The following Comments are submitted at the request of the Internal Revenue Service (the "Service"), in connection with the 2014-2015 guidance project regarding the term "political subdivision," 1 and at the request of the Office of the Tax Legislative Counsel, Department of Treasury. The Comments are also a follow-up to the May, 2014 meeting of the Committee on Tax Exempt Financing (the "Committee") of the American Bar Association Section of Taxation (the "Section").
For interest on a bond to be excluded from gross income for federal income tax purposes, the bond must be a "state or local bond" under section 103(a). 2 Regulation section 1.103-1(a), in relevant part, provides:
Interest upon obligations of a State, territory, a possession of the United States, the District of Columbia, or any political subdivision thereof (hereinafter collectively or individually referred to as "state or local governmental unit") is not includable in gross income ….
Regulation section 1.103-1(b) further provides:
The term "political subdivision," for purposes of this section denotes any division of any State or local government unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit.
The leading case that considered a predecessor version of the above Regulations, Commissioner of Internal Revenue v. Shamberg's Estate ("Shamberg"), 3 held that there are three elements of sovereign power: (1) the power of eminent domain, (2) the power to tax, and (3) the police power. Although Shamberg only required that part or a portion of those powers be present to conclude that an entity created under state law for a governmental purpose is a political subdivision, subsequent authorities indicate that possession of only an insubstantial amount of any or all sovereign powers is not sufficient. From time to time, the Service has issued administrative guidance following Shamberg, elaborating on the amount and type of sovereign powers sufficient for such qualification. Thus, until recently the definition of a political subdivision has been understood to be settled and limited to the considerations set forth in Shamberg, with questions mainly arising as to whether an entity has sufficient sovereign powers to be a political subdivision. 4
The definition of a political subdivision for purposes of tax-advantaged financings came back to the forefront in Technical Advice Memorandum 201334038 (the "2013 TAM"). The 2013 TAM addresses the status of a particular issuer (the "Issuer") as a political subdivision. Parts of the 2013 TAM appear to set forth new substantive requirements not previously considered in the various statutory, administrative or judicial precedents. The 2013 TAM states that:
[t]he term "political subdivision" is defined in Reg. § 1.103-1(b) as "any division of any state or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit."
The phrase "division of a state or local government" must be read in the context of the purpose of Section 103, which is to provide subsidized financing for State and local government purposes. The Code permits the benefit of this subsidy to be passed on to private persons under some circumstances, but only if a governmental unit determines that the issuance of such bonds is appropriate. A governmental unit is inherently accountable, directly or indirectly, to a general electorate. In effect, Section 103 relies, in large part, on the democratic process to ensure that subsidized bond financing is used for projects which the general electorate considers appropriate State or local government purposes. A process that allows a private entity to determine how the bond subsidy should be used without appropriate government safeguards cannot satisfy Section 103.
The 2013 TAM concludes that because the Issuer is not directly or indirectly answerable to the electorate, it is not a division of a State or local government, and therefore it is not a political subdivision that may issue tax exempt bonds. The TAM points to the "division" language in Regulation section 1.103‑1(b) to require "accountability, directly or indirectly, to a public electorate." As discussed more fully herein, accountability has not previously been required to achieve political subdivision status and control has been analyzed as a factor in whether sovereign power has been delegated,
The Committee is concerned that auditors of tax exempt bonds may use the 2013 TAM to apply a new standard not based on existing law, thereby creating significant uncertainty in a well-established transactional practice that relies on unqualified tax opinions. Audits based on the new analysis in the 2013 TAM could have a substantial adverse impact on existing issuers and could prove costly to state and local governments. Moreover, although the 2013 TAM cannot be used as precedent, the mere presence of the quoted language in a published administrative determination creates uncertainty with regard to the standard to be applied by a tax lawyer, an issuer, or the Service when evaluating political subdivision status of an entity.
It is not the objective of these Comments to make any comment about whether the Issuer in the 2013 TAM qualifies as a political subdivision. Instead, in light of the new requirements that the 2013 TAM seems to impose to qualify as a political subdivision, we recommend that the 2013 TAM be withdrawn or modified to conform with existing precedent. The Committee also recommends that the Service and Treasury issue a notice providing interim guidance prior to the issuance of new political subdivision regulations and stating that any change to the definition of political subdivision will apply solely on a prospective basis.
The remainder of these Comments first provides a more in depth discussion of the 2013 TAM, second provides a review of existing law on the issue of political subdivision as it relates to the issuance of tax advantaged obligations, and, third, provides an analysis of existing law in the context of the 2013 TAM and new regulations addressing political subdivision status. ■
1 Under the initial 2014-2015 Priority Guidance Plan, and the most recently published plan (the second quarter update), both available at http://www.irs.gov/uac/Priority-Guidance-Plan, there is a project listed in the Tax Exempt Bonds section for "Guidance on the definition of political subdivision under Section 103 for purposes of the tax exempt, tax credit, and direct pay bond provisions."
2 References to the "section" refer to the Internal Revenue Code of 1986, as amended (the "Code"); and all references to the Regulations refer to income tax regulations promulgated under the Code.
3 144 F. 2d 998 (2d Cir. 1944), cert. denied, 323 U.S. 792 (1945). Commissioner v. White's Estate, 144 F.2d 1019, 44‑2 U.S.T.C. 710 (2d Cir. 1944), cert. denied, 323 U.S. 792, 65 S. Ct. 433 (1945) ("White's Estate") was a companion case to Shamberg and examined bonds issued by the Triborough Bridge Authority.
4 A relatively succinct statement of the law is provided in the quoted language from GCM 36994 (February 3, 1977) set forth at part III.F of the Discussion below. The GCM goes so far as to state that "we consider the meaning of political subdivision for purposes of section 103(a)(1), to be well established."