In February 2016, the IRS proposed revisions to the definition of "political subdivision" for purposes of tax-exempt bonds and other obligations, including loans, issued by state and local governments. Issuers of tax-exempt obligations would be most directly affected by the proposed regulations if finalized in their current form. However, community banks may also have an interest in the proposed changes that could limit the types of projects that qualify for tax-exempt financing.
As a general rule, interest income earned on debt obligations of a state or political subdivision is exempt from U.S. income tax. An entity generally qualifies as a political subdivision if it has been delegated, under state law, the right to exercise at least one of the sovereign powers: taxation, eminent domain and police. In many cases, states or local governments have delegated rights to exercise a part of their sovereign powers to certain special assessment districts. Typically, these districts are formed to provide infrastructure improvements for roads, water, sewer, gas, power, reclamation, drainage, irrigation, schools, fire protection, port facilities and libraries, for example. Because of the delegation of powers by states or local governments, these types of assessment districts often issue tax-exempt debt and, consequently, obtain more favorable financing terms and greater access to credit than private businesses.
The proposed regulations add new requirements to qualifying as a political subdivision that may prohibit certain special assessment districts from issuing tax-exempt debt. In addition to possessing one or more sovereign powers, described above, the proposed regulations would require that a political subdivision serve a governmental purpose and be governmentally controlled. Briefly, under these new requirements:
- For there to be a governmental purpose, an entity, such as an assessment district, must carry out the public purpose set forth in the legislation that created it and provide a significant public benefit with only "incidental" private benefit, and
- Governmental control must be vested in either a general purpose state or local government unit or in an electorate established under state or local law. If a "small faction" of private persons control an electorate (say, due to sparse population) that electorate's control may not constitute governmental control of the entity.
These new requirements are of great concern to many special assessment districts because, as drafted, they may prevent them from issuing tax-exempt debt in the future.
Monitor Future Events
The IRS has scheduled a public hearing for June 6 for interested persons to comment on the proposed regulations. Based on the written comments provided the IRS (available to the public at www.regulations.gov), many commenters are recommending the proposed regulations be substantially revised or withdrawn altogether. Bankers will want to monitor future developments, and if the proposed regulations are finalized, consider additional due diligence procedures when making loans to, or investing in, debt obligations of political subdivisions, including special assessment districts.