Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 77-55

1977-1 C.B. 18

Section 103 -- Tax-Exempt Interest

IRS Headnote

Industrial development bonds; exempt small issue. A state's issuance of industrial development bonds in 40 lots of $1 million each on the same day under a single bond indenture, all maintained under a single pooled security by a single trustee, is considered to be a single $40 million issuance that is not an exempt small issue under section 103(b)(6)(A) of the Code, and the interest is not excludable under section 103(a)(1).

Full Text

Rev. Rul. 77-55

Advice has been requested whether, under the circumstances described below, the interest on bonds to be issued by a state will be excludable from the gross incomes of the bondholders under the provisions of section 103(a)(1) of the Internal Revenue Code of 1954.

The state proposed to issue obligations the proceeds of which will be loaned to local nonprofit industrial development corporations at a low rate of interest. The obligations will be industrial development bonds within the meaning of section 103(b)(2) of the Code. The industrial development corporations will use the bond proceeds to acquire and construct industrial development projects. The industrial development corporations will sell or lease the projects to business corporations in a financing transaction that results in the relending of the bond proceeds to business corporations and passes through to the business corporations the benefit of the low interest rate charged by the state. The business corporations will be the principal users of the projects.

The state proposes to issue $40,000,000 of Series A bonds that will be divided into 40 lots of $1,000,000 each. The lot number of each bond will be printed on the face of the bond, and the projects financed by each lot will be identified with that lot on the records of the state. The projects to be financed with the proceeds of any $1,000,000 lot of bonds will not necessarily be known at the time that the bonds are issued but will be identified with that lot on the records of the state at the time the proceeds are first used to pay the costs of the projects.

A commercial bank will act as the trustee under the terms of the bond indenture. The bank will create a separate lot account in a bond settlement fund, established under the bond indenture to receive the proceeds from the sale of each lot. At the closing of the sale of the bonds, the underwriter selling the bonds will give the bank a check for the aggregate price of all lots sold in the transaction. If the forty $1,000,000 lots are sold to the underwriters at a 2 percent discount, the underwriters will deliver a check for $39,200,000 to the bank at closing. The bank will credit a pro rata share of the $39,200,000 to each lot account. Any cost of financing as well as legal or printing expense will be paid by the bank upon receipt of a requisition from the state. Such cost will be charged pro rata to each of the lot accounts. After the costs of financing have been provided for in this manner, the balances in each lot account will be transferred to corresponding lot accounts in a project fund established under the indenture.

The state will authorize a specific loan for each industrial development project it plans to finance and will designate the particular lot account in the project fund to which the project is assigned. The bank will then divide the relevant account into separate project accounts for each project designated to the particular lot account. The total project authorizations assigned to each lot will not exceed $1,000,000 (or the lesser total balance in the lot account). The bank will make disbursements of amounts authorized to be loaned upon receipt of requisitions by the state identifying the project, and will charge each disbursement to the separate project account in question.

Pursuant to the indenture, payments from the lot accounts in the project fund will be made only upon certification by the state that there are no outstanding obligations described in section 103 of the Code, the proceeds of which were used with respect to facilities having the same principal user that are either located in the same incorporated municipality or the same county (but not in any incorporated municipality) or that are contiguous or integrated with facilities in another county such that the aggregate face amount of the applicable lot would be treated as exceeding $1,000,000. The state will also certify that no two lots of bonds will be used by the same principal user in the same incorporated municipality or in the same county (but not in any incorporated municipality). The indenture will prohibit the financing of a single facility from more than one lot account.

Any amounts remaining in the relevant lot account after all projects designated thereto have been completed will be transferred to the corresponding account of that lot in a revenue fund established under the indenture. Such amounts may include both (1) amounts authorized for loans but not requisitioned, and (2) amounts not yet authorized for any loan.

Payments by local nonprofit industrial development corporations of principal or interest on the loans in respect of any project will be made to the bank and will be credited to the appropriate lot account in the revenue fund. Moreover, payments to the bondholders of principal and interest on the bonds will be made by the bank and charged to the appropriate lot account in the revenue fund. To the extent that the amounts in a lot account on a date when a payment of principal or interest is due are inadequate, the necessary amount will be paid from the general account in the revenue fund. The general account in the revenue fund will be maintained by the bank pursuant to the indenture and will be credited with funds received by the state from repayments of certain loans that the state has made out of appropriated funds.

Investments of amounts credited to different accounts in the project fund or the revenue fund will be made on a pooled basis. No such investments will violate the arbitrage rules of section 103(c) of the Code. The income on such investments will be credited to the various accounts on the basis of their proportionate shares of the investment pool.

Amounts credited to the account of a lot of bonds will be pledged for payment of debt service on that lot. Such pledged amounts may be used for loans on new projects provided the new loans will comply with the requirements concerning the $1,000,000 limitation, and that the payments of principal or interest on the loans will be credited to the account of the lot in question. The bank will implement the pledge by maintaining cash or investments under the indenture equal to the total amounts credited to the accounts of the various lots. Any balance remaining in a lot account when the bonds of that lot have been retired will be transferred to the general account of the revenue fund where it may be used for any purpose, including debt service on the bonds of any other lot.

Automatic data processing equipment will be used to store the account data. The equipment will be programmed so that the balance in any account will be ascertainable by the bank.

Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state, a territory, or a possession of the United States, or any political subdivision of any of the foregoing, or of the District of Columbia.

Section 103(b)(1) of the Code provides that, except as otherwise provided in section 103(b), any industrial development bond shall be treated as an obligation that is not an obligation described in section 103(a)(1).

Section 103(b)(6)(A) of the Code provides that section 103(b)(1) shall not apply to any obligation issued as part of an issue the aggregate authorized face amount of which is $1,000,000 or less and substantially all of the proceeds of which are to be used (i) for the acquisition, construction, reconstruction, or improvement of land or property of a character subject to the allowance for depreciation, or (ii) to redeem part of all of a prior issue which was issued for purposes described in (i).

In the instant case, there will be a single bond indenture handled by a single trustee, all the bonds will be issued on the same day, and there will be a single, pooled security.

This pooled security will arise in part because, if there is an excess amount in a separate lot account, such excess can be used to fund deficiencies in any other lot account. In addition, the general account in the revenue fund, which will be funded from the general revenues of the state, can be used to pay principal and interest on any lot of bonds to the extent that the amounts in any lot account are inadequate. It will be to this general account in the revenue fund that the investors will look for security (rather than to any specific asset) prior to the time when the project to be financed by the particular lot account will be known.

Since all of the bonds will be issued simultaneously, the bonds will be issued under a single bond indenture, and all of the bondholders will, in substance, look to the same pool of assets as security, such bonds will be considered a single issuance with an aggregate authorized face amount of $40,000,000. Therefore, the Series A bonds will not be an exempt small issue under section 103(b)(6)(A) and the bonds will not qualify for treatment under section 103(a)(1).

Accordingly, the interest to be paid on the Series A bonds will not be excludable from the gross incomes of the bondholders under section 103(a)(1) of the Code.

Compare Rev. Rul. 74-380, 1974-2 C.B. 32, wherein three bond issuances made on the same day under separate indentures of trust are not aggregated for purposes of section 103(b)(6)(A) of the Code.