Last week Mike Cullers summarized Treasury’s latest addition to the final private activity bond regulations – the “Allocation and Accounting Regulations” — which were published earlier that week (LINK).   This week we begin to focus on the details of those Regulations, beginning with the much appreciated “anticipatory remedial action” rule (the “ARA Rule”). [1]

Prior to issuance of the ARA Rule, any well-advised governmental bond issuer carefully planned and approached a transaction constituting a “deliberate action” with the remedial action rules in mind, but recognizing that a remedial action could not be taken until after the deliberate action occurred.  Thus if the issuer chose to defease or redeem its nonqualified bonds, it had to do so after the deliberate action to realize the beneficial effect of the remedial action, with the bizarre consequence that Treasury not only encouraged but required issuers to leave tax-exempt bonds outstanding longer than they otherwise might.  Now, more than 18 years after the remedial action regulations were issued, Treasury has finally broadened the defeasance/redemption remedial action to allow pre-deliberate action remediation, although with substantial restrictions.  After summarizing the ARA Rule, we will share our recommendations below as to how the ARA Rule should be further broadened without jeopardizing the policy toward private business use reflected in the new Allocation and Accounting Regulations.

Unless a “remedial action” is taken, an issue of tax-exempt bonds will become taxable private activity bonds if the issuer takes a “deliberate action” subsequent to the issue date that causes the private business tests or the private loan financing test to be met.  The remedial action rules of Treas. Reg. §1.141-12 have since their issuance in 1997 permitted redemption of nonqualified bonds within 90 days “of” (read “after”) a deliberate action as a remedial action or, if the bonds were not subject to redemption within this 90 day period, defeasance to the first optional redemption date.[2]   (In addition to the redemption/defeasance, a series of preliminary requirements also must be satisfied.)  Thus if an issuer decided to lease one floor of a bond-financed four-floor building to a private person, the issuer could remediate excess private business use by redeeming the nonqualified bonds only after the lease was entered.  It was never clear why this timing restriction existed.  It imposed at least a nuisance, if not worse, on many issuers, and impeded Treasury’s over-arching objective of encouraging issuers to take tax-exempt bonds off the market as early as possible.

Treasury has now gone some distance toward rectifying this limitation.   The ARA Rule adds as an additional remedial action the redemption or defeasance of nonqualified bonds at any time before the deliberate action occurs provided that, on or before the date the bonds are redeemed or defeased, the issuer declares its “official intent” identifying “the financed property or loan with respect to which the remedial action is being taken and describe[s] the deliberate action that potentially may result in the private business tests being met (for example, sale of financed property that the buyer may then lease to a nongovernmental person).”[3]  Treas. Reg. §1.141-12(d)(3).  The ARA Rule further provides:  “Rules similar to those in §1.150-2(e) (regarding official intent for reimbursement bonds) apply to declarations of intent under this paragraph (d)(3), including deviations in the descriptions of the project or loan and deliberate action and the reasonableness of the official intent.”

The imposition of the declaration requirement in the ARA Rule leaves several unanswered questions.  For example, how specific does the statement of the possible deliberate action need to be?  Also, must the issuer expect the deliberate action to occur, or is the mere possibility of the deliberate action sufficient to warrant the remedial action?  The ARA Rule provides mixed guidance on these questions.  On the one hand, the Rule states that the new declaration requirement is “similar” to that of the reimbursement regulations (Reg. 1.150-2(e)).  This could be interpreted as requiring (i) a statement of the specific type of deliberate action contemplated, and (ii) a “reasonable expectation” that the deliberate action will occur.

On the other hand, the ARA Rule provides as an example a very practical application:  issuer sells bond-financed property to another governmental entity that may lease the property to a private person.  This is an excellent example of the usefulness of the ARA Rule in that the issuer may never know whether a deliberate action occurs; the ARA Rule allows the issuer to take remedial action at (or before) the time of the sale irrespective of when, if ever, the deliberate action occurs.  This example implies that the nature of the potential private business use need not be described with any specificity, as the example merely states the possibility of a lease.  One would hope that the declaration could be even further broadened to include a sale or a lease as, presumably, if the issuer does not know whether the buyer might lease the property, the issuer likely also would not know whether the buyer might sell the property.  This would be a very practical interpretation of the ARA Rule that would be consistent with its purpose of facilitating timely removal of tax-exempt bonds from the market.

Also in the example the issuer appears to have no idea as to the likelihood of a deliberate action, particularly as that event would be entirely out of the control (and possibly knowledge) of the issuer.  Thus the example suggests that the absence of a reasonable expectation of the deliberate action does not preclude use of the ARA Rule.  Again this is a common sense application of this Rule that is entirely consistent with its purpose.

In summary based on the example, it appears that the description of the deliberate action can be very general and that the expectation threshold for anticipatory remediation is considerably less than a reasonable expectation of a deliberate action – possible requiring only that the possibility of a deliberate action is recognized.  Further, unlike the reimbursement regulations, there appears to be no time limit as to the occurrence of the deliberate action that is being remediated.  The time limits of the reimbursement regulations are set forth in Treas. Reg. §1.150-2(d), which is not referenced in the ARA Rule (which references only Treas. Reg. §1.150-2(e)).

This interpretation of the ARA Rule is not only consistent with the example provided by Treasury but also with the spirit of the Allocation and Accounting Regulations.  Those Regulations allow all private business use of a project to be allocated first to qualified equity spent for the project without consideration of whether the nature of future private business use is known when the project is financed and without requiring that the issuer reasonably expect any private business use.  Extending this principle, where an issuer replaces some or all of the tax-exempt financing of a project with a non-tax-advantaged source of funding – the equivalent of qualified equity — a corresponding amount of the project should then not be subject to private business use limitations.  Let’s hope that future guidance from the IRS will clarify this interpretation of the ARA Rule.

And one final point – now that Treasury has accepted the idea of anticipatory remedial action, the IRS should extend the concept to the Voluntary Closing Agreement Program.  Surely the IRS can conclude that it has the authority to enter into closing agreements on an anticipatory basis and that doing so is consistent with the purpose of the Program.  This would be a good time to eliminate the cumbersome practice of reaching a preliminary agreement with the IRS on a closing agreement before a deliberate action occurs and then waiting for the deliberate action before actually entering into the closing agreement.

[1] Thanks to our retired partner Jack Browning for this title, demonstrating that even after retirement this stuff can still be fun!

[2]  In addition to redemption or defeasance, certain other remedial actions are also permitted by the Treasury Regulations.

[3] Note that redemption/defeasance is the only remedial action permitted on an anticipatory basis as it is the only remedial action susceptible to anticipatory application.