COMMENTS ON REGULATIONS UNDER SECTION 141
OF THE CODE AS THEY RELATE TO OUTPUT FACILITIES Introduction | Part I | Part Ia | Part Ib | Back to Contents INTRODUCTION The Committee has organized its comments by focusing on the particular functions of output facilities rather than dealing with these subjects together the way they are handled in the Temporary Regulations. Thus, after discussing the law prior to the 1986 Act and the effects of that Act on output facilities, we deal first with the impact of the Temporary Regulations on electric generation facilities, next on the treatment of transmission and distribution facilities, and finally on provisions that deal with both types of facilities. We recognize that this approach may result in some duplication and overlap, but we believe it is useful to evaluate separately how the Temporary Regulations deal with these different types of facilities. Because the Temporary Regulations for the first time apply the general provisions of the 1997 Final Regulations to output facilities, we also discuss the application of the 1997 Final Regulations. BASIC CONCEPT OF USE AND EFFECT OF 1986 LEGISLATION Under the regulations applicable under the 1954 Code ("the Subparagraph 5 Regulations" or "Subparagraph 5"), the standard for judging sales of output was whether the use of the output had the effect of "transferring to non-exempt persons the benefits of ownership of such facilities and the burdens of paying the debt service on governmental obligations used directly or indirectly to finance such facilities, so as to constitute the indirect use by them of a major portion of such proceeds." Reg. §1.103-7(b)(5). The legislative history of the 1986 Act is inconclusive, but we believe the better reading is that Congress did not intend to change this test except to the limited extent specified in that legislation. The Temporary Regulations, however, substantially change the meaning of the benefits and burdens test in a restrictive way that has no parallel in other similar areas of tax law. Because we believe this question of the interpretation of the effect of the 1986 Act on prior law is so fundamental, we discuss it at some length. Introduction | Part I | Part Ia | Part Ib | Back to Contents 1954 Code The industrial development bond provisions had their genesis in proposed regulations that were published in the Federal Register March 23, 1968. 1 These regulations predated the enactment of statutory provisions regarding industrial development bonds. All of the examples of transactions contained in those proposed regulations involved actual use of a facility through ownership or lease. Similarly, when statutory industrial development bond provisions were enacted by Congress later that year, the subject of concern was financing facilities to be leased to, or owned by, private business. In the legislative history of those provisions, there was no suggestion that use of the output of a facility constituted use of the facility or the bond proceeds. Regulations proposed on January 13, 1969, similarly discussed only transactions involving ownership or lease and did not address the use of output of facilities. During 1970, the IRS received two ruling requests involving electric facilities. In one, half the output of a nuclear plant was to be sold by a municipal utility at cost to an investor-owned utility pursuant to a take or pay contract for most of the life of the facility. PLR 7011120430A (Nov. 12, 1970). 2 In the other, a very significant portion of the output of a generating facility owned by a municipal utility was to be sold to a rural electric cooperative for an extended period of time until the municipal utility needed the capacity, under a contract providing very favorable terms to the cooperative and giving the cooperative management and substantial control of the facility. PLR 7101260590A (Jan. 26, 1971). 3 The IRS then published proposed regulations on June 5, 1971 that, for the first time, provided that sales of output could result in use of an output facility and the proceeds of the bonds issued to finance the facility. Under these proposed regulations, take and take-or-pay contracts were described merely as examples of the type of contracts that could pass the benefits and burdens to a purchaser. A copy of these proposed regulations is attached as Appendix A. On July 15, 1971, a ruling was requested on whether a requirements contract for sale of output from a municipal utility to a cooperative that was its biggest customer, providing about 28 percent of its revenues, gave rise to impermissible use. The contract was for a term of 16 years, with a further period of 18 years during which a fixed amount of energy was to be purchased. A favorable ruling was issued. PLR 7108270510A (Aug. 27, 1971). The final Subparagraph 5 Regulations were issued the following year. Those final regulations did not refer to take and take-or-pay contracts as examples, but rather as the type of contracts that did pass the benefits and burdens. This background underscores the significance of the fact that in the final Subparagraph 5 Regulations the IRS limited private use to take and take or pay contracts (and certain underlying arrangements). The combination of the issuance of a favorable ruling on a requirements contract in PLR 71082270510A and the change from the June 5 proposed regulations (which contemplated that various types of contracts could pass the benefits and burdens) to the August final Subparagraph 5 Regulations, which were limited to only take and take or pay contracts, makes clear that the IRS intended to cover only contracts similar to ownership or lease. Moreover, it should not be surprising that the Subparagraph 5 Regulations contain no exceptions for short -term contracts or for arrangements entered into subsequent to the issuance of bonds. Nobody thought they were relevant. As discussed above, each of the ruling requests that had come before the IRS involved contracts in existence at the time bonds were to be issued, each involved sales for a term at least approximating the life of the bonds, each involved substantial obligations on the part of the purchaser and each, except perhaps the requirements contract situation, involved substantial attributes of ownership. The IRS had concluded long-term contracts were the problem 4 and believed tax-exemption was determined on the date of issuance. 5 The IRS’s alteration of its position on change in use 6 was more than 20 years away. During the period leading to the 1986 Act, there were significant developments in the concept of "use" in connection with other provisions of the tax law. For example, property "used by" a tax-exempt or governmental entity was not eligible for the investment credit. IRC §48(a)(4)-(5) (prior to repeal by section 211 of the 1986 Act). "Used by" had been limited by regulation to property "leased by," Reg. §1.48-1(j)-(k), and some extremely liberal rulings had been issued under those regulations. 7 Similarly, property used in the trade or business of a public utility was public utility property subject to limited investment credit and potentially restricted depreciation. IRC §46(c)(3)(B), 46(f) (prior to repeal by Section 211 by the 1985 Act), IRC §168(i)(10). These rules on tax-exempt use and use by public utilities stemmed from the same type of policy considerations involved in section 103, namely that when the nexus between property eligible for tax benefits and a person not entitled to those tax benefits becomes sufficiently close, the benefits should not be available. These concerns led to the enactment of section 7701(e) in 1984 to provide criteria to determine when a transaction styled as a service contract or other arrangement is sufficiently similar to a lease that certain tax benefits should be denied. Section 7701(e) applies for all purposes of the Code and provides a list of facts and circumstances that should be analyzed in determining whether the tax benefits should be denied. These factors include physical possession, control of the property, significant economic or possessory interest (itself a multi-factor test, taking into account whether the property is dedicated to the service recipient for a substantial portion of the useful life of the property, whether the service recipient shares the risk if the property declines in value or benefits if it appreciates or shares in operating economies or bears the risk of loss of the property), concurrent use to serve multiple parties, the relationship of the price for services to the rental value, and the risk to the service provider of failure to provide the service. While this provision does not control for purposes of section 103, it provides guidance as to what Congress considered relevant in cases involving remarkably similar considerations, and the 1986 Act should not be considered to depart radically from this type of standard without a very clear statement of intent to do so. Introduction | Part I | Part Ia | Part Ib | Back to Contents The 1986 Act and the Legislative History The Conference Report to the 1986 Act stated with respect to the bond provisions: As part of this reorganization, the present-law rules contained in Code sections 103 and 103A are divided, by topic, into 11 Code sections (secs. 103 and 141-150). The conferees intend that, to the extent not amended, all principles of present law continue to apply under the reorganized provisions. [emphasis added] Conference Report at II-686.
Aside from changing the quantitative limits on private use, the only relevant amendments that were made to the private use provisions were (1) to provide that use by all persons other than governmental entities (as opposed to persons other than exempt persons) and other than as members of the general public is to be taken into account (section 141(b)(6)) and (2) to direct the Treasury to amend its regulations to eliminate the requirement of a 3 percent guaranteed minimum payment (section 7703(i) of the 1986 Act.) These very limited statutory changes do not provide any basis for a sweeping change in the basic concept of the benefits and burdens test. Clarification that use by the general public is not private use should not be construed as a very restrictive provision, but rather simply as clarification of a safe harbor. This conclusion is reinforced by the statutory structure: the statute provides that general public use is not private use, not that all use other than general public use is private use. 8 The IRS adopted this analysis in the 1997 Final Regulations, which provide not only that use by the general public is never private use, but also that there are activities other than use by the general public that are not private business use. Similarly, the direction that the 3 percent rule be repealed should not be read as meaning that all but the smallest or shortest contracts should be ignored. The 3 percent rule excluded persons each of which paid "annually" a guaranteed minimum payment not exceeding 3 percent of the average annual debt service. Thus, what was contemplated by the Subparagraph 5 Regulations was that people would be counted who acting together each paid "annually" over an extended period of time, the contract term, more than 3 percent of debt service. The rule was considered to be the equivalent of excluding persons who took 3 percent of the nameplate capacity for the contract term. In fact, footnote 12 of the Conference Report states that: The conference agreement directs the Treasury Department to modify its present regulations (Treas. Reg. sec. 1.103-7(b)(5)) for determining the portion of an output facility that is privately used to reflect the reduced limits on such use. Specifically, the Treasury is directed to delete the special exception under which users of three percent or less of the output of a facility are disregarded in calculating whether the issue satisfies the trade or business use and security interest test. [emphasis added] Conference Report at II-689.
It is not surprising that, in an environment where private use of a facility is limited to 10 percent or $15 million of proceeds, persons taking 3 percent of the output for the contract term under guaranteed payment contracts should not be ignored, but the enactment of this directive should not be read as requiring anything more than a correlative reduction in the limitation for exclusion of guaranteed purchasers. Nonetheless, the legislative history of the 1986 Act contains conflicting and confusing statements regarding narrow categories of transactions that fall into the general public use category, namely pooling transactions and 30 day spot sales. We believe these examples should be regarded as safe harbors rather than exclusive examples. The IRS appears to agree because both in the Temporary Regulations and in the 1997 Final Regulations, as noted, the IRS recognizes that there is use other than use as a member of the general public that is not private use. The leadership of Congress apparently also agreed, as evidenced by its approval of a non-conforming pooling arrangement for WPPS. Blue Book, n. 63 at 1164. This conclusion is supported by other legislative history indicating that prior law concepts involving actual or beneficial use are to be continued. Thus, the House Report states: The general concept of use applicable under present law is retained under the bill. Thus, as under present law, a person may be treated as a user of bond proceeds or bond-financed property as a result of (1) ownership, or (2) actual or beneficial use of the property pursuant to a lease, a management or incentive payment contract, or an arrangement such as a take-or-pay or other type of output contract. House Report at 521.
The same general approach is stated in a slightly different form in both the Senate Report and the Conference Report. Senate Report at p. 812; Conference Report at II-687-88. We think this general background is relevant to our specific comments below because it demonstrates that, in the 1986 Act, Congress intended only limited changes to the definition of private use. Introduction | Part I | Part Ia | Part Ib | Back to Contents |