CCA 200030003: Credit enhancement raises doubts about tax-exempt bonds

Plain-English summary

An authority issued bonds for a proposed development, while a separate credit enhancement backed by payments under a federal lease was expected to cover debt service. Chief Counsel advised that the arrangement appeared inconsistent with the purpose of the tax exemption for state and local bonds because the issuer was unlikely to pay the debt service itself. The federal lease payments also appeared to create an indirect federal guarantee under section 149, but Counsel requested the lease before a final determination. A possible arbitrage argument under section 148 needed more factual development, especially about the property appraisal and whether the bond issue exceeded the project's needs. This was field service advice, not a final case determination.

Ruling snapshot

• Question: Did the credit enhancement, federal lease, or size of the issue threaten the bonds' tax-exempt status?
• Outcome: Advice given; further development recommended before asserting several positions.
• Key authorities: IRC §§ 103, 148, and 149; Treas. Reg. § 1.148-10; Rev. Rul. 94-42.

Full text (IRS public release)

                            DEPARTMENT OF THE TREASURY
                              I NTERNAL REVENUE SERVI CE
                                 WASHINGTON, D.C. 20224
                                      April 18, 2000


Number: 200030003
Release Date: 7/28/2000
CC:DOM:FS:FI&P
TL-N-5272-99
UIL: 148.00-00; 149.02-00

  INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE


MEMORANDUM FOR


FROM:                Deborah A. Butler
                     Assistant Chief Counsel CC:DOM:FS

SUBJECT:             Credit Enhanced Bonds


       This Field Service Advice responds to your memorandum dated January 11,
2000. Field Service Advice is not binding on Examination or Appeals and is not a
final case determination. This document is not to be cited as precedent.


LEGEND:

Development                          =
Town                                 =
Districts                            =

State                                =
District A                           =

District B                           =

Authority                            =

Individual X                         =
Individual Y                         =
Appraiser                            =
Corporation 1                        =
Corporation 2                        =

                          2


Corporation 3         =
Corporation 4         =
Corporation 5         =
Limited Partnership   =
City                  =
Bonds                 =

Class A REMIC Bonds   =

Class B REMIC Bonds   =

Year 1                =
Year 2                =
Year 3                =
Year 4                =
Year 5                =
Year 6                =
Date 1                =
Date 2                =
a                     =
b                     =
c                     =
d                     =
e                     =
f                     =
g                     =
h                     =
i                     =
j                     =
k                     =
l                     =
m                     =
n                     =
o                     =
p                     =

                                           3


ISSUES:

1.  Whether the issuance of bonds was structured in such a manner that it was
expected that the credit enhancement provider would pay the debt service on the
bonds rather than the issuer.

2.  Whether the credit enhancement for the bonds, which is secured by lease
payments received from a United States agency, creates an indirect federal
guarantee of the bonds.

3. Whether the issuance of bonds was an abusive arbitrage device that
overburdened the market for tax-exempt bonds.

CONCLUSION:

1. Based on the facts provided, it appears that the credit enhancement provider,
rather than the issuer, would pay the debt service on the bonds. Such arrangement
may be inconsistent with the purposes of section 103 of the Internal Revenue Code.

2. The credit enhancement for the bonds is secured by lease payments received
from a United States agency. The arrangement appears to create an indirect
federal guarantee of the bonds.

3. There is an argument that the bond issuance overburdened the market
considering the amount of bonds that have been issued without a clear
governmental purpose. We recommend additional development before asserting
this position, however.


FACTS:

Background

      The Development is located in Town. In Year 1, Districts were organized to
provide water, sewer, street, park, safety, and recreation improvements within the
Development. Districts are quasi-municipal corporations created under the laws of
State and are political subdivisions.

        The preparation and approval of a service plan is a requirement under State
statute for the organization of a District. The service plans for each District consist
of a financial and engineering survey showing how proposed services are to be
provided and financed.

                                           4


       In Year 2, District A filed for bankruptcy protection under Chapter 9 of the
United States Bankruptcy Code after it defaulted on general obligation bonds it had
issued in the amount of $a. In connection with District A' s subsequent
reorganization, Corporation 1 purchased from District A b acres of property within
Development for $c, or approximately $d per acre. Individual X is the sole owner of
Corporation 1. Further, Individual Y is a Vice President of Corporation 1 and a
director of each of the Districts.

         District A originally acquired the property that was sold to Corporation 1 by
foreclosing on a lien against the original developer of the Development. The
original developer acquired the property, e acres, in Year 3 for less than $f per
acre. The purchase price for the property was determined by Appraiser, an
independent appraiser.

       As a result of the events culminating in District A's bankruptcy, each of the
Districts and Town executed an agreement requiring each District to submit an
amendment to its service plan outlining its anticipated development before
beginning any future development within Development. Town will not formally
consider amendments to any District’s Service Plan until all Districts amend their
service plans.

The Current Transaction

       Authority was organized in Year 4 under State law as a nonprofit corporation
to further the purposes of District B. Authority is authorized to issue bonds and
other obligations payable from the revenues of the Authority. Individuals X and Y
are members of the board of directors of Authority.

        On Date 1, Authority issued the Bonds. The Bonds were issued for the
purpose of acquiring real property upon which Authority purportedly intended to
construct certain public improvements, including a golf course and recreational
facilities. In fact, proceeds were used to acquire g acres of land and water rights
within the Development from Corporation 1 for $h, or approximately $i per acre. At
the time of the acquisition, Corporation 1 was the owner of approximately j% of the
property within the Development. The purchase price for the property was also
determined by Appraiser.

      The Bonds are limited obligations of Authority payable solely from funds held
under the Indenture (including capitalized interest deposited from the proceeds of
the Bonds), revenues of the Authority and payments made under a credit
enhancement. Revenues include all income, rents, receipts, and profits of the
Authority. The offering documents for the Bonds, however, indicate that revenues

                                            5


were expected to consist primarily of amounts generated by the operation of a golf
course.

        In connection with the issuance of the Bonds, the Districts also entered into
the Operating Agreement and the Intergovernmental Agreement obligating the
Districts to provide funds to District B for payment to Authority to the extent that its
revenues are insufficient to pay debt service on the Bonds. Such funds would be
derived from a mill levy that is subject to certain limitations, including a k mill
limitation on taxable property within the Districts. However, the Operating
Agreement and the Intergovernmental Agreement do not become effective until an
amendment to the Districts’ service plans authorizing the mill levy is approved by
the Town, or the Districts receive an opinion of counsel that the mill levy may be
imposed without regard to any service plan amendment.

        Authority also entered into the Development Agreement with Corporation.
The Development Agreement provides that, until the mill levy described in the
Operating Agreement and the Intergovernmental Agreement is imposed,
development charges will be assessed on the property Corporation owns in
Development. Such charges are to equal the amount which would be generated by
a mill levy against all of the taxable property in the Districts. The charges to be
imposed by the Authority, however, are determined by its board of directors. Your
memorandum indicates that no payments have been received from Corporation
under the Development Agreement.

       Prior to issuing the Bonds, Authority obtained a market analysis and revenue
projection with respect to the planned golf course and the residential development
of the Districts. The analysis, performed by Appraiser, concluded that projected
revenues are expected to be sufficient to pay debt service on the Bonds. Appraiser
based its conclusions on the assumption that Town will grant required zoning
changes in a timely manner.

       The purchase price for the sale of the property to Authority was determined
by using the market analysis described above. As there has been no development
of the property and few, if any, comparative sales, the price was calculated by
considering the highest and best use of the property in Development. This
appraisal takes into account cash flow from the facilities Authority expected to
construct. In contrast to this valuation, you indicate that District A acquired l acres
within Development in Year 5 for $m per acre.

        At the time of issuance, Authority had not obtained any of the necessary
permits or zoning changes to construct the golf course or other recreational
facilities. Consequently, the offering memorandum for the Bonds discloses that if

                                          6


those facilities are not completed, there will be no revenues for the payment of debt
service. Further, the offering memorandum states that if the golf course and
recreational facilities are built, but the residential development is not completed,
then the amount of revenues collected by the Districts could be insufficient to pay
debt service on the Bonds.

       Your memorandum indicates that Town has not approved amendments to any
of the Districts’ service plans and, as recently as Year 6, Town was not even
considering amendments to any service plan. No infrastructure construction has
begun in Development. At the present time there are no material contracts with
respect to the development of the Project. Moreover, substantial additional
financing would have to occur to commence construction.


The Credit Enhancement

       As stated, the Indenture for the Bonds provides that the payment of principal
and interest on the Bonds should be credit enhanced by Corporation 2.
Corporation 2 commenced operation on Date 1, for the purpose of providing the
credit enhancement on the Bonds. Corporation 2 is a wholly owned subsidiary of
Corporation 3. Individual X is the president of Corporation 2 and owns n% of
Corporation 3.

       Under the Credit Enhancement Agreement between Corporation 2 and
Authority, Corporation 2 guaranteed payment of the Bonds from Date 2 until
maturity or redemption. The Indenture provides that all payments of principal and
interest on the Bonds (except for interest for the period prior to Date 2) shall be
made from the proceeds of draws on the credit enhancement. A portion of the Bond
proceeds funded a debt service reserve fund sufficient to meet debt service
payments until the time the credit enhancement became effective. Upon issuing the
Bonds, the Authority paid Corporation 2 a $o fee for the credit enhancement, which
amount equals 6% of the Bond proceeds. Corporation 2 turned the fee over to
Corporation 3.

       Corporation 4 was formed solely to purchase certain loans from its parent
company, Corporation 3, and to issue its real estate mortgage investment conduit
bonds (“REMICS”). Corporation 4 is wholly owned by Corporation 3 and
commenced its operations on Date 1 by issuing its Class A REMIC Bonds and its
Class B REMIC Bonds (together with the Class A REMIC Bonds, the "REMIC
Bonds”). The REMIC Bonds are payable from notes secured by lease payments
constituting a general obligation of the United States.

                                          7


       The proceeds from the Class A REMIC Bonds were used to make loans to
Limited Partnership to construct an office building in City. Your memorandum
indicates that Individual X also used the proceeds from the sale of land to the
Authority to finance construction of the building in City. Limited Partnership issued
notes with respect to the loans received. Limited Partnership is the owner of the
office building. Corporation 5 holds a 50% interest in Limited Partnership.
Individual X and family members own 100% of Corporation 5.

       Limited Partnership entered into a 20 year lease of the office building with a
United States agency, acting by and through the General Services Administration
(the “Government Lease”). Limited Partnership assigned the payments under the
lease to Corporation 4 as collateral for the construction loans. The notes and lease
agreement received from Limited Partnership provide the security for the REMIC
Bonds. Payments under the Government Lease begin on Date 2. Such payments
are sufficient to pay principal and interest on the REMIC Bonds.

       In exchange for all its no-par value stock, Corporation 2 acquired the Class B
REMIC Bonds from Corporation 4. To secure its obligations under the Credit
Enhancement Agreement with Authority, Corporation 2 then pledged and delivered
to the trustee for the Bonds the Class B REMICS.

       A credit rating agency stated that the Bonds and the REMIC Bonds are
secured ultimately by the U.S. Government’s obligation to make payments under
the Government Lease. The coupon rates and maturities on the Bonds are similar
to the those on the Class B REMIC Bonds.

       The offering memorandum for the Bonds provides that it is a condition to
issuance of the Bonds that counsel for the United States render an opinion that the
obligation under the lease constitutes an absolute and unconditional obligation of
the United States. In the event any payments that are due under the lease are not
made, Limited Partnership or the trustee would be entitled, in the opinion of counsel
for the government, to enforce the payment obligations of the United States in
accordance with the terms of the Lease.

       Finally, from Date 2, all payments of principal and interest on the Bonds has
apparently been made from draws on the credit enhancement. Authority is required
to reimburse Corporation 2 for amounts paid under the Credit Enhancement
Agreement, but has currently not done so as it has no source of revenues.


LAW AND ANALYSIS:

                                           8


1. Rev. Rul. 94-42

       Section 103(a) of the Internal Revenue Code1 provides that gross income
does not include interest on any state or local bond. Treas. Reg. § 1.103-1
provides that interest on obligations of a state, territory, a possession of the United
States, the District of Columbia, or any political subdivision thereof is not includable
in gross income except as otherwise provided.

       The exclusion from gross income of interest on obligations of states
and political subdivisions thereof is not all-embracing and applies only where
consistent with the purposes of section 103. See, United States Trust
Co. of New York v. Anderson, 65 F.2d 575, 579 (2d Cir. 1933). An overriding
purpose of section 103 is to enable state and local governments to borrow at
subsidized interest rates to carry out governmental purposes. Rev. Rul. 94-42,
1994-2 C.B. 15.

       Further, Rev. Rul. 94-42 provides that amounts paid or accrued under an
agreement guaranteeing payment on bonds is not excludable from gross income
under section 103 if the agreement is not incidental or is in substance a separate
debt instrument or similar investment when purchased. An agreement is
considered as both incidental and not a separate debt instrument or similar
investment only if, at the time it is purchased, the amount paid to obtain the
agreement is reasonable, customary, and consistent with the reasonable
expectation that the issuer of the bonds, rather than the insurer, will pay debt
service on the bonds.

       In Rev. Rul. 94-42, a County issued zero coupon bonds having a 30 year
maturity and a stated redemption price of $204x. The bonds were payable solely
from the revenues of the facility acquired with the bonds. At the time of issuance,
there was significant risk that revenues from the facility would be insufficient to pay
debt service.

       In an unrelated transaction, M, the sole holder of the bonds, entered into an
agreement with G. Under the agreement, M paid G 14x in exchange for G
guaranteeing the payment of all scheduled debt service on the bonds to M or any
subsequent holders. G then purchased 14x of U.S. Treasuries, in connection with
its agreement with M. The Treasuries had a yield of 9.6%. The Treasuries were
transferred to a trust to secure the payment of the bonds. The principal and



      1
        References to the Internal Revenue Code are to the 1986 Code unless
otherwise stated.

                                           9


interest on the Treasuries will be sufficient to pay off all debt service on the bonds.
G is unrelated to either the County or M.

       The agreement with G allowed M to obtain the highest rating for the bonds
from a national rating agency. M then sold the bonds to the general public for a
price of $20x, giving the purchasers an annual yield of approximately 8.3%.

       Rev. Rul. 94-42 held that treating amounts paid or accrued under the G
agreement as excludable from gross income would be inconsistent with the
purposes of section 103. Amounts paid or accrued under an agreement
guaranteeing payment on bonds is not excludable from gross income under section
103 if the agreement is not incidental or is in substance a separate debt instrument
or similar investment when purchased. Id.

       While the facts of the instant case do not fit squarely within those described
in Rev. Rul. 94-42, the information provided calls into question the economic
substance of this transaction. It is axiomatic that the economic substance of a
transaction, rather than its form, governs for tax purposes. Gregory v. Helvering,
293 U.S. 465 (1935). The characterization of a transaction by the parties is not
determinative for Federal tax purposes. Paulsen v. Commissioner, 469 U.S. 131
(1985).

      First, it is questionable whether any of the parties to this transaction
expected Authority to generate sufficient revenues to pay the required debt service
on the Bonds. To this day, there is doubt regarding the economic viability of the
Development as construction has yet to commence. The market analysis prepared
by Appraiser concluded that the proposed golf course would generate sufficient
revenues to pay debt service, but at the time it was prepared the Districts had yet to
obtain the necessary approval from Town to even begin infrastructure development.
From the information provided, it appears that there is still no clear plan for
beginning construction.

      Further, it is acknowledged that additional financing would be required to
proceed with any development as the proceeds from the Bonds merely provided for
the acquisition of the real property. Although Authority entered into a number of
agreements with the Districts providing for an alternative source of revenues, those
agreements were also contingent upon the parties obtaining approval from the local
government, a process which apparently has not been started. Accordingly, given
the number of contingencies that would have to occur before Authority earned any
revenues, there is a valid argument that the parties did not reasonably expect
Authority to pay the debt service on the Bonds.

                                          10


       In addition, the facts suggest that the Credit Enhancement Agreement was
not merely incidental to the Bonds, but, in substance, a separate debt instrument to
which bondholders would look for the payment of debt service. The REMIC Bonds
were issued by Corporation 4 ostensibly to provide financing for the construction of
the office building in City. The REMIC Bonds are backed by the payments due
under the Government Lease. While the Class A REMIC Bond proceeds were
apparently loaned to Limited Partnership, the Class B REMIC Bonds were obtained
by Corporation 3 and pledged to secure the Credit Enhancement Agreement with
Authority. Since it appears unlikely that Authority will have sufficient revenues to
pay debt service on the Bonds, the Credit Enhancement Agreement, ultimately
secured by the Government Lease, is arguably separate from, rather than incidental
to, the Bonds.

      Based on the facts provided, there is a strong argument that the parties
expected the Credit Enhancement Agreement, rather than Authority, to pay debt
service on the Bonds. The Credit Enhancement Agreement, secured by the Class
B REMICS, appears to be a separate debt instrument, rather than incidental to the
Bonds. Accordingly, the transaction was arguably structured in a manner that is
inconsistent with the purposes of section 103. See Rev. Rul 94-42.

2. Federal Guarantee

      Section 103(a) of the Internal Revenue Code provides that gross income
does not include interest on certain State or local bonds. Section 149(b)(1),
however, provides that section 103(a) does not apply to a State or local bond that is
federally guaranteed.

      Section 149(b)(2) provides that a bond is federally guaranteed, if:

      (i) the payment of debt service on the bond is guaranteed, in whole or in part,
      by the United States or any agency or instrumentality thereof;

      (ii) 5 percent or more of the proceeds of the issue of which the bond is a part
      is to be used to make loans, the payment of which is to be guaranteed in
      whole or in part by the United States or any agency or instrumentality
      thereof, or is to be directly or indirectly invested in federally insured deposits
      or accounts; or

      (iii) the payment of debt service on the bond is otherwise indirectly
      guaranteed in whole or in part by the United States or any agency or
      instrumentality thereof.

                                          11


       The prohibition under section 149 applies not only to direct guarantees, but
also in circumstances where an underlying arrangement may result in the federal
government indirectly guaranteeing debt service on an obligation. Congress
intended that the determination of whether a federal guarantee exists be based on
the underlying economic substance of a transaction, taking into account all facts
and circumstances. See H.R. Rep. No. 99-426, at 1013 (1985).

      The legislative history to section 149 suggests that an indirect federal
guarantee may arise where the federal government contracts to purchase the
output of a bond-financed facility. Id. Similarly, where the federal government
leases property there may be an indirect guarantee by the United States.

       In the instant case, no facts have been developed that would evidence a
direct guarantee by the federal government. The current question, rather, is
whether the payments received under the Government Lease, that ultimately secure
the Credit Enhancement Agreement, create an indirect federal guarantee of the
Bonds.

        As discussed, we concur there is a question as to whether Authority expected
to have sufficient revenues to pay debt service on the Bonds. The Indenture
specifically states that all payments of principal and interest on the Bonds (except
for interest for the period prior to Date 2) shall be made from draws on the credit
enhancement. It is beyond dispute that the Credit Enhancement Agreement is
secured by the payments under the Government Lease.

       Moreover, the offering memorandum for the Bonds provides that it is a
condition for issuance of the Bonds that counsel for the United States render an
opinion that the obligation to pay rent under the lease constitutes an absolute and
unconditional obligation of the government. In the event any payments that are due
under the lease are not made, Limited Partnership or the trustee would be entitled
to enforce the payment obligations of the United States in accordance with the
terms of the lease.

       The legislative history to section 149 specifically states that payments under
a governmental lease may constitute an indirect guarantee. From the facts
provided, it appears that the Bonds are indirectly guaranteed by the federal
government. The issuance of the Bonds was apparently conditioned on the parties
obtaining an opinion from government counsel that the Government Lease was an
unconditional obligation of the federal government. This may be a contractual
obligation of the federal government of the type described in the legislative history.
Before making a final determination with respect to this matter, we request that you
provide us with a copy of the lease in question so that we may examine the terms.

                                         12


3. Anti-Abuse

       Treas. Reg. § 1.148-10(a) generally provides that bonds of an issue are
arbitrage bonds under section 148 if an "abusive arbitrage device" is used in
connection with the issue. Furthermore, section 1.148-10(a) provides that
paragraph (a) of section 1.148-10 is to be applied and interpreted broadly to carry
out the purposes of section 148, as further described in section 1.148-0 of the
regulations.

      Treas. Reg. § 1.148-10(a)(2) generally defines abusive arbitrage device as
any action that has the effect of (i) enabling the issuer to exploit the difference
between tax-exempt and taxable interest rates to obtain a material financial
advantage and (ii) overburdening the tax-exempt bond market.

       Treas. Reg. § 1.148-10(a)(4) generally provides that an action overburdens
the tax-exempt bond market if it results in issuing more bonds, issuing bonds
earlier, or allowing bonds to remain outstanding longer than is otherwise
reasonably necessary to accomplish the governmental purpose of the bonds, based
on all the facts and circumstances. Factors evidencing an overissuance include the
issuance of an issue the proceeds of which are reasonably expected to exceed by
more than a minor portion (as defined in section 148(e)) the amount necessary to
accomplish the governmental purposes of the issue, or an issue the proceeds of
which are, in fact, substantially in excess of the amount of sale proceeds allocated
to expenditures for the governmental purposes of the issue.

       From the facts provided, there is a potential argument that the Bonds
overburden the tax-exempt bond market. Since formation of the Districts,
approximately $p of bonds have been issued on a tax-exempt basis without any
resulting development. Substantial additional financing would be required to even
begin the required infrastructure improvements in Development. At the time the
Bonds were issued, the permits and zoning changes necessary to begin
construction had not been obtained. As a result, there is a valid question as to
whether Authority expected to have sufficient revenues to pay debt service on the
Bonds. The doubt surrounding the economic viability of the Development raises the
question as to whether there was a legitimate governmental purpose behind the
issuance of the Bonds and whether more tax-exempt bonds were issued than
necessary.

       However, an argument that an issuance of bonds constitutes an abusive
arbitrage device is highly dependent on the facts and circumstances. To
successfully argue that the Bonds overburdened the market, it would be necessary
to challenge the validity of the property appraisal and market analysis performed by

                                           13


Appraiser. Although the facts indicate that the Appraiser’s report was, at the very
least, overly optimistic, there is insufficient information to prove it was flawed at the
time it was prepared. Accordingly, we recommend additional development before
asserting this argument.


CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:

       Based on the available facts, we concur that the transaction in question
appears inconsistent with the intent of section 103. The troubled financial history of
the Development, the questions concerning the fair market value of the underlying
real estate, the relationship between the parties, and the amount of bonds issued
all provide evidence that the transaction was structured so that the Credit
Enhancement Agreement would pay debt Service on the Bonds rather than
Authority. Such evidence would support the argument that the principles stated in
Rev. Rul. 94-42 are applicable and interest on the Bonds is not tax-exempt.

       Further, there is a strong argument that the payments under the Government
Lease create an indirect federal guarantee proscribed by section 149. Evidence
supporting this argument includes the offering memorandum providing that the
issuance was contingent upon obtaining a legal opinion that the lease arrangement
was a valid obligation of the United States and the fact that the Indenture provides
that all debt service after Date 2 is paid from by the Credit Enhancement
Agreement, which in turn is secured by the lease payments.


                 Arguing that the Bonds violate section 103 because the debt service
is expected to be paid by the Credit Enhancement Agreement is not only fact
sensitive, but requires reliance on a revenue ruling that has not been tested in any
jurisdiction. Similarly, there is virtually no published guidance or judicial authority
regarding what constitutes an indirect federal guarantee.

                                         14




       Your memorandum also indicates that purchasers of the Bonds were to
exchange the Bonds pursuant to an “Exchange Offer.” From the information
available, however, we are unable to ascertain the details of this arrangement. To
properly address the issues in this case, we believe it is necessary to develop this
point.

      Finally,
                                              it may be helpful to have our legal

                                         15


position supported by technical advice. We are willing to provide any additional
assistance you may require in preparing this case for a request for technical
request.

      Please call if you have any further questions.




                                By:    Joel E. Helke
                                      JOEL E. HELKE
                                      Branch Chief
                                      Financial Institutions & Products




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