing

5 Requirement of an Issuer Definition of a Political Subdivision Taxation Power Condemnation Power Police Power

6 Issuers that are not Political Subdivisions Instrumentalities of Political Subdivisions Joint Powers Authorities

7 63-20 Nonprofit Corporations Created by Political Subdivision Obligations Authorized by Political Subdivision Solely Charitable Purposes Right of Political Subdivision to Acquire Unencumbered Title the Financed Property

8 Requirement of an Obligation Capital Leases: Benefits and Burdens of Ownership with Lessee Transfer of Title to Lessee for No Consideration at end of Lease Term

9 Non-appropriation Clauses Market Risk Status of Lease as Tax-Exempt Credit Enhancement

10 Mixed Asset Financings Service Contract Example Capital Acquisition Working Capital Financing Tax Analysis

11 Bank Qualified Obligations Cost of Carry Deduction Market Opportunity: Banks and Financial Institutions $1 Million Small Issuer Exception Requirement of Designation by Issuer Available for Governmental Purpose and 501(c)(3) Bonds

12 Qualified 501(c)(3) Borrowers Charitable Purposes of the Borrower Prohibition on Unrelated Business Use Avoidance of Volume Cap Change in Use Provisions

13 Other Tax Requirements Prohibition of Federal Guarantee of Obligations Prohibition on Advance Refundings Information Reporting Requirements

14 Other Tax Requirements Continued Bond Registration Prohibition on Hedge Bonds

15 Concepts of Public Use and Private Use Private Activity Bonds Private Payment and Security Tests Private Loan Tests Exceptions General Public Use Certain Short-Term Use Arrangements

16 Concepts of Public Use and Private Use Continued Measurement of Private Business Use Qualified Management Contracts Research Agreements

17 Qualified Private Activity Bonds General Types of Qualified Private Activity Bonds General Requirements Applicable to Qualified Bonds Use of Proceeds Limitations

18 Qualified Private Activity Bonds Continued Public Use Requirement Volume Cap Requirement Substantial User Requirement Maturity Limitation

19 Qualified Private Activity Bonds Continued Limitation on Land Acquisition Prohibition on Acquisition of Existing Property

20 Qualified Private Activity Bonds Continued Certain Prohibited Uses Public Approval Requirement Restrictions on Financing Issuance Costs Alternative Minimum Tax

21 Qualified 501(c)(3) Bonds Charitable Borrowers Use in Charitable Purposes Prohibition on Unrelated Business Use Exception From Volume Cap

22 Enhanced Use Leasing Benefits from Enhanced Use Leasing Credit Quality Essential Government Facilities Joint Federal/State Initiatives

23 Enhanced Use of Existing Facilities or Land Scoring Characterization Operating Lease Capital Lease Characteristics of Operating Lease Ownership Remains with the Lessor No Bargain Purchase Price Lease Term Less Than 75% of Economic Life Present Value of Lease Payments is Less Than 90% of FMV of Asset General Purpose Asset Private Sector Market

24 Use of Operating Leases Out Lease of Existing Property Special Purpose Entity Financing In Lease of Improved Property Enhanced Use Leases as Platforms Improvement of Existing Facilities Research and Development Focus Essential Governmental Facilities High Credit Rating and Low Cost of Capital

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26 Transaction Structure Rent Trustee / Investors Trust Indenture NNSA M&O Contract M&O Contractor Lease Owner Loan Agreement IDB Issuer Quitclaim Deed Development Agreement Developer Construction Contract Design-Build Team

27 Thank You for Coming Gregory V. Johnson Patton Boggs LLP 1660 Lincoln Street, Suite 1900 Denver, CO (303)

28 Advanced Municipal Lease Financing: Equipment Leasing for Research and Development Gregory V. Johnson Patton Boggs LLP 1660 Lincoln Street, Suite 1900 Denver, CO Tel: (303) Fax: (303) v1

29 TABLE OF CONTENTS INTRODUCTION... 1 Page Benefits from Leasing... 1 Benefits from Tax-exempt Leasing... 1 Benefits from Enhanced Use Leasing... 2 TAX-EXEMPT FINANCING OF HIGH TECH EQUIPMENT... 2 Legal Requirements for Tax Exemption... 2 Requirement of an Issuer...2\\ Definition of a Political Subdivision... 3 Instrumentalities of Political Subdivisions Corporations... 3 Requirement of an Obligation...4\\ Capital Leases... 5 Nonappropriation Clauses... 5 Mixed Asset Financings... 6 Bank Qualified Obligations... 6 Other Requirements for Tax Exemption... 7 Information Reporting Requirements... 7 Private Activity Bonds... 7 General Public Use... 8 Certain Short-Term Use Arrangements... 8 Measurement of Private Business Use... 8 Qualified Management Contracts... 9 Research Agreements General Types of Qualified Private Activity Bonds General Requirements Applicable to Qualified Bonds Use of Proceeds Public Use Requirement Substantial User Requirement Maturity Limitation Limitation on Land Acquisition Acquisition of Existing Improved Property Certain Prohibited Uses Public Approval Requirement Restrictions on Financing Issuance Costs Alternative Minimum Tax Qualified Nonprofit Financings TAXABLE ENHANCED USE LEASE FINANCING OF EQUIPMENT Benefits from Enhanced Use Leasing Origins of the Concept of Enhanced Use Scoring Capital vs. Operating Lease Obligations Scoring Capital Leases v1 - i -

30 Scoring Operating Leases Criteria for an Operating Lease Use of Operating Leases Enhanced Use Leases as Platforms Typical Enhanced Use Leasing Structure v1 - ii -

31 INTRODUCTION Set forth below is a discussion of certain federal income tax and other issues regarding lease financing of equipment for research and development by governmental agencies. These transactions often occur in the context of sponsored research activities involving charitable nonprofit universities and institutes, as well as state and federal agencies. Two particular types of transactions are discussed below. One concerns the use of taxexempt financing for the acquisition of equipment by governmental and 501(c)(3) charitable entities. The second concerns the use of taxable enhanced use leasing as a format to finance high technology equipment, particularly in the context of joint state and federal development efforts. Benefits from Leasing There are many advantages for charitable entities and governmental agencies in using lease financing for the acquisition of high technology equipment. In virtually every state, units of government are constrained in some fashion by constitutional and statutory limitations on their financing activities. These provisions may limit the purposes for which bonds or other taxexempt obligations, such as leases, may be issued or may limit the aggregate amount of such obligations or require prior electoral approval or impose other limitations that impact financing transactions. Lease purchase financing can be a way in which political subdivisions are able to accomplish their financing needs without suffering the burdens of such limitations. In some states, lease purchase financings are exempt from prior voter approval requirements, particularly if they are subject to annual renewal by the lessee. Lease purchase financing also may fall within exceptions to aggregate debt limitations, and may allow a broader use of funds as a source of repayment than might be the case with other forms of financing. All of these opportunities make lease financing for states and local governments appealing from a financial perspective. Benefits from Tax-exempt Leasing. The advantage most focused upon in traditional lease financing for state and local governments is the potential availability of an exemption from federal income taxation of the interest component of the lease obligation. The origin of this advantage is in the provisions of Section 103(a) of the Internal Revenue Tax Code of 1986, as amended (the Tax Code ). That Section of the Tax Code provides that interest on obligations issued or incurred by a state or any of its political subdivisions, or on behalf any of such entities, is excludable from gross income for federal income tax purposes. This means that an investor in a governmental lease obligation may exclude from his gross income the interest component of the lease obligation. In most states, interest on municipal obligations (at least those issued within the state) is similarly exempt from state income taxation. This is a substantial advantage to an investor. For instance, if an investor were willing and interested in acquiring a taxable obligation at 8% per annum, that same investor would likely be willing to accept a lower interest rate (for instance 6.5% per annum) if the investor knows that he will not be required to pay federal or state income taxation on the interest component. Thus, the tax-exempt equivalent of an 8% obligation is, in this example, a 6.5% obligation. From a governmental entity s perspective, availing itself of the exemption from federal and state income taxation on its obligations, including lease obligations, means a cheaper cost of capital. Cheaper capital means public projects are less expensive to finance and, in some cases, v1

32 the availability of tax exempt finance is a critical difference between a project which is feasible and one which cannot be financed by the government. Benefits from Enhanced Use Leasing. As more fully described below, the federal government has become increasing active in the financing of high technology equipment through the use of the enhanced use leasing structure. Often, these financings are structured on a joint initiative basis with a state or local governmental unit. The term enhanced use leasing applies to a category of financing structures which allows federal agencies to utilize the value of existing assets to facilitate the acquisition of new or improved equipment and facilities; hence the term enhanced use. This financing technique has been used with increasing frequency by a number of federal agencies and departments, particularly for the acquisition of buildings and equipment for high technology research and development purposes. While the participation of the federal government results in the treatment of the lease as taxable for federal income tax purposes, the participation of the federal government in this form of financing often produces a higher credit rating and a lower cost of capital than would otherwise be the case. TAX-EXEMPT FINANCING OF HIGH TECH EQUIPMENT Legal Requirements for Tax Exemption The United States Congress, the Internal Revenue Service and the federal courts have generally held that access to tax-exempt financing by states and local governments is not an absolute right. For more than 40 years, Congress has legislated and the IRS has issued regulations and rulings in the area of tax-exempt financing. These regulations, rulings and legislation have limited the types of issuers who qualify for tax-exemption, have regulated the nature of the projects that may be financed, have placed limitations on the ability of political subdivisions to invest the proceeds of such financings, and have generally limited, restricted and regulated access to tax-exempt financing. Indeed, members of Congress and the Executive Branch have indicated more than once their belief that it is well within the power of Congress to deny all access by political subdivisions to tax-exempt finance. No such draconian step has been formally announced, but Congress and the Internal Revenue Service have regulated access to tax exempt finance in a wide variety of ways. The legislative and regulatory activities of Congress and the IRS have made tax-exempt financing one of the most complicated and complex areas of the tax law. Notwithstanding these facts, access to tax-exempt financing by political subdivisions remains a key element in almost every capital undertaking that states and local governmental units pursue today. The benefits of tax-exempt financing are typically viewed as being worth the cost of compliance with the very technical requirements imposed on governmental issuers of obligations. In order to qualify for tax-exemption, a lease obligation with a governmental unit must meet all the requirements that have been imposed in this area, to the same extent as would be true with a bond or any other traditional form of governmental borrowing. Requirement of an Issuer Only certain types of local governmental entities may borrower on a tax-exempt basis. The beginning point for determining whether tax-exempt finance is available for a proposed v1 2

33 project, therefore, is the identity of the borrower or other obligated party under the proposed financing. The proposed borrower (or lessee in the case of a lease financing) must be a state, a political subdivision of the state, or an instrumentality authorized to issue obligations on behalf of a state or a political subdivision. States are easy to identify, but political subdivisions and instrumentalities oftentimes are far more complex in nature. If the lessee or other obligated party is not a tax-exempt issuer, the transaction cannot be accomplished on a tax-exempt basis. Definition of a Political Subdivision. The determination of whether an entity qualifies as a political subdivision, and therefore has the ability to act as a borrower or issuer of taxexempt obligations, requires an examination of whether the entity possesses governmental powers. These powers typically are characterized as involving the power of taxation, the power of condemnation, and the power to impose governmental-type regulations that is commonly referred to as police power. The tax law states that if an entity is to be a political subdivision, it must possess a substantial quantity of these powers. Thus, the question of whether an entity is an issuer for tax-exempt purposes typically turns on how much governmental power it has been delegated under state law. An entity may be created by statute, may look like a government, but may not necessarily be a political subdivision. Divisions, agencies, bureaus or departments of political subdivisions, while normally thought of as governmental units, may not themselves have the power to borrow and therefore are not issuers for tax-exempt purposes. In these circumstances, a parent organization, such as a board of trustees of a university, the state legislature, or perhaps the executive of the governmental unit, may be required to approve the financing in order for the borrowing powers of the political subdivision to come into play. For instance, a lease obligation with a research department of a university may not qualify for tax-exemption unless the governing board of the university approves the execution of the agreement and the terms of the financing. Oftentimes, counsel must examine the underlying statutory authority to determine whether the agency or bureau in question has been delegated the power to borrower money and incur obligations which would be viewed by the Internal Revenue Service as obligations of the political subdivision. In absence of such statutory authority, the obligation may not be taxexempt. Instrumentalities of Political Subdivisions. For a variety of reasons, political subdivisions over the years have created entities or instrumentalities to act on their behalf. Sometimes such entities are created in order to insulate the political subdivision from financial exposure. In other circumstances, agencies or entities are created and invested with specific powers to finance projects in areas requiring specialized expertise. The key element of the statutory authority of these entities in each case is the specific grant of power and authority to the agency in question to issue obligations or incur obligations on behalf of the state government that creates the agency. If they have such powers, these entities qualify as tax-exempt issuers even though they may have no power to tax, no power to condemn property, and no real police powers of any appreciable extent Corporations. In other circumstances, even more exotic entities have been created for the purpose of issuing obligations or other obligations on behalf of political subdivisions and, in many cases, these entities qualify for tax-exempt financing. For instance, it is common in many states for universities and other state agencies to create wholly v1 3

34 nongovernmental entities to issue obligations on their behalf. Oftentimes, these entities are created specifically for the purpose of allowing a lease financing to occur. For instance, a university may desire to finance research facility, but be precluded from issuing bonds for such purpose by state debt limitations. In response to these circumstances, many state universities have created nonprofit corporations to issue obligations on their behalf for the purpose of allowing such financings to occur. A typical form for such entity is a nonprofit corporation under state law. The IRS has recognized the ability of such entities to issue obligations on behalf of the underlying governmental unit if certain requirements are met. Under Revenue Ruling 63-20, and subsequent rulings, the ability of nonprofit corporations or other nongovernmental entities to issue obligations on behalf of local governments has been recognized and accepted by the Internal Revenue Service. Revenue Ruling outlines the terms and conditions under which a nonprofit corporation may be deemed to be an on behalf of issuer and therefore be entitled to issue taxexempt obligations or incur tax-exempt leases on behalf of the political subdivision that creates it. The general requirements under Revenue Ruling for a nonprofit corporation to be treated as an on behalf of issuer for tax purposes include the following: (a) The political subdivision must specifically authorize the creation of the nonprofit corporation as a finance entity; (b) The political subdivision must approve the issuance of obligations or the incurrence of a lease or other obligation by the nonprofit corporation; (c) The nonprofit corporation must act solely for charitable or other purposes, and no private person or entity may benefit directly or indirectly from the activities of the nonprofit corporation; and (d) The political subdivision must have the right to acquire unencumbered title to the financed property when the bonds, leases or other obligations of the instrumentality have been retired. Using the authority of Revenue Ruling 63-20, it has been common for political subdivisions to create nonprofit corporations to issue revenue obligations to finance public improvements. The proceeds of the revenue obligations are used to construct or acquire the capital asset, which is then leased to the political subdivision under a lease purchase or other similar agreement. Typically, the lease purchase obligation contains a provision that allows the political subdivision to terminate the lease obligation on an annual basis without penalty. These nonappropriation clauses typically result in the lease obligation not being treated as a debt of the underlying political subdivision for state law purposes. These financing structures can therefore allow a political subdivision to obtain long-term tax-exempt financing for a capital asset without creating a debt for state law purposes, thereby avoiding requirements of voter approval and other limitations and requirements applicable to bond issues. Requirement of an Obligation As noted above, Section 103(a) of the Tax Code provides that only obligations issued by or on behalf of a state or any of its political subdivisions may qualify for an exemption from v1 4

35 federal income taxation. In traditional municipal finance, the question of whether an obligation is present is often not an issue. Obligations include general obligation bonds, revenue bonds, tax increment bonds and all similar forms of bonds, notes, or promises to pay which evidence the exercise of the borrowing power by a political subdivision. In order for a governmental or municipal lease to qualify for tax-exemption, it too must constitute an obligation within the meaning of the Tax Code. In the leasing context, the question of whether a proposed financing results in the creation of an obligation is oftentimes more complex than in traditional governmental finance. Not all leases are necessarily obligations within the meaning of the Tax Code, and not all leases therefore may qualify for tax-exempt treatment. If a political subdivision were to rent space in a building using a lease obligation, that rental agreement very likely is not an obligation which qualifies for tax-exempt treatment. In the typical commercial lease arrangement, a political subdivision acquires the right to use a facility in exchange for the payment of rent to the landlord. Because such lease transactions do not involve a borrowing by the political subdivision, nor the acquisition of an ownership interest in the underlying asset, they are not tax-exempt obligations within the meaning of the Tax Code. Capital Leases. In order for a lease to constitute an obligation, it must be a financing transaction. Typically, this means that the lease is treated as a capital lease for tax purposes, rather than an operating lease. Often leases are asset purchase or acquisition vehicles for a governmental agency that is acting as the lessee. These types of leases are most often treated as capital leases and therefore potentially qualify as tax-exempt obligations. Capital leases allow a political subdivision to acquire an asset through the exercise of the borrowing power. The benefits and burdens of ownership to the financed property transfer to the political subdivision under a capital lease immediately upon execution of the lease document. Under a capital lease, a political subdivision is typically required to pay rental as a condition of the acquisition of the asset. While technical title may remain in the lessor entity for the duration of the lease, a capital lease provides that upon payment of the lease obligation in full, title to the financed asset transfers to the political subdivision at the termination of the lease obligation. During the life of the lease obligation, a political subdivision has all of the benefits and burdens of ownership of the property. Unless the lease obligation with a governmental unit is structured in this manner, with the result that is deemed to be a capital lease, the obligation will not qualify for taxexempt financing. Nonappropriation Clauses. As noted above, some political subdivisions use lease financing as a mechanism for avoiding the creation of debt for state law purposes. A common element of such leases is a nonappropriation clause as described above. A nonappropriation clause allows the political subdivision to terminate the lease on an annual basis. With a nonappropriation clause, the decision to renew the lease each year rests with the political subdivision, and the political subdivision may terminate the lease without penalty in the event it fails to appropriate funds to renew the lease transaction. The IRS has recognized that, where the other elements of a capital lease are present, the use of a nonappropriation clause for this purpose does not prevent the lease from being treated as a capital lease and therefore an obligation for purposes of tax-exempt financing. In addition, the IRS has recognized that a transfer of the risk of nonappropriation to a third party credit enhancer, such as a bond or financial guarantee insurer or other guarantor, also does not impair the tax-exempt treatment of the lease obligation. This v1 5

36 ruling was important because it opened the door to local governments with strong credit ratings to use lease financing for capital asset acquisition without giving up the cost benefits they have enjoyed through their access to bond insurance and other forms of credit enhancement. Mixed Asset Financings. As described above, if a lease agreement is properly structured as a purchase and other wise meets the test of an obligation under the Tax Code, it may qualify for tax-exempt treatment. Special issues sometimes arise in the context of mixed asset financings. These are lease financings where tangible and intangible assets are combined in a common financing. One example might involve combining a service contract with an item of equipment and using a single lease agreement to finance the acquisition of both items. The equipment, being a tangible asset, fits relatively easily within the parameters of a lease financing. The intangible service contract piece is less easily conceived of as an item of leased property. While the outcome will vary with the circumstances of each financing, a mixed asset financing can be viewed from a tax perspective as really two financings: 1) a capital acquisition of equipment and 2) a working capital financing used to generate cash to prepay a service contract. The Tax Code limits or regulates the ability to use tax-exempt financing for working capital purposes in some cases, as more fully described below. In addition, in lease financings that are required to have nonappropriation clauses to avoid creating debt for state law purposes, expending lease proceeds for intangible assets may create credit concerns on the part of investors. Bank Qualified Obligations Perhaps one of the most important issues in lease financing or other tax-exempt transactions is that which arises when commercial banks purchase tax-exempt obligations. Historically, the Internal Revenue Service has taken the position that interest on obligations incurred to acquire or carry tax-exempt obligations is not deductible. Thus, if a taxpayer borrows money with the intent and purpose of acquiring tax-exempt obligations, the taxpayer may not deduct the interest on that borrowing. As a result of this position, the IRS over many years attempted to argue that commercial banks that pay interest on deposits and take tax-exempt obligations into their investment portfolio should similarly be denied a deduction on a portion of the interest they pay depositors. The IRS was unsuccessful in arguing to the Tax Court and in other forums that a sufficient nexus existed between the act of accepting deposits and the act of investing in tax-exempt obligations. As a result, the IRS was not successful in arguing that it had the authority to deny the cost of carry deduction to commercial banks and other depository institutions which pay interest on deposits and purchase tax-exempt obligations for their investment portfolios. All of this changed in 1986 when Congress adopted certain amendments to the Tax Code that appear in Section 265. That section provides generally that no deduction is allowed for amounts otherwise allowable as a deduction for certain expenses and interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from federal income taxation. Moreover, in the case of a financial institution, no deduction is allowed for that portion of the taxpayer s interest expense allocated to tax-exempt interest, except for certain tax-exempt obligations for which a special exemption exists. The effect of the amendments to Section 265 is to conclusively establish the existence of a nexus between accepting deposits and investing in tax-exempt obligations. The effect of these amendments was v1 6

37 to substantially reduce the economic value of tax-exempt obligations for commercial banks, save only for the special exception created as part of the amendment. That exception is available for smaller issuers of tax-exempt obligations, or other tax-exempt obligations, and is very important in the marketing of leases and other smaller financing instruments to commercial banks. Tax Code Section 265(b)(3) permits partial deductibility of a financial institution s interest expense allocable to acquiring tax-exempt obligations if, among other things, the taxexempt obligation is issued by an issuer that does not reasonably anticipate issuing in excess of $10 million in tax-exempt bonds (or other tax-exempt obligations, such as lease agreements) during the calendar year in which the bank qualified obligation is issued (referred to as a qualified small issuer ). This exception applies to governmental purpose obligations and qualified 501(c)(3) obligations, and obligations issued to refund such obligations, if designated as such by a qualified small issuer. Obligations issued to current refund prior obligations are treated as qualified tax-exempt obligations, and do not count toward a $10 million determination, if the amount of the refunding issue does not exceed the prior obligations and if the average maturity date of the refunding obligation is not later than the average maturity date of the prior obligations and if the refunding obligations have a maturity date not later than 30 years after the date the original qualified tax-exempt obligation was issued. As a result of this exception, commercial banks may purchase or carry tax-exempt obligations, including tax-exempt leases, without suffering a reduction in their cost of carry deduction, if the obligations are issued by a qualified small issuer which designates such obligations as the beneficiary of the exception, as described above. Other Requirements for Tax Exemption Information Reporting Requirements. Whenever tax-exempt obligations are issued, the Tax Code requires that an information return be filed with the Internal Revenue Service. Form 8038 is used for private activity obligations and Form 8038-G is used for governmental purpose obligations. Thus, one of the procedural steps that is an absolute requirement in any lease financing which is intended to be structured on a tax-exempt basis is the filing of the appropriate form (8038 or 8038-G, depending on the type of financing) with the IRS. That filing is required to occur by the 45 th day of the calendar quarter after the quarter in which the financing occurred. A failure to meet the deadline will mean a complete denial of tax-exemption unless the IRS grants a special extension, which typically occurs only in unusual circumstances. Private Activity Bonds In general, private activity bonds are obligations (including leases) of a state or a local government used to finance improvements that are used in the trade or business of a nongovernmental entity and the payment or security for which is derived from private sources. In addition, private activity bonds also include obligations, the proceeds of which are loaned by the governmental entity to a private entity. Where these circumstances are present, the obligation constitutes a private activity bond and is taxable, unless a specific exemption is otherwise available. The threshold for private use and private payment or security is 10% v1 7

38 Where more than 10% of the proceeds of the bond issue (or 10% of the proceeds of the lease financing) is used directly or indirectly in the trade or business of a nongovernmental person, and more than 10% of the debt service on the obligation is paid or secured from private sources, the obligation is a private activity bond. If the facilities in question are used for a purpose that is unrelated to a governmental purpose, that 10% threshold becomes 5%. In addition, if 5% or more of the proceeds is lent by a political subdivision to a nongovernmental person, that fact alone makes the obligations private activity bonds. As a result of these amendments to the tax laws, political subdivisions generally are prohibited from extending the benefits of tax-exempt finance to nongovernmental persons unless one or more specific exemptions to that treatment is available. As described below, there are various categories of qualified private activity bonds which have been specifically recognized by Congress in amendments to the Tax Code as types of private activity bonds, which will nonetheless qualify for tax-exemption. The first step, however, is to determine whether an obligation is to be treated as a private activity bond (as opposed to a governmental purpose bond) because of private use or benefit of the financed property and private payment or security for the obligation. General Public Use. Private business use does not include use as a member of the general public. Thus, if one or more private entities use financed property in the same manner as members of the general public, such use does not necessarily result in prohibited private use. However, use of financed property by nongovernmental persons in their trades or businesses is treated as general public use only if the property is intended to be available and in fact is reasonably available for use by natural persons not engaged in a trade or business. Use of the financed facility under an arrangement that conveys priority rights or other preferential benefits is not use on the same basis as the general public. Rights that are generally applicable and uniformly applied do not convey priority rights. Rights may be treated as generally applicably and uniformly applied even if (a) different rights apply to different classes of users, if the differences in rights are customary and reasonable; and (b) a specially negotiated arrangement is entered into, but only if the user is prohibited by federal law from paying generally applicable rates and the terms of the arrangement are as comparable as reasonably possible to generally applicable rates. For these reasons, private use is always closely examined in the tax-exempt finance context to determine whether the use is on terms different from that which the general public may access. Certain Short-Term Use Arrangements. The Tax Code and the regulations issued thereunder create certain safe harbor exceptions for short-term usages. For instance, temporary exclusive use for up to 200 days under certain circumstances, as well as other exceptions for use under 150-day arrangements, are created which allow private use of financed property for short periods of time without adversely affecting the tax-exempt nature of the financing. Measurement of Private Business Use. Under the Tax Code, all private business uses are aggregated for purposes of determining whether the prohibited threshold of private business use has been crossed. The amount of private business use of financed property is calculated v1 8

39 according to the average percentage of private business use during the measurement period. That period begins on the later of the date the obligations are issued or the date the property is placed in service, and ends on the earlier of the last date of reasonably expected economic life or the last maturity date of any obligations issued to finance the property. Average percentage of private business use equals the average of the percentages of private business use during the various one-year calculation periods within the measurement period. The regulations provide guidance for calculating the level of private use in the case of property used for both private businesses and governmental use. If such use occurs at different times, the average amount of private business use generally is based on the amount of time that the property is used for private business use as a percentage of total time for all actual use. Equipment down time, or time under which there are no uses of the financed property, is time that is disregarded for purposes of this calculation. If property is used for governmental use and private business use simultaneously, the entire facility is treated as having private business use. If the governmental use and business use, however, is on the same basis, the average amount of private business use may be determined on a reasonable basis that reflects the proportionate benefit to be derived by the various users of the facility. Discrete portions of a financed facility are treated as separate facilities for purposes of calculating the level of private business use of such property. The amount of private business use of common areas is based on a reasonable method that properly reflects the proportionate benefit to be derived by the users of the financed facility. Neutral costs must be allocated ratably among the other purposes for which the proceeds are used. Private business use commences on the first date on which there is a right to actual use by the nongovernmental person. However, if ownership or other long-term use is involved, and the issuer enters into an arrangement for private business use a substantial period (10% of the measurement period) before the right to actual use commences, private business use commences on the date of the arrangement. If private business use is reasonably expected as of the issue date to have a significantly greater fair market value than the governmental use of the obligation financed facilities, the average amount of private business use must be determined according to the relative reasonably expected fair market values of use. This determination of relative fair market value may be made as of the date the property is acquired or as of the date it is placed in service if this determination is not reasonably possible on the issue date. Relative reasonable expected fair market value must be determined by taking into account the amount of reasonably expected payments for private business use in a manner that properly reflects the proportionate benefit to be derived from the private business use. Qualified Management Contracts Political subdivisions often desire to access the resources of the private sector in the management or operation of their public facilities. Governmental entities hire management companies to operate and maintain their facilities and pay such companies fees in exchange for v1 9

40 those services. In the context of high technology equipment, a vendor servicing agreement may be essential to the proper maintenance of the equipment. Under the very restrictive requirements for private activity obligations described above, the use of a private manager of a governmental facility could impair the ability of the political subdivision to use tax-exempt finance for the acquisition of the project. States and local governments were concerned about this potential result, and as a result, the IRS has adopted regulations that describe the circumstances under which a management or operations arrangement with a private entity will not adversely affect the ability of the project to qualify for tax-exempt financing. Where the requirements of these regulations are met, the management and operations agreement is deemed to be a qualified management contract. Qualified management contracts do not produce prohibited private use and therefore will not adversely affect the tax-exemption of the financing used to acquire the facility and will not result in the creation of a prohibited private activity bond. Whenever a political subdivision seeks to engage the resources of the private sector to operate or maintain a tax-exempt financed facility, a qualified management contract is typically required in order to avoid adversely affecting the tax-exemption of the financing. Under the qualified management contract rules, which appear primarily in Revenue Procedure 97-13, the arrangement must be a managerial one. The management contract will result in prohibited private business use if the service provider is treated in substance as the lessee or owner of the financed property for federal income tax purposes. Thus, management contracts cannot be used as a subterfuge for greater private use that would be the case in a normal management and operations arrangement. The qualified management contract regulations provide that a qualified management contract must not provide for compensation for services rendered based, in whole or in part, on a share of net profits from the operation of the facility. Revenue Procedure states that reimbursement of the service provider for actual and direct expenses paid by the service provider to unrelated parties is not by itself treated as compensation. The Revenue Procedure further provides that net profits compensation will not be involved if compensation is based on (a) a percentage of gross revenues (or adjusted gross revenues) of the facility or a percentage of expenses from the facility, but not both, (b) a capitation fee, or (c) a per unit fee. In addition, a productivity award equal to a stated dollar amount based on increases or decreases in gross revenues, reductions in total expenses, but not both, in any annual period during the contract term, generally does not cause the compensation to be based on a prohibited share of net profits. Revenue Procedure states five general types of arrangements that will qualify as qualified management contracts. (a) 95% Periodic Fixed-Fee Arrangement and 15 to 20-Year Contract Duration. At least 95% of the compensation must be based on a periodic fixed fee. The terms of the contract, including all renewal options, must not exceed the lesser of 80% of the reasonably expected useful life of the financed property and 15 years (20 years for certain public utility property ). A one-time fixed dollar incentive award based on a gross revenue or expense target (but not both) is permitted. (b) 80% Periodic Fixed-Fee Arrangement and 10 to 20-Year Contracts. At least 80% of the compensation is based on a periodic fixed fee. The contract term, including all renewal options, must not exceed the lesser of 80% of the reasonably expected useful life of the v1 10

41 financed property and 10 years (or 20 years for public utility property). A one-time fixed dollar incentive award based on gross revenues or expense target (but not both) is permitted. (c) 50% Fixed-Fee Arrangements and 5-Year Contracts. Either 50% of the compensation is based on a periodic fixed fee or 100% of the compensation is based upon a capitation fee or a combination of a capitation fee and periodic fixed fee. The contract term, including renewal options, must not exceed five years and the contract must be terminable by the qualified user (the governmental entity or certain nonprofit corporations) without penalty or cause at the end of the third year of the contract term. (d) Per Unit Fee Arrangements and Certain 3-Year Contracts. All of the compensation is based on a per unit fee or a combination of a per unit fee and a periodic fixed fee. The term of the contract, including all renewal options, must not exceed three years. The contract must be terminable by the qualified user without penalty or cause by the end of the second year. (e) Percentage of Revenue or Expense Fee Arrangements and Two-Year Contracts. All the compensation for services is based on a percentage of fees charged or a combination of per unit fee and a percentage of revenue or expense fee. The term of the contract, including renewal options, must not exceed two years and the contract must be terminable by the qualified user without penalty or cause at the end of the first year of the contract. The contract must involve services to third parties or certain startup situations. Periodic fixed fees, and capitation fees and per unit fees may be automatically increased according to a specified, objective, external standard that is not linked to the output or efficiency of a facility. Revenue Procedure states the general rule that the service provider must not have any role or relationship with the qualified user that substantially limits the qualified user s ability to exercise its rights under the contract, based on all the facts and circumstances. A safe harbor is provided if (a) not more than 20% of the voting power of the governing body of the qualified user is vested in the service provider, (b) overlapping board members do not include the chief executive officer of the service provider or its governing body or the qualified user or its governing body, and (c) the service provider and the qualified user are not related parties for purposes of the Tax Code. Research Agreements. The IRS has adopted special rules regarding research facilities and prohibitions on private use. These circumstances will come into play where a lease financing is undertaken with a university or other research entity that is either a governmental agency or 501(c)(3) corporation. In such circumstances, care must be exercised to ensure that any private benefits associated with sponsored research at the facility do not give rise to prohibited private use. Under the regulations, an agreement by a nongovernmental person to sponsor research performed by a governmental person (such as a public university) may result in private business use of the property based upon the facts and circumstances. An arrangement that results in the sponsor of the research being treated as the lessee or owner of the financed property for federal income tax purposes will give rise to private business use of the financed property v1 11

42 Revenue Procedure sets forth conditions under which a research agreement between a governmental person and a nongovernmental sponsor does not result in prohibited private business use. Under that procedure, a research arrangement relating to property used for basic research is permitted if any license or other use or resulting technology by the sponsor is permitted only on the same terms as the recipient would permit use by any unrelated, nonsponsoring party. In this regard, the sponsor is typically required to pay a market price for its use of the technology at the sponsored facility. The price to be paid for the products of the research must be determined at the time the licensed property or other resulting technology is available for use. The revenue procedure does not require that persons other than the sponsor be permitted to use the technology. However, the price paid by the sponsor must be no less than the price that would be paid by a nonsponsoring party, if the nonsponsoring party were entitled to access to the products of research. The foregoing rules apply to corporate sponsored research arrangements at tax-exempt financed facilities. In the case of cooperative research agreements, Revenue Procedure provides a slightly different approach. A research arrangement relating to property used pursuant to a joint industry-governmental cooperative research arrangement is permitted if (a) multiple unrelated sponsors agree to fund governmentally-performed basic research, (b) the research to be performed and the manner in which it is performed is determined by the qualified user, (c) title to any patent or other product incidentally resulting from the basic research lies exclusively with the qualified user, and (d) sponsors are entitled to no more than a nonexclusive royalty-free license to use the product at the end of any research. As is apparent from the foregoing, the concept of use for purposes of private activity obligations is complex and subtle. Whenever a private entity has a right to use a tax-exempt financed facility on a basis that is different from that under which the general public may use the facility, a strong potential for private use exists. Lease arrangements between governmental agencies and for-profit users are a clear case of prohibited private use. As is apparent in the case of research facilities, prohibited business use can arise from far less than a lease arrangement. The ability to enjoy the fruits or benefits of a facility, or consume its output, or control its operation, are all ways in which the facility may be deemed to be used by a private entity which potentially creates a private activity bond. Generally, the Tax Code looks at the question of prohibited business use on a reasonable expectations basis. This means that whether a facility is deemed to have prohibited private business use is generally determined on the basis of the expectations of the governmental entity at the time the facility is financed. Whenever those reasonable expectations change, the governmental agency is required to take action to address the subject of prohibited private use. Either the use must be fashioned in a way that is permitted, such as a qualified management contract or qualified research facility agreement, or the issuer must take steps to retire the debt. This has significance for leasing transactions in particular. Normally an investor in a lease obligation expects that the lease will run its course and, accordingly, the lease will be priced on that basis. If expectations concerning private use arise, and if as a result the lease must be refinanced or retired before its term, the tax-exemption of the financing may be preserved at the expense of the investor s expectations. The alternative is a serious one. Under normal circumstances, if the financing results in prohibited private use, the obligation may be taxable v1 12

43 back to the point at which that use first began, whether or not the issuer at the time expected that the private use would be prohibited. General Types of Qualified Private Activity Bonds The exceptions under the Tax Code for certain types of qualified private activity bonds generally relate to the type of facility which is being finance, or the type of entity that is the borrower of the proceeds of the issue. The most important exception to the requirement that private activity bonds are taxable is the exception charitable not-for-profit corporations whose charitable purpose has been recognized by the Internal Revenue Service under Section 501(c)(3) of the Tax Code. This private activity bond exception has particular application to the financing of high tech equipment for research and development purposes by nonprofit charitable universities and institutes engaged in research activities. As more fully described below, a qualified 501(c)(3) obligation issue is a financing the proceeds of which are used in the charitable activities of 501(c)(3) nonprofit corporations. These financings are typically undertaken for charitable entities whose purposes are religious, educational, cultural or scientific in nature. General Requirements Applicable to Qualified Obligations Each of the foregoing categories of qualified private activity obligations must meet certain requirements. Some of those requirements are specific to the type of exemption and are described later in these materials. Some requirements, however, are generally applicable to all types of qualified private activity bonds and are described below. Use of Proceeds. The Tax Code requires that 95% or more of the net proceeds of the issue be used to finance exempt facilities. Net proceeds is defined as the proceeds of an issue reduced by amounts in reasonably required reserve or replacement funds. The proceeds of the issue include investment proceeds earned from the investment of proceeds during the construction period. Public Use Requirement. A facility financed with exempt facility obligations must be available on a regular basis for general public use. Substantial User Requirement. The Tax Code provides that a private activity bond shall not be a qualified obligation for any period during which the bond is owned by a person who is a substantial user of the facilities financed with the obligations or a related person of such substantial user. Thus, private beneficiaries of qualified private activity bonds are essentially precluded from investing in obligations issued to finance their own facilities. Maturity Limitation. The Tax Code provides that the weighted average maturity of exempt facility obligations may not exceed 120% of the weighted average reasonably expected useful life of the facilities financed. Limitation on Land Acquisition. The Tax Code provides that a private activity obligation shall not be a qualified obligation if (a) it is issued as part of an issue on 25% or more of the net proceeds of the issue are used directly or indirectly for the acquisition of land, or (b) v1 13