Avoiding Tax Traps in Selling or Leasing Municipal Assets
September 22, 2015
Avoiding Tax Traps in Selling or Leasing Municipal Assets
Reprinted with permission from the September 22, 2015 issue of The Legal Intelligencer
© 2015 ALM Media Properties, LLC.
Further duplication without permission is prohibited. All rights reserved.
Municipalities, school districts and other governmental entities in Pennsylvania may want to sell or lease their assets for a variety of reasons. For governmental entities facing financial distress, they may sell or lease assets to generate a substantial upfront payment that can be used for a variety of purposes, including paying down debts resulting from labor and personnel costs, pension and other retirement benefits, or a costly litigation judgment. A governmental entity may also sell assets if it owns unused or underused public buildings that were constructed at a time of rosy growth projections that failed to materialize. Or, it may simply have no further need of an asset and wish to remove the insurance, maintenance and other costs associated with it.
If a governmental entity intends to sell or lease its assets, one of the first steps that should be taken is to evaluate the proposed transaction from a federal income tax perspective. Governmental entities will often acquire and construct public assets through the issuance of tax-advantaged bonds or notes (for clarity, referred to herein as an “obligation”).
A “tax-advantaged” obligation is an obligation entitled to special benefits under the Internal Revenue Code (the “Code”). In most cases, the benefit is that interest paid to investors is not subject to federal income tax (resulting in lower borrowing costs to the government). The interest on certain obligations may instead be taxable, with the “tax-advantaged” benefit being in the form of either a federal tax credit (paid to the investor) or a federal subsidy (paid directly to the public entity as the issuer of the obligation).
If tax-advantaged obligations are still outstanding at the time of a sale, lease or other disposition of an asset financed with such obligations, the transaction may adversely affect the tax-advantaged status of the obligations. Failure to comply with the rules and regulations in the Code may result in the obligations losing their tax-advantaged benefits. For tax-exempt obligations, this means that the interest on the obligations will no longer be tax-exempt – and, such determination of taxability is generally retroactive to the date of the original issuance of the obligation.
One such rule of the Code that comes up in the context of a sale or lease of public assets is the so-called “Private Use” rule. Generally, assets financed by governmental entities using proceeds of tax-advantaged obligations may only be devoted to public use; they may not be used by private persons. Unless the governmental entity intends to sell or lease the asset to another governmental entity or, in certain circumstances, a 501(c)(3) tax-exempt organization, the Private Use rule will usually be violated – with the result that the obligations lose their tax-advantaged status.
Recognizing that governments regularly dispose of their assets, the Internal Revenue Service has published rules – commonly referred to as the “remedial action” rules – that address the consequences of the Private Use rule in the context of such transactions. As suggested from the name, the remedial action rules do not exempt the governmental entity from the Private Use rule; rather, the remedial action rules merely absolve the governmental entity of the consequences of the violation of the Private Use rule. Thus, if the governmental entity satisfies the requirements of the remedial action rules, the transaction, while resulting in a violation of the Private Use rule, will nevertheless be deemed to not affect the tax-advantaged status of the underlying obligations.
The remedial action rules require the governmental entity to meet five conditional requirements in order to qualify for relief under the rules. If the five requirements are met, the governmental entity may take a remedial action to avoid a determination of taxability, by choosing one of three permissible remedial actions set forth in the rules.
The Five Conditional Requirements
Reasonable Expectations: The governmental entity must have reasonably expected at the time of original issuance that the obligations would not violate the Private Use rule. In other words, at the time the obligations were issued, the governmental entity could not have reasonably foreseen that it would later sell the asset financed by the obligations.
Reasonable Maturity: The weighted average maturity of the obligations must not be greater than 120% of the average reasonably expected economic life of the property that was financed with the proceeds of the obligations.
Fair Market Value Consideration: The transaction involving the public asset must be on an arms-length basis, and any consideration received by the governmental entity must be based on the fair market value of the asset.
Disposition Proceeds Are Gross Proceeds: Any proceeds realized from the transaction (“disposition proceeds”) are subject to the arbitrage and rebate requirements of the Code, which place limits on the investment of the disposition proceeds. In most cases, the return on investment will be capped at a rate equal to the rate on the original obligation.
Proceeds Spent for an Exempt Purpose: The disposition proceeds must originally have been spent for a tax-exempt purpose permitted by the Code before the governmental entity sold the asset. This requirement does not apply, however, if the disposition proceeds are used to refund the affected bonds.
The Three Permissible Remedial Actions
If all five conditional requirements are met, the governmental entity may take one of three permissible remedial actions to cure the violation of the Private Use rule. The most common remedial action taken is to simply use all or a portion of the disposition proceeds to pay off the affected obligations. If the amount of the obligations affected by the transaction exceeds the amount of disposition proceeds, the governmental entity will still qualify by applying all of the disposition proceeds towards the redemption – but only if the disposition proceeds are exclusively cash.
The other two remedial action options available to the governmental entity leave the affected obligations outstanding. The first of these two options involves an alternative use of the disposition proceeds. The governmental entity can take this remedial action by using all of the disposition proceeds for new projects that independently meet the Code’s rules. To use this option, the disposition proceeds must be exclusively cash, and must be spent for their new qualified purpose within two years. If the governmental entity does not anticipate using all of the proceeds on the new project within that time period, it must use the excess proceeds on a partial redemption, in accordance with the first remedial action. For example, a municipality that sells a police station financed with tax-advantaged obligations could apply all of the proceeds from the sale to the construction of a fire station.
The third remedial action option involves an alternative use of the transaction assets. The governmental entity must evaluate whether the use of the assets by the purchaser (or lessee) independently qualifies for tax-advantaged treatment. Even if this test is met, the governmental entity is restricted in its use of the disposition proceeds, and must use them solely to pay debt service on the outstanding issue that was affected by the transaction. For example, if a municipality sold its water system assets to a private water company, the purchase by the private entity may qualify if the assets sold meet the requirements for “exempt facility bonds” under the tax code.
If the remedial action rules are not met, the governmental entity need not necessarily abandon its plans to sell or lease assets. It might consider applying for relief with the Internal Revenue Service through its voluntary closing agreement program (“VCAP”). Under VCAP, governmental entities may seek to enter into a closing agreement with the IRS to minimize the negative consequences of a particular transaction. Generally, under a closing agreement the governmental entity must agree to redeem the affected obligations at their earliest call date, and pay a “closing agreement fee” to the IRS. VCAP is not available if the IRS has already opened an examination of the bonds or has challenged the tax-advantaged status of the bonds.
The amount of the closing agreement fee is generally equal to the present value of the taxpayer exposure from the issue, measured from the tax year for which a tax payment would be due within three years of the date of disclosure of the transaction to the IRS, to the date on which the affected obligations are redeemed. The IRS may agree to reduce the amount of the fee under certain circumstances, including where the governmental entity has implemented post-issuance compliance procedures.
Governmental entities considering VCAP should be aware that the IRS is currently in the process of finalizing changes to the program, and will announce those changes through the publication of revisions to its Internal Revenue Manual (“IRM”). Potential VCAP applicants should carefully review the revisions once available. Interestingly, the IRS recently indicated that as part of the revisions, it will stop offering reductions in closing agreement fees for participants that have adopted post-issuance compliance procedures. This change will become effective six months after the date of publication of the IRM revisions.
Municipalities, school districts and other governmental entities are encouraged to consult with their professional advisors before engaging in any asset transaction, as careful planning before the contracts are signed is a necessity. Failure to do so can lead to unnecessary tax penalties and compliance costs that otherwise could have been avoided.
Timothy J. Horstmann is a public finance and tax attorney with the law firm of McNees Wallace & Nurick LLC in Harrisburg. Tim advises public sector clients in matters related to state, local and federal taxation. He represents governmental issuers, school districts and nonprofits in connection with the structuring of taxable and tax-exempt revenue bond and general obligation bond financings for a variety of capital projects, including manufacturing facilities, hospitals and other health care facilities, parking facilities, schools and higher education institutions and water and sewer projects. He also has represented both the buyers and sellers of public assets in the context of public-private and public-public partnerships. Tim can be reached firstname.lastname@example.org.