Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 78-21

1978-1 C.B. 26

Sec. 61
Sec. 103

IRS Headnote

Industrial development bonds; water facility used primarily by nonexempt person. A water supply system constructed by a state to furnish water from a state reservoir primarily to a nonexempt corporation for business use does not meet the public use test of section 1.103-8(a)(2) of the regulations, even though it will also furnish less than 20 percent of its capacity to a small number of individual customers and the state will grant a water district serving several cities an option to purchase water from the system each year.

Full Text

Rev. Rul. 78-21

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 proposes to issue $10,000,000 of industrial development bonds, as described in section 103(b)(2) of the Code, to finance the acquisition and construction of a water supply system.

The state will enter into an agreement with a corporation that is not an "exempt person" within the meaning of section 103(b)(3) of the Code to provide water from a state reservoir for use by the corporation in its business operations for a specific number of years. In order to furnish the water to the site of the corporation's activities, the state will construct extensive pipeline and pumping facilities.

The state also will enter into an agreement with a water district that furnishes water to several cities located within the state. Under the terms of the agreement the state will grant the water district an option, exercisable at any time within a specific number of years, to purchase certain quantities of water each year. In order to exercise its option, the water district will be required to construct a pipeline connecting its water system with the state's water system. The pipelines of the two systems are a substantial distance apart. The water district currently has sufficient water to satisfy the needs of the cities it serves, but anticipates that there may be a water shortage at some future time.

In addition to the water to be furnished to the corporation, approximately 25 individual customers will be furnished water by tapping into the water supply line at various points along the line. The individual customers will receive less than 20 percent of the total capacity of the water supply system.

Section 103(a)(1) of the Code provides, in part, that gross income does not include interest on obligations of states and political subdivisions thereof.

Section 103(b)(1) of the Code provides, in part, that industrial development bonds shall not be treated as obligations of states and political subdivisions thereof.

However, section 103(b)(4)(G) of the Code provides, in part, that the provisions of section 103(b)(1) shall not apply to any obligation that is issued as part of an issue substantially all of the proceeds of which are used to provide certain exempt facilities including facilities for the furnishing of water if the water is available on reasonable demand to members of the general public.

Section 1.103-8(a)(2) of the Income Tax Regulations provides, in part, that to qualify as an exempt facility for purposes of section 103(b)(4) of the Code, the facility must serve or be available on a regular basis for general public use as contrasted with similar types of facilities that are constructed for the exclusive use of a limited number of nonexempt persons in their trades or businesses.

Rev. Rul. 76-494, 1976-2 C.B. 26, holds that a water facility will not meet the public use requirement of section 1.103-8(a)(2) of the regulations because the aggregate amount of water available to the general public is small (20 percent of capacity) in comparison with the amount of water available (80 percent of capacity) for use by a limited number of nonexempt persons in their trades or businesses.

Although the proposed water supply system will be used to furnish water to a small number of individual customers scattered along the pipelines, it will be used primarily for furnishing water to the nonexempt corporation for use in its trade or business similar to the situation described in Rev. Rul. 76-494. Further, any future use of the water supply system by the water district through the exercise of its option to obtain water is speculative and may not be considered in determining if the system qualifies as an exempt facility. Since the water supply system will be used primarily by the nonexempt corporation, the public use test described in section 1.103-8(a)(2) of the regulations will not be satisfied and the water supply system will not qualify as an exempt water facility within the meaning of section 103(b)(4)(G) of the Code.

Accordingly, the interest on the bonds to be issued by the state will not be excludable from the gross incomes of the bondholders under the provisions of section 103(a)(1) of the Code.