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OFFICERS
Chair
William H. Caudill
Houston, TX
Chair-Elect
Karen L. Hawkins
Yachats, OR
Vice Chairs
Administration
Charles P. Rettig
Beverly Hills, CA
Committee Operations
Scott D. Michel
Washington, DC
Continuing Legal Education
Joan C. Arnold
Philadelphia, PA
Government Relations
Julian Y. Kim
Washington, DC
Pro Bono and Outreach
Bahar A. Schippel
Phoenix, AZ
Publications
Julie A. Divola
San Francisco, CA
Secretary
Catherine B. Engell
New York, NY
Assistant Secretary
Katherine E. David
San Antonio, TX
COUNCIL
Section Delegates to the
House of Delegates
Richard M. Lipton
Chicago, IL
Armando Gomez
Washington, DC
Last Retiring Chair
George C. Howell, III
Richmond, VA
Members
Alan I. Appel
New York, NY
Larry A. Campagna
Houston, TX
T. Keith Fogg
Villanova, PA
Kurt L.P. Lawson
Washington, DC
R. David Wheat
Dallas, TX
John F. Bergner
Dallas, TX
Thomas D. Greenaway
Boston, MA
Roberta F. Mann
Eugene, OR
Carol P. Tello
Washington, DC
Gary B. Wilcox
Washington, DC
Adam M. Cohen
Denver, CO
Sheri A. Dillon
Washington, DC
Ronald A. Levitt
Birmingham, AL
Christopher S. Rizek
Washington, DC
Melissa Wiley
Washington, DC
LIAISONS
Board of Governors
Pamela A. Bresnahan
Washington, DC
Young Lawyers Division
Vlad Frants
Newark, NJ
Law Student Division
Scott Woody
University Park, NM
DIRECTOR
John Thorner
Washington, DC
Section of Taxation
Suite 400
1050 Connecticut Avenue, NW
Washington, DC 20036
202-662-8670
FAX: 202-662-8682
E-mail: [email protected]
August 10, 2017
Internal Revenue Service
Attn: CC:PA:LPD:PR (Notice 2017-38)
Room 5205
PO Box 7604
Ben Franklin Station
Washington, DC 20224
Re: Comments on Notice 2017-38 (Proposed Regulations Under Section 103)
Dear Ladies and Gentlemen:
Enclosed please find comments on Notice 2017-38 regarding proposed regulations
under section 103 (“Comments”). These Comments are submitted on behalf of the
American Bar Association Section of Taxation and have not been approved by the House of
Delegates or the Board of Governors of the American Bar Association. Accordingly, they
should not be construed as representing the position of the American Bar Association.
Sincerely,
William H. Caudill
Chair, Section of Taxation
Enclosure
cc: Hon. Steven T. Mnuchin, Secretary, Department of the Treasury
Hon. David Kautter, Assistant Secretary (Tax Policy), Department of the Treasury
Hon. John A. Koskinen, Commissioner, Internal Revenue Service
Dana L. Trier, Deputy Assistant Secretary (Tax Policy), Department of the
Treasury
Thomas West, Tax Legislative Counsel, Department of the Treasury
William M. Paul, Acting Chief Counsel and Deputy Chief Counsel (Technical),
Internal Revenue Service
AMERICAN BAR ASSOCIATION
SECTION OF TAXATION
COMMENTS REQUESTED BY NOTICE 2017-38 ON THE PROPOSED
POLITICAL SUBDIVISION REGULATIONS UNDER SECTION 103
These comments (the “Comments”) are submitted on behalf of the American Bar
Association Section of Taxation (the “Section”) and have not been approved by the House of
Delegates or Board of Governors of the American Bar Association. Accordingly, they should
not be construed as representing the position of the American Bar Association.
Principal responsibility for preparing these Comments was exercised by Mark O.
Norell Vice Chair of the Section’s Committee on Tax Exempt Financing (the “Committee”).
Substantive contributions were made by Ellen Aprill, David Cholst, James Eustis, and Scott
Lilienthal. The Comments were reviewed by Charles Cardall Vice Chair of the Committee.
The Comments were further reviewed by Julian Y. Kim, the Section’s Vice Chair (Government
Relations).
Although the members of the Tax Exempt Financing Committee who participated in
preparing these Comments have clients that might be affected by the federal tax principles
addressed by these Comments or have advised clients on the application of such principles, no
such member (or the firm or organization to which such member belongs) has been engaged
by a client to make a government submission with respect to, or otherwise to influence the
development or outcome of, the specific subject matter of these Comments.
Contact:
Date:
Mark O. Norell
212-318-3047
August 10, 2017
- 2 -
AMERICAN BAR ASSOCIATION
SECTION OF TAXATION
COMMENTS REQUESTED BY NOTICE 2017-38 ON THE PROPOSED POLITICAL
SUBDIVISION REGULATIONS UNDER SECTION 103
On April 21, 2017, President Trump (the “President”) issued Executive Order 13789 (the
“Executive Order”). The Executive Order directed the Secretary of the Treasury to review all
significant tax regulations issued by the Treasury Department (“Treasury”) on or after January 1,
2016 (the “2016 Regulations”) and to issue an interim report to the President that identifies those
2016 Regulations that (1) impose an undue financial burden on U.S. taxpayers; (2) add undue
complexity to the Federal tax laws; or (3) exceed the statutory authority of the Internal Revenue
Service (the “Service”).
In response to the Executive Order, the Service issued Notice 2017-38 (the “Notice”), in
which Treasury identified eight 2016 Regulations (the “Selected Regulations”) that Treasury
concluded impose an undue financial burden on U.S. taxpayers or add undue complexity to the
Federal tax laws. Notably, the Selected Regulations include proposed regulations under section
1031 on Definition of Political Subdivision (the “Proposed Regulations”).2 Although the Section
recognizes and appreciates the work by Treasury and the Service in issuing the Proposed
Regulations, the Section believes that its withdrawal will best serve the tax system.
The law on the definition of a political subdivision has been well settled for over 100 years.
The current political subdivision regulations are based on the leading decision of Commissioner v.
Shamberg,3 which in turn heavily relied on and cited a 1914 opinion of U.S. Attorney General
James McReynolds.4 Current Treasury Regulation section 1.103-1 followed the straightforward
test set forth in Shamberg and the 1914 AG Opinion, and was amended with minor changes in
1938, 1939, 1957, 1972, and 1977.5
1 Unless otherwise specifically stated, all references herein to a “section” or the “Code” shall be references to the
Internal Revenue Code of 1986, as amended; and all references to the “Regulations” shall be references to the
Treasury Regulations promulgated under the Code.
2 81 F.R. 8870 (February 23, 2016).
3 144 F.2d 998 (2d Cir. 1944), cert. denied, 323 U.S. 792 (1945).
4 Income Tax—Special Assessment Districts, 30 Op. Atty. Gen. 252, 253 (1914) (the “1914 AG Opinion”).
5 The current regulations state that “[t]he term “political subdivision”, for purposes of this section denotes 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. As thus defined, a political subdivision of any State or
local governmental unit may or may not, for purposes of this section, include special assessment districts so
created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee, school, harbor, port
improvement, and similar districts and divisions of any such unit.”
- 3 -
The Proposed Regulations arose from an IRS guidance project that followed the IRS’
release of Technical Advice Memorandum 201334038 (the “TAM”).6 The TAM addressed the
status of a particular issuer as a political subdivision, and the Section believes that the TAM
addressed a highly unusual factual situation and should not serve as the basis for broader guidance.
The Proposed Regulations would replace the well-known and long-standing one-part
sovereign power test that applies to a division of a state with a three-part test, adding a new test
relating to governmental purpose (the “Governmental Purpose Requirement”) and a new test
relating to governmental control (the “Governmental Control Requirement”). Each of these new
tests includes various sub-tests, some of which require an inherently subjective “facts and
circumstances” analysis. The Proposed Regulations thus would impose complicated additional
requirements which are not supported by the precedents in this area and add undue complexity to
the Federal tax laws.
The Section has commented on the subject matter on two prior occasions, on May 5, 2015
(the “May 2015 Comment Letter”),7 and on May 5, 2017 (the “May 2017 Comment Letter”),8
copies of which are attached hereto. Advised that the release of Proposed Regulations was
imminent, the May 2015 Comment Letter did not argue against the Proposed Regulations. Instead,
the Section in its May 2015 Comment Letter provided a thorough review of the precedent in the
area, noted that the legal analysis set forth in the TAM is not supported by the judicial, regulatory
or administrative precedent, and recommended that the TAM be withdrawn, or modified to
conform with existing precedent.
The Section submitted the May 2017 Comment Letter in response to the Proposed
Regulations. That letter expressed concern that the broad sweep of the Proposed Regulations, if
finalized, would cast doubt on the status of many existing political subdivisions, noted that the
Proposed Regulations do not provide a useful clarification of the definition of a political
subdivision and would provide less certainty than the existing Regulations, noted the Service’s
attempt to address private use issues through the political subdivision rules, and noted that the
Proposed Regulations are overreaching in many specific areas.
Based on U.S. Census Bureau data, there are tens of thousands of governmental entities
eligible to issue tax-exempt or tax-advantaged bonds.9 The Section believes that the Proposed
6 TAM 201334038 (June 17, 2015).
7 American Bar Association, Section of Taxation, Comments on the Definition of Political Subdivision (May 5,
2015), available at
www.americanbar.org/content/dam/aba/administrative/taxation/policy/050515comments.authcheckdam.pdf.
8 American Bar Association Section of Taxation, Comments on the Definition of Political Subdivision for Tax
Exempt Bonds and Other Tax Advantaged Bonds (May 5, 2017), available at
www.americanbar.org/content/dam/aba/administrative/taxation/policy/050517comments.pdf.
9 See the following Census Bureau links: https://www.census.gov/govs/go/municipal_township_govs.html and
https://factfinder.census.gov/faces/tableservices/jsf/pages/productview.xhtml?src=bkmk (last updated March 2,
2016), showing over 90,000 political subdivisions. Many of the entities listed may not be authorized to issue
bonds or have the requisite sovereign power.
- 4 -
Regulations, if finalized in their current form, would (i) impose an undue financial burden on U.S.
taxpayers; (ii) add undue complexity to the Federal tax laws; and (iii) exceed the statutory authority
of the Service. Upon further consideration, the Section, therefore, supports the withdrawal of the
Proposed Regulations.
Undue Financial Burden on U.S. Taxpayers
The current Regulations defining a political subdivision are brief, to the point and
contained within a single paragraph.10 They are accompanied by lean but adequate judicial and
administrative guidance. In contrast, the substantive language of the Proposed Regulations runs
12 paragraphs, and the substantive language of the preamble runs 15 paragraphs. The Proposed
Regulations replace the one-part sovereign power test with a three-part test that includes a new
and complicated Governmental Purpose Requirement and a similarly new and complicated
Governmental Control Requirement, and we believe this proposed three-part test inevitably would
lead to many interpretive questions in an otherwise settled area of the law. The education, research
and analysis with regard to existing and new issuers will necessarily impose significant financial
burdens on issuers, and ultimately U.S. taxpayers.
If the Proposed Regulations were to be finalized, an overwhelming majority of issuers
would be expected to take any corrective action necessary to comply with the final regulations.
However, the Section believes there is widespread agreement that very few current issuers engage
in conduct susceptible of being characterized as even potentially abusive. To require all issuers to
re-examine their current status as political subdivisions and potentially make corrective changes
would be unnecessary and costly in light of the minimal level of abuse that the Proposed
Regulations appear to target.
Undue Complexity to the Federal Tax Laws
A significant portion of the May 2017 Comment Letter addresses the unnecessary and
unsupported complexity of the Proposed Regulations. The May 2017 Comment Letter, on pages
12 through 16, also notes that the Proposed Regulations, if finalized, could prove to be unworkable
and un-administrable.
The proposed three-part test would require issuers and their advisors to spend considerable
time, effort and cost evaluating whether the new requirements are satisfied, notwithstanding the
belief, stated above, that the conduct of only a few issuers could be considered even potentially
abusive. Furthermore, given the broad scope of the new proposed requirements, interpretive
questions are likely to arise adding further complexity. For example, the Government Control
Requirement may result in litigation over election processes and force changes to state laws
concerning the appointment of governing boards.
Many traditional local governmental units may have difficulty establishing that they
qualify as political subdivisions under the Governmental Control Requirement of the Proposed
Regulations. The Proposed Regulations could interfere with public-private partnerships that have
10 Reg. § 1.103-1(b).
- 5 -
long been acceptable and could impose unnecessary cost and complexity that is contrary to current
goals of incentivizing improved and new infrastructure. Although limited grandfathering is
provided for “pre-existing” issuers, the new requirements would apply to existing issuers that plan
to issue debt for new purposes as well as new issuers.
Statutory Authority of the IRS
The Section believes that any change to the definition of political subdivision status is a
Congressional matter given the current long-standing and straightforward test for what is a political
subdivision. As stated in the May 2017 Comment Letter on page 5, “even in 1937, the Attorney
General refused to depart from the previous Attorney General’s analysis in 1914, because the
definition of political subdivision was already too entrenched to be changed. The Attorney General
conceded in the 1937 opinion that, after 22 years of consistent application of the definition of a
political subdivision, ‘any change in policy should be made only in accordance with legislative
direction or judicial decision.’ If the definition was too entrenched to change administratively in
1937, then the passing of almost 80 years has only solidified it.”
A political subdivision should continue to be – as it has always been – a municipal
corporation or a division of that state or local government to which the state has delegated a
substantial amount of at least one of the three sovereign powers. This approach respects
constitutional principles of comity. Care is needed to avoid disturbing intergovernmental relations
by imposing federal standards on inherently state law arrangements for the distribution of
sovereign rights
Chevron U.S.A. v. Natural Resource Defense Council Inc. 11 provides that when a court
reviews an agency’s construction of a statute that it administers, the first inquiry is “whether
Congress has directly spoken to the precise question at issue. If the intent of Congress is clear that
is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously
expressed intent of Congress.” Here, we believe that Congress’ intent is clear. In providing an
overview of the changes to the then present law, H. Rep. 99-426 at 519 states that:
The determination of whether an entity is a qualified governmental unit continues
to be made in the same manner as under present law. In general, therefore, an entity
is a political subdivision (and therefore a qualified governmental unit) only if it has
more than an insubstantial amount of one or more of the following governmental
powers: the power to tax, the power of eminent domain, and the police power (in
the law enforcement sense).
In providing a summary overview of the amendments to the then present law, H.R. Conf. Rep. No.
841, 99th Cong. 2d Sess. (1986) at 447 states that “[t]he conferees intend that, to the extent not
amended, all principles of present law continue to apply under the reorganized provisions.” This
legislative history not only states that it is the intent of Congress to continue present law, but it
goes on to state the standard – i.e., the one-part sovereign power test. The intent of Congress has
11 467 U.S. 837, 842 (1984).
- 6 -
been unambiguously expressed, and under Chevron, courts and the Service must give that intent
effect.
In the interest of time, the Tax Section now submits these comments regarding the
Proposed Regulations. The Tax Section may submit comments on others of the Selected
Regulations in a later submission.
OFFICERS
Chair
William H. Caudill
Houston, TX
Chair-Elect
Karen L. Hawkins
Yachats, OR
Vice Chairs
Administration
Charles P. Rettig
Beverly Hills, CA
Committee Operations
Scott D. Michel
Washington, DC
Continuing Legal Education
Joan C. Arnold
Philadelphia, PA
Government Relations
Julian Y. Kim
Washington, DC
Pro Bono and Outreach
Bahar A. Schippel
Phoenix, AZ
Publications
Julie A. Divola
San Francisco, CA
Secretary
Catherine B. Engell
New York, NY
Assistant Secretary
Katherine E. David
San Antonio, TX
COUNCIL
Section Delegates to the
House of Delegates
Richard M. Lipton
Chicago, IL
Armando Gomez
Washington, DC
Last Retiring Chair
George C. Howell, III
Richmond, VA
Members
Alan I. Appel
New York, NY
Larry A. Campagna
Houston, TX
T. Keith Fogg
Villanova, PA
Kurt L.P. Lawson
Washington, DC
R. David Wheat
Dallas, TX
John F. Bergner
Dallas, TX
Thomas D. Greenaway
Boston, MA
Roberta F. Mann
Eugene, OR
Carol P. Tello
Washington, DC
Gary B. Wilcox
Washington, DC
Adam M. Cohen
Denver, CO
Sheri A. Dillon
Washington, DC
Ronald A. Levitt
Birmingham, AL
Christopher S. Rizek
Washington, DC
Melissa Wiley
Washington, DC
LIAISONS
Board of Governors
Pamela A. Bresnahan
Washington, DC
Young Lawyers Division
Vlad Frants
Newark, NJ
Law Student Division
Scott Woody
University Park, NM
DIRECTOR
John Thorner
Washington, DC
Section of Taxation
Suite 400
1050 Connecticut Avenue, NW
Washington, DC 20036
202-662-8670
FAX: 202-662-8682
E-mail: [email protected]
May 5, 2017
The Honorable John Koskinen
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024
Re: Comments on the Definition of Political Subdivision for Tax-Exempt Bonds and
Other Tax-Advantaged Bonds
Dear Commissioner Koskinen:
Enclosed please find a comments on the definition of political subdivision for tax-
exempt bonds and other tax-advantaged bonds (“Comments”). These Comments are
submitted on behalf of the American Bar Association Section of Taxation and have not been
approved by the House of Delegates or the Board of Governors of the American Bar
Association. Accordingly, they should not be construed as representing the position of the
American Bar Association.
The Section of Taxation would be pleased to discuss the Comments with you or your
staff if that would be helpful.
Sincerely,
William H. Caudill
Chair, Section of Taxation
Enclosure
cc: William M. Paul, Acting Chief Counsel and Deputy Chief Counsel (Technical),
Internal Revenue Service
Victoria Judson, Associate Chief Counsel (Tax Exempt & Government Entities),
Internal Revenue Service
Helen M. Hubbard, Associate Chief Counsel (Financial Institutions & Products),
Internal Revenue Service
Sunita Lough, Commissioner, Tax Exempt & Government Entities Division,
Internal Revenue Service
Thomas West, Acting Assistant Secretary (Tax Policy) and Tax Legislative Counsel,
Department of the Treasury
John J. Cross, Associate Tax Legislative Counsel, Department of the Treasury
APPENDIX A
AMERICAN BAR ASSOCIATION
SECTION OF TAXATION
COMMENTS ON THE DEFINITION OF POLITICAL SUBDIVISION FOR TAX EXEMPT
BONDS AND OTHER TAX-ADVANTAGED BONDS
These comments (the “Comments”) are submitted on behalf of the American Bar
Association Section of Taxation (the “Section”) and have not been approved by the House of
Delegates or Board of Governors of the American Bar Association. Accordingly, they should not
be construed as representing the position of the American Bar Association.
Principal responsibility for preparing these Comments was exercised by David Cholst of
the Section’s Committee on Tax Exempt Financing (the “Committee”). Substantive contributions
were made by Ellen Aprill, John Blyth, Matthias Edrich, Tina Kyle, Nancy Lashnits, Vanessa
Lowry, William McBride, Darren McHugh, Rene Moore, Mark Norell, Lillian Plata and Tim
Stratton. The Comments were reviewed by Stefano Taverna, Chair of the Committee, Todd
Cooper Vice Chair of the Committee and Clifford Gerber, of the Section’s Committee on
Government Submissions. The Comments were further reviewed by Julian Kim, the Section’s
Vice Chair (Government Relations).
Although the members of the Tax Exempt Financing Committee who participated in
preparing these Comments have clients who might be affected by the federal tax principles
addressed by these Comments or have advised clients on the application of such principles, no
such member (or the firm or organization to which such member belongs) has been engaged by a
client to make a government submission with respect to, or otherwise to influence the development
or outcome of, the specific subject matter of these Comments.
Contact: David Cholst
312-845-3862
Date: May 5, 2017
- 2 -
EXECUTIVE SUMMARY
The Committee submits these comments on proposed regulations1 that would
redefine “political subdivision” for purposes of tax-advantaged state or local bonds,2 issued
by the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the
“Service”) on February 23, 2016 (the “Proposed Regulations”) pursuant to the request in
the Proposed Regulations for comments.
Section 103(a) allows taxpayers to exclude interest on a state or local bond from
gross income for federal income tax purposes if the bond meets certain requirements.3 A
“state or local bond” is an obligation of “a state, territory, a possession of the United States,
the District of Columbia, or any political subdivision thereof.”4 Current Treasury
Regulations define the term “political subdivision” to mean “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 a state or local governmental unit.”5
The leading case interpreting the meaning of “political subdivision” under the Code
and Treasury Regulations, Commissioner v. Shamberg’s Estate,6 refers to the three classic
sovereign powers – taxation, eminent domain and police power. The Service has followed
Shamberg since the case was decided in 1944. The Service has made clear that an entity
must have the ability to exercise a substantial amount of at least one of the three sovereign
powers to be a political subdivision under current law. Neither Congress nor Treasury has
changed the language of the Treasury Regulations that defines a political subdivision since
1 Prop. Reg. §1.103-1, 81 Fed. Reg. 8870 (Feb. 23, 2016), corrected 81 Fed. Reg. 13305 (March 14,
2016).
2 Tax-advantaged bonds include tax-exempt bonds meeting the requirements of section 103 and also
tax credit and direct-pay bonds meeting the requirements of section 54A and certain other sections.
3 Unless these comments state otherwise, any reference to a “section” refers to that section of the
Internal Revenue Code of 1986, as amended, and any reference to “Regulation section” or “Reg. §”
refers to that section of title 26 of the Code of Federal Regulations.
4 Reg. § 1.103-1(a).
5 Reg. § 1.103-1(b).
6 144 F.2d 998 (2d Cir. 1944), cert. denied, 323 U.S. 792 (1945). Comm’r v. White’s Estate, 144 F.2d
1019, 44-2 U.S.T.C. 710 (2d Cir. 1944), cert. denied, 323 U.S. 792, (1945) (“White’s Estate”) was
a companion case to Shamberg and examined bonds issued by the Triborough Bridge Authority.
- 3 -
1936.7 The definition of a political subdivision stands out as one of the few issues in tax-
exempt bond law that has been largely settled for decades.
In 2013, in an examination of bonds issued by a community development district
in Florida,8 the Service, Office of Chief Counsel, released a technical advice memorandum
(the “TAM”),9 which appeared to add requirements to the longstanding definition of a
political subdivision. The TAM focused on the first clause of the regulatory definition of
political subdivision, “any division of any state or local governmental unit,” and asserted
that such language imposed an additional substantive requirement beyond the sovereign
powers requirement. The TAM concluded that, because the district was organized “to
perpetuate private control and avoid indefinitely responsibility to an operator that is
controlled directly or indirectly by a public electorate, either directly or through an elected
state or local governmental body,” the district served private interests instead of public
interests, and consequently was not a division of a state or local governmental unit and
therefore not a political subdivision. Commenters criticized the rationale of the TAM as
inconsistent with case law, other precedent and other published guidance and legislative
intent and as creating uncertainty in a settled area of law. In response to written and oral
requests from Treasury and the Service for comments on the definition of political
subdivision, the Committee submitted comments on the TAM on May 5, 2015 (the “2015
Comments”), 10 and asked the Service to withdraw the TAM and, if needed, make any
changes to the regulatory definition of political subdivision through the notice and
comment process. In response, Treasury and the Service issued the Proposed Regulations.
The Committee appreciates the responsiveness of Treasury and the Service to requests that
additional published guidance be provided and that the Committee (and others) be given
an opportunity to make public comments.
The Proposed Regulations would replace the one-part sovereign power test that
applies to a division of a state with a three-part test, adding a test relating to governmental
purpose (the “Governmental Purpose Requirement”) and a test relating to governmental
7 Regulations 94 (1936), 1 Fed. Reg. 1802, 1818 (Nov. 14, 1936). (“The term ‘political subdivision,’
within the meaning of the exemption, denotes 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 of the state or Territory.”)
8 The examination has since been closed without any conclusions on the merits.
9 TAM 201334038 (August 23, 2013).
10 Letter from ABA Section of Taxation to The Honorable John Koskinen, Commissioner of the
Service regarding Comments on the Definition of Political Subdivision (May 5, 2015), at 16
(available at
http://www.americanbar.org/content/dam/aba/administrative/taxation/policy/050515comments.aut
hcheckdam.pdf).
- 4 -
control (the “Governmental Control Requirement”). The Proposed Regulations thus
would impose additional requirements beyond the requirements the Service imposed in the
TAM even though the preamble does not cite additional precedent beyond that cited in the
TAM. The Proposed Regulations would also allow the Service to expand the definition of
political subdivision by publishing guidance in the Internal Revenue Bulletin.
The Preamble to the Proposed Regulations (the “Preamble”) states that Treasury
and the Service issued the Proposed Regulations “to clarify the definition of political
subdivision to provide greater certainty to prospective issuers and to promote greater
consistency in how the definition is applied across a wide range of factual situations.” In
public comments, Treasury and Service officials have said that they intended the Proposed
Regulations to focus surgically on the narrow problem of certain special districts that are
privately controlled. They have said that Treasury and the Service did not intend for the
vast majority of traditional issuers to be affected by the Proposed Regulations.
Nevertheless, the Committee is concerned that the broad sweep of the Proposed
Regulations will cast doubt on the status of many existing political subdivisions that, for a
variety of legitimate reasons, have governance structures and purposes that do not align
with the Proposed Regulations. The Committee is likewise concerned that the Proposed
Regulations do not provide a useful clarification of the definition of a political subdivision
and that the Proposed Regulations would provide less certainty than the existing Treasury
Regulations.
The Proposed Regulations by their scope also would apply to the determination of
private use. By changing their political subdivisions status, certain entities would not only
be prohibited from issuing tax-advantaged bonds, but they would also be treated as private
users. The private activity consequences of such a definitional change are likewise
important. For example, it is relatively common for a state agency to issue bonds, the
proceeds of which are lent to a separate subdivision of the state. Should the second
subdivision no longer be treated as a governmental user of bond financed property, the
interest on the bonds issued by the first subdivision would no longer be tax-exempt. As
written, the Proposed Regulations attempt to address private use issues through political
subdivision rules. The Committee believes that this indirect method of controlling private
use is inappropriate. A more direct approach using the private use rules under section 141
would be preferable. The Committee also believes that the Proposed Regulations are
overreaching in many specific areas. Therefore, as we discuss in greater detail below, the
Committee recommends that Treasury and the Service again propose the Proposed
Regulations with a narrower scope, incorporating the following changes:
a. Treasury and the Service should address the use-related concerns they
have identified through private activity bond regulations.
b. Requirements, if any, other than the requirement of sovereign power,
should be revised to include only indicia of being a governmental person, so that
- 5 -
governmental entities not meeting a control requirement or a governmental purpose
requirement could nonetheless be political subdivisions and not be private users if
they demonstrated sufficient other indicia of governmental entity status.
c. Although the Committee does not recommend retaining the
governmental control requirement (described below), if retained in the narrower
context of private use, it should to be changed to emphasize a lack of private control
rather than the presence of governmental control.
d. Although the Committee does not recommend retaining the
governmental purpose requirement (described below), if retained in the narrower
context of private use, it should be narrowed to avoid penalizing entities that
provide traditional benefits to private entities as well as the general public and that
present more generally accepted indicia of public purposes. In particular, the
Committee strongly recommends that the “no more than incidental private benefit”
provision be removed.
e. A more tailored approach should be used with development districts.
f. The Service should be able to treat individual entities or classes of
entities as political subdivisions without publication in the Internal Revenue
Bulletin.
- 6 -
Analysis and Recommendations
I. Background
In May 2015, this Committee provided comments to the Service regarding the
TAM. The thrust of the 2015 Comments was to point out that, to make any changes to the
definition of a political subdivision, the notice and comment process should have been used
instead of the enforcement process. The 2015 Comments noted that, in relevant precedent
and in the view of the Service up through the time of the TAM, “political subdivision status
is rarely, if ever, resolved on the basis of a lack of public purpose.” Thus, the 2015
Comments argued, there was no precedent or need for a separate public purpose
requirement in the definition of a political subdivision. As to what is now the governmental
control requirement, the 2015 Comments noted that the precedent on what makes a political
subdivision also did not contain a separate governmental control requirement. The 2015
Comments noted that in the first modern revenue rulings that describe the indicia of a
political subdivision – Rev. Rul. 77-16411 and Rev. Rul. 77-16512 – there was no
evaluation of control of the entities under consideration, and that the Service did not
describe control as an independent requirement. At most, governmental control has been
a substitute for establishing political subdivision status for an entity with relatively weak
sovereign powers, as shown in Rev. Rul. 59-393.13
The existing definition of “political subdivision” simply provides that the term
means “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. As thus defined, a political subdivision of any state or local governmental unit
may or may not, for purposes of this section, include special assessment districts so created,
such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee, school,
harbor, port improvement and similar districts and divisions of any such unit.” 14 The
regulation was last amended in July 1972.
The existing definition focuses on delegation by the state or local governmental
unit of its sovereign power to a division of such state or local governmental unit. The focus
11 1977-1 C.B. 20.
12 1977-1 C.B. 21.
13 1959-2 C.B. 457 There, a soil conservation district was determined to be a political subdivision
where the state had strong control of the district and, on dissolution, all of the district’s assets
reverted to the state, even though the district had relatively weak rule-making and taxing powers.
14 Reg. § 1.103-1(b).
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of the existing regulations comes from court precedent, specifically Shamberg15 and the
companion case of White’s Estate.16 In each case, the analysis of whether an entity is a
political subdivision depends on whether it has been delegated at least a substantial amount
of sovereign powers.
In support of the governmental control requirement (described below), the
Preamble of the Proposed Regulations cites only a single revenue ruling, Rev. Rul. 69-
453.17 Rev. Rul. 69-453 does not address political subdivisions. It instead addresses
instrumentalities, a different type of entity with different characteristics and powers. While
Treasury and the Service take the position in the Proposed Regulations that control by a
broad electorate is an essential element of a political subdivision today, it fails to cite any
authority for the proposition that an entity that has a substantial amount of one of the
sovereign powers must also be governmentally controlled to be a political subdivision.
The governmental control requirement in the Proposed Regulations, furthermore,
does not take into account the historical and longstanding realities of how many political
subdivisions are organized for legitimate government purposes. The heart of this new
standard is that control by a small faction of private interests is fundamentally not
governmental control. This is a distinction based not on precedent or legislative intent but
on an unsupported position that a political subdivision must be controlled directly or
indirectly by a large electorate because small electorates are inherently private in nature.
That position has not been accepted by the courts.18 For example, most states have
longstanding statutes pursuant to which sovereign power is delegated to entities with public
functions controlled by narrow electorates based on property ownership of benefitted
property. Examples include irrigation and flood control districts. These narrow electorates
have withstood court challenges by the Service as well as constitutional challenge and have
been effective tools of land development and management for over half a century. In
addition, many entities that have long been treated as political subdivisions for purposes of
section 103 and related sections are controlled by unelected boards that are independent of
the state and political subdivisions that formed them. Governance structures such as these
15 144 F.2d 998 (2d Cir. 1944), cert. denied, 323 U.S. 792 (1945).
16 144 F.2d 1019, 44-2 U.S.T.C. 710 (2d Cir. 1944), cert. denied, 323 U.S. 792, (1945). The Court of
Appeals for the Ninth Circuit reached a similar result in Commissioner v. Birch Ranch & Oil Co.,
192 F.2d 924 (9th Cir. 1981), which concerned the status of a [special district], Reclamation District
No. 2035. The status of a similar district as a political subdivision was later upheld by the United
States Supreme Court in the face of a constitutional challenge by residents who were not entitled to
vote because they were not landowners. Sayler Land Company v. Tulare Lake Basin Water Storage
District, 410 U.S. 719 (1973).
17 1969-2 C.B. 182.
18 See, e.g., Birch Ranch & Oil Co., supra.
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have been sanctioned by the United States Supreme Court,19 but the Proposed Regulations
question their political subdivision status simply because voting power over the
governmental unit is not dispersed over more than an arbitrary number of electors. Where
governing boards are appointed, the Proposed Regulations require appointment by a
general-purpose unit of government. In many cases, governing boards of traditional units
of government are appointed by other local government officials but not by general-
purpose units of government.
The addition of new control and voting requirements are evidence that Treasury
and the Service believe that the premise underlying the Shamberg standard – that
delegation of a substantial amount of sovereign powers is not done lightly – is no longer
true. Shamberg relies on two opinions of the U.S. Attorney General, one issued in 191420
and the other issued in 1937.21 Language in Shamberg and early precedents presuppose
that states pay close attention to the delegation of sovereign powers. The following passage
from the 1914 Attorney General’s Opinion is indicative:
Undoubtedly, the legislature might attempt to grant the power of
taxation to a district for purposes purely private, but every
presumption is against a construction to that effect, and it should
not be indulged where the purposes for which the power of
taxation have been granted have by long usage been treated as
public and have been sustained as such by the state courts.22
While from time to time23 the power of eminent domain has been delegated to
private entities to accomplish large scale projects, none of those entities were political
subdivisions because the economic benefits of their activities would not accrue to the
benefit of a governmental unit.24 Although the facts uncovered in the audit that gave rise
to the TAM have caused some to question the basic premise underlying Shamberg, the
19 See Ball v. James, 451 U.S. 355 (1981); Salyer Land Co. v. Tulare Lake Basin Water Stor. Dist.,
410 U.S. 719 (1973).
20 30 Op. Att’y Gen. 252 (1914).
21 38 Op. Att’y Gen. 563 (1937).
22 30 Op. Att’y Gen. at 254.
23 See, e.g., Rev. Rul. 57-193, 1957-1 C.B. 364.
24 For example, upon dissolution, the assets owned by those entities and built by using such strong
governmental, yet delegated, powers would not be distributed to the states. See, e.g., Rev. Rul. 83-
131, 1983-2 C.B. 184 (reversing Rev. Rul. 57-193 on grounds that when state law was changed to
allow assets to no longer escheat to the state but to the members of the electric coops, the tax status
of those entities changed and no longer qualified as political subdivisions).
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Committee sees no evidence of reduced oversight of the delegation process. Therefore,
there is no reason to believe that such oversight will not continue.
II. Political Subdivision Status is a Legislative Matter
Recent concerns expressed by federal officials about the erosion of the foundational
premises of the political subdivision definition (i.e., governmental oversight), deserve
serious inquiries that extend beyond the regulatory realm. Although it is certainly true that
the subsidy inherent in tax-advantaged debt is a federal subsidy, the subsidy flows
originally from constitutional principles of comity.25 Care is necessary to avoid disturbing
intergovernmental relations by imposing federal standards on inherently state law
arrangements for the distribution of sovereign rights. Therefore, the Committee believes
that such inquiry is a Congressional matter.
The fact that this inquiry is a Congressional matter is evidenced by the fact that the
political subdivision definition has remained virtually unchanged since an Attorney
General’s Opinion in 1914.26 Even in 1937, the Attorney General refused to depart from
the previous Attorney General’s analysis in 1914, because the definition of political
subdivision was already too entrenched to be changed. The Attorney General conceded in
the 1937 opinion that, after 22 years of consistent application of the definition of a political
subdivision, “any change in policy should be made only in accordance with legislative
direction or judicial decision.”27 If the definition was too entrenched to change
administratively in 1937, then the passing of almost 80 years has only solidified it.
The legislative history supports this conclusion. In 1986, Congress reviewed the
existing rules related to tax-exempt bonds, including the requirement that tax-exempt
bonds be issued only by states or political subdivisions of states. Many of the tax-exempt
bond provisions were revised at that time. However, with respect to the definition of
“political subdivision,” Congress was quite clear that the existing standard based on
Shamberg did not need to be changed, clarified or restricted. Congress understood that
bond issuers needed to possess substantial sovereign powers in order to issue tax-exempt
25 While in South Carolina v. Baker, 485 U.S. 505 (1988), the Court implied that there was little
constitutional protection of the right to issue tax-exempt bonds, commenters have indicated that
there may remain certain constitutional protections related to tax-exempt financing. Support for the
continued constitutional protection of tax-exempt interest on municipal bonds may be found in the
following articles: Maxwell A. Miller & Mark A. Glick, The Resurgence of Federalism: The Case
for Tax-Exempt Bonds, 1 TEX. REV. L. & POL. 25 (1997); Patricia A. Trujillo, Municipal Bond
Financing After South Carolina v. Baker and the Tax Reform Act of 1986: Can State Sovereignty
Reemerge? 42 TAX LAW 147 (1998).
26 30 Op. Att’y Gen. 252 (1914).
27 38 Op. Att’y Gen. at 566 (1937).
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bonds, but did not suggest any additional requirements. Page 1157 of the General
Explanation of the 1986 Tax Reform Act (May 4, 1987), prepared by the staff of the Joint
Committee on Taxation (the “General Explanation” or “Bluebook”), stated:
The determination of whether an entity is a qualified
governmental unit continues to be made in the same manner as
under prior law. In general, therefore, an entity is a political
subdivision (and therefore a qualified governmental unit) only if
it has more than an insubstantial amount of one or more of the
following governmental powers: the power to tax, the power of
eminent domain, and the police power (in the law enforcement
sense).28
The Proposed Regulations call to mind an earlier regulatory project with a similar
goal. In 1976, Treasury issued proposed regulations to define the requirements of a
“constituted authority” of a state or a political subdivision that is eligible to issue bonds
“on behalf of” that state or political subdivision.29 Those proposed regulations would have
imposed a governmental purpose and a governmental control requirement on an entity that
sought to qualify as a constituted authority. Those proposed regulations faced many of the
same criticisms that many stakeholders have made to the Proposed Regulations. After
sustained criticism, Treasury and the Service ultimately abandoned the constituted
authority regulations.30 While the Committee appreciates the concerns of Treasury and
the Service with the facts that formed the basis for the TAM, like the proposed constituted
authority regulations before them, the Proposed Regulations could prove to be unworkable
and un-administrable.
III. A More Targeted Approach Should Be Used
Treasury and the Service have a legitimate interest in limiting private control or
benefit from tax-advantaged financings. Treasury and the Service also expressed the desire
to surgically tackle this issue. For many types of tax-advantaged bonds, private use is not
a concern. Thus, rather than fundamentally rethinking the definition of political
subdivision, Treasury and the Service could preclude private entities that control issuers
28 General Explanation of the 1986 Tax Reform Act (May 4, 1987) at 1157. The reference continues
with footnote 46. Congress was aware that certain governmental units possessed such sovereign
powers but also qualified as section 501(c)(3) organizations. The footnote makes it clear that such
entities are treated as governmental units for purposes of tax-exempt bond rules. Although the
language is “governmental unit” rather than “political subdivision,” that is also the language used
on page 1156, where the Bluebook describes the entities that can issue tax-exempt bonds.
29 41 Fed. Reg. 4829 (Feb. 2, 1976).
30 LR-8-73, 1984-1 C.B. 592 (Jan. 1, 1984).
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from benefiting from tax-advantaged bonds through a more targeted approach in the private
use arena. Private business use is defined in Regulation section 1.141-3 as business use by
a nongovernmental person. Governmental person and nongovernmental person are defined
in Regulation section 1.141-1 (the “Private Activity Bond Rules”). Although the term
“governmental person” overlaps with the concept of “political subdivision”, they have
separate attributes.31 Since the Private Activity Bond Rules are designed to address
situations where the benefit of tax-advantaged financing has been transferred improperly
to private parties,32 those regulations should be used to address the concerns of Treasury
and the Service.
In order to better identify where narrow changes in the Private Activity Bond Rules
could be made, we should first identify the abuse the Proposed Regulations are trying to
prevent by discussing and addressing the Governmental Control and the Governmental
Purpose requirements (described below) added by the Proposed Regulations.
A. Governmental Control and Governmental Purpose
The Proposed Regulations require that a political subdivision be governmentally
controlled and serve a governmental purpose. We understand both of these standards as
attempts to limit the amount of private benefit that can be obtained via tax-advantaged
financings. The Proposed Regulations propose two new standards in this regard, by
providing that an entity is not a political subdivision if it is controlled by a private faction
or if it provides more than incidental private benefit to a private party. At the heart of these
limitations is the concept that if an entity is controlled by a very limited number of
individuals, then the entity should not be allowed to finance projects at lower interest rates
attributable to the exclusion from income that section 103 provides, because such benefit
is beyond the scope of what Congress allows.33
31 Regulation section 1.141-1 defines governmental person to include a state or local governmental
unit. State or local governmental unit is defined in both current Regulation section 1.103-1 and the
Proposed Regulations to include political subdivisions of states.
32 See Reg. § 1.141-2(a) (providing that “[t]he purpose of the private activity bond tests of section 141
is to limit the volume of tax-exempt bonds that finance the activities of nongovernmental persons,
without regard to whether a financing actually transfers benefits of tax-exempt financing to a
nongovernmental person.”). Those Regulations further provide that “[t]he private activity bond
tests serve to identify arrangements that have the potential to transfer the benefits of tax-exempt
financing, as well as arrangements that actually transfer these benefits, [and that t]he regulations
under section 141 may not be applied in a manner that is inconsistent with these purposes.”
33 Congress has specifically allowed the use of tax-exempt and other tax-advantaged bonds for the
private benefit of private persons. See, e.g., I.R.C. §142.
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1. Governmental Control and Private Factions
The Proposed Regulations define “control” as the “ongoing” power to direct
significant actions of an entity, by providing for three control tests (benchmarks). They
are: (1) the power both to approve and remove a majority of the entity’s governing board,
(2) the power to elect a majority of the governing body in periodic elections of reasonable
frequency, or (3) the power to approve or direct the significant uses of funds or assets of
the entity in advance of that use. The Proposed Regulations address neither the right to
dissolve an entity nor procedures intended to ensure the governmental purpose integrity of
the entity’s assets upon dissolution.
While the three benchmarks provide indicia of control, they should be viewed as
non-exclusive because control can be established in other ways. For example, joint powers
entities should continue to be treated as political subdivisions. Many tax-advantaged bond
issuers that have historically been considered a political subdivision were created by
multiple cities, counties and other political subdivisions, to jointly carry out their common
governmental purposes.34 Joint agencies benefit their members by bringing the advantage
of lowered construction costs for large projects and lower operation costs resulting from
economies of scale. Common examples of facilities financed by such entities are ports,
airports, transit systems, water and sewer systems, electrical power distribution and
generation facilities and joint incarceration facilities. Clarification of this point would be
desirable. In addition, the Proposed Regulations and the Preamble inconsistently use
singular and plural forms for controlling entities. While we believe that the intent was to
allow governmental control by multiple controlling entities (or electorates), clarification
on this point is desirable.
a. Voting Electorates and Size
Different voting electorates are often used for different governmental functions.
Counties or other similar entities often create districts for water and sewer or other similar
purposes. The boundaries of a school district, for example, often do not correlate with the
boundaries of a larger municipality (e.g., a city or town). Likewise, members of a
governing body of a county may be elected from voting districts whose boundaries do not
correspond with the boundaries of the water and sewer districts or other districts created
by the county. It is thus often the case that residents of a particular district will not have
any political control over a majority of the elected officials of another district. In essence,
such a district is controlled jointly by several different electorates of different districts. It
is important that such entities not be treated as privately controlled.
34 While some joint action agencies do not possess sufficient sovereign powers to qualify as political
subdivisions, other joint action agencies do possess substantial eminent domain powers and are
appropriately treated as political subdivisions under current law.
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Under the Proposed Regulations, small municipalities might have trouble
establishing that their electorates are not private factions, and therefore would fail the
governmental control test of the Proposed Regulations, particularly when the related person
concept is applied to individual voters who may belong to a small number of families.35
Even within long-established and fairly well-populated counties, a bond-issuing district
itself may have very few voters. For example, a water and sewer district containing
numerous vacation homes may have very few registered voters (because it has few legal
residents). Notwithstanding the significant property value in the district to support the
bonds, a vote for a multi-million-dollar financing of a new water and sewer system
connected to the county’s treatment plant could be submitted to a total of only four or five
eligible voters. Governmental entities should not be treated as private users of bond-
financed assets, even in the case of a very limited number of eligible voters, simply because
the size of an electorate poorly correlates with whether an entity is transferring private
benefits improperly.
b. Approval and Removal Powers
Governing boards comprising governmental officials elected by a general
electorate or appointed by another division of the state, whose officials are elected by a
general electorate, should never cause the entity not to be treated as a governmental entity,
regardless of the size of the electorate or the removal powers of the appointing division.
One of the nonexclusive benchmarks of the Proposed Regulations is the power “both to
approve and to remove a majority of the governing body of the entity.” We understand
that this definition was borrowed from Regulation section 1.150-1(e). Many governmental
units are controlled by boards or officers that are directly elected by the resident voters of
a specific geographic area. Voting by such general electorates is restricted to natural
persons. When such a general electorate controls an entity, that entity should never be
treated as controlled by a private faction, regardless of size. Many units of government are
established and controlled by boards of other governmental entities or by designated
35 The application of the “related party” definition in Regulation section 1.150-1(b) incorporates the
related person definition in section 144(a)(3), a definition that incorporates complex ownership tests
and family relationship tests designed for application at a point in time to a transaction, not the
management of an electorate. Small municipalities often include many related persons. Individuals
are related to ancestors, descendants, spouses, siblings and half siblings. Thus, an electorate
controlling a village with a population of 75 persons might be composed of as few as 25 electors
who are members of 7 families. Also, there is no clarity on how to count two unrelated individuals
for purposes of determining the number of unrelated voters, when each is related to a second
individual. Thus, to determine if the electorate is a “private faction” will require a determination of
the number of unrelated members of the electorate. The Proposed Regulations do not make clear
whether unregistered individuals who might be allowed to vote if they had registered are part of the
electorate. Records for determining how voters, or those who might be eligible to register to vote,
are related might not exist. This rule will be extremely difficult for bond counsel to apply and for
the Service to enforce in an efficient manner.
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officials who vote for the members of the governing board of a controlled entity. Such
electorates may be quite small. An official elected by a three-member board consisting of
officers who are themselves selected by state law process should also meet the appropriate
standard for governmental control.
In the case of an appointed board, whose members are appointed by elected officials
of a different governmental unit or by officials who themselves have been so appointed,
there also is no tax abuse so long as the term of appointment is reasonable and limited
under state law. The Proposed Regulations include a list of methods of establishing control
that could be read to be satisfied only when an entity has the power both to appoint and
remove without cause. We do not believe that this result is intended or appropriate. So
long as the term of appointment is reasonable, there does not appear to be a tax abuse,
regardless of the appointer’s removal powers. Therefore, whether the control is by an
electorate or a governmental unit or an elected or appointed official of another
governmental entity, the Committee believes that the power to choose and replace with
reasonable frequency should provide sufficient indicia that a private party is not extracting
impermissible private benefit from a financing and that an entity should be treated as a
governmental entity.
c. Ongoing Control Requirement
The requirement of “ongoing” control essentially distorts the legitimate
governmental purposes for which state and local governmental units often form political
subdivisions. The Proposed Regulations suggest that a state or a local governmental unit
needs to exercise operational control over the entity’s ongoing day-to-day activities.
Sometimes day-to-day control of a governmental unit is at least temporarily removed from
political control in order to allow a unit to be run professionally without interference from
a political party. State and local governmental units delegate sovereign powers to various
public entities. Their rationale for doing so and the nature and extent of control that they
exercise will vary extensively from state to state and locality to locality. State and local
governmental units also often delegate sovereign powers to a subordinate governmental
unit for administrative expediency. The Proposed Regulations’ new rule for ongoing
operational control would not only limit the sovereign’s administrative flexibility, but
could very likely impose on a state (or a local government) a degree of ongoing
involvement it sought to avoid in making the delegation or division in the first place.
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2. Governmental Purpose and Incidental Private Benefit
The Proposed Regulations require a political subdivision to serve a governmental
purpose, the determination of which is to be made based on all the facts and circumstances,
including “among other things” whether the entity “carries out the public purposes that are
set forth in the entity’s enabling legislation and whether the entity operates in a manner
that provides a significant public benefit with no more than incidental private benefit.”36
The Preamble cites Rev. Rul. 90-74,37 a ruling under section 115(1), as the basis for the
requirement that an entity must not provide more than an incidental benefit to private
persons to be a political subdivision. While Treasury and Service officials have stated
publicly that the limit on more than incidental private benefit was intended to clarify the
governmental purpose requirement, the Committee believes that it actually provides less
clarity and it is an inappropriate standard in this context.
Section 115(1) allows separately incorporated entities to exclude from their gross
income for tax purposes any income they earn in the exercise of an essential governmental
function that accrues to a state or local governmental entity. Although the requirement
does not come from the text of section 115(1), the Service incorporated it as a requirement
from the area of law applicable to section 501(c)(3) organizations. In both the section
115(1) and section 501(c)(3) contexts, the meaning of “more than incidental private
benefit” is unclear. For example, an entity often must obtain a private letter ruling from
the Service to be sufficiently comfortable that it qualifies for the exclusion from gross
income under section 115(1). These private letter rulings are the sole source of guidance
on the meaning of the incidental private benefit standard under section 115(1).
An incidental private benefit standard is inconsistent with the current regulatory
regime and the legislative history of section 103. Indeed, governmental units cannot
efficiently provide for public benefit without also providing private benefit. Although such
private benefit might in some cases be considered incidental to the public benefits obtained,
in many cases, an issuer, an examining agent or bond counsel might find it difficult to
conclude that such benefit was incidental. Public entities often provide substantial benefit
to private entities in exchange for general improvements for the public. For example, cities
often provide grants to private developers, professional sports teams or other private
persons in order to increase taxable assessed valuation, sales tax collections, income or
earnings tax collections, hotel/motel tax collections, entertainment tax collections and
rental car tax collections. Federal tax law recognizes that issuers of tax-advantaged bonds
may also provide substantial benefits to private persons so long as privately used facilities
are allocated to amounts not derived from proceeds of tax-advantaged bonds. For example,
36 Prop. Reg. § 1.103-1(c)(3).
37 1990-2 C.B. 34.
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the recently released allocation and accounting regulations38 specifically recognize eligible
mixed-use projects. If an issuer is able to allocate “qualified equity” to the privately used
portions of an eligible mixed-use project, neither section 103 nor section 141 should be an
impediment to the use of tax-advantaged financing. Last, Congress has made the
determination that certain tax-advantaged bonds,39 and therefore the issuers of tax-
advantaged bonds, may provide significant benefit to private persons. The Code already
includes provisions for ensuring that such bond issues also provide significant public
benefit.40 Because the standard under section 115 is unclear and is not appropriate for
issuers of tax-advantaged bonds, the Committee recommends that Treasury withdraw the
incidental private benefit standard.
3. Conclusions Regarding Governmental Control and Purposes
The governmental control standard is not appropriate in this context because it fails
to take into account the varying composition of electorates, and the ways in which each
one of the 50 states (and the territories) actually subdivides itself. In order to make the
rules regarding the size of an electorate administrable, a different rule that employs a
neutral factor would have to be established when evaluating whether an impermissible
private benefit is intended to be extracted from tax-advantage financings. When an
electorate is composed of individual citizens, the related person concept is not appropriate
to apply. So long as membership in the electorate is dependent only on factors that are
neutral in nature and that do not imply any allegiance to a private entity, we can take
comfort in the notion that different people will have different interests, thereby assuring an
“absence of private use.” The Committee believes that residency, citizenship and
minimum age of individuals (not of trusts, partnerships or corporations) are examples of
such neutral factors.
The incidental benefit standard within the governmental purpose standard is
likewise not appropriate in this context, for the reasons described above. Incidental may
simply be the wrong word. Regulation section 1.141-3(d)(5) provides an exception to
private use for “incidental use.” Incidental use relates to use that does not involve physical
possession.41 If this standard is applied to “incidental benefit,” it will be very hard to
conclude that a governmental entity does not provide more than incidental private benefit.
A better term might be “concomitant.” Private benefits that flow naturally from the public
38 Reg. § 1.141-6.
39 For example, qualified zone academy bonds, enterprise zone bonds, tax-exempt solid waste disposal
bonds, tax-exempt small issuer manufacturing bonds and tax-exempt multifamily housing bonds.
40 For example, the public approval requirement, the governmental ownership requirement for certain
facilities, and rate setting or approval requirements for certain facilities.
41 Incidental use under Reg. § 1.141-3(d)(5) also includes vending machines and similar facilities.
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benefits provided by the governmental unit should not disqualify the unit even if those
private benefits confer physical possession on significant amounts of property.
B. The Private Activity Bond Rules
1. Absence of Private Control
A more administrable way of assuring that a private party cannot extract excess
benefits from a bond issue (whether because its allegiances are to a private party or because
its operations fail to have a public purpose) is to make “absence of private control” a factor
in the determination of whether the entity is a governmental entity, rather than an absolute
requirement. Because the purpose of these requirements is to avoid private control, it is
more appropriate to reverse the presumption underlying that requirement. It is possible for
an entity not to be controlled either by a qualifying electorate or by a general purpose
governmental entity and yet not be controlled by any private entity (for example, a unit
controlled by a self-perpetuating board). Thus, the Private Activity Bond Rule could
prohibit private control, rather than require governmental control (“Absence of Private
Control”).
Absence of Private Control should be found whenever an electorate (referred to
herein as a “general electorate”) is open to all members of a broadly defined class such as
individual residents, regardless of its size, all in accordance with state law limitations
regarding residency for that particular unit. Absence of Private Control should be found
whenever the official is himself or herself elected by a qualifying electorate or appointed
by another official who so qualifies. There is no need to require that the appointment be
by an entity possessing substantial amounts of all sovereign powers, or for that matter any
political subdivision at all.
2. Assumption of Public Purpose if State Law is followed
An important indication of whether a governmental entity fulfills a governmental
purpose is whether the entity serves a “public purpose.” State law is the most important
indicator of whether an entity created under state law serves a public purpose. The enabling
legislation under which local governmental entities are created generally includes the
purposes for which such entities are validly created.42 In evaluating the public purpose of
an entity, the federal government should pay great deference to the state law findings, in
accordance with comity principles described above, and long-standing legal and judicial
interpretations. The role of Treasury in evaluating the public purpose of a unit of local
42 Such purposes may include providing services, fostering growth, increasing employment and
eliminating blight.
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government should be limited to ensuring a limitation on private use.43 We therefore
recommend that new standards provide for an assumption of public purpose if an entity is
validly formed under state law.
Governmental units often provide benefit to private persons even when they fulfill
their stated public purpose. For example, such governmental units (including states
themselves) often issue private activity bonds benefitting private persons. Occasionally, a
governmental unit may provide private benefits by acting outside state law authorized
activities. Treasury should clarify that private activities that would create more than
concomitant private benefit as a result of ultra vires activities of the governmental entity
should not disqualify the entity from being a governmental entity for bond issues unrelated
to such ultra vires activities.
3. Possible Alternatives
Regulation section 1.141-1(b) provides that a “[g]overnmental person means a state
or local governmental unit as defined [sec.] 1.103-1 or any instrumentality thereof [and
that i]t does not include the United States or any agency or instrumentality thereof.” A state
or local governmental unit includes any political subdivision of the state. Political
subdivisions have more than an insubstantial amount of sovereign powers and this has
always been the critical element that distinguishes them from other types of entities.
However, to be a political subdivision, an entity also must be governmental in nature. We
propose looking at common indicia of a “public” or “governmental” entity as part of the
definition of “political subdivision” rather than looking at control. Many types of entities
are “public” or “governmental” in nature. As discussed above, governmental control, in
the sense of the Proposed Regulations, by another entity or by an electorate is not the
unifying factor among different classes of governmental entities.
There are, however, common indicia of a “public” or “governmental” entity. All
political subdivisions (other than states) are formed by other governmental entities or
pursuant to state statutes to carry out a purpose of the forming entity. All governmental
entities are governed by governing bodies subject to public record laws and various public
procedural and fiduciary requirements. Further, and most importantly, assets of a
governmental entity must revert to another governmental entity if the first entity is
43 A public purpose is generally present with any governmental unit. Indeed, a simple regulatory
requirement of serving a governmental purpose would not be disruptive because governmental
purpose would always be assumed. While the Proposed Regulations indicate that the determination
will be based on, “among other things,” certain enumerated criteria, potential issuers will be
concerned that those enumerated indicia are indeed requirements. If Treasury intends that those
enumerated criteria are just possible ways of demonstrating governmental purpose, the language
should be clarified to indicate that the enumerated criteria are not required.
- 19 -
dissolved.44 All of these facts: formation by a governmental entity (or pursuant to state
statute) to address a public need; public function, or public purpose; being subject to public
record, public meeting and procedural requirements; fiduciary limitations; and limitation
on transfer of assets upon dissolution are solid indicia about the “governmental” nature of
an entity. These factors should form the basis on which a governmental entity is found on
a safe-harbor basis. These governmental entities (or divisions of the state or political
subdivision thereof), when entrusted by state law with more than an insubstantial amount
of sovereign powers, have all of the indicia of a political subdivision. This definitional
change of what constitutes a governmental person is, therefore, consistent with the
definition of political subdivision in the current Regulations.
Alternatively, Treasury and the Service could address these concerns by modifying
the anti-abuse rules currently in place in Regulation section 1.141-14. Under the general
anti-abuse rule, in some cases, bond issues could be viewed as having “a principal purpose
of transferring to nongovernmental persons (other than as members of the general public)
significant benefits of tax-exempt financing in a manner that is inconsistent with the
purposes of section 141.” In such situations, the Service has the power to measure private
use “on a basis that reasonably reflects the economic benefit in a manner different” from
the manner provided in the private use measurement rules, and the Service also has the
power to measure private payments or security “on a basis that reasonably reflects the
economic substance of those payments.” Example 1 of Regulation section 1.141-14(b)
addresses a situation where a city uses bond proceeds to build a governmentally owned
road while making a loan to a private corporation from general revenues that otherwise
would have been used to build that road. The example provides that a principal purpose of
the financing arrangement is to transfer to the corporation significant benefits of the tax-
exempt financing and provides that the Service can reallocate bond proceeds to the private
loan made to the corporation, which makes interest on the bonds taxable. The rationale
behind this example could be extended to a situation where the issuer’s benefits accrue to
a private party and could address the areas, as described above.
A third alternative could be for Treasury and the Service to add provisions to
Regulation sections 1.141-1 and 1.141-3 to clarify that failure to establish “public purpose”
or Absence of Private Control results in private use of bond financed facilities.
Modifications of Regulation sections 1.141-1 and 1.141-3 would make those uses subject
to the exceptions of Regulation section 1.141-3(c), (d) and (e) that apply to other types of
private use, subject to the same measurement rules of Regulation section 1.141-3(g) and
subject to the allocation rules of Regulation section 1.141-6.
44 In Rev. Rul. 83-131, 1983-2 C.B. 184, the Service reversed the outcome of a prior ruling, Rev. Rul.
57-193, 1957-1 C.B. 364, and determined that an electric and telephone membership corporation no
longer qualified as a political subdivision of a state when state law was amended by allowing, on
dissolution, all assets remaining after the payment of debts to be distributed among members of the
corporation rather than the state.
- 20 -
4. Development Districts
The Preamble states that Treasury and the Service are concerned about the potential
for excessive private control of development districts by individual developers and by the
inappropriate private benefit realized by developers as a result of the excessive issuance of
tax-exempt bonds by development districts. Entities whose primary purpose is to facilitate
the development of residential and commercial areas (“development districts”) are a
longstanding and critical means for development of designated geographic areas that are
not otherwise served by the surrounding governments. For example, development districts
are often responsible for street, traffic and safety improvements, water and sanitation
improvements and services, parks and recreation improvements and services and public
transportation infrastructure.
A development district generally funds governmental services by imposing
assessments or levying fees or taxes on businesses, customers, landowners or residents
within its boundaries. These assessments, fees and taxes commonly support debt service
payments on the development district’s bonds. The concept behind development districts
is that growth pays for itself. Because a development district typically only encompasses
a specific designated geographic area within the delegating governmental entity’s
boundaries, the delegating governmental entity is able to ensure that growth within a
development district pays for itself without burdening residents in surrounding areas. In
some cases, state law or the applicable approving governmental entity may require a
development district to provide services outside of its boundaries, such as water service to
neighboring districts and municipalities. In these instances, the neighboring communities
also benefit by receiving services that are at least partially funded from the growth created
by the development district.
The typical life cycle of a development district includes an initial build-out period.
The build-out period is the period of time during which public infrastructure within the
development district is financed, constructed and completed. During the build-out period,
growth in population (whether businesses, landowners or residents) accelerates but is
limited by how quickly supporting public improvements can be completed. For small
developments, this build-out period may last only a few months. For larger developments,
however, the build-out periods usually extend for several years simply because more and
larger public improvements need to be built. At the start of construction, the development
district will have a reasonable estimate of how long the build-out period will last. However,
unexpected events after development begins may extend the build-out period. Such events
can include economic downturns that reduce population growth within the area, natural
disasters or unexpected financial difficulties of the entities responsible for constructing the
public improvements on behalf of the development district or of the landowners that are
interested in developing or selling real property within the development district.
- 21 -
While businesses, landowners and residents within a governmental entity’s
jurisdiction will benefit from development within it, these benefits are concomitant with
the principal public purpose of the governmental entity. Such entities are formed and
operated in a manner that is intended not to pass the benefits of tax-advantaged financing
to any particular businesses or individuals but to develop the area as a whole. Their self-
sustaining growth benefits all residents and owners within its jurisdiction and in the
surrounding communities. In addition, governmental control of most development
districts, within the current meaning of the Proposed Regulations, will exist by the time the
build-out period is complete.
In addition, individual developers are not free from governmental controls even
during the build-out period. The governmental entity establishing the development district
usually retains the ability to dissolve it or at least to prevent it from taking actions that
contradict the applicable service plan, operating plan or legal framework within which the
development district must operate. These economic, legal and procedural controls should
be sufficient to conclude that, even during the temporary build-out period, the development
district is ultimately accountable to the public under state or local law.
Current law also supports the provision of relief for development districts. For
example, Regulation section 1.141-3(d)(4) and the legislative history of the Tax Reform
Act of 1986 already generally recognize that “temporary use by developers” can be a
legitimate use of tax-advantaged bond proceeds. Similarly, for example, in Rev. Rul. 82-
21,45 even prior to the existence of a specific exception for temporary use, the Service
concluded that the existence of a private holdover tenant in a building would not cause
bonds used to finance the acquisition of the building to have disqualified private activity.46
The ruling provides further support for the concept that private use during an initial period
should not affect the status of bonds that were not issued for purposes of providing that
private use.47
We believe that the Proposed Regulations have not sufficiently taken into account
the public benefits provided by development districts, and that the Proposed Regulations
also do not take into account the statutory safeguards under state law and current law
described above. State and local law generally govern the creation of development districts
45 1982-1 C.B. 17.
46 The ruling predates the Code (enacted in 1986) and so it uses the terms “major portion” and “trade
or business test,” which, if satisfied, would have caused the bonds to become “industrial
development bonds.” These concepts are similar to the current law terms “private business use test”
and “private activity bonds.”
47 Rev. Rul. 82-21, 1982-1 C.B. 17, specifically distinguishes Rev. Rul. 77-352, 1977-2 C.B. 34, which
ruled that an issue of bonds satisfied the trade or business test where the building purchased with
bond proceeds was purchased specifically for the purpose of leasing it to private persons.
- 22 -
by governmental entities. Development districts are legally separate entities that are
typically delegated substantial and significant sovereign powers by a governmental entity,
usually the power to tax or the power of eminent domain. Development districts can be
created by legislative action, court action or public referendum, and any such creation
usually involves agreement and approval by a governmental entity that would be
considered a political subdivision under the Proposed Regulations. Often, before a state or
local governmental unit creates a development district, it will hold public hearings to
receive additional public input. Usually, the state or local governmental entity that created
the development district maintains oversight over the entity by virtue of the ability of the
state or local governmental entity to repeal the development district’s authorizing
legislation, or by failing to renew the development district’s operating or service plan or
other authorizing charter, or by requiring regulatory approval of ongoing capital
expenditures. Therefore, we recommend that development districts be treated as
governmental entities under the Private Activity Bond Rules, unless they fail to show the
indicia described above.
The availability of such governmental person status for development districts could
be made subject to anti-abuse limitations, such as being available only to development
districts that do not deliberately alter their boundaries (i.e., gerrymander) while under
private control to exclude eligible members of the “general electorate” from partaking in
any necessary public approval requirement under state law or that change state law by
making board member appointments for life. The general three-year transition rule for
entities formed within 30 days of the finalization of the Proposed Regulations does not
provide sufficient relief for a development district. As noted above, the build-out period
can vary significantly between smaller developments and larger developments, including
as a result of unexpected circumstances that would not be within the control of a
development district. Therefore, any safe-harbor relief should not prescribe a specific
maximum term of years for the build-out to occur.
IV. Municipal Corporations
While Regulation section 1.103-1(b) currently defines the term “political
subdivision” 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” (emphasis added), the Proposed Regulations do not treat municipal
corporations as per se governmental units. The current Regulations recognize that a state
could have two types of divisions – those that have been expressly delegated more than
insubstantial sovereign powers and those that are municipal corporations. The Committee
is not aware of municipal corporations that do not have sovereign powers. Nonetheless,
the proposed definition is too narrow to cover the vast range of state and local governmental
entities that have been established over the decades. Many states incorporate many types
- 23 -
of local units as “municipal corporations.”48 For example, local governmental units within
the states of Arizona, Ohio, Massachusetts, Maryland and West Virginia, among others,
incorporate and are referred to as “municipal corporations.” Although a city and/or a
county may be designated by state statute as a municipal corporation, many other types of
entities are as well.
We understand that the term “municipal corporation” has no clear federal definition
and the meaning of “municipal corporation” under state law varies by state. Generally, we
believe that the federal government should defer to state law concerning the manner in
which a state decides to subdivide itself. The Proposed Regulations state that among
others, political subdivisions include general purpose governmental entities such as cities
and counties and special purpose governmental entities such as special assessment districts.
The universe of political subdivision issuers cannot be fully described by the three
examples of cities, counties and special assessment districts. Many special purpose
districts use other sources of revenues (taxes or operating revenues), not assessments of
property owners, to operate and maintain their facilities as well as pay the debt service on
their debt obligations. There are many special purpose districts that are not assessment
districts and are designated by state statutes as municipal corporations. For example,
various utility districts, public parking districts, transportation districts, community
development districts, school districts, community college districts, state universities, port
districts, airport authorities and other entities may use revenues from the general public to
pay, in whole or in part, operating costs and debt service.
Any entity that a state has seen fit to provide with substantial amounts of taxing,
police and eminent domain power, such as is the case of municipal corporations, is clearly
a division of that state and should have the same abilities to issue tax-advantaged bonds as
that state itself. It may be that in most cases such entities would also meet the other
requirements of the Proposed Regulations, but the inquiry might be difficult and a clear
conclusion about the governmental control or governmental purpose requirements might
be unnecessarily burdensome to obtain. Therefore, the Committee cannot see a compelling
rationale for removing the provision that municipal corporations are, per se, political
subdivisions. Furthermore, and more simply, because we recommend that the definition of
political subdivision not be changed and a more narrow approach in the Private Activity
Bond Rules be taken, we believe that the definition of a municipal corporation should
remain unchanged as well.
48 In fact, the District of Columbia (though treated as a state under the Proposed Regulations) is
designated as a municipal corporation in the original federal authorizing legislation and in the
District’s own Official Code. D.C. Official Code Sec. 1-102.
- 24 -
V. Guidance Through Internal Revenue Bulletin
The Proposed Regulations provide that the Service can publish guidance in the
Internal Revenue Bulletin setting forth additional circumstances in which an entity
qualifies as a political subdivision. 49 The circumstances (or indicia) upon which a
determination of whether an entity qualifies as a governmental entity under the Private
Activity Bond Rules should be clearly set forth in those regulations without any further
need for additional guidance. The Service may find that some entities may present
situations for which a private letter ruling or technical advice memorandum would be
appropriate. It should also be possible for the enforcement arm of the Service – Tax
Exempt Bonds – to enter into closing agreements dealing with the status of an entity as a
governmental entity. This type of guidance and these agreements, however, are not
published in the Internal Revenue Bulletin. Therefore, we believe that the requirement for
publication in the Internal Revenue Bulletin should be removed.
VI. Conclusion
Treasury should substantially amend and propose the Proposed Regulations.
Treasury should not change the existing test for political subdivision status, which is an
issue that extends beyond the regulatory realm. As the legislative history of the Tax
Reform Act of 1986 and legal precedent show, political subdivision status is a
Congressional matter. A political subdivision should continue to be, as it has always been,
an entity which is a municipal corporation or a division of that state or local government
to which the state has delegated a substantial amount of at least one of the three sovereign
powers.
This Committee believes that the perceived abuse is an overreaction to a highly
unusual factual situation that discounts the many benefits provided by development
districts. Furthermore, this Committee believes that a narrow revision to the private
activity bond rules would be sufficient to address the concerns described in the preamble
to the Proposed Regulations. Treasury and the Service should remove the governmental
purpose and the governmental control requirements, by adopting governmental entity safe-
harbor indicia, evidencing an absence of private purpose and an absence of private control
in the private activity bond rules. Any public purpose criterion included in the indicia
should be deferential to state law. Finally, a section 115(l) standard should not be
incorporated in this area of law.
49 Prop. Reg. § 1.103-1(c)(5).
OFFICERS
Chair
Armando Gomez
Washington, DC
Chair-Elect
George C. Howell, III Richmond, VA
Vice Chairs
Administration
Leslie E. Grodd
Westport, CT
Committee Operations
Thomas J. Callahan
Cleveland, OH
Continuing Legal Education
Joan C. Arnold
Philadelphia, PA
Government Relations
Peter H. Blessing
The Honorable John Koskinen
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224
May 5, 2015
Section of Taxation
Suite 400
1050 Connecticut Avenue, NW
Washington, DC 20036
202-662-8670
FAX: 202-662-8682
E-mail: [email protected]
New York, NY
Pro Bono and Outreach
C. Wells Hall, III
Charlotte, NC
Publications
Alice G. Abreu
Philadelphia, PA
Secretary
Thomas D. Greenaway
Boston, MA
Assistant Secretary
Catherine B. Engell
New York, NY
COUNCIL
Section Delegates to the
House of Delegates
Richard M. Lipton
Chicago, IL
Susan P. Serota
New York, NY
Last Retiring Chair
Michael Hirschfeld
New York, NY
Members
Jody J. Brewster
Washington, DC
Julie Divola
San Francisco, CA
Fred F. Murray
Washington, DC
Charles P. Rettig
Beverly Hills, CA
Bahar Schippel
Phoenix, AZ
Megan L. Brackney
New York, NY
Lucy W. Farr
New York, NY
Mary A. McNulty
Dallas, TX
John O. Tannenbaum
Hartford, CT
Stewart M. Weintraub
West Conshohocken, PA
Alan I. Appel
New York, NY
Larry A. Campagna
Houston, TX
T. Keith Fogg
Villanova, PA
Kurt L.P. Lawson
Washington, DC
Cary D. Pugh
Washington, DC
LIAISONS
Board of Governors
Pamela A. Bresnahan
Washington, DC
Young Lawyers Division
Travis A. Greaves
Washington, DC
Law Student Division
Lauren Porretta
New York, NY
DIRECTOR Janet J. In
Washington, DC
Re: Comments on the Definition of Political Subdivision.
Dear Commissioner Koskinen:
Enclosed please find comments requesting guidance on the definition of political
subdivision for tax exempt bonds and other tax-advantaged bonds (“Comments”). These
Comments are submitted on behalf of the American Bar Association Section of Taxation
and have not been approved by the House of Delegates or the Board of Governors of the
American Bar Association. Accordingly, they should not be construed as representing the
position of the American Bar Association.
The Section would be pleased to discuss the Comments with you or your staff if
that would be helpful.
Sincerely,
Armando Gomez
Chair, Section of Taxation
Enclosure
cc: Mark J. Mazur, Assistant Secretary (Tax Policy), Department of the Treasury
Emily S. McMahon, Deputy Assistant Secretary (Tax Policy), Department of the
Treasury
Tom West, Tax Legislative Counsel, Department of the Treasury
William J. Wilkins, Chief Counsel, Internal Revenue Service
Victoria Judson, Associate Chief Counsel (Tax Exempt & Government Entities), Internal
Revenue Service
Sunita Lough, Commissioner, Tax Exempt & Government Entities Division, Internal
Revenue Service
APPENDIX B
AMERICAN BAR ASSOCIATION
SECTION OF TAXATION
COMMENTS ON THE DEFINITION OF POLITICAL SUBDIVISION FOR
TAX EXEMPT BONDS AND OTHER TAX-ADVANTAGED BONDS
These comments (the “Comments”) are submitted on behalf of the American Bar
Association Section of Taxation (the “Section”) and have not been approved by the House of
Delegates or Board of Governors of the American Bar Association. Accordingly, they should
not be construed as representing the position of the American Bar Association.
Principal responsibility for preparing these Comments was exercised by Mark Norell of
the Section’s Committee on Tax Exempt Financing (the “Committee”). Substantive
contributions were made by David Cholst, Matthias Edrich, James Eustis, Carol Lew, Scott
Lilienthal, Vanessa Lowry and Victoria Ozimek. Assistance was also provided by Courtney
Chen of the American Bar Association’s Law Student Division. The Comments were reviewed
by Nancy M. Lashnits, Chair of the Committee, Stefano Taverna, Vice Chair of the Committee,
John O. Swendseid, of the Section’s Committee on Government Submissions. The Comments
were further reviewed by Peter H. Blessing, the Section’s Vice Chair (Government Relations).
Although the members of the Tax Exempt Financing Committee who participated in
preparing these Comments have clients who might be affected by the federal tax principles
addressed by these Comments or have advised clients on the application of such principles, no
such member (or the firm or organization to which such member belongs) has been engaged by a
client to make a government submission with respect to, or otherwise to influence the
development or outcome of, the specific subject matter of these Comments.
Contact: Mark O. Norell
(212) 839-8644
Date: May 5, 2015
1
EXECUTIVE SUMMARY
These Comments are submitted in connection with the 2014-2015 guidance project
announced by the Department of the Treasury (“Treasury”) and the Internal Revenue Service
(the “Service”) regarding the term “political subdivision.”1
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
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.”
2
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
3
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.
4
DISCUSSION
I. DISCUSSION OF THE 2013 TAM
The 2013 TAM outlines a two-part test for determining whether an entity may issue
bonds the interest on which is exempt from gross income for federal income tax purposes. This
test requires both that (1) the entity be “a division of a state or local government” and (2) it be
delegated sufficient sovereign powers.5
Because of questions about control from the Service, the Issuer in the 2013 TAM argued
that it was sufficiently controlled by the state to be a political subdivision and pointed to
numerous legal restrictions placed upon it by state law. The Service disagreed that these
restrictions were sufficient because the restrictions did not “address the fact [that] the [i]ssuer
was organized and operated to perpetuate private control and avoid indefinitely responsibility to
a public electorate, either directly or through another elected state or local governmental body.”
The 2013 TAM did not rely on any authority involving tax exempt bonds in concluding
that the issuer in the 2013 TAM is not a political subdivision. Rather, the only authority cited
was Rev. Rul. 83-131,6 which held that certain North Carolina electric and telephone
membership corporations are not exempt from diesel fuel excise taxes and other federal excise
taxes on four different grounds.7 The 2013 TAM summarizes Rev. Rul. 83-131 as follows:
[the membership] corporations did not qualify as political subdivisions, in part
because they were ‘not controlled directly or indirectly by a state or local
government,’ but rather by a board of directors ‘independent of such authority.’
After concluding that such membership corporations were not divisions of a state or local
governmental unit and did not have sufficient sovereign power to be political subdivisions, the
revenue ruling inquired whether the membership corporations would nevertheless be eligible for
excise tax exemptions because sales “could be considered to be made for the exclusive use of a
state or local government.” As described more fully below, the 2013 TAM quoted from the
discussion in Rev. Rul. 83-31 that addressed an excise tax exception and not from the analysis
that determined the political subdivision status of the membership corporations.
As discussed more fully below, Rev. Rul. 83-131 does not provide support for the new
requirements set forth in the 2013 TAM for political subdivision status, i.e., accountability to a
general electorate. Neither the language of Rev. Rul. 83-131, nor the related GCM, address the
criteria set forth in the 2013 TAM, i.e., the requirement of inherent accountability, directly or
indirectly, to a general public electorate; appropriate safeguards to prevent a private entity from
determining how the bond subsidy should be used; and a general public to which the general
electorate is responsible. If these additional requirements are to be imposed, they should be
developed through a process whereby the public is provided an opportunity to comment.
5 The “Law and Analysis” section of the 2013 TAM has two subsections: the first, “Is Issuer a Division of a State
or Local Government?” and the second, “Has Issuer been Delegated Sovereign Power?” 6 1983-2 C.B. 184.
7 The Service cites this authority with the citation signal “Cf.” which ordinarily tells the reader that the cited
authority provides only indirect support by analogy for the author’s proposition.
5
II. CURRENT LAW: CASES AND REVENUE RULINGS
In considering an entity’s political subdivision status for purposes of issuing tax exempt
bonds, the Service and Treasury should look solely to existing cases, authorities cited in those
cases, regulations and published rulings that deal directly with political subdivision status of
entities that issue tax advantaged bonds. The key authorities, in addition to the regulations, are
the three court cases, an Attorney General Opinion, and four revenue rulings, all of which are
summarized below.
A. Commissioner of Internal Revenue v. Shamberg’s Estate and the 1914 AG
Opinion
As discussed briefly above, Shamberg was one of the first cases to interpret the meaning
of “political subdivision” in the context of tax exempt bonds. Shamberg 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 (now named the Port Authority of New York and New Jersey) (the
“Port Authority”), which was created as a body corporate and politic by a compact between the
states of New York and New Jersey. The compact was approved by Congress, which granted the
Port Authority the power to build, own, and operate terminals, bridges, tunnels, and other
transportation facilities to facilitate transportation by land, water and air. The governing board of
the Port Authority was appointed equally by the Governors of both states and its assets revert to
the states upon dissolution. Each Governor has the right to veto any action of the Board of the
Port Authority. Although Shamberg is best known for articulating the three sovereign powers,
the court in Shamberg quotes and relies on two U.S. Attorney General Opinions asserting that a
political subdivision must be a public entity in addition to exercising a substantial amount of at
least one of the sovereign powers. In the first U.S. Attorney General Opinion (“1914 AG
Opinion”), Attorney General James McReynolds was asked whether a special assessment district
is a “political subdivision.”8 As quoted in Shamberg, Attorney General James McReynolds
responded by stating that:
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 a portion of those functions
of the State which by long usage and the inherent necessities of government have
always been regarded as public. The words ‘political’ and ‘public’ are
synonymous in this connection. (Dillon Municipal Corporations, 5th ed., sec. 34.)
It is not necessary that such legally constituted ‘division’ should exercise all the
functions of the State of this character. It is sufficient if it be authorized to
exercise a portion of them.9
The court in Shamberg did not set forth requirements to qualify as a division and did not
8 Attorney General McReynolds paraphrased the question as follows: “whether special assessment districts created
under the laws of the several States for the purpose of the improvement of streets and public highways, the provision
of sewerage, gas, light, and the reclamation, drainage, or irrigation of considerable bodies of land within the same
are ‘political subdivisions’ of the State within the meaning of the above proviso [the exemption from tax under the
1913 act].” 9 144 F.2d 998, at 1021. 30 Op. Atty. Gen. 252, 253 (1914).
6
address either control by a governmental unit or accountability to the general electorate. Rather,
it provides that so long as a state, acting within its constitutional powers, delegates substantial
sovereign power, the division will qualify as a political subdivision. The 1914 AG Opinion, as
well as Shamberg, expressly state that what constitutes a division is “any division’ made by
proper authorities, acting within their constitutional powers, for the purpose of carrying out a
portion of those functions of the state which by long usage and the inherent necessities of
government have always been regarded as public.” This legal view demonstrates significant
deference to states and localities in determining what will qualify as a division so long as
functions that traditionally have been regarded as public are carried out.
The 1914 AG Opinion applies the test for “political subdivision” to a special assessment
district by looking at whether the district’s functions are “public.” Shamberg cites language
stating that the “words ‘political’ and ‘public’ are synonymous” and that an entity is a political
subdivision if it exercises “public functions,”10
even if it did not have each of the three
enumerated sovereign powers.11
This language is the basis for determining if the entity is
furthering a public purpose.
B. Seagrave Corporation
In Seagrave Corporation v. Commissioner,12
the Tax Court considered whether private,
nonprofit corporations, established under general incorporation laws of various states, for the
purpose of operating volunteer fire companies, qualified as political subdivisions of the
respective states for purposes of the exclusion of interest from federal income tax on debt issued
by such corporations.
The Tax Court held that the corporations are not political subdivisions and stated as
follows:
They may be political, in the sense that ‘political’ is synonymous with ‘public,’
but they are not subdivisions of the State. It may be conceded the volunteer fire
companies perform a public function in the sense that they perform the same
function that is generally carried on by municipal fire departments. But the
volunteer fire companies here involved are not in any sense subdivisions of the
States where they are located. They were not created by any special statutes and
they received no delegation of any part of the State’s power. It is not enough that
they perform a public service. They cannot be called a subdivision of the State
unless there has been a delegation to them of some functions of local government.
The volunteer fire companies were all formed under general incorporation laws of
the various states. They do not render services prescribed by law. They perform
services prescribed by their constitutions and bylaws as do any other corporations
10
1914 AG Opinion at 253 (“If, then, the special assessment districts to which you refer be lawfully created by a
State for the purpose of exercising a portion of its public functions so defined, they are ‘political subdivisions
thereof.’”) 11
Id. (“It is not necessary that such legally constituted ‘division’ should exercise all the functions of the State of this
character. It is sufficient if it be authorized to exercise a portion of them.”) 12
38 T.C. 247 (1962) (“Seagrave”).
7
created under the general incorporation laws of the State. The fact that they were
created by virtue of and in compliance with general incorporation laws does not
mean they are clothed with any state power.
The relations between the fire companies and the municipalities they serve are
purely voluntary. No power of the State could compel them to render any
services and the State, or its political subdivision, the municipality, could not be
compelled to accept their services. They are free associations created by the
voluntary acts of their incorporators, and not by any legislative action. They can
be dissolved at the will of the corporate members.
Petitioner refers us to State statutes providing city, State, and county funds may or
shall be contributed to support volunteer fire companies; State statutes granting
exemptions from State property and excise taxes; and State statutes providing for
instruction of volunteer firemen at State expense. Such statutes do not add up to
any delegation of any part of State authority. All that such statutes do is
recognize such companies perform a public function and should be encouraged by
grants of financial aid and State tax exemptions.
Seagrave shows that there are limitations to what type of entity will qualify as a
subdivision of a state, i.e., entities formed under a state’s general nonprofit corporation law will
not qualify, even if intended to serve a public purpose. However, nowhere does the court
suggest that factors such as control, or accountability to the general public (except in the sense of
being able to be compelled to act), are requirements to qualify as a political subdivision. The
case simply stands for the proposition that a nonprofit corporation will not qualify as a
subdivision of a state where, even though performing functions of a public nature, it is formed
voluntarily under the general incorporation laws, is not compelled by law to render any services,
and can be dissolved at the will of the corporate members.
C. Philadelphia National Bank
Philadelphia National Bank and Philadelphia National Corporation v. United States of
America,13
considered whether Temple University (“Temple University” or the “University”), a
state-related school in Pennsylvania, is a political subdivision of the Commonwealth of
Pennsylvania (the “Commonwealth of Pennsylvania” or the “Commonwealth”) or whether the
obligations issued by Temple University could be treated as issued on behalf of the
Commonwealth of Pennsylvania.
Temple University had close ties with and was dependent upon the Commonwealth of
Pennsylvania, but no delegation of essential governmental functions occurred. The Board of
Trustees included 39 members: three Commonwealth of Pennsylvania ex-officio members
(Governor, Secretary of Education and Mayor of Philadelphia); 12 members appointed by the
Governor, President of the Senate and Speaker of the House; and 24 private citizens elected by
the board of trustees (“leaving the majority of non-public trustees with the power to manage and
control the university”). The University was subject to limited audit of expenditures by the
13
666 F2d 834 (3d. Cir. 1981) (“Philadelphia National Bank”).
8
Commonwealth Auditor General and the president of the school was required to make annual
reports to the Commonwealth legislature. The Commonwealth General Assembly was permitted
to set tuition rates if it made adequate appropriations, otherwise the management and control of
University affairs are conducted by the board of trustees. The Commonwealth was allowed to
provide facilities for the University.
Philadelphia National Bank (the “Bank”) sued for a refund of taxes paid on interest
received from loans to Temple University contending that Temple University is a political
subdivision. The district court concluded that the University was a political subdivision and
issued debt on behalf of the Commonwealth. On appeal, the U.S. argued that the University was
not delegated sovereign power.
The circuit court stated that the University could obtain exemption if it were deemed a
political subdivision or if it issued obligations “on behalf of” the Commonwealth of
Pennsylvania. The court noted that there is “surprisingly little decisional law on what constitutes
a political subdivision within the meaning of section 103 and notes that ‘the leading - and almost
only - cases on point’ are Shamberg and White’s Estate.”
The court noted that “the method utilized by the legislature to establish a state
relationship with Temple [University] is unique and the resulting body is not the same as a
traditional authority or political subdivision.” The court compared and contrasted the
characteristics of Temple University to the facts of each of Shamberg and White’s Estate. The
court also stated that because the case must be resolved in the context of the Code, it was
necessary to evaluate the delegation of state sovereignty discussed in Shamberg and White’s
Estate. The court concluded its political subdivision analysis by stating that “[a]t most, the
university has been given a limited authorization to exercise one small aspect of the police power
- one that has been delegated to private organizations as well. With such a minimal grant of
police power, and with no eminent domain or taxing power, Temple [University] cannot be said
to be a political subdivision.” The court did not state that the political subdivision test includes
an “accountability to the general electorate” requirement.
The court next considered whether the obligations issued by Temple University were
issued “on behalf of” the Commonwealth of Pennsylvania. The court cited White’s Estate for
alter ego principles, and cited Regulation section 1.103-1 relating to obligations issued “on
behalf of” a state or local governmental unit by constituted authorities. It then stated that a
constituted authority is a wholly owned governmentally controlled entity, performing a wholly
governmental function, [that] is created to be in effect the alter ego of the governmental unit.
The court further stated that:
[n]o such identity, control, or intent, however, exists between Temple [University]
and the Commonwealth of Pennsylvania. Nor is there any language in the
Commonwealth Act that purports to make Temple the alter ego of the state. The
wording of the statute itself and the opinion of the Pennsylvania Supreme Court in
Mooney make that apparent. We cannot say, therefore, that Temple [University]
issued its obligations “on behalf of” the Commonwealth of Pennsylvania.”
For on-behalf-of issuer status, it must be shown that the entity rises to the level of an
9
“alter ego” of the state, for which purpose identity of interest, control and intent are relevant.
The lack of control by the Commonwealth of Pennsylvania over Temple was one of the grounds
for concluding that Temple’s obligations were not issued on behalf of the Commonwealth.
Although the court addressed control, it did so only in connection with on-behalf-of
status, which became relevant only after the court had concluded that Temple University was not
itself a political subdivision of the Commonwealth of Pennsylvania. Importantly, the
Philadelphia National Bank court did not find it necessary to address the issue of Temple
University’s governing board control in its analysis of the elements required to be a political
subdivision.
D. Revenue Ruling 59-373
Rev. Rul. 59-373,14
considered whether a soil conservation district created under the
Colorado Soil Conservation Act qualified as a political subdivision. The analysis of the Service
is as follows:
For the purpose of section 103 of the Code, it has been held that divisions of a
state which are formed to achieve a recognized public purpose and whose revenue
and assets inure only to the benefit of the state constitute political subdivisions of
the state even though the sovereign powers delegated to the division are limited in
degree (citations omitted).
In the instant case, the soil conservation districts of the State of Colorado are
created to carry out a recognized public purpose and are vested in this regard with
limited rule making and taxing powers. Prior to their dissolution, their revenues
and assets are available only for the purpose of carrying out soil conservation
programs and, upon dissolution, the assets of a conservation district are sold and
the net proceeds are deposited with the State Treasurer to the credit of the state
board to defray the costs of establishing other soil conservation districts. If at any
time after such fund is established there shall be no soil conservation districts in
existence in the state, then any balance remaining in the state fund shall be
transferred to the general fund of the State.
Accordingly, it is held that soil conservation districts created under the laws of the
State of Colorado constitute political subdivisions of that State within the
meaning of section 103 of the Code. Therefore, interest on obligations issued by
such districts is excludable from gross income of recipients thereof in computing
their Federal income tax liabilities.
Rev. Rul. 59-373 demonstrates the facts and circumstances nature of political subdivision
status. A facts and circumstances analysis is appropriate because the governmental purposes to
be achieved by any particular entity will vary significantly across political subdivisions and the
types of sovereign power (tax, police and eminent domain) needed to achieve the governmental
purposes will vary from case-to-case. States would presumably wish to be careful not to
14
1952-2 C.B. 37.
10
delegate more sovereign powers than are necessary to achieve the desired governmental purpose.
Despite limited rule making and taxing power, the soil conservation district in Rev. Rul.
59-373 was determined to be a political subdivision, implying that “weak” sovereign powers can
be shored up with strong control and historic public purposes.15
E. Revenue Ruling 73-563
Rev. Rul. 73-563,16
addressed whether a rapid transit authority (the “RTA”) qualified as a
political subdivision of a state. The RTA, a public corporation, was created by an act of the state
legislature to plan, acquire, finance, maintain and administer a rapid transit system within a
specific geographic area encompassing several participating counties. The development of a
mass transit system by the RTA was declared to be an essential governmental function by the
state constitution. The governing body of the RTA was the board of directors comprised of
members appointed by each of the participating local governmental bodies.
Rev. Rul. 73-563 states the following with regard to the standard for being a political
subdivision for purposes of issuing tax exempt bonds:
Section 1.103-1 of the Income Tax Regulations provides, in part, that the term
“political subdivision” denotes 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.
Three generally recognized sovereign powers of states are the police power, the
power to tax, and the power of eminent domain (citations omitted).
The RTA was not authorized to exercise directly the power to tax and the power of
eminent domain. Instead, the state legislature conferred the benefit of such powers on the
authority by providing channels through which such powers may be exercised by the
participating local governmental bodies to assist the authority. The authority had the power to
set rates, determine routes, and enforce its regulations by maintaining a security force and was,
thus, considered to possess police powers. The ruling found that the authority was granted a
sufficient portion of the sovereign powers of the state to perform the essential governmental
function for which it was created and concluded that the authority qualifies as a political
subdivision of the state within the meaning of Regulation section 1.103-1.
F. Revenue Rulings 77-164 and 77-165
Rev. Rul. 77-164,17
considered whether a community development authority (the “CDA”)
created by the legislature of a state qualified as a political subdivision within the meaning of
15
See GCM 36994 (sovereign power can exist “in a minor degree” but all facts and circumstances must be
considered including public purpose and control). Additionally, the Service noted that a majority of the governing
board of the soil conservation district was elected by landowners in the district with no discussion of how many
landowners were necessary to constitute a “general electorate.” 16
1973-2 C.B. 24. 17
1977-1 C.B. 20.
11
Regulation section 1.103-1(b). The CDA was created under state laws, which allowed a private
developer to petition a county to establish a CDA within a county for purposes of encouraging
and overseeing the orderly development of a new community. Under the state law, the CDA had
the power to impose, collect and receive service and user fees and other charges to cover the
costs of carrying out the purpose of developing new communities by three methods: an income
charge, a flat fee, or a valuation charge. Such fees were to be used for the construction,
operation and maintenance of community buildings, recreation facilities, streets, lighting, and
other capital improvements that would benefit the property owners. The CDA was also
empowered to enter into agreements with the county whereby the county could, in its discretion,
acquire property by eminent domain for the CDA. State laws provided that the CDA had no
power or authority over (1) zoning or subdivision regulation, (2) fire or police protection, or (3)
water supply or sewage treatment and disposal unless such services could not be obtained from
existing political subdivisions. The CDA had the power to adopt and enforce rules as to the use
of community facilities, but such power did not invalidate the exercise of police power by a
municipal corporation. The exercise of police power by a municipal corporation would prevail
in the case of a conflict of powers exercised by both the CDA and the applicable municipal
corporation.
Rev. Rul. 77-165,18
considered whether a certain state university qualified as a political
subdivision within the meaning of Regulation section 1.103-1(b). The university was established
under state law and supported by legislative appropriations from general funds. The state
university was authorized to create a police force for the purpose of regulating traffic, motor
vehicles and speed limits only on its campus and to issue citations, impose fines, and arrest
persons for the purpose of detaining them until the city police arrived. Under state law, the
legislature was permitted to make limited and specific delegations of the state’s power of
eminent domain to the university by passing specific legislation stating the purpose for which
exercise of the power by the university was restricted. Several delegations had been made for
purposes such as acquiring a residence hall and a university dining hall.
Both revenue rulings set forth the following language to be used as the standard for being
a political subdivision for purposes of issuing tax exempt bonds:
Section 1.103-1(b) of the regulations provides, in part, that the term “political
subdivision” denotes any division of any state or local governmental unit that is a
municipal corporation or that has been delegated the right to exercise part of the
sovereign power of the unit.
Three generally acknowledged sovereign powers of states are the power to tax,
the power of eminent domain, and the police power (citations omitted). It is not
necessary that all three of these powers be delegated. However, possession of
only an insubstantial amount of any or all sovereign powers is not sufficient. All
of the facts and circumstances must be taken into consideration, including the
public purposes of the entity and its control by a government. (emphasis added)
Rev. Rul. 77-164 concluded that (1) the CDA’s power to impose and collect service and
18
1977-1 C.B. 21.
12
user fees was not analogous to the power to tax, (2) the CDA was not vested with any power of
eminent domain, and (3) the CDA did not possess police power, and concluded that the CDA did
not qualify as a political subdivision within the meaning of Regulation section 1.103-1(b). GCM
36994, which reviewed the revenue rulings prior to their release, specifically considered
restrictions placed on sovereign powers and stated that the critical inquiry is not whether the
power is somewhat restricted but whether the actual power exists.
Rev. Rul. 77-165 concluded that (1) support by legislative appropriations was not the
equivalent of the exercise of the power of taxation, (2) the right to exercise the power of eminent
domain in specific projects designated by the legislature did not represent a substantial right to
exercise the power of eminent domain, and (3) the limited power of regulating traffic within its
confines and a limited arrest power are not a delegation of a substantial police power.
Accordingly, the state university did not qualify as a political subdivision.
These rulings appear to be the first time that the Service specifically stated that all the
facts and circumstances must be taken into account and mentioned as such circumstances “public
purpose” and “control by a government.” The context in which the statement was made is very
important. The context indicates that all facts and circumstances are to be taken into account in
determining whether the entity has adequate sovereign power. The context does not suggest that
either public purpose or control by a government is a requirement of political subdivision status
independent of the inquiry into sovereign power. Furthermore, none of the authorities that we
have reviewed indicate that control is a requirement independent of such inquiry.
The notion that public purpose and control are part of the facts and circumstances when
determining if the entity has sufficient sovereign power, and that control and public purpose are
not independent requirements, is further captured in the language of GCM 36994, which
reviewed and analyzed Rev. Rul. 77-164 and Rev. Rul. 77-165 prior to the revenue rulings being
finalized. GCM 36994 states as follows:
The definition provided in Treas. Reg. § 1.103-1(b) has been construed, clarified
and acknowledged in a significant number of cases and rulings (citations omitted).
Though the concept of “sovereign power” has not been conclusively defined and
the required quantity of such power has not been specified with numerical
accuracy, the meaning of “part of the sovereign power” of the state, as used in
Treas. Reg. § 1.103-1(b), is well understood. “Sovereign power” has been
recognized, in general, to include “the powers of taxation and eminent domain
and the police power.” G.C.M. 36832 at 7. An entity need not possess all three
of those powers, but whatever powers the entity does possess must be substantial
in their effect, as are the enumerated powers, as well as in amount. See
Commissioner v. Shamberg’s Estate …. Whatever doubt exists as to exactly what
constitutes the minimum amount of required “sovereign power” this Office is
unprepared to concede that the possession of only one sovereign power is
sufficient. We arrive at this conclusion after considering that the enumerated
sovereign powers (taxation, eminent domain, police) can exist in an entity in only
a minor degree and recognizing that all the facts and circumstances must be taken
into consideration, including the public purposes of the entity and control of the
entity by a government (See Rev. Rul. 71-485)…
13
GCM 36994 further states that “we consider the meaning of ‘political subdivision’ for
purposes of ection 103(a)(1), to be well settled.” Nowhere does either revenue ruling or the
GCM indicate that control or public purpose are stand-alone requirements. The sentence that
mentions “all the facts and circumstances must be taken into consideration, including the public
purposes of the entity and control of the entity by a government” addresses whether the entity
has sufficient enumerated sovereign powers. If either control or public purpose was intended as
a requirement independent of the sovereign power inquiry, GCM 36994 would have provided a
discussion on control and public purpose, particularly in light of the fact that prior authorities did
not mention control and public purpose as independent requirements. Significantly, neither
ruling discussed how the governing board of the entity in question was selected or made any
reference to a general electorate as a necessary factor.
III. ANALYSIS
A. Introduction
This section first provides a brief summary of Rev. Rul. 83-131 and shows that reliance
on Rev. Rul. 83-131 in the 2013 TAM is misplaced. Second, the section sets forth why the
Service should rely exclusively on authorities (cases and revenue rulings) addressing political
subdivision status in the tax advantaged bond area. Third, we address considerations pertinent to
potential new regulations addressing political subdivision: public purpose, division status, and
control.
B. Rev. Rul. 83-131
Rev. Rul. 83-131 reversed a prior revenue ruling which held that certain North Carolina
electric and telephone membership corporations qualified as political subdivisions for purposes
of excise tax exemptions.
Rev. Rul. 83-131 essentially has four conclusions: (1) “the [membership] corporations
… are not divisions of a state or local government unit but are financially autonomous and not
controlled by a state or local government,” (2) “the [membership] corporations do not have
sufficient sovereign power to qualify as political subdivisions,” (3) because “the membership
corporations are not controlled directly or indirectly by a state or local government [, but
instead,] the business and affairs of the corporations are controlled by a board of directors that is
independent of such authority,” the membership corporations do not qualify for the excise tax
exception based on control by an agency of a state or local government, and (4) the membership
corporations do not satisfy the excise tax exception for organizations performing a traditional
governmental function on a nonprofit basis” because “neither providing electric services nor
providing telephone services is a traditional governmental function because electric and
telephone services are not generally provided by state or local governments directly.”
The thinking of the Service on “division” and control notions is apparent from the
following two statements in GCM 37629 (July 31, 1978), which addressed political subdivision
status in a draft of the revenue ruling prior to its release.19
19
GCM 38659 (March 19, 1981) also evaluated a draft of the Rev. Rul. 83-131 prior to it being finalized, although
14
The electric membership corporations also fail to meet the definition of political
subdivision on the ground that they are not a “division” of [a state or local
governmental unit]. The electric corporations are organized and operated by their
user members for their own benefit and without assistance from any state or local
governmental unit. The absence of stringent control of the electric corporations
by a government and the corporations’ lack of public purposes afford further
proof that the electric corporations are not political subdivisions.
…
We would also take issue with designating the telephone [membership]
corporations as ‘divisions’ of the state …. The telephone corporations are
organized and controlled by their user members and managed by a board of
directors. They are financially autonomous and their operations are solely for the
benefit of their own members. Therefore, the corporations are neither sufficiently
controlled by a government nor motivated by wholly public purposes. As a result,
the telephone corporations are not political subdivisions. (emphasis added)
In support of its ruling that the Issuer is not a political subdivision for tax exempt bond
purposes, the 2013 TAM presumably relied on the following passage from Rev. Rul. 83-131,
which addressed the control issue and held that the membership corporations in Rev. Rul. 83-131
were not divisions of a state or local governmental unit:
[T]he corporations in the present case are not divisions of a state or local
government unit but are financially autonomous and not controlled by a state or
local government. Also, they are not motivated by wholly public purposes.
Thus, the Service concluded in Rev. Rul. 83-131 and GCM 37629 that the membership
corporations were not divisions of the state of North Carolina. The above quoted language of
GCM 37629 shows that the concern of the Service in Rev. Rul. 83-131was a lack of control by a
governmental unit, and the ability of the district to operate for the benefit of the controlling
members of the Issuer rather than for “wholly public purposes.”20
Recognizing that the GCMs
GCM 38659 only addressed exclusive use excise tax exemptions. While General Counsel Memoranda provide the
rationale behind administrative ruling, they are not legal precedent, and are infrequently reviewed when evaluating
issues such as political subdivision status. See http://www.irs.gov/uac/General-Counsel-Memoranda. Accordingly,
much of the practicing bar may not even be aware of the language from GCM 37629 and GCM 38659 quoted
herein. 20
Additionally, there are significant factual differences between the 2013 TAM and Rev. Rul. 83-131. Unlike the
entities in GCM 37629 and Rev. Rul. 83-131, the entity in the 2013 TAM was not a membership corporation but
instead was a community development district formed under a specific state statute as a governmental entity for state
law purposes and controlled by a governing board elected in the district pursuant to a statutory mandated election
process. Further, on dissolution of the membership corporations in Rev. Rul 83-131, any assets remaining after
payment of debts were to be distributed among members of the corporations. Rev. Rul. 83-131 in fact revoked Rev.
Rul. 57-193, in part, on this basis, i.e., a prior version of the North Carolina statute provided for distribution of assets
to the state on dissolution. In the 2013 TAM, on dissolution, assets remaining after payment of debts were to be
distributed to a local government or political subdivision. Under the facts of the GCM, the entities in question were
membership corporations organized and operated by their user members for their own purpose and GCM 37629
stated that the absence of control of the membership corporations and a lack of public purpose were evidence that
15
are not authority, we believe that they nevertheless provide useful perspective in this regard.
After concluding that such membership corporations were not divisions of a state or local
governmental unit, Rev. Rul. 83-131 inquired whether the membership corporations would
nevertheless be eligible for excise tax exemptions because sales “could be considered to be made
for the exclusive use of a state or local government.” While explaining the application of
“exclusive use of a state or local government exception” to the facts of the electric and telephone
membership corporations,” Rev. Rul. 83-131 set forth the language actually quoted in the 2013
TAM, i.e., that the corporations are not “controlled, directly or indirectly, by a state or local
government [but rather], the business and affairs of the corporations are controlled by a board of
directors that is independent of such authority” and concluded that the membership corporations
were not so controlled by a state or local government. Thus, the language of Rev. Rul. 83-131
that is quoted from and relied on in the 2013 TAM is not part of the analysis of Rev. Rul. 83-131
that was used to determine the political subdivision status of the corporations. Instead, it
addressed one of the excise tax exceptions.
Further, Rev. Rul. 83-131 does not provide support for the accountability to a general
electorate requirement set forth in the 2013 TAM. Neither the language of Rev. Rul. 83-131, nor
the related GCM, address the criteria set forth in the 2013 TAM, i.e., the requirement of inherent
accountability, directly or indirectly, to a general public electorate; appropriate safeguards to
prevent a private entity from determining how the bond subsidy should be used; and a general
public to which the general electorate is responsible. If these additional requirements are to be
imposed, they should be developed through a process whereby the public is provided an
opportunity to comment.
C. Relevant Authorities for Definition of “Political Subdivision”
Rev. Rul. 77-143 and 78-276 state that term “political subdivision” has been defined
consistently for all federal tax purposes as denoting either a division of a state or local
government that is a municipal corporation or a division of such state or local government that
has been delegated the right to exercise sovereign power.
While the notion of a consistent definition may have been accurate at some point in time,
the Committee believes that the use of authorities addressing “on behalf of” issuer status, excise
tax exemptions, and section 115 obfuscate the analysis. This is because political subdivision
status, “on behalf of” issuer status, excise taxes exemptions, and section 115 are often considered
at the same time. While control is an important consideration with respect to “on behalf of”
issuer status, excise tax exemptions, and section 115 status, it is not a specific requirement
applicable to political subdivision status.
Such confusion is illustrated in the 2013 TAM and the Philadelphia National Bank case.
The 2013 TAM quotes language from Rev. Rul. 83-131 for control notions that is applicable to
specific excise tax exemptions that have no bearing on the status of the issuer as a political
subdivision. The Philadelphia National Bank case analyzes control of Temple University with
the entity does not qualify as a political subdivision. Neither Rev. Rul. 83-131 nor GCM 37629 stated that control is
a requirement to qualify as a political subdivision.
16
respect to on behalf of issuer status but not with respect to political subdivision status. To avoid
confusion, when issuing further guidance on the definition of political subdivision for purposes
of tax-advantaged debt, the Committee recommends that Treasury and the Service should rely
exclusively on case law and rulings relating to the issuance of tax exempt financings (i.e., the
precedents discussed above) and that the regulations carefully differentiate between political
subdivision status and other legal statuses (e.g., “on behalf of,” integral parts, and section 115
statuses).
D. Public Purpose Considerations
To qualify as a political subdivision, an entity must further a recognized public purpose.
The 1914 AG Opinion language cited by Shamberg states that the entity needs to have been
created:
. . . for purposes of carrying out a portion of those functions of the State which by
long usage and inherent necessities of government have always been regarded as
public. The words ‘political’ and ‘public’ are synonymous in this connection.
Similarly, Seagrave states that an entity “cannot be called a subdivision of the State
unless there has been a “delegation [ ] of some functions of local government.”
The concept of public purpose needs to be flexible as the necessities of government
change over time. Public purpose is not addressed at length in this comment letter because, in
our experience, political subdivision status is rarely, if ever, resolved on the basis of a lack of
public purpose. However, if Treasury and the Service plan to further define or explain what
constitutes a public purpose, any developments on this point should be addressed through
proposed regulations and, although the federal government would bear the cost, consideration
could be given to allowing significant discretion to state and local governments to determine
what constitutes a public purpose.
E. “Division” Considerations
The last hundred years have shown that a narrow or strict approach to determining when
an entity qualifies as a political subdivision is unworkable to achieve the administration of state
and local governments. Generally, division status has been found where proper authorities of a
state, acting within their constitutional powers, provide for a delegation of some of their
governmental functions and sufficient sovereign powers. Nowhere in the leading authorities or
the regulations is it suggested that accountability to the general public is a requirement to qualify
as a political subdivision. As stated above, Regulation section 1.103-1(b) simply states that a
political subdivision is “any” division, provided that there is sufficient sovereign power.
Regulation section 1.103-1 does not specify any requirements needed to qualify as a “division,”
or “political subdivision.”
The most specific precedent for what constitutes a division is the language set forth in
Shamberg and the 1914 AG Opinion, which both state that:
the term “political subdivision” is broad and comprehensive and denotes any
division of the State made by the proper authorities thereof, acting within their
17
constitutional powers, for the purpose of carrying out a portion of those functions
of the State….
This language has been in place for more than 100 years. The 1914 AG Opinion is dated
January 30, 1914 and Shamberg, which was decided 30 years later (August 24, 1944), goes on to
state:
The term ‘political subdivision’ may be used in statutes in more than one sense. It
may designate a true governmental subdivision such as a county, township, etc.,
or, as held in the Attorney General’s opinion under consideration, it may have a
broader meaning, denoting any subdivision of the state created for a public
purpose although authorized to exercise a portion of the sovereign power of the
state only to a limited degree.
The quoted language shows that “division” is intended to have a broad meaning. The
only requirements to be a “division” discussed in Shamberg are that the division be “created by
proper authorities [of a state], acting within their constitutional powers … for the purpose of
carrying out a portion of those functions of the State which by long usage and the inherent
necessities of government have always been regarded as public.”
The history of Regulation section 1.103-1 is set forth in Appendix II. The regulation has
not changed in any significant respect from its initial adoption in 1936. Minor changes were
made in 1938, 1939, 1957, 1972, and as recently as 1977. With regard to “division,” the
regulation states that a political subdivision is:
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. As thus defined, a political subdivision of any State or local
governmental unit may or may not, for purposes of this section, include special
assessment districts so created, such as road, water, sewer, gas, light, reclamation,
drainage, irrigation, levee, school, harbor, port improvement, and similar districts
and divisions of any such unit.
Regulation section 1.103-1 does not go as far as Shamberg and the 1914 AG Opinion by
stating that a division must be made by the proper authorities of a state, acting within
constitutional powers, for the purpose of carrying out a portion of the functions of a state.
Regulation section 1.103-1 does not mention control or public purpose. The only articulated
standard in the regulation is that the political division be “a division of any state or local
governmental unit” and that the division be delegated the right to exercise part of the sovereign
power of the governmental unit.
The Committee acknowledges that not every entity created pursuant to state law will
qualify as a political subdivision. For example, in Seagrave, the Tax Court found that private
nonprofit corporations established under the state’s general incorporation statute to function as
volunteer fire departments are not subdivisions despite performing public functions. The Tax
Court stated that the volunteer fire companies were not in any sense subdivisions of the
respective states and that they were not created by any special statutes, and that they received no
18
delegation of any part of the state’s power. It is not enough that they perform a public service.
They cannot be called a subdivision of the state if there has been no delegation to them of some
functions of local government.
The Committee is not aware of any judicial precedent, regulatory proposal or other
guidance, or any private letter ruling,21
that sets forth considerations or standards for being a
division of a state similar to those set forth in the 2013 TAM (e.g., inherently accountable,
directly or indirectly, to a general electorate; a democratic process to ensure that subsidized bond
financing is used for projects which the general electorate considers appropriate state or local
government purposes; safeguards to ensure that governmental units determine how the bond
subsidy should be used). The Committee believes that the division language of the regulations is
satisfied if the division is established by a proper authority of a state, acting within its
constitutional power, for the purpose of carrying out governmental functions.
F. Control and Accountability Considerations
Accountability to a governmental unit or to a general electorate can also be thought of as
“control.” Under current law, control is not an independent requirement to establish political
subdivision status. Neither Shamberg nor the 1914 AG Opinion refers to control as an
independent requirement of political subdivision status. The closest notion to control is the
language that provides that a division is to be “made by [ ] proper authorities acting within their
constitutional powers….”
In the context of tax advantaged bonds and political subdivision status, “control” was first
mentioned in Rev. Rul. 77-164 and Rev. Rul. 77-165. There was no evaluation of control of the
entities under consideration (i.e., the CDA in Rev. Rul. 77-164 or the university in Rev. Rul.
77-165). Additionally, control was not described as an independent requirement. When
evaluating whether an entity has been granted sufficient sovereign powers, all facts and
circumstances are to be considered, including control. In Rev. Rul. 59-393, despite limited rule
making and taxing power, the subject soil conservation district was determined to be a political
subdivision where the state had strong control and, on dissolution, all assets were to be provided
to the state. Rev. Rul. 59-393 establishes that where there is a minimal delegation of sovereign
power, strong control can be used to establish that an entity qualifies as a political subdivision.
In various governmental contexts, it appears that Treasury and the Service have been
moving toward a requirement of control by superior governmental units. For example, in the
context of whether an entity is an “instrumentality” for purposes of section 141, the Committee
understands that the Service will not issue a favorable private letter ruling unless the applicant
establishes control by a governmental unit. In proposed rulemaking under section 414(d),
Treasury and the Service are proposing that (a) the term political subdivision of a state be
defined as a regional, territorial, or local authority, such as a county or municipality (such as, a
municipal corporation), that is created or recognized by state statute to exercise sovereign
21
A discussion of private letter rulings (“PLR” or “PLRs”) issued to date on political subdivision status in these
comments was considered but it was decided not to include such discussion because: (1) such rulings are based on
particular facts and circumstance of a particular issuer and all relevant facts and circumstance may or may not have
been mentioned in the private rulings, and (2) PLRs have no precedential value.
19
powers, where the governing officers are either appointed by state officials or publicly elected,
and (b) in making the determination of whether an entity is an agency or instrumentality of a
state or political subdivision of a state, a significant factor is whether the entity’s governing
board or body is controlled by a state (or political subdivision thereof). Importantly, the Service
has repeatedly stated that section 414(d) provisions are not be applicable to the analysis under
section 103.
The Committee does not advocate that control should be a separate requirement for an
entity to qualify as a political subdivision. The Committee also strongly recommends against a
stringent control standard. A separate control requirement must be carefully considered and
developed, and Treasury and the Service need to be mindful that issuers with varying levels of
control by other governmental units have been in place for long periods of time. Such issuers
will need flexibility and continued access to federally subsidized financing for needed public
improvements.
However, if Treasury and the Service intend control to be an independent consideration
or otherwise to be developed as relevant to political subdivision status, that change should be
developed in proposed regulations so that all interested parties are put on notice of any potential
changes and have an opportunity to comment. Further, if control is to be developed as a
consideration, the Committee believes that a facts and circumstances analysis should be used
because the governmental purposes to be achieved by an issuer will vary significantly across
political subdivisions, and the types of sovereign powers (tax, police and eminent domain)
needed to achieve the governmental purposes will vary from case-to-case.
IV. CONCLUSION AND RECOMMENDATIONS
The legal analysis set forth in the 2013 TAM, which would impose new requirements for
qualifying as a political subdivision, is not supported by judicial, regulatory or administrative
precedent. Accordingly, we believe that the 2013 TAM should be withdrawn, or modified to
conform with existing precedent.
While we do not comment on whether the Issuer in the 2013 TAM qualifies as a political
subdivision or whether the interest on the bonds that it issued is excludable from gross income of
the holders thereof, we do recommend, however, that the Service reconsider the analysis set
forth in the 2013 TAM. Our concern is that the analysis used in the 2013 TAM imposes new
requirements for qualifying as a political subdivision that are not supported by existing legal
precedent and could call into question a variety of financing structures that have been used for
many years in many states.22
Although the 2013 TAM cannot be used as precedent, it has been and will be reviewed
22
In the 2013 TAM, the Service stresses that the Issuer was organized and operated to perpetuate private control by
the developer and avoid responsibility to a public electorate. This language suggests that the Service was concerned
with notions related to private inurement, private benefit to the developer, and private use, rather than the political
subdivision status of the Issuer. These concerns may better be addressed under the private use rules rather than on
the basis of whether an issuer is a political subdivision. A discussion of private use issues of the Issuer are beyond
the scope of these Comments.
20
by practitioners and auditors alike and creates uncertainty with regard to the standard to be
applied when evaluating political subdivision status. Audits of other issuers based on the
additional requirements stated in the 2013 TAM would be inappropriate and costly to state and
local governments. Questions also arise about the relevance and significance of the
considerations in the 2013 TAM when opinions are to be issued, particularly in the context of
issuing the unqualified opinions which are generally required of bond counsel in the tax exempt
bond market.
Given the strong need for certainty in the tax exempt transactional practice, we also
recommend that Treasury and the Service issue a Notice providing interim guidance and stating
that proposed regulations will be issued providing an updated definition of political subdivision
for purposes of issuing tax-advantaged bonds. Consistent with the recommendations of the
House of Representatives Committee on Appropriations,23
such a Notice should also state that
any change to the definition of political subdivision will apply solely on a prospective basis.
Attached in Appendix I is a suggested outline of such a Notice and several examples that might
be considered for inclusion in the Notice. Should Treasury and the Service decide to pursue a
proposed notice, the Committee would be pleased to further discuss these examples and any
proposed analysis for the determination of whether an entity qualifies as a “division” and provide
any other helpful input.
23
H. Rep. 113-508, at 20 (2014) stated:
Guidance on the Definition of Political Subdivision.--The Committee is concerned that recent
actions by the IRS have caused confusion concerning the definition of a political subdivision
under the tax exempt bond rules, including for entities long-recognized as political subdivisions,
and have resulted in the inability to move forward with or the delay of economic development
projects throughout the country. The Committee encourages the IRS to issue guidance to clarify
the definition of political subdivision, to provide opportunity for public comments prior to any
changes, and to make changes, if any, prospective.
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APPENDIX I
Outline of Proposed Notice Addressing Definition of Political Subdivision
Purpose of the Notice
Update published guidance with respect to the definition of the term political subdivision for
purposes of section 103 (Rev. Rul. 77-164 and Rev. Rul. 77-165)
Set forth examples (see below)
Background
Include description of Reg. § 1.103-1 and cases and revenue ruling set forth in the Tax
Exempt Financing Committee’s Comments
Describe concerns of the Service in this area
Describe concerns of practitioners and the industry in this area (e.g., concerns regarding
adverse effect of the TAM on construction of traditional municipal infrastructure)
Acknowledge market practice regarding delivery of unqualified opinions
Scope and Application
Treasury and the Service expect to promulgate proposed regulations
General Guidance
o Acknowledge that there are numerous different structures for governmental units/political
subdivision throughout the United States (hundreds)
o Given the variety of structures, there is a need for a “principled approach” to establishing
political subdivision status, i.e., a highly engineered approach would be inflexible and
would not work
o Totality of circumstances is to be considered
o Consider an approach similar to Announcement of Proposed Rule Making for
determining if an entity is an agency or instrumentality of a state for governmental plan
(section 414(d)) purposes, i.e., look to all facts and circumstances. Two categories of
factors, main factors and others factors; to be modified/refined to address relevant
considerations for political subdivision status.
o Discuss role of control and how it is established
o Discuss “public purpose” and how it is established
o Consider grandfathering entities in place [as of ______][for more than __ years].
Alternatively, consider grandfathering debt issued prior to the publication of Final
Regulations in the Federal Register.
Examples
Example 1 – Special Irrigation District. Special Irrigation District X was created pursuant
to the laws of State Y to provide irrigation for the area under its jurisdiction which
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encompasses a rural area with approximately 10 farms. Special Irrigation District X is
governed by an independent board of directors elected by a limited number of landowners in
its jurisdiction based upon acreage. Special Irrigation District X has the right to condemn
property and the power to impose property taxes. Special Irrigation District X is also subject
to oversight by State Y in that it must submit annual financial reports to State Y and must
follow state laws pertaining to public meetings, bonded indebtedness, recordkeeping, and
elections. Special Irrigation District X is a political subdivision.
Example 2 – Mutual Ditch Company. Mutual Ditch Company Z was created pursuant to
general non-profit cooperative corporation laws of State Y for the purpose of constructing
and operating irrigation ditches to deliver irrigation water from a reservoir to farms adjacent
to the ditches. Ten farms served by Z’s ditches and the owners are also the owners of the
rights to all of the water that flows through Z’s ditches. The owners, by virtue of their
ownership of the water rights to the water that flows through Z’s ditches, are the members of
Z, which is a membership corporation that does not issue stock. Z is governed by an
independent board of directors elected by its members, each of which has a vote that is
weighted according to the acre-feet of water rights owned by that member that are
transported in Z’s ditches. Z has the right to condemn property for the purpose of
constructing, operating and maintaining its ditches. Z is not subject to any of the laws of Y
that apply to governmental entities, such as open meeting laws, public records laws, laws on
bonded indebtedness and laws on governmental elections. Z is however subject to the same
level of supervision by the state attorney general as are other cooperative non-profit
corporations. Z does not have any of the immunity from tort liability that governmental
entities in Y typically have, and on dissolution, Z’s assets, after all of Z’s creditors are paid,
are divided among Z’s members, in the same proportion as that used to determine a
member’s weighted vote. Z is not a political subdivision because it is not a municipal
corporation or a division of state or local government.
Example 3 – General Purpose District. A tax district in state is formed under state statute
by County approval (the “District”) to provide essential governmental functions to an area
within County for which development is planned by a single private developer (“D”). At the
time of formation of the District and during an initial development period D is likely to be
the sole property owner. D intends to proceed with all reasonable speed to develop and sell
the land within the District to members of the general public for commercial use. The
District, whose board is initially elected by the sole landowner, issues bonds and uses the
bond proceeds to finance facilities for traditional governmental functions, including
extensions of municipal water systems, street construction and paving, curbs, storm water
collection, sidewalk and street-light installation, and sewage disposal. The bonds will be
repaid and secured by assessments on the property. D and the District reasonably expect that
property will be sold or ground leased long term to at least two unrelated parties who will
become eligible to elect board members and that the board will be controlled by board
members unaffiliated with the initial developer within 5 years. The District is a political
subdivision because it (i) is a division of state or local government, and (ii) has been
delegated more than an insubstantial amount of the power to tax.
Example 4 – Homeowners’ Association. Homeowner’s association (“HOA”) is formed
under state’s general non-profit cooperation laws and state’s laws governing common interest
communities. These laws requires the creation of associations organized under general for-
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profit or non-profit corporation law to govern commonly owned areas in a common interest
community and to enforce the covenants that apply to all real property within the boundaries
of the common interest community by virtue of covenants, declarations and restrictions in the
deeds to property in the common interest community. Each person who is an owner of
property in the common interest community is a member of the HOA, but only for so long
that person owns property in the common interest community. HOA provides open space
and parks, a clubhouse and swimming pool, tennis courts, and limited security services to
and for the benefit of the members of HOA, and their renters and guests. The HOA has no
power of eminent domain. It does have the right to charge assessments against all property
in the common interest community other than HOA owned property and it employs a private
security service which provides guards and other safety related services to protect HOA
owned property and limited security services for all property in the common interest
community. HOA is subject to regulation and supervision by the state as an association
governing a common interest community, which include rules about access to records, a
member’s right to attend meetings of the board of directors, and elections of directors and
elections on changes in covenants and by-laws. These rules are not the same as the public
meetings laws, public records laws and election laws applicable to governmental entities in
the state, and HOA does not have any of the immunity from tort liability that governmental
entities in the state typically have. On dissolution, HOA’s assets, after all of HOA’s creditors
are paid, are divided among HOA’s members. The HOA is not a political subdivision
because it is not a municipal corporation or a division of state or local government and it has
not been delegated more than an insubstantial amount of any of the sovereign powers of
eminent domain, taxation or the police power
Example 5 – Commercial Development District. (i) District X is a special district created
under the constitution of State Y and specifically formed under a specific state law (the
“Act”). The boundaries of District X are located entirely within City Z, which must consent
to the creation of District X prior to any election confirming the District. The stated public
purposes of District X are economic development and the expansion of commerce. The Act
specifically allows District X to develop streets, water and wastewater facilities, roads,
sidewalks, lighting, parking, rail and recreational facilities and other public facilities, and to
finance such improvements through the issuance of bonds supported by ad valorem taxes on
all property within District X if authorized by a majority of the voters. The Act may be
amended by the state legislature from time to time.
District X is expected to be a primarily commercial district. Initially, all of the property
within the boundaries of District X will be owned by a single for-profit developer
(“Developer”). As development occurs, Developer intends to sell or lease portions of the
property within the District to other commercial entities unrelated to Developer, but there is
no guarantee that such sales will occur or when they may occur.
Pursuant to provisions of the Act, temporary directors are appointed by a state agency
(the “Agency”) after receiving from the owners of a majority of the assessed value of the real
property within the boundaries of District X a petition naming such temporary directors. As
the sole landowner in District X, the Developer named the temporary directors. Pursuant to
state law, before issuing any bonds or other obligations, the temporary directors must hold an
election to confirm the establishment of District X and to elect permanent directors.
Pursuant to a valid election under state law, eligible voters in District X have authorized
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the imposition of an ad valorem tax on all property owners in District X. District X is subject
to state public meeting and public records laws applicable to governmental entities, and its
governing body members and employees are subject to state public conflict of interest,
financial reporting and disclosure and other ethics laws generally applicable to government
officials and government employees. Upon dissolution, the assets of District X will be
liquidated to pay its obligations, and the remainder distributed to City Z.
District X is a political subdivision because it (i) is a division of state or local
government, and (ii) has been delegated more than an insubstantial amount of the power to
tax.
(ii) The facts are the same as above except that eligible voters (defined under state
law to be owners of property located in District X and residents of District X) are likely to be
corporations and other legal entities that are not natural persons, and the number of resident
voters in District X is limited and is expected to remain limited. Resident voters may have a
relationship to the Developer. The fact that there will be a limited number of voters does not
prevent District X from being a division of state or local government and a political
subdivision.
(iii) The facts are the same as above except that in connection with the creation of
District X, the voters have also authorized the issuance of bonds for the purpose of extending
existing rail facilities, which are owned by a private user. The primary purpose of District X
is to further economic development by extending rail facilities, which will be accomplished
by granting proceeds of the bonds to a private user to build the additional rail facilities,
which will be owned and operated by the private user. District X will receive no payments
from such private user, and the bonds will be paid solely from the ad valorem taxes on
property within District X.
The fact that District X intends to issue bonds the proceeds of which will be used for
private business use that will indirectly benefit the Developer, who may exercise some level
of control over the election of the board of directors, does not prevent District X from being a
division of state or local government and a political subdivision.
Example 6 – Retail and Commercial Office District. (i) County A determines to promote
development of a blighted area located within its boundaries. In response to a request for
proposals issued by County A, Developer D submits a proposal for a mixed-use office and
retail development for the area. As part of the proposal, Developer D proposes the formation
of District B to finance public infrastructure for the project consisting of what will be
governmentally owned streets, sidewalks, streetlights, and water and sewer facilities. District
B is a unit of special purpose government formed under specific state law (the “Act”). The
Act authorizes the formation of special districts for the purpose of financing specified
categories of infrastructure improvements through the issuance of bonds. District B is
authorized to levy and collect more than an insubstantial amount of ad valorem taxes on all
non-exempt real property located within District B. As required under the Act, Developer D
submits a petition to County A for the formation of District B describing the proposed
infrastructure improvements, the amount of bonds to be issued, and the source of repayment
of the bonds. County A approves the formation of District B by legislative action. Initially,
Developer D is the only property owner and the only eligible elector within District B.
District B is a governmental entity under state law, e.g., it is subject to public meetings and
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public records laws applicable to governmental entities, its employees and officers are
subject to public conflict of interest, financial reporting and disclosure, and public ethics laws
applicable to public employees and officials. The election of its governing board is subject to
state’s general public election laws. Under the Act, District B must provide annual financial
reports and audits to County A. Upon dissolution, the assets of District B will be liquidated
to pay its obligations, and the remainder distributed to County A. Pursuant to the Act, the
governing board of District B is elected by eligible electors of the District, consisting of
owners of property in the District. District B is a political subdivision because it (i) is a
division of state or local government, and (ii) has been delegated more than an insubstantial
amount of the power to tax.
(ii) The result does not change if Developer D is expected to retain ownership of
substantially all of the real property located in the District for the foreseeable future and to
lease space to retail and business tenants.
Interim Guidance and Reliance
Notice provides interim guidance. Issuers of tax exempt bonds may rely on the Notice for
any actions taken with respect to tax exempt bonds on or before the effective date of Final
Regulations under section 103 that implement the guidance in the Notice.
Treasury and the Service may amend or supplement the guidance in this Notice as
circumstances warrant.
Request for Comments
Before any notice of proposed rulemaking is issued with respect to the guidance set forth in
the Notice, consideration will be given to any written public comments on the Notice that are
timely submitted.
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APPENDIX II
Legislative Acts
Tariff Act of 1913, Section II (Income Tax), Paragraph B:
That in computing net income under this section there shall be excluded the interest upon
the obligations of a State or any political subdivision thereof, and upon the obligations of
the United States or its possessions;1
Revenue Act of 1934, § 22(b)(4):
(4) TAX-FREE INTEREST.—Interest upon (A) the obligations of a State, Territory, or
any political subdivision thereof, or the District of Columbia; or (B) obligations of a
corporation organized under Act of Congress, if such corporation is an instrumentality of
the United States; or (C) the obligations of the United States or its possessions. Every
person owning any of the obligations enumerated in clause (A), (B), or (C) shall, in the
return required by this title, submit a statement showing number and amount of such
obligations owned by him and the income received therefrom, in such form and with such
information as the Commissioner may require. In the case of obligations of the United
States issued after September 1, 1917 (other than postal savings certificates of deposit)
and in the case of obligations of a corporation organized under Act of Congress, the
interest shall be exempt only if and to the extent provided in the respective Acts
authorizing the issue thereof as amended and supplemented, and shall be excluded from
gross income only if and to the extent it is wholly exempt from the taxes imposed by this
title;2
REGULATIONS
Regulations 94 (1936)3
Art. 22 (b)(4)-1. Interest upon State Obligations. – Interest upon the obligations of a
State, Territory, or any political subdivision thereof, or the District of Columbia is
exempt from the income tax. Obligations issued by or on behalf of the State or Territory
or a duly organized political subdivision acting by constituted authorities empowered to
issue such obligations, are the obligations of a State or Territory or a political subdivision
thereof. Special tax bills issued for special benefits to property, if such tax bills are
legally collectible only from owners of the property benefited, are not the obligations of a
State, Territory, or political subdivision. The term “political subdivision”, within the
meaning of the exemption, denotes 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 of the State or Territory. As thus defined, a political subdivision of a
State or Territory may, for the purpose of exemption, include special assessment districts
1 Ch. 16, 38 Stat 168 (1913).
2 Ch. 277, 48 Stat 687 (1934).
3 1 Fed. Reg. 1802, 1818 (Nov. 14, 1936).
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so created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee,
school, harbor, port improvement, and similar districts and divisions of a State or
Territory. (emphasis added)
26 CFR § 3.1-1 (1938):
3.22 (b) (4)-1 Interest upon State obligations. Interest upon the obligations of a State,
Territory, or any political subdivision thereof, or the District of Columbia is exempt from
the income tax. Obligations issued by or on behalf of the State or Territory or a duly
organized political subdivision acting by constituted authorities empowered to issue such
obligations, are the obligations of a State or Territory or a political subdivision thereof.
Special tax bills issued for special benefits to property, if such tax bills are legally
collectible only from owners of the property benefited, are not the obligations of a State,
Territory, or political subdivision. The term “political subdivision,” within the meaning
of the exemption, denotes 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 of the State or Territory. As thus defined, a political subdivision of a State or
Territory may, for the purpose of exemption, include special assessment districts so
created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee,
school, harbor, port improvement, and similar districts and divisions of a State or
Territory. (emphasis added)
Regulations 101 (1939)4
ART. 22 (b) (4)-1. Interest upon State obligations. Interest upon the obligations of a
State, Territory, or any political subdivision thereof, or the District of Columbia is
exempt from the income tax. Obligations issued by or on behalf of the State or Territory
or a duly organized political subdivision acting by constituted authorities empowered to
issue such obligations, are the obligations of a State or Territory or a political subdivision
thereof. Special tax bills issued for special benefits to property, if such tax bills are
legally collectible only from owners of the property benefited, are not the obligations of a
State, Territory, or political subdivision. The term “political subdivision,” within the
meaning of the exemption, denotes 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 of the State or Territory. As thus defined, a political subdivision of a
State or Territory may or may not, for the purpose of exemption, include special
assessment districts so created, such as road, water, sewer, gas, light, reclamation,
drainage, irrigation, levee, school, harbor, port improvement, and similar districts and
divisions of a State or Territory. (emphasis added)
4 4 Fed. Reg. 611, 634 (Feb 10, 1939) (emphasis added). See also Shamberg (“The provisions of the foregoing
Article of Regulations 94 were amended in Treasury Regulations 101, promulgated under the Revenue Act of 1938
so that the words “or may not” follow the word “may” in the last sentence.”).
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Reg. § 1.103-1(b) (1972):5
(a) 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, except as provided under section 103(c) and (d) and the regulations thereunder.
(b) Obligations issued by or on behalf of any State or local governmental unit by
constituted authorities empowered to issue such obligations are the obligations of such a
unit. However, section 103(a)(1) and this section do not apply to industrial development
bonds except as otherwise provided in section 103(c). See section 103(c) and §§1.103-7
through 1.103-12 for the rules concerning interest paid on industrial development bonds.
See section 103(d) for rules concerning interest paid on arbitrage bonds. Certificates
issued by a political subdivision for public improvements (such as sewers, sidewalks,
streets, etc.) which are evidence of special assessments against specific property, which
assessments become a lien against such property and which the political subdivision is
required to enforce, are, for purposes of this section, obligations of the political
subdivision even though the obligations are to be satisfied out of special funds and not
out of general funds or taxes. The term “political subdivision,” for purposes of this
section denotes 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. As thus defined, a political subdivision of any State or local governmental
unit may or may not, for purposes of this section, include special assessment districts so
created, such as road, water, sewer, gas, light, reclamation, drainage, irrigation, levee,
school, harbor, port improvement, and similar districts and divisions of any such unit.
(emphasis added)
5 T.D. 6220, 25 Fed. Reg. 11,402 (1956) (as amended by T.D. 7199, 37 Fed. Reg. 15,486 (1972)).
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