120 T.C. No. 12
UNITED STATES TAX COURT
CITY OF SANTA ROSA, CALIFORNIA, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 7310-00B. Filed May 13, 2003.
P petitions this Court pursuant to sec. 7478, I.R.C., seeking a declaration that interest on certain bonds will be exempt from taxation under sec. 103(a), I.R.C. P proposes to issue bonds of $140 million to finance the construction of a pipeline. The pipeline will dispose of wastewater generated in P’s subregional sewage and water reclamation system. P has entered into an agreement obligating P to deliver, and a utility company to accept, an average of 11 million gallons of wastewater per day. The utility company will use the wastewater to activate geysers and produce steam for the generation of electricity. P will receive no payments from the utility company for the wastewater. P will enter into agreements with irrigators along the pipeline obligating P to supply wastewater for consideration not to exceed 5 percent of the debt service on the bonds. At least 95 percent of the debt service on the bonds will be paid by sewer demand fees imposed on users of P’s sewage system. The sewage ratepayers use the pipeline as members of the general public. The pipeline is an integral part of - 2 -
P’s sewage system, and it was constructed for the purpose of disposing of the wastewater generated in P’s sewage treatment process.
R determined that the bonds will be private activity bonds under sec. 141(b)(1) and (2), I.R.C., and that interest on the bonds will not be exempt from taxation under sec. 103(a), I.R.C.
Held: Private business use does not exceed 10 percent of the proceeds of the bond issue. The private business use test of sec. 141(b)(1), I.R.C., is not met. The proposed bonds are not private activity bonds, and interest on those bonds will be excludable under sec. 103(a), I.R.C.
David L. Miller and David A. Walton, for petitioner.
Gary W. Bornholdt and Timothy L. Jones, for respondent.
OPINION
RUWE, Judge: This is an action for declaratory judgment
pursuant to section 7478.1 Petitioner requested a ruling from
respondent that interest on bonds it proposes to issue will be
excludable from gross income under section 103(a), and that the
proposed bonds will not be private activity bonds within the
meaning of section 141(a). Respondent determined that the
proposed bonds will constitute private activity bonds, and any
interest on the proposed bonds will not be excludable from gross
income under section 103(a). The issue for decision is whether
1 Unless otherwise indicated, all section references are to the Internal Revenue Code currently in effect, and all Rule references are to the Tax Court Rules of Practice and Procedure. - 3 -
interest on the proposed bonds will be excludable from the gross
income of prospective bondholders under section 103(a).
Background
This case was submitted fully stipulated under Rule 122.
The stipulation of facts, the stipulation as to administrative
record, and the attached exhibits are incorporated herein by this
reference.
Petitioner is a political subdivision of the State of
California and has taxing powers, police powers, and powers of
eminent domain under the constitution and laws of that State.
Petitioner owns and operates a subregional sewage and water
reclamation system, which includes facilities for collection and
treatment of sewage and other effluent, tertiary treatment of the
wastewater produced therefrom, a reservoir for storing
wastewater, pipelines, and other facilities for the
transportation of wastewater to discharge points.2 This system
serves approximately 250,000 people in central Sonoma County,
California, including the cities of Santa Rosa, Rohnert Park,
Cotati, and Sebastopol, as well as a portion of the
unincorporated area of Sonoma County. As of July 31, 1996, the
system had a capacity for 18 million gallons of wastewater per
day, which was disposed of by means of urban irrigation, created
2 Wastewater or effluent generated by petitioner’s sewage treatment process receives tertiary treatment under California Department of Health Services standards before any discharge. - 4 -
wetlands in the Santa Rosa Plain, agricultural irrigation, and
discharge to the Russian River via the Laguna de Santa Rosa.3
In recent years, population growth and other factors
prompted petitioner to find other alternatives for disposal of
wastewater. On April 18, 1995, the Santa Rosa City Council
agreed to consider five alternatives to deal with the increasing
amounts of wastewater:
Alternative 1: No Action (No Project).
Alternative 2: South County Reclamation; agricultural irrigation and associated reclaimed water storage in areas south of Santa Rosa.
Alternative 3: West County Reclamation; agricultural irrigation and associated reclaimed water storage in areas west of Santa Rosa.
Alternative 4: Geysers Recharge; injection of reclaimed water for recharge of the Geysers steamfield located in northeastern Sonoma County.
Alternative 5: Discharge; release of reclaimed water to the Russian River or Laguna de Santa Rosa at a design discharge rate of up to 20 percent of river flow.
After those alternatives were discussed and considered,
petitioner chose a modified form of alternative 4, the “Geysers
3 According to a document entitled “Comparison of Alternatives and Statement of Overriding Considerations”:
The current Basin Plan limits Russian River discharges to 1% of the flow at the point of discharge, and the City of Santa Rosa is operating under an interim permit granting discharge at up to 5% discharge of Russian River flow with permission from the Executive Officer of the Regional Water Quality Control Board. - 5 -
Alternative”, which provides for the disposal of wastewater
through a pipeline to various electric utility, industrial,
agricultural, commercial, residential, and other users. Under
this proposal, a pipeline, four pumping stations, tanks,
connection equipment, control systems, power systems, and a
storage tank will be constructed. The pipeline will be
constructed in two sections. The first section will run from the
sewage treatment plant and reservoir to the base of a mountain, a
distance of 29 miles. This section will have a capacity of 40
million gallons of wastewater per day. The second section will
run a distance of 12 miles from the base to the top of the
mountain, where a thermally active geyser steamfield is located.
This section will have a capacity of 12.1 million gallons of
wastewater per day.
On April 14, 1998, petitioner entered into an agreement with
Union Oil Co. of California, NEC Acquisition Co., and Thermal
Power Co. (collectively Company).4 Petitioner agreed to deliver
to Company approximately 11 million gallons of wastewater per day
over the 30-year term of the contract.5 In exchange, Company
agreed to accept approximately 11 million gallons of wastewater
4 Company is a “nongovernmental person” under sec. 141 and the regulations. 5 The agreement speaks in terms of an “Annual Amount” and obligates petitioner to deliver, and Company to accept, 4,015 million gallons of wastewater each year (an average of 11 million gallons per day). - 6 -
per day and also agreed to provide the electricity necessary to
operate three of petitioner’s pumping stations. The wastewater
must meet the California Department of Health Services standards
for tertiary treatment, and Company will have the right to access
petitioner’s facilities and records to test the water or verify
its quality. Company will pay no fees, directly or indirectly,
to petitioner for use of the wastewater.
Company will use the wastewater to generate electricity for
sale to customers. To do so, Company has to take the wastewater
and inject it into the ground where the wastewater will become
heated and produce steam. Petitioner will not receive any
revenues from or other interest in Company’s electricity
operation. Petitioner will provide all labor, materials, and
capital for the construction, operation, and maintenance of the
pipeline and related facilities from the existing sewage system
to a “point of delivery connection”.6 Company will provide all
labor, materials, and capital for the construction, operation,
and maintenance of additional pipeline and related facilities
from the point of delivery, as well as the electric supply
facilities for three of the four pumping stations along the
6 Petitioner is obligated to supply the wastewater at a “point-of-delivery connection”. The agreement defines the term “point of delivery” as “the point at which * * * [petitioner] delivers water to * * * [Company] located at the discharge flange of the storage distribution tanks”. - 7 -
pipeline.7 Company will own or lease the geyser steamfield, the
facilities for injecting the wastewater into the ground, the
facilities for generating electricity, and the electric supply
facilities for the pumping stations.
According to the agreement, a failure by either party to
receive or deliver the obligated amounts of wastewater will
require mediation. If mediation fails, the nondefaulting party
can either declare the defaulting party in breach of the contract
or seek specific performance.8 If Company should breach the
contract within the first 20 years of its term, petitioner can
terminate the contract and collect liquidated damages of $3
million for each year remaining on the contract up to a maximum
of 10 years. During the last 10 years of its term, Company can
terminate the contract at any time provided it gives notice to
petitioner and pays $3 million for each year remaining in the
contract’s term. Petitioner does not expect that the contract
with Company will be breached by either party or that Company
will pay petitioner any liquidated damages.
7 The agreement states: “[Company] shall provide the electricity, at no cost to * * * [petitioner], to operate pumping stations two, three and four, or any substitute stations.” The three pumping stations will pump the wastewater uphill to the point of delivery. 8 A nondefaulting party can request a temporary restraining order and a preliminary injunction to prevent a default under the agreement or to compel performance. - 8 -
Of the 40 million gallons of wastewater per day that could
conceivably pass through the first section of pipeline,
approximately 29 million gallons will be available for various
users (irrigators) along its route.9 Those users are expected to
consist of vineyards and other growers, ranchers, homeowners in
large rural settings, parks, and others. Petitioner intends to
enter into agreements with the irrigators for periods of 10 to 20
years, which will guarantee a certain amount of wastewater at a
negotiated cost to the irrigators.10 Petitioner’s ruling request
represents that “Aggregate amounts received from the Irrigation
Contracts will not exceed 5 percent of debt service on the
Bonds.”
General rates and charges (sewer demand fees) are presently
imposed on users of petitioner’s sewage system. The various fees
are set by an ordinance which provides a generally applicable
9 This assumes 11 million gallons per day of wastewater will be transported to the geyser steamfield for use by Company. However, an exhibit entitled “Table of Delivery Rates” shows that estimated flows of wastewater per day to the geyser steamfield will range from 9.0 million gallons in April and May to 12.1 million gallons in November, December, and January. 10 According to petitioner, irrigators must take water from the pipeline in the winter and spring when greater amounts of wastewater are available and fill ponds and reservoirs for future use. It is unlikely that those users will have ponds or reservoirs currently in place, and each user could incur significant capital expenditures for construction of ponds and reservoirs, as well as the related pumping and connection equipment. Those users will want assurances that the pipeline will be built and that they will be guaranteed a certain amount of the wastewater. - 9 -
published rate schedule. There are no specially negotiated rate
arrangements for the disposal of sewage among users of the sewage
system. The sewage disposal functions of petitioner’s sewage
system are available for general public use. The sewer demand
fees will secure and will be used to pay the debt service on the
bonds. Debt service on the bonds will require petitioner to
increase the sewer demand fees. Petitioner expects, as of the
issue date, that the sewer demand fees will pay more than 95
percent of the debt service on the bonds.
On June 2, 1998, petitioner adopted a resolution authorizing
the issuance of bonds (Series 1998A bonds). On September 17,
1998, petitioner issued taxable bonds of $31 million, the
proceeds of which, according to petitioner, were used to finance
the costs of the first phase of construction and acquisition in
the Geysers Alternative. Petitioner proposes to issue additional
bonds of $140 million to finance anticipated costs of completing
the project and expects to use $31 million of the issue to refund
the taxable bonds on a tax-exempt basis.
Discussion
A. Introduction
Gross income includes all income from whatever source
derived including interest. Sec. 61(a)(4). Under section
103(a), gross income does not include interest on any State or
local bond. However, section 103(a) does not apply to “Any - 10 -
private activity bond which is not a qualified bond (within the
meaning of section 141).” Sec. 103(b)(1). We must determine in
the instant case whether the bonds that petitioner proposes to
issue are private activity bonds.11 The parties stipulated that
the bonds will not be qualified bonds. See sec. 141(e).
The term “private activity bond” means any bond that is part
of an issue which meets: (1) The private business use test of
section 141(b)(1) and the private security or payment test of
section 141(b)(2), or (2) which meets the private loan financing
test of section 141(c). Sec. 141(a). The parties agree that the
only issue in the instant case is whether the proposed bonds meet
the private business use test and the private security or payment
test (collectively the private business tests). If the private
business tests are met, the bonds are private activity bonds.
See sec. 141(a)(1); City of New York v. Commissioner, 103 T.C.
11 Under sec. 7478, the Tax Court shall have jurisdiction, in a case of actual controversy involving a determination by the Secretary, to make a declaration whether interest on proposed bonds will be excludable from gross income under sec. 103(a). The burden of proof is on petitioner as to the grounds set forth in respondent’s notice of determination and is on respondent as to any ground upon which he relies and which is not stated in the notice of determination. Rule 217(c)(2)(A) and (B); City of New York v. Commissioner, 103 T.C. 481, 482 (1994), affd. 70 F.3d 142 (D.C. Cir. 1995). Our decision in this case is based upon the administrative record and the stipulation of facts. Rule 217(a); City of New York v. Commissioner, supra at 482. We assume that the facts represented in the administrative record and in the stipulations are true. Rule 217(b)(1); City of New York v. Commissioner, supra at 482. - 11 -
481, 498 (1994), affd. 70 F.3d 142 (D.C. Cir. 1995); sec. 1.141-
2(c), Income Tax Regs.12
Section 141(b)(1) provides that an issue meets the “private
business use test” if more than 10 percent of the proceeds of the
issue are to be used for any private business use. “Private
business use” means use (directly or indirectly) in a trade or
business carried on by any person other than a governmental unit.
The use of the bond proceeds by all nongovernmental persons is
aggregated to determine whether the private business use test is
met. Sec. 1.141-3(a)(3), Income Tax Regs. However, use as a
member of the general public is not taken into account.13 Sec.
141(b)(6)(A). For purposes of this test, the use of financed
property is treated as the direct use of proceeds. Sec. 1.141-
3(a)(1), Income Tax Regs. Both actual and beneficial use by a
nongovernmental person may be treated as private business use.
Sec. 1.141-3(b)(1), Income Tax Regs. Any use other than a
private business use is considered a government use. Sec.
141(b)(7).
12 Bonds are private activity bonds if the issuer reasonably expects, as of the issue date, that the bonds will meet the private business tests. Sec. 1.141-2(d)(1), Income Tax Regs. This inquiry takes into account reasonable expectations about events and actions over the entire stated term of an issue. Sec. 1.141-2(d)(2), Income Tax Regs. 13 Use of financed property by the general public does not prevent bond proceeds from being used for a private business use because of other use. Sec. 1.141-3(c)(4), Income Tax Regs. - 12 -
The “private security or payment test” of section 141(b)(2)
relates to the nature of the security for, and the source of, the
payment of debt service on a bond issue. Sec. 1.141-4(a), Income
Tax Regs. This test is met if the payment of the principal of,
or the interest on, more than 10 percent of the proceeds of the
bond issue is directly or indirectly: (1) Secured by any
interest in property used or to be used for a private business
use, or payments in respect of such property, or (2) to be
derived from payments (whether or not to the issuer) in respect
of property, or borrowed money, used or to be used for a private
business use. Sec. 141(b)(2).14
The regulations under section 141 provide special rules to
determine whether arrangements for the purchase of output from an
“output facility” cause an issue of bonds to meet the private
business tests. Sec. 1.141-7(a), Income Tax Regs.15 The term
14 Payments taken into account as private payments and payments or property taken into account as private security are aggregated. Sec. 1.141-4(a)(2), Income Tax Regs. However, the same payments are not taken into account as both private security and private payments. Id. 15 The parties’ arguments on brief cite the temporary regulations published on Jan. 18, 2001 (66 Fed. Reg. 4661), and effective Jan. 19, 2001. After the filing of briefs in this case, final output facility regulations were promulgated and are generally effective with respect to bonds sold on or after Nov. 22, 2002. See sec. 1.141-15(f)(1), Income Tax Regs. The provisions in the temporary regulations that the parties rely upon and the provisions in the final regulations do not differ in any material respect. For convenience, we cite the final regulations in this opinion. - 13 -
“output facility” is defined as “electric and gas generation,
transmission, distribution, and related facilities, and water
collection, storage, and distribution facilities.” Sec. 1.141-
1(b), Income Tax Regs. If the output facility regulations apply,
any output contract must be analyzed under section 1.141-7(c),
Income Tax Regs., which identifies those contracts that have the
effect of transferring substantial benefits of owning the bond-
financed facility and substantial burdens of paying the debt
service on bonds used to finance the facility (the benefits and
burdens test). The general regulations under section 141(b)(1)
and (2), see secs. 1.141-3 and 1.141-4, Income Tax Regs., then
apply to determine whether other types of arrangements for use of
an output facility cause an issue to meet the private business
tests, sec. 1.141-7(a), Income Tax Regs.
B. Private Business Tests
We must decide whether the proposed bonds meet the private
business use test of section 141(b)(1). If that test is met, we
must then decide whether the proposed bonds meet the private
payment or security test of section 141(b)(2). Our primary focus
is on whether Company’s arrangement with petitioner results in a - 14 -
private business use of the financed pipeline.16 Our resolution
of the issues presented represents a matter of first impression.
1. Arguments of the Parties
Respondent determined that petitioner’s arrangement with
Company conveys priority rights to the capacity of the pipeline
and results in private business use of more than 10 percent of
the bond proceeds under section 141(b)(1). Respondent also
determined that payments received from the sewage ratepayers are
private payments that represent more than 10 percent of the debt
service on the bonds under section 141(b)(2).
Petitioner argues that the only purpose for constructing the
pipeline is the governmental purpose of sewage disposal. It
contends that the arrangement with Company does not involve any
use by Company of the financed pipeline and that Company uses
only the wastewater that is disposed of through that pipeline.
Petitioner contends that Company’s use of the wastewater begins
only when the disposal function of the pipeline is completed and
Company takes responsibility for the waste byproduct. Petitioner
argues, in the alternative, that, if Company’s arrangement is
16 Respondent addresses his determination and his contentions on brief to Company’s arrangement with petitioner. He does not rely on the arrangements with the irrigators. Payments from the irrigators will not exceed 5 percent of the debt service on the proposed bonds. Further, as we discuss below, the sewage ratepayers use the pipeline as members of the general public. Therefore, their use cannot cause the pipeline to be private business use property. - 15 -
determined to be a “use” of the pipeline: (1) The use is
incidental to petitioner’s governmental use and is not a special
legal entitlement or special economic benefit, see sec. 1.141-
3(b)(7)(i) and (ii), Income Tax Regs., that results in private
business use; or (2) Company’s arrangement should be analyzed
under the output facility regulations as an output contract.
With respect to the application of the output facility
regulations, petitioner argues that the financed pipeline is an
output facility. Petitioner contends that the pipeline is a
water facility since it distributes wastewater to Company and the
irrigators. Accordingly, petitioner argues that Company’s
arrangement with petitioner should be analyzed under the output
facility regulations. Petitioner contends that the arrangement
with Company will not have the effect of transferring the
substantial burdens of paying debt service on the proposed bonds
since Company pays nothing for the wastewater.
Respondent determined that the bond-financed pipeline is “an
integral part of the City’s sewage system” and is not a water
facility and that the term “output facility” does not include
“facilities for the disposal of treated wastewater.” He agrees
with petitioner’s primary contention (in the context of the
private business use test) that the pipeline carries out the
sewage function of petitioner’s sewage system, it provides for
the final disposal of wastewater, it was not built to provide - 16 -
water to Company, and the wastewater is merely a byproduct of the
sewage system.
2. Sewage Ratepayers
We first decide whether the sewage ratepayers use the
pipeline as members of the general public, since this
determination is relevant in deciding whether the private
business tests are met. Under section 141(b)(6)(A), use as a
member of the general public is not considered a private business
use. Use of financed property by nongovernmental persons in
their trades or businesses is treated as general public use only
if the property is intended to be available, and in fact is
reasonably available, for use on the same basis by natural
persons not engaged in a trade or business. Sec. 1.141-3(c)(1),
Income Tax Regs.
Petitioner argues that the use by the sewage ratepayers
involves general public use, that their use is excepted from the
definition of private business use, and that such use is not
taken into account for purposes of section 141(b)(1). Respondent
made no determination as to whether the use by the sewage
ratepayers represents general public use. Further, on brief,
respondent states that he has never considered whether the use by
the sewage ratepayers involves general public use, because
whether those ratepayers are using the pipeline as members of the - 17 -
general public has no bearing on Company’s private business use
of that property.
The sewage ratepayers’ use of the pipeline is based on
removing and ultimately disposing of their sewage and is also
based on their residence within the service area of the sewage
system. There are no specially negotiated rate arrangements with
the sewage ratepayers for the disposal of their sewage. See sec.
1.141-3(c)(2), Income Tax Regs. Ordinances set uniform and
standardized sewer rates and connection fees for all users in the
service area of the sewage system. The sewage disposal functions
of petitioner’s sewage system are available for general public
use. We hold that the sewage ratepayers’ use of the pipeline
constitutes general public use.
3. Use of the Pipeline
Respondent’s determination considered three users and two
different uses of the financed pipeline:
The City Project is used by Company, the irrigators, and the ratepayers. Use of the City Project by the ratepayers is based on removing and ultimately disposing of their sewage. In contrast, use of the City Project by the Company and the irrigators is based on supplying the wastewater for use in the geyser field or on irrigable property.
He relies solely on Company’s purported use of the financed
pipeline and concludes that such use is a private business use of
more than 10 percent of the proceeds of the bond issue. For the
reasons stated below, we disagree. - 18 -
First, we cannot agree that Company’s arrangement to receive
and to dispose of wastewater represents a private business use of
the financed pipeline. It is respondent’s position in the
context of the output facility regulations that the pipeline’s
purpose is the disposal of wastewater, that it is an integral
part of petitioner’s sewage facilities, and that it is not a
facility which distributes water. Indeed, in respondent’s reply
brief at 32, he states that “the Contract with the Company is not
an arrangement for the purchase of output, but rather was entered
for the purpose of disposing of the Wastewater.” Also, in his
reply brief at 35 n.12, he states that “Rather than meeting the
definition of an output facility, the Pipeline Project may meet
the definition of a sewage facility [in section 142(a)(5) and
section 1.142(a)(5)-1(a)(iv), Income Tax Regs.] in that it is
property used for the collection, storage, use, processing, or
final disposal of wastewater.” If the purpose of the pipeline is
waste removal and if it is a sewage facility that is used for the
disposal of wastewater, Company’s use of the wastewater would
begin after the pipeline’s sewage disposal purpose was completed.
The only use involved in Company’s arrangement with
petitioner is the use of a set amount of wastewater from the
pipeline. However, the wastewater is not financed property, and
respondent agrees that the wastewater is merely a waste byproduct
of petitioner’s sewage facilities. Company’s use of the - 19 -
wastewater begins after the pipeline’s disposal process is
complete. Disposal of wastewater is petitioner’s only purpose
for constructing the pipeline. We cannot agree that Company’s
use of what respondent terms “Wastewater”, and suggests is waste,
involves a use of the financed pipeline when petitioner’s sole
purpose for constructing the pipeline was to dispose of the
wastewater. Company simply provides petitioner with a place in
which to dispose of a certain amount of wastewater in an
environmentally acceptable manner and, in turn, gets rights to
that wastewater. In the circumstances of this case, Company’s
role in the disposal of the wastewater does not translate into a
use of the sewage facilities.
Petitioner contends that, regardless of whether Company’s
use of the wastewater can be construed semantically as some use
of the pipeline, any such use of the pipeline is not a private
business use because taking the wastewater from the pipeline is
incidental to the governmental sewage treatment and disposal
purpose of that facility.17 Petitioner relies upon the following
17 Petitioner claims that from its perspective, “it is irrelevant who takes the Treated Water and what they do with it so long as the Treated Water is used in an environmentally sound manner in accordance with applicable law and relevant public policy.” Petitioner adds that if it could accomplish its governmental purpose of sewage treatment and disposal by simply emptying the wastewater into a lake or pit at the top of the mountain, the cost of the pipeline would be the same and the sewage ratepayers would still be paying increased rates for the disposal of the wastewater. - 20 -
statements in the Staff of Joint Comm. on Taxation, General
Explanation of the Tax Reform Act of 1986, at 1152 (J. Comm.
Print 1987), which discuss the reasons for the enactment of the
private business use test:
Congress believed that * * * [the] diversion of governmental bond proceeds to nongovernmental users should be limited, but without setting the threshold amount so low that de minimis or incidental usage of government facilities and services by private users might cause interest on an issue to be taxable. [Emphasis added.]
In response to petitioner’s contentions respondent argues
that “A legitimate governmental purpose cannot negate
impermissible private business use.” He suggests that uses of a
bond-financed facility that are incidental to its governmental
purpose are taken into account under the private business use
test and that neither the Code nor the regulations provides a
general exception for incidental use. He argues that the
references to the terms “incidental” and “de minimis” in the
General Explanation, which petitioner relies upon, “simply refer
to amounts of private business use that fall below the statutory
threshold established by Congress”; i.e., private business use
which is less than 10 percent of the proceeds of an issue of
bonds.
First, we agree with respondent that neither the Code nor
the regulations provide a general exception for incidental use of
proceeds or financed property, except for the 10-percent - 21 -
statutory threshold and the specific exceptions under the
regulations.18 Indeed, in the paragraph following the language
that petitioner relies upon in the General Explanation, the Staff
of the Joint Committee states at 1152:
“To accomplish this, the Act generally defines as a private activity (i.e., nongovernmental) bond any bond of which more than 10 percent of the proceeds is to be used in a trade or business of any person or persons other than a governmental unit”. [Emphasis added.]
The statute, as finally enacted, demonstrates that the intended
exception of de minimis and incidental usage was accomplished, at
least in part, with the implementation of the 10-percent
threshold.19 Nevertheless, this does not indicate, as respondent
18 See sec. 1.141-3(b)(4)(iii)(A), Income Tax Regs., which excepts arrangements from the definition of a management contract if they are “solely incidental to the primary governmental function or functions of a financed facility”; sec. 1.141- 3(d)(2), Income Tax Regs., which excepts use incidental to financing arrangements; and sec. 1.141-3(d)(5), Income Tax Regs., which provides that incidental uses of a financed facility are disregarded to the extent that those uses do not exceed 2.5 percent of the proceeds used to finance the facility. 19 Sec. 103(b)(2)(A) of the 1954 Code employed a trade or business test similar to the private business use test in sec. 141(b)(1). That provision prohibited private business use involving a “major portion” of bond proceeds. Regulations under that section provided that use of more than 25 percent of bond proceeds represented use of a “major portion”. Sec. 1.103- 7(b)(3)(iii), Income Tax Regs., 37 Fed. Reg. 15487 (Aug. 3, 1972). The Senate amendment preceding the enactment of the Tax Reform Act of 1986, Pub. L. 99-514, 100 Stat. 2085, proposed to amend sec. 103(b)(2)(A) to incorporate this 25-percent threshold. However, the 10-percent threshold was ultimately adopted. H. Conf. Rept. 99-841 (Vol. II), at II-687 (1986), 1986-3 C.B. (Vol. 4) 1, 687. - 22 -
suggests, that the characterization of use as incidental to the
overall governmental purpose of a financed facility has no
relevance. On the contrary, we believe this characterization has
relevance not only in determining whether a particular
arrangement or special economic benefit constitutes private
business use, but also in determining whether such a use of
proceeds or financed property exceeds the 10-percent threshold.
The regulations provide a list of the circumstances under
which a nongovernmental person is treated as a private business
user of proceeds and financed property. The list includes
ownership, leases, management contracts, output contracts, and
research agreements. See sec. 1.141-3(b)(2) through (6), Income
Tax Regs. The regulations also identify a catch-all category:
“Any other arrangement that conveys special legal entitlements
for beneficial use of bond proceeds or of financed property that
are comparable to the special legal entitlements” listed above.
Sec. 1.141-3(b)(7)(i), Income Tax Regs.
Respondent determined that Company’s reservation of a
certain capacity of wastewater from the pipeline is a special
legal entitlement for the use of that facility. He relies on
section 1.141-3(b)(7)(i), Income Tax Regs., and contends that the
priority rights that Company has under its contract with
petitioner are comparable to those arrangements listed in the
regulations. Specifically, he relies on the example contained in - 23 -
the flush language of section 1.141-3(b)(7)(i), Income Tax Regs.,
which provides that “an arrangement that conveys priority rights
to the use or capacity of a facility generally results in private
business use.”
Petitioner argues that its contract with Company does not
fall into any of the categories of special legal entitlements
listed in section 1.141-3(b)(2) through (6), Income Tax Regs.
Further, petitioner contends that this contract is not comparable
to any of those arrangements for purposes of section 1.141-
3(b)(7)(i), Income Tax Regs., except output contracts. If the
arrangement is comparable to an output contract, then petitioner
argues that the output facility regulations should apply. We
agree with petitioner.
Company does not have any rights which involve, or are
comparable to, the ownership, leasing, or management of financed
property.20 Company’s arrangement provides only rights to
receive the wastewater that is disposed of through the pipeline.
The only arrangement, of those listed in the regulations, to
which we might conceivably view Company’s rights to be comparable
20 Par. (b)(2) of sec. 1.141-3, Income Tax Regs., targets ownership of financed property; par. (b)(3) targets leases of financed property; par. (b)(4) targets management contracts for services involving all, a portion of, or any function of, a facility; par. (b)(6) targets research agreements provided the nongovernmental sponsor of the research is treated as the lessee or owner of the financed property for Federal income tax purposes. - 24 -
is an output contract. See sec. 1.141-3(b)(5), Income Tax Regs.
However, respondent determined that Company’s contract with
petitioner is not an output contract, and the pipeline is not an
output facility. Indeed, respondent argues on brief that “The
Contract with the Company is not an arrangement for the purchase
of output, but rather was entered for the purpose of disposing
[of] the Wastewater.” Given respondent’s position and his
agreement that the pipeline is a sewage facility, we cannot agree
that Company’s rights are comparable to an output contract or any
of the arrangements listed in the regulations. We cannot agree
that Company has any special legal entitlements with respect to
the financed pipeline. Company simply receives the waste product
that petitioner disposes of through that facility.
Respondent also argues for the first time on brief that the
private business use test is met because the facts and
circumstances establish that Company receives a special economic
benefit with respect to the financed pipeline. In most cases,
the private business use test is met only if a nongovernmental
person has special legal entitlements to use the financed
property under an arrangement with the issuer. Sec. 1.141-
3(b)(1), Income Tax Regs. However, section 1.141-3(b)(7)(ii),
Income Tax Regs., provides a special rule for facilities that are
not used by the general public:
(ii) Special rule for facilities not used by the general public. In the case of financed property that - 25 -
is not available for use by the general public (within the meaning of paragraph (c) of this section), private business use may be established solely on the basis of a special economic benefit to one or more nongovernmental persons, even if those nongovernmental persons have no special legal entitlements to use of the property. In determining whether special economic benefit gives rise to private business use it is necessary to consider all of the facts and circumstances, including one or more of the following factors--
(A) Whether the financed property is functionally related or physically proximate to property used in the trade or business of a nongovernmental person;
(B) Whether only a small number of nongovernmental persons receive the special economic benefit; and
(C) Whether the cost of the financed property is treated as depreciable by any nongovernmental person.
Respondent contends that this special rule is met in this case
because “the Pipeline Project is not available for use on the
same basis by persons not engaged in a trade or business. Treas.
Reg. § 1.141-3(c)(1).” We disagree.
The pipeline is available for use by members of the general
public. The pipeline is an integral part of petitioner’s sewage
system. The sewage ratepayers use the sewage system, including
the pipeline, as members of the general public. They use that
system to dispose of their sewage, and they pay what the record
reflects to be uniform and standardized rates set by ordinance.
There are no specially negotiated rate arrangements, and all - 26 -
users of the pipeline for sewage disposal appear to use that
facility on a generally equivalent basis.
Respondent seems to suggest that we focus on Company’s
particular use, i.e., its use of the wastewater from the
pipeline, and whether members of the general public use the
wastewater on the same basis as Company. We do not believe that
is the appropriate inquiry under section 1.141-3(b)(7)(ii),
Income Tax Regs. This special rule focuses on whether the
financed pipeline is available for use by the general public. We
conclude that it is since the sewage ratepayers’ sewage disposal
use is as members of the general public. Their use is
unobstructed by any incidental use and rights that Company may
have to the wastewater following its disposal through the
pipeline. Accordingly, section 1.141-3(b)(7)(ii), Income Tax
Regs., does not apply, and the special economic benefit that
Company receives from the pipeline is not sufficient alone to
give rise to a private business use.
Even if we were to assume that petitioner’s arrangement with
Company is a private business use of the pipeline, respondent’s
determination raises significant questions as to whether such use
exceeds 10 percent of the bond proceeds. Respondent determined:
In this case, one requirement imposed by Company is that approximately C gallons of wastewater be delivered each day to the geyser field during the term of the Contract. This represents a reservation of about 27% of the capacity of the Multi-Use Pipeline and nearly 100% of the Geyser Field Pipeline. This special - 27 -
legal entitlement of Company, a nongovernmental person, causes City Project to be privately used in the trade or business of Company. Because more than 10% of the Bond proceeds will be used by a nongovernmental person in its trade or business, the private business use test of § 141(b)(1) will be met if the Bond proceeds are used as proposed.
Section 141(b)(1), the regulations thereunder, and the
legislative history indicate that only private business use,
alone or in the aggregate, which exceeds 10 percent of the
proceeds of the bond issue causes the private business use test
to be met. It is clear that section 141(b)(1) requires a
quantification or a valuation of the private business use(s) for
purposes of determining whether such use exceeds this threshold.
The regulations provide a methodology for measuring private
business use of financed property. The amount of private
business use is determined according to the average percentage of
private business use of financed property during the measurement
period. Sec. 1.141-3(g)(1), Income Tax Regs. In general, the
measurement period begins on the later of the issue date of the
bond issue or the date the property is placed in service and ends
on the earlier of the last date of the reasonably expected
economic life of the property or the latest maturity date of any
bond of the issue financing the property. Sec. 1.141-3(g)(2)(i),
Income Tax Regs. The average percentage of private business use
is the average of the percentage of private business use during - 28 -
the 1-year periods within the measurement period. Sec. 1.141-
3(g)(3), Income Tax Regs.
In general, the percentage of private business use of
property for any 1-year period is the average private business
use during that year. Sec. 1.141-3(g)(4)(i), Income Tax Regs.
This average is determined by comparing the amount of private
business use and use that is not private business use (government
use) during that year. Id. In the case of a facility in which
actual government use and private business use occur at different
times, the average amount of private business use generally is
based on the amount of time that the facility is used for private
business use as a percentage of the total time for all actual
use. Sec. 1.141-3(g)(4)(ii), Income Tax Regs. In the case of a
facility in which government use and private business use occur
simultaneously, the entire facility is generally treated as
having private business use. Sec. 1.141-3(g)(4)(iii), Income Tax
Regs. If, however, there is also private business use and actual
government use on the same basis, the average amount of private
business use may be determined on a reasonable basis that
properly reflects the proportionate benefit to be derived by the
various users of the facility (for example, reasonably expected
fair market value of use). Id.
Respondent fails to explain in his determination how a
reservation of a certain capacity of wastewater disposed of - 29 -
through the pipeline translates into a use of more than 10
percent of the bond proceeds. However, on brief, he seeks to
explain his position. He contends that petitioner’s governmental
use and Company’s purported private use of the pipeline occur
simultaneously. Accordingly, he claims that the entire pipeline
is treated as used in a private trade or business under section
1.141-3(g)(4)(iii), Income Tax Regs. We disagree.
First, even if we were to assume that Company uses the
pipeline, we cannot agree that petitioner’s governmental use and
Company’s private use would be simultaneous. Petitioner uses the
pipeline to dispose of the wastewater it generates as a byproduct
of its sewage system. Its use commences at its existing sewage
facilities and ends at the point-of-delivery connection.
Company, on the other hand, has agreed to assist petitioner in
disposing of a set amount of the wastewater. In exchange,
Company will have rights to use that amount of wastewater at the
point-of-delivery connection. Only then will Company commence
its use of the wastewater. We cannot agree that these
circumstances establish a simultaneous use. Any use by Company
of the pipeline is incidental and does not occur at the same time
as petitioner’s disposal use.21
21 If we were to characterize the pipeline in a different manner than the way respondent characterized that facility in the context of the output facility regulations, we might characterize the financed pipeline as performing a dual function. It disposes (continued...) - 30 -
Respondent’s attempts to quantify or value Company’s
purported use of the pipeline in terms of a reservation of the
capacity of the pipeline are unavailing. We cannot agree with
respondent that his analysis represents a rational measurement of
Company’s alleged use of the pipeline. In his attempt to
quantify or value Company’s alleged use of the pipeline,
respondent fails to account for the sewage ratepayers’ use of the
pipeline to dispose of their sewage. Nevertheless, in other
parts of his determination he relies upon the sewage ratepayers’
use of the pipeline. Further, respondent’s attempt at measuring
Company’s use is not reconcilable with his characterization of
the pipeline as a sewage facility which was constructed for the
purpose of wastewater disposal. His measurement fails to account
for the presence of this governmental purpose, and, instead,
relies solely on what he views as a reservation of the capacity
of the pipeline. We cannot agree that a reservation of what
respondent agrees is a waste byproduct of petitioner’s sewage
21 (...continued) of the wastewater that is produced as part of petitioner’s sewage system, and it distributes water to Company for use in its electricity operations. However, that is not the characterization that respondent advocates in this case. On the contrary, he suggests that the pipeline’s purpose is waste removal and that it does not perform a water distribution function. - 31 -
facilities equates with a use of 27 to 100 percent of the
pipeline facility which disposes of such waste.22
Given the circumstances of this case and the arguments of
the parties, the more appropriate view is that Company does not
use the financed pipeline in any quantifiable amount, and,
certainly, not in an amount in excess of 10 percent of the bond
proceeds. In support of this view, we note that Company pays
nothing to petitioner for its purported use of the financed
pipeline, or, for that matter, the wastewater. Company simply
agrees to dispose of the wastewater that it receives, and in
exchange it is given rights to use the water in its electricity
operations. The sewage ratepayers, on the other hand, will pay
fees for the disposal of their sewage which will amount to at
least 95 percent of the debt service on the bonds used to finance
the pipeline. This, in our view, indicates that at least 95
percent of the financed pipeline will be used for sewage
disposal. This represents a more accurate reflection of the use
of the pipeline than respondent’s determination that more than 10
percent of the pipeline will be used by Company.
22 Also, we note that sec. 1.141-3(d)(5), Income Tax Regs., excepts incidental uses of a financed facility which do not exceed 2.5 percent of the proceeds used to finance the facility. In responding to the potential application of that provision, respondent states without explanation that the latter provision does not apply “in light of the extensive rights the Company has with respect to the capacity of the Pipeline Project.” - 32 -
We hold that the private business use test is not met.
Accordingly, the proposed bonds will not be private activity
bonds.23 Interest on those bonds will be excludable from gross
income under section 103(a).
Decision will be
entered for petitioner.
23 A bond issue meets the private business tests of sec. 141(b) if it meets both the private business use test and the private security or payment test. City of New York v. Commissioner, 103 T.C. at 498. Because the bond issue in the instant case fails to meet the private business use test, it is unnecessary for us to discuss whether the private security or payment test is met.