Rev. Rul. 85-68

1985-1 C.B. 37, 1985-22 I.R.B. 4.

INDUSTRIAL DEVELOPMENT BONDS; TRADE OR BUSINESS TEST; SECURITY INTEREST

TEST; PARITY BONDS

Published: June 3, 1985

26 CFR 1.103-7: Industrial development bonds.

(Also Sections 61, 7805: 1.61-7. 301.7805-1.)

  Industrial development bonds; trade or business test; security interest test; parity bonds. The obligations of the last issue in a series of several separate issues of municipal parity bonds will be industrial development bonds described in section 103(b)(2) of the Code if such issue satisfies both the trade or business test and the security interest test, whether or not any of the earlier issues in the series also satisfies those two test.

ISSUE

  Will bonds that a political subdivision of a state proposes to issue under the circumstances set out below be 'industrial development bonds' within the meaning of section 103(b)(2) of the Internal Revenue Code?

FACTS

  University L, which qualifies as a political subdivision of a state, adopted a resolution to issue bonds to finance an expansion program for L's facilities. L issued three separate series of registered revenue bonds during 1975, 1977, and 1979 under the bond resolution and used the bond proceeds to construct facilities exclusively for the use of L. All the bonds issued under the resolution are equally and ratably secured and payable solely from the income derived by L from rates, fees, and charges imposed by L for the use of the facilities. The three series of bonds are not industrial development bonds as

described in section 103(b)(2) of the Code.

  L proposes to issue another series of registered bonds under the resolution to finance additional facilities under the expansion program.

  L will enter into 10-year leases with prospective users of the new facilities. The prospective users will not be exempt persons within the meaning of section 103(b)(3) of the Code. The nonexempt persons will use 100 percent of the facilities.

  The least payments from the nonexempt users will include amounts sufficient to pay debt service (payment of principal and interest) on the bonds during the life of the leases. The revenues from the proposed facilities and the revenues from previous bond-financed facilities will be commingled in L's revenue fund. The projected revenues from the proposed facilities, pursuant to the leases, will equal 15 percent of the total revenues for a 10-year period from all bond- financed facilities. The total revenues will be pledged as security for payment of debt service on the proposed bonds, as well as debt service on the bonds already issued.

  The bonds will not be arbitrage bonds within the meaning of section 103(c)(2) of the Code.

LAW AND ANALYSIS

  Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state or its political subdivisions.

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

  Section 1.103-7(b) of the Income Tax Regulations defines industrial development bonds as obligations that meet the 'trade or business test' and the 'security interest test.' The trade or business test is satisfied if a major portion (more than 25 percent) of he bond proceeds is used in the trades or businesses of nonexempt persons. The security interest test is met if a major portion (more than 25 percent) of the payment of the principal of or interest on the bonds is secured by an interest in property used in a trade or business or by payments in respect of property, or borrowed money, used or to be used in a trade or business.

  Section 1.103-7(b)(3) of the regulations provides that the trade or business test relates to the use of proceeds of a bond issue. The test is met if all or a major portion (more than 25 percent) of the proceeds of a bond issue is used in a trade or business carried on by a nonexempt person. For example, if all or a major portion of the proceeds of a bond issue is to be lent to one or more private business users, or is to be used to acquire, construct, or reconstruct facilities to be leased or sold to such private business users, and such proceeds or facilities are to be used in trades or businesses carried on by them, such proceeds are to be used in a trade or business carried on by persons who are not exempt persons and the debt obligations comprising the bond issue satisfy the trade or business test.

  Section 1.103-7(b)(4) of the regulations provides that the security interest test relates to the nature of the security for, and the source of, the payment of either the principal of or interest on a bond issue. The nature of the security for, and the source of, the payment may be determined from the terms of the bond indenture or on the basis of an underlying arrangement. An underlying arrangement can be inferred from all the facts and circumstances. A pledge of the full faith and credit of a state or local governmental unit will not prevent a debt obligation from otherwise satisfying the security interest test. For example, if the payment of either the principal or interest on a bond issue is secured by both a pledge of the full faith and credit of a state or local governmental unit and any interest in property used or to be used in a trade or business, the bond issue satisfies the security interest test.

  In Rev. Rul. 80-251, 1980-2 C.B. 40, a city proposes to issue general obligation bonds to provide loans to developers of industrial buildings. Although the city will secure all loans to developers with mortgages on the facilities financed by the loans, neither the buildings nor the loan repayments by the developers will be security for payment of the debt service on the bonds. The city will levy sufficient ad valorem taxes to pay the debt service on the bonds. The payments received from the developers will be placed in the general fund of the city. However, it is anticipated that over the term of the bonds, the principal and interest payments to be made by the developers and the total debt service on the bonds will be approximately equal in present value. Rev. Rul. 80-251 concludes that the trade or business test will be met because the buildings financed by bond proceeds will be used in the trades or businesses of nonexempt persons. It further concludes that an underlying arrangement will always be inferred if the payments to be made by the industrial user or users and the debt service on the bonds are approximately equal in present value. Other facts that tend to show an underlying arrangement are, first, that payments made by the industrial user are material to the security for the bonds, and second, that the identity of the industrial user can be determined at the time of issue. Therefore, the security interest test will be met because, pursuant to an underlying arrangement, payment of debt service on the bonds will be derived from payments in respect of property or borrowed money used in the trades or businesses of nonexempt persons. Because both the trade or business test and the security interest test are met, the bonds will be industrial development bonds within the meaning of section 103(b)(2) of the Code.

  In this case, the bond proceeds will be used to provide facilities for use by nonexempt persons. Because a major portion of the facilities to be financed by the bond proceeds will be used in the trades or businesses of the nonexempt persons, a major portion of the bond proceeds will be considered used in the trades or businesses of nonexempt persons and the trade or business test described in section 1.103-7(b)(3) of the regulations will be met.

  In the case of revenue parity bonds the revenue from both the existing and the proposed new facilities financed by bond issues will usually be pledged as security for payment of debt service on the proposed bond issue. Thus, additional revenue is frequently pledged as security along with the revenues to be generated by the proposed new facilities to be acquired with the proceeds from the proposed bond issue.

  The facilities to be financed with the proceeds of the proposed bonds in this case will produce sufficient revenues to pay the total debt service on the proposed bonds. The additional security pledged in the form of revenues from previous projects, when combined with the revenues from the proposed facilities, will form a pool of revenues from which debt service on the proposed bonds will be paid.

  Section 1.103-7(b)(4) of the regulations illustrates that a pledge of the full faith and credit of a state or local governmental unit together with a pledge of any interest in property used in a trade or business will not prevent a debt obligation from meeting the security interest test. Likewise, the pledge of revenues from other sources together with a pledge of the revenues from the bond-financed facility will not prevent the proposed bonds from meeting the security interest test.

  Further, section 1.103-7(b)(4) of the regulations provides that the security interest test will be met if an underlying arrangement is inferred by the facts and circumstances. Rev. Rul. 80-251 illustrates that an underlying arrangement to provide security for bonds is inferred in situations where bonds secured by ad valorem taxes will be issued to provide loans to nonexempt developers but the loan repayments by the developers will not be pledged as security for debt service on the bonds. Rev. Rul. 80-251 specifically holds that if the debt service on the bonds and the loan repayments are approximately equal in present value, the security interest test will be met because the payment of debt service on the bonds will be derived from payments in respect of property or borrowed money used in the trades or businesses of nonexempt persons.

  In this case the revenues from the facilities to be financed with the proposed bond proceeds will be equal to the debt service on the proposed bonds. The arrangements to provide additional security by also pledging revenues from prior bond-financed facilities is similar, in effect, to the underlying arrangement described in Rev. Rul. 80-251 because the arrangement serves to reduce the amount of the revenues that will be derived from facilities used in the trades or businesses of nonexempt persons that are required to be pledged as security. The pledging of the revenues from prior facilities will not prevent the proposed bonds from meeting the security interest test.

  Although additional revenues from prior bond-financed facilities will also be pledged as additional security for payment of debt service on L's proposed bonds, the revenues from the proposed facilities will be sufficient to pay all debt service on the proposed bonds. The revenues from the proposed facilities will be inferred to be the true source of payment of debt service on the proposed bonds. Therefore, because the payment of all the debt service on L's proposed bonds will be secured by payments in respect of the proposed facilities to be used in the trades or businesses of nonexempt persons, the security interest test will be met. Furthermore, even if the revenues to be derived from the bond-financed facility will not be approximately equal to the debt service on the proposed bonds, an underlying arrangement will be inferred provided the revenues will be more than 25 percent of either principal or interest on such bond issue. This is because the payment is material to the security of the bonds and the nonexempt user is identified at the time of the bond issue. See Rev. Rul. 80-251.

HOLDING

  The bonds to be issued by L will be industrial development bonds within the meaning of section 103(b)(2) of the Code because both the trade or business test and the security interest test will be met. The interest on the bonds will not be excludable from gross income under section 103(a)(1) unless the bonds qualify for one of the exception provisions under section 103(b)(4), (5), or (6).

PROSPECTIVE APPLICATION

  Pursuant to the authority contained in section 7805(b) of the Code, this revenue ruling will not apply to 'parity bonds' sold prior to June 3, 1985, the date this revenue ruling is published in the Internal Revenue Bulletin. In addition, this revenue ruling will not apply to 'parity bonds' sold on or after June 3, 1985, if the proceeds of such obligations are to be used to complete construction begun before June 3, 1985, or construction to be begun pursuant to a binding contract entered into before June 3, 1985.

Rev. Rul. 85-68, 1985-1 C.B. 37, 1985-22 I.R.B. 4.