The Internal Revenue Service (IRS) published proposed regulations (Proposed Regulations) concerning the public approval requirements of Section 147(f) of the Internal Revenue Code of 1986, as amended, (the Code) (REG-128841-07) in the Federal Register on September 9, 2008.  These Proposed Regulations govern tax-exempt private activity bonds issued by state and local governments and, while generally restating existing law, contain one provision that goes beyond what we understand to be existing law and may unintentionally impede the legitimate use of tax-exempt bonds.  The public has until December 8, 2008, to provide any comments on the Proposed Regulations before they are finalized.  Arent Fox LLP has submitted comments to the IRS expressing the following concerns with the Proposed Regulations.

Specifically, the Proposed Regulations include a proposed extension of the “substantial deviation” concept to the amount borrowed.  By law, a governmental issuer must hold a public hearing before it may approve the issuance of private activity bonds.  Prior to the hearing, the issuer must publish notice in local newspapers listing, among other things, the expected issue size of the bonds (the Public Notice).  Under existing law, if there is any “substantial deviation” between the content of the Public Notice and the financed project, the requirements of the law are not considered to have been satisfied.  The Proposed Regulation extends this principle from deviations as to size, location and use of the proposed facility to include any deviation of more than 5 percent between the expected issue size listed in the Public Notice and the actual issue size (excluding amounts allocable to certain reserves). 

The stated intent of the Proposed Regulation is to codify existing law.  There is, however, no precedent for this application of the substantial deviation principle to issue size.  Current law requires that the use of the bonds must be described in the Public Notice, but it does not impose a restriction on a difference between the expected and actual issuance size.  In fact, existing practice is to round up the amount of the proposed issue described in the Public Notice to make certain that it adequately covers the range of possible costs to be incurred in connection with the proposed bond-financed facility.  Construction costs, of course, may be somewhat uncertain when the Public Notice is given, particularly for projects that will be developed over long periods as permitted under the bond-financing rules.  Accordingly, a Public Notice will frequently specify a significantly greater expected issuance than is ultimately needed to avoid the need to repeat the approval process if additional costs arise.

In fact, the extension of the substantial deviation restriction to dollar amount is incompatible with the Code Section 147(f) plan of financing approval principles.  Under these rules, a single Public Notice can describe multiple tranches of bond financing as long as all tranches are issued within three years after the date of the first issue and the first issue is sold within one year of public approval – in other words, a public approval of a plan of finance is intended to be good for up to four years.  If the Proposed Regulations are adopted, it would likely nullify the plan of finance approach as it is almost impossible for a borrower to estimate the costs to be incurred over a four-year time period within a 5 percent margin of error.  In reality, it is often difficult to estimate accurately even one year in advance, much less four years, especially given the volatility of construction costs.

As a public policy matter, the application of the substantial deviation rules to the issue size is particularly inappropriate for 501(c)(3) bonds which, (unlike other private activity bonds) are not subject to volume caps.  The purpose of the Public Notice is to allow the public to voice concerns about the proposed bond-financed facility and to inform the government of issues that may be germane to the financing of those projects with certain reserve bonds.  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.  The effect of a project on the community, however, does not vary based on issue size (or cost), and where the approval of one project does not prejudice the future approval of other projects because they would not be competing for the volume cap, the issue size is not a relevant public concern.  Even where there may be a public interest in the cost of a 501(c)(3) facility such as a hospital where costs may effect rates, the certificate of need or other public approval mechanism is a more appropriate means of cost regulation than the public approval process applicable to the bonds. 

In fact, the possible result of the extension of the substantial deviation rules to issue size has the potential of creating, in some cases, an unintended over-burdened tax-exempt bond market because, if adopted, it may force borrowers to issue more bonds than are actually needed to ensure that the issue falls within 5 percent of the amount listed in the Public Notice, even if the proceeds are not necessary for the completion of the project.  Accordingly, we would suggest that the extension of the substantial deviation rules to issue size is inappropriate, particularly as applied to 501(c)(3) bonds which, for most purposes under the 1986 Code, are treated like essential purpose bonds, which are exempt entirely from the public approval requirements.   

The Proposed Regulations may be found at Regulations.gov.

If you have any questions about the Proposed Regulations, or would like an Arent Fox attorney to assist you in providing comments to the IRS on the Proposed Regulations, please contact one of the practitioners listed below.

Richard Newman
newman.richard@arentfox.com
202.857.6170

Rick Krainin
krainin.richard@arentfox.com
212.484.3918

Eve Corbin
corbin.eve@arentfox.com
202.828.3432

Steve Kahn
kahn.stephen@arentfox.com
202.857.6186

David Dubrow
dubrow.david@arentfox.com
212.484.3957