March 25, 2016 The Tax Lawyer

Comments on the Definition of Political Subdivision for Tax-Exempt Bonds and Other Tax-Advantaged Bonds

Volume 69, No. 2 - Winter 2016

ABA Section of Taxation

Abstract

    The phrase “political subdivision” appears in over 131 sections of the Internal Revenue Code and the only definition in the regulations is set forth in Regulation section 1.103‑1. Revenue Ruling 77‑143 and Revenue Ruling 78‑276 state that the term “political subdivision” has been defined consistently for all federal tax purposes.

    In 1914, when asked whether special assessment districts for the purpose of improving streets and public highways, and similar infrastructure are political subdivisions, U.S. Attorney General James McReynolds stated the term political subdivision is broad and comprehensive and denotes any division of the State made by the proper authorities thereof, acting within their constitutional powers, for the purpose of carrying out functions of the State which by long usage and the inherent necessities of  government have always been regarded as public. (1914 AG Opinion)     

    In 1936, regulations were released stating that the term political subdivision, within the meaning of the tax exemption, means any division of the State or Territory which is a municipal corporation, or to which has been delegated the right to exercise part of the sovereign power.

    In 1944, Commissioner of Internal Revenue v. Shamberg’s Estate (Shamberg), the leading case interpreting the meaning of political subdivision, was decided. The case analyzed the exclusion from gross income of interest on bonds held by Alexander Shamberg’s estate and issued by the Port of New York Authority. The case cited the 1914 AG Opinion and the above regulation, and held that there are three elements of sovereign power (the power of eminent domain, the power to tax, and the police power) and required that only 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.

    In 1977, G.C.M. 36,994 (February 3, 1977) went so far as to state that “we consider the meaning of political subdivision for purposes of section 103(a)(1), to be well established.” Most authorities addressing the meaning of political subdivision reference Regulation section 1.103-1 and Shamberg. Until recently the definition of a political subdivision has been understood by the bar to be relatively well 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. If the Service changes the definition of political subdivision for purposes of section 103, the change may have implications for purposes of the other Code sections that apply to political subdivisions.

    The definition of a political subdivision returned to the forefront in Technical Advice Memorandum 2013-34-038 (the 2013 T.A.M.) in the context of tax-advantaged financings. The 2013 T.A.M. addresses the political subdivision status of Village Center Community Development District (the Issuer), a special purpose local government under Florida law located in a central Florida retirement community. Displeased with the control the community developer exerted on the Issuer’s governing board, the Service challenged the tax-exempt status of the Issuer’s bonds.

    While the facts recited in the 2013 T.A.M. seem to indicate that the Issuer had some power of eminent domain (but not the power to tax or police power), the Service states that the “mere delegation of sovereign power is not sufficient to treat the Issuer as a political subdivision.” The Service focused on the Issuer’s status as a division of a state or local government and concluded that it was not a political subdivision because of a lack of control over the Issuer by a state or local government.

    The 2013 T.A.M. raises significant concerns that the Service may apply a new standard, not based on current law, in determining whether an entity qualifies as a political subdivision. This Article is not intended to comment on whether the Issuer in the 2013 T.A.M. qualifies as a political subdivision. In light of the new requirements that the 2013 T.A.M. seems to impose to qualify as a political subdivision, this Article recommends that the 2013 T.A.M. be withdrawn or modified to conform with existing precedent, and 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.

    This Article first provides a brief introduction to the tax-exempt-financing area. Second, it provides a more in-depth discussion of the 2013 T.A.M. Third, it provides a review of existing law on the issue of political subdivision as it relates to the issuance of tax advantaged obligations. Fourth, it provides an analysis of existing law in the context of the 2013 T.A.M. and new regulations addressing political subdivision status. Finally, it sets forth conclusions and recommendations.

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