Water-system improvements satisfy governmental and exempt-facility tests

Plain-English summary

A state political subdivision planned bonds to improve two physically distinct raw-water systems. It proposed governmental bonds for the upstream system, whose take-or-pay contracts were expected to produce less than 10 percent private business use. It proposed exempt-facility bonds for the downstream system, which included pumps, canals, a reservoir, shared monitoring equipment, and related construction services. The issuer represented that a substantial portion of the downstream supply would remain available to the public, including at least 25 percent for residential users and municipal water districts, and that governmental units operated the facilities. The IRS ruled that the upstream proceeds stayed within the 10 percent private-use limit and that the downstream improvements qualified as facilities for furnishing water under IRC § 142(e). It did not rule that interest on the bonds would be tax-exempt under IRC § 103.

Ruling snapshot

• Question: Did the two water-system portions satisfy the private-use limit for governmental bonds and the furnishing-water test for exempt-facility bonds?
• Outcome: Approved on both requested classifications, without ruling on the bonds' overall tax-exempt status
• Key authorities: IRC §§ 103, 141, and 142(a)(4), (e); Treas. Reg. §§ 1.141-7 and 1.150-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201507002 Third Party Communication: None
Release Date: 2/13/2015 Date of Communication: Not Applicable
Index Number: 142.05-00, 141.01-04
Person To Contact:
------------------------------------- ------------------------, ID No. ------------------
----------------------------------------------------- ----------------------------------------------------
------------------- Telephone Number:
---------------------------------- ----------------------
Refer Reply To:
CC:FIP:BRANCH 5
PLR-118266-14
Date:
October 28, 2014

Legend

Issuer = -------------------------------------------------------------------

Bonds = --------------------------------------------------------------------------------

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State = --------------------------

Authority = ----------------------------------------

Canal A = -----------------------

Canal B = ----------------------

Canal C = ------------------------

Lake S = ------------------

Lake T = ---------------------

River U = --------------------------------

River V = -----------------------

PLR-118266-14 2

Supply X = -------------------------------------------

Supply Y = ----------------------------------------

a = ----

b = ------------

c = ------------

d = --------

e = --------

f = --------

Dear ------------------:

This is in response to the request for a ruling submitted on behalf of Issuer pertaining to
the proposed issuance of the Bonds in part as governmental bonds (as defined in
§ 1.150-1(b) of the Income Tax Regulations) and in part as exempt facility bonds under
§ 142 of the Internal Revenue Code (Code).

FACTS AND REPRESENTATIONS

Issuer makes the following representations. Issuer was formed by State as a political
subdivision and governmental agency of State to develop, conserve, and protect the
water resources of River U watershed. Issuer owns and operates various facilities for
collecting, storing, and distributing raw water for industrial, municipal, and irrigation
purposes.

Issuer collects, stores, and distributes raw water from Supply X and Supply Y primarily
on the basis of gravity. The delivery points for Supply Y are approximately a miles
downstream from Supply X. Supply X consists solely of stored water rights in the
amount of b acre-feet per year (afpy), while Supply Y, totaling c afpy, consists primarily
of run-of-river water rights from River U and River V and some stored and developed
water rights.

Supply X is collected and stored at Lake S and delivered or expected to be delivered to
Issuer’s customers with contracts for the delivery of Supply X water (Supply X
customers). Supply X facilities are owned and operated by Issuer and include a dam
and reservoir at Lake S, diversion channels, a service outlet pond, flood gates, and

PLR-118266-14 3

other property such as a maintenance shop, warehouse, and a communications tower
(Supply X Facilities).

Supply Y facilities consist of a pump station at Lake T, Canal A into which the pump
station transfers Issuer’s run-of-river water supply from River U (and certain available
stored and developed water rights) flowing through Lake T, a reservoir (Reservoir),
Canal B, Canal C, and a pump station on Canal C (Canal C pump station) (collectively
referred to as Supply Y Facilities). Issuer’s run-of-river water supply from River V runs
through a canal owned, operated, and maintained by Authority, a governmental unit,
that traverses both Canal B and Canal C (Authority Canal). Canal C pump station
transfers Issuer’s run-of-river water supply from Authority Canal into Canal C. Issuer’s
customers with contracts for the delivery of Supply Y water (Supply Y customers)
receive raw water at various delivery points on Canal A, Canal B, and Canal C.

Other than Canal C pump station, which is owned and operated by Authority, Supply Y
Facilities are owned and operated by Issuer. Issuer and Authority have entered into an
agreement whereby Authority operates Canal C pump station to transfer, upon request
by Issuer, Issuer’s River V run-of-river water supply from Authority Canal into Canal C
for delivery to Issuer’s customers that receive water from Canal C. Authority’s
customers have no rights to the use of, and receive no benefit from, Canal C pump
station.

The contracts entered into between Issuer and its Supply X customers and Supply Y
customers are take or pay contracts (within the meaning of § 1.141-7(c)(4)) that require
the customer to purchase raw water in accordance with generally applicable schedules
or rates. Issuer has the right to adjust the water rates from time to time to cover the
cost of the administration of, and capital improvements to, the water supplies, including
principal and interest on outstanding bonds that were used to finance the water supply
and its improvements. Water rate increases are applicable to both Supply X customers
and Supply Y customers.

Supply X customers consist of an industrial user and municipal water districts. Issuer
has entered into a take or pay contract with an industrial customer, and expects to enter
into take or pay contracts with municipal water districts, for the delivery of all of the raw
water from Supply X. Based on such agreements, Issuer expects that less than 10
percent of Supply X will be used by the industrial customer, while the remainder will be
used by municipal water districts.

Supply Y customers consist of industrial and irrigation users and municipal water
districts. Issuer has entered into take or pay contracts for the delivery of d percent of
Supply Y. Its contracts with industrial and irrigation customers account for e percent
(over 10 percent) of Supply Y.

PLR-118266-14 4

Issuer represents that it will make the remaining unallocated f percent of Supply Y
available to members of the general public, including making reasonable
accommodation for any additional infrastructure necessary to deliver the requested
amounts to the delivery point for such customers, and will not deny access to such
portion of Supply Y upon request. Issuer represents that it will make available at least
25 percent of Supply Y to residential users and municipal water districts throughout the
term of the Bonds.

Although Issuer has the right to move excess supply from Supply X, if any, downstream
for delivery to Supply Y customers, Issuer has not exercised its right to release such
excess water downstream in recent history and does not expect that it will need to do so
in any significant amount in the future. Supply Y customers do not have rights to stored
water from Supply X, and Supply X customers do not, or will not, have rights to water
deliveries from Supply Y. In addition, Supply X customers have no physical ability to
receive water from Supply Y, because Supply Y is downstream from Supply X and no
portion of Supply Y is being moved upstream.

Issuer proposes to issue the Bonds in part as governmental bonds to finance capital
improvements to Supply X Facilities (Supply X Improvements) and in part as exempt
facility bonds to finance improvements to Supply Y Facilities (Supply Y Improvements).

As part of Supply Y Improvements, Issuer plans to construct a new pump station at or
near the point where Authority Canal traverses Canal B (Canal B pump station). Issuer
will own and operate Canal B pump station to transfer Issuer’s River V run-of-river
supply from Authority Canal into Canal B for delivery to Issuer’s customers connected to
Canal B. Neither Authority nor its customers will have rights to the use of, or benefit
from, Canal B pump station.

In addition, Issuer proposes to use proceeds of the Bonds to finance certain services
and equipment. The services consist of construction management, inspection, and
testing relating to the construction of Supply X Improvements and Supply Y
Improvements. To the extent that the services pertain solely to Supply X Improvements
or to Supply Y Improvements, Issuer will allocate the costs of these services to the
construction of Supply X Improvements and the Supply Y Improvements, respectively.
Issuer will allocate services that relate to the construction of both Supply X
Improvements and Supply Y Improvements based on the relative costs of Supply X
Improvements and Supply Y Improvements. Issuer proposes to use proceeds of
governmental bonds for the costs of the services allocable to Supply X Improvements
and proceeds of exempt facility bonds for the costs of the services allocable to Supply Y
Improvements.

The equipment consists of supervisory control and data acquisition equipment that will
permit Issuer to measure water flow levels in the canals and to capture customer flow
data on a real-time basis for Supply X and Supply Y. Some of the equipment will relate

PLR-118266-14 5

solely to the monitoring of Supply X or to the monitoring of Supply Y and will be
allocated respectively. To the extent that the equipment relates to monitoring both
Supply X and Supply Y, Issuer will allocate the costs of such equipment between
Supply X and Y based on the relative water supply. Issuer proposes to use proceeds of
governmental bonds for the costs of the equipment serving, or allocable to, Supply X.
Issuer proposes to use proceeds of exempt facility bonds for the costs of the services
allocable to the costs of equipment serving, or allocable to, Supply Y. (We refer to
Supply X Facilities, Supply X Improvements, and the equipment allocable to Supply X,
collectively, as Improved Supply X Facilities. We refer to Supply Y Facilities, Supply Y
Improvements, and the equipment allocable to Supply Y, collectively, as Improved
Supply Y Facilities.)

LAW AND ANALYSIS

Section 103(a) provides that, except as provided in § 103(b), gross income does not
include interest on any state or local bond. Section 103(b)(1) provides that § 103(a)
shall not apply in the case of any private activity bond which is not a qualified bond
(within the meaning of § 141).

I. Private Business Use

Section 141(a) provides that the term “private activity bond” means any bond issued as
part of an issue which meets the private business use test and the private security or
payment test, or which meets the private loan financing test. Section 141(b)(1) provides
that an issue meets the private business use test if more than 10 percent of the
proceeds of the issue are to be used for any private business use. Section 141(b)(2)
provides that an issue meets the private security or payment test if the payment of the
principal of, or interest on, more than 10 percent of the proceeds of such issue is (under
the terms of such issue or any underlying arrangement) directly or indirectly (A) secured
by an interest in (i) property used or to be used for a private business use, or
(ii) payments in respect of such property, or (B) to be derived from payments (whether
or not to the issuer) in respect of property, or borrowed money, used or to be used for a
private business use.

Section 141(b)(6)(A) provides that for purposes of the private business use tests, the
term “private business use” means use (directly or indirectly) in a trade or business
carried on by any person other than a governmental unit. For this purpose, use as
member of the general public shall not be taken into account. Section 141(b)(7) provide
that the term “government use” means any use other than a private business use.

Section 1.141-7 provides special rules to determine whether arrangements for the
purchase of output from an output facility cause an issue of bonds to meet the private
business tests. For this purpose, unless otherwise stated, water facilities are treated as
output facilities. Section 1.141-1(b) defines output facilities as electric and gas

PLR-118266-14 6

generation, transmission, distribution, and related facilities, and water collection,
storage, and distribution facilities.

Section 1.141-7(c)(1) provides that the purchase pursuant to a contract by a
nongovernmental person of available output of an output facility (output contract)
financed with proceeds of an issue is taken into account under the private business test
if the purchase has the effect of transferring the benefits of owning the facility and the
burdens of paying the debt service on bonds used (directly or indirectly) to finance the
facility (the benefits and burdens test). Section 1.141-7(c)(2) provides that the benefits
and burdens test is met if a non-governmental person agrees pursuant to a take
contract or a take or pay contract to purchase available output of a facility. Section
1.141-7(b)(4) provides in part that a take or pay contract is an output contract under
which a purchaser agrees to pay for the output under the contract, whether or not the
output facility is capable of providing the output. Section 1.141-7(d) provides that if an
output contract results in private business use under § 1.141-7, the amount of private
business use generally is the amount of output purchased under the contract.

Section 1.141-7(h)(1) provides that whether output sold under an output contract is
allocated to a particular facility (for example, a generating unit), to the entire system of
the seller of that output (net of any uses of that system output allocated to a particular
facility), or to a portion of a facility is based on all the facts and circumstances.
Significant factors to be considered in determining the allocation of an output contract to
a financed property are the following:

i. The extent to which it is physically possible to deliver output to or from a
particular facility or system.
ii. The terms of a contract relating to the delivery of output (such as delivery
limitations and options or obligations to deliver power from additional sources).
iii. Whether a contact is entered into as part of a common plan of financing for a
facility.
iv. The method of pricing output under the contract, such as the use of market rates
rather than rates designed to pay debt service of tax-exempt bonds used to
finance a particular facility.

Section 1.150-1(b) defines governmental bonds as any bond of an issue of tax-exempt
bonds in which none of the bonds are private activity bonds.

Issuer proposes to use proceeds of the governmental bond portion of the Bonds to
finance Supply X Improvements, the services allocable to Supply X Improvements, and
the equipment allocable to Supply X. Given the nature of these expenditures and
Issuer’s operation of its facilities, the use of these proceeds will be the same as the use
of Supply X Facilities. Thus, private business use of the proceeds is determined by
analyzing the contracts for water from Supply X. We first determine the allocation of
contracts as between Supply X and Supply Y and the respective facilities.

PLR-118266-14 7

Issuer represents that it has entered into, or expects to enter into, take or pay contracts
for all of Supply X. It has entered into take or pay contracts for d percent of Supply Y.
The delivery points for Supply Y are approximately a miles downstream of Supply X.
While Issuer has the legal right and physical ability to deliver excess water, if any, from
Supply X downstream to Supply Y customers, Supply Y customers have no rights to
Supply X. Issuer has not exercised its right to release such excess water downstream
in recent history and does not expect that it will need to do so in any significant amount
in the future. Supply X customers do not have any rights or ability to receive water from
Supply Y. Accordingly, we conclude that the contracts between Issuer and Supply X
customers are allocable to Improved Supply X Facilities and the contracts between
Issuer and Supply Y customers are allocable to Improved Supply Y Facilities.

Based on its actual and expected contracts, Issuer expects less than 10 percent private
business use of Supply X. Accordingly, the contracts for water from Supply X will result
in less than 10 percent private business use of the proceeds of the Bonds Issuer
proposes to spend for the costs of Supply X Improvements, the services allocable to
Supply X Improvements, and the equipment allocable to Supply X.

II. Facilities for the Furnishing of Water

Section 141(e)(1) provides, in part, that the term “qualified bond” includes an exempt
facility bond. Section 142(a)(4) provides that the term “exempt facility bond” includes
any bond issued as part of an issue 95 percent or more of the proceeds of which are to
be used to provide facilities for the furnishing of water. Section 142(e) provides that, for
purposes of § 142(a)(4), the term “facilities for the furnishing of water” means any facility
for the furnishing of water if (a) the water is or will be made available to members of the
general public (including electric utility, industrial, agricultural, or commercial users), and
(b) either the facility is operated by a governmental unit or the rates for the furnishing or
sale of the water have been established or approved by a state or political subdivision
thereof, by an agency or instrumentality of the United States, or by a public service or
public utility commission or other similar body of any state or political subdivision
thereof.

Issuer proposes to spend proceeds of the exempt facility bond portion of the Bonds for
the costs of Supply Y Improvements, the services allocable to the Supply Y
Improvements, and the equipment allocable to Supply Y. Thus, we consider whether
Supply Y Improvements and equipment allocable to Supply Y are facilities for the
furnishing of water under § 142(e). Supply Y Improvements and the equipment
allocable to Supply Y will be used in conjunction with the Supply Y Facilities.
Accordingly, we must determine whether Improved Supply Y Facilities are facilities for
the furnishing of water. See H.R. Conf. Rep. No. 95-1800, at 237 (1978), 1978-3 (Vol.
1) C.B. 521, at 571 (“[T]o … be a facility for the furnishing of water, the facility must be a
component of a system or project which furnishes water.”).

PLR-118266-14 8

First, we determine the nature of Improved Supply Y Facilities. Improved Supply Y
Facilities consist of pump stations, canals, a reservoir, and functionally related and
subordinate property, used by Issuer to collect, store, and distribute raw water to Supply
Y customers. Accordingly, we conclude that Improved Supply Y Facilities are facilities
for the furnishing of water.

Next, we determine whether Improved Supply Y Facilities are or will be used by Issuer
to make water available to members of the general public (including electric utility,
industrial, agricultural, or commercial users). Issuer represents that it will make the
remaining unallocated f percent of Supply Y available to members of the general public
and will not deny access to such portion of Supply Y upon request. Issuer represents
that it will make at least 25 percent of Supply Y available to residential users and
municipal water districts throughout the term of the Bonds. We conclude that water
from Supply Y is or will be available to members of the general public because a
substantial portion of Supply Y will be made available to residential users or municipal
water districts. See S. Rep. No.95-1263, at 142-43 (1978), 1978-3 (Vol. 1) C. B. 315, at
440-41.

Finally, we determine whether Improved Supply Y Facilities are operated by a
governmental unit or the rates for the furnishing or sale of Supply Y have been
established or approved by the appropriate government body. Issuer represents that it
is a political subdivision and government agency of State. It is, therefore, a
governmental unit for purposes of § 142(e). Issuer operates all of Supply Y Facilities,
except Canal C pump station. Canal C pump station is operated by Authority, a
governmental unit. Accordingly, we conclude that Improved Supply Y Facilities are
operated by a governmental unit.

As Improved Supply Y Facilities meet all of the requirements of § 142(e), Improved
Supply Y Facilities are facilities for the furnishing of water for purposes of § 142(a)(4).
Therefore, Supply Y Improvements, including the services allocable to Supply Y
Improvements, and the equipment allocable to Supply Y are facilities for the furnishing
of water for purposes of § 142(a)(4).

CONCLUSIONS

Accordingly, we conclude:

1. That the private business use of the proceeds to be used for Supply X
   Improvements, the services allocable to Supply X Improvements, and the
   equipment allocable to Supply X does not exceed 10 percent; and
2. That Supply Y Improvements, including the services allocable to Supply Y
   Improvements, and the equipment allocable to Supply Y constitute facilities for
   the furnishing of water under § 142(e).

PLR-118266-14 9

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter, including whether the interest on the Bonds will be excludable from gross
income under § 103(a).

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                   Sincerely,

                                   Associate Chief Counsel
                                   (Financial Institutions & Products)

                                                   /S/
                                By: _________________________
                                   Johanna Som de Cerff
                                   Senior Technician Reviewer
                                   Branch 5