On February 22, 2016, the Internal Revenue Service (the “IRS”) published new proposed regulations (the “Proposed Regulations”) in the Federal Register providing guidance as to the definition of a “political subdivision” for purposes of tax-exempt bonds.

Background

Under the Internal Revenue Code, tax-exempt bonds must be issued by a qualified “political subdivision” in order to qualify for tax exemption. Traditionally, the determination as to whether an entity qualified as a political subdivision was based on a legal analysis of whether an entity had been delegated the right to exercise a substantial amount of one or more of the three essential sovereign powers (i.e., the power to tax, the power of eminent domain, and police power). Beyond possessing a substantial amount of one or more of such powers, there have been no specific rules as to whether an entity must be performing a governmental function or under specific governmental control in order to qualify as a political subdivision. In 2013 and 2015, the IRS released and issued a pair of Technical Advice Memoranda (known as the “Villages TAMS”) which significantly narrowed the definition of “political subdivision” in a way that potentially excluded some entities that had previously qualified under the traditional definition. The IRS, in essence, concluded that the subject Villages entity was not a political subdivision because, among other reasons, there was insufficient public control of the entity. In response to requests for clarification and the uncertainty caused by the issuance of the Villages TAMS, the IRS issued the Proposed Regulations, which would replace the aforementioned traditional analysis with a new, three-part test, summarized here. If adopted, the new rules would provide new limitations on the types of entities that qualify as a political subdivision.

Summary of New Rules

Under the Proposed Regulations, an entity must meet all three of the following requirements in order to constitute a political subdivision:

1. Sovereign Powers Test: The entity must be empowered to exercise a substantial amount of at least one of the three sovereign powers: eminent domain, police power and/or taxing power.
2. Governmental Purpose Test: The entity must carry out public purposes set forth in its enabling legislation and then operate in a manner that “provides significant public benefit with no more than incidental private benefit.” The Proposed Regulations provide no further analysis as to what “significant public benefit” or “incidental private benefit” might mean.
3. Governmental Control Test: The entity must be “governmentally controlled.”
   1. “Control” is defined as any of the following:
      1. The right or power both to approve and remove a majority of the entity’s governing board;
      2. The right or power to elect a majority of the board in periodic elections of reasonable frequency; or
      3. The right or power to approve or direct the significant use of funds or assets of the entity.
   2. Control of the entity by an elected board satisfies the Governmental Control Test so long as the electorate is not a “private faction.” The Proposed Regulations state: “Control by a small faction of individuals, business corporations, trusts, partnerships or other persons is fundamentally not governmental control.” A “private faction” is an electorate comprised of an “unreasonably small number of private persons” as follows:
      1. If the combined votes of the 3 largest voters will determine the election, the electorate is unreasonably small. Therefore, 5 or fewer electors is always too small.
      2. If the combined votes of the 11 largest voters will determine the election, the electorate is not unreasonably small. Therefore, 20 electors or more is always large enough.
      3. Between 5 and 20 electors is a gray area which will depend on the “facts and circumstances.”
   3. For purposes of such voter counts, “related parties” would be counted as one vote.
   4. The following example illustrates what constitutes a “private faction”: Assume an electorate consists of 20 unrelated private persons with equal, five-percent shares of the total votes. Such an electorate would not be considered “unreasonably small” because a minimum number of 11 members of that electorate would be necessary to achieve a majority of the votes. On the other hand, if a district has five families of five people (all of whom are of voting age) for a total electorate of 25, the electorate would be considered unreasonably small because, under the related party rule, each family would be considered one voter and three families could control the outcome.

Effective Date and Transition Rule

The Proposed Regulations generally would not apply to outstanding bonds and would only apply to new bonds issued 90 days after the rules are finalized. Additionally, the new rules would not apply to refundings of bonds issued prior to their effective date if the weighted average maturity of the bonds is not extended as part of the refunding transaction. A three-year transition period after the regulations are finalized is set forth in the new rules in order to allow time for existing entities to restructure as necessary to meet the requirements of the regulations so that such entities do not cause interest on the related bonds to be taxable, including for purposes of determining whether bonds that are subject to the new regulations are private activity bonds.

Requests for Public Comments

Developer districts are not specifically addressed in the Proposed Regulations, but the preamble to the Proposed Regulations states: “The Treasury Department and IRS seek public comment on whether it is necessary or appropriate to permit such districts to be political subdivisions during an initial development period; how such relief might be structured; what specific safeguards might be included in the recommended relief to protect against potential abuse; and whether the proposed prospective effective dates and transition periods in §1.103-1(d) of the Proposed Regulations provide sufficient relief.” Public comments on the Proposed Regulations may be submitted until May 23, 2016. A public hearing will be held on June 6, 2016. Members of the Public Finance Department at Sherman & Howard L.L.C. will be commenting on the Proposed Regulations.