WASHINGTON -- The IRS' proposed rule on sewage facilities "will have the unintended effect of denying tax-exempt financing" for wastewater treatment facilities that have some private involvement but "provide essential municipal services," the Environmental Protection Agency warned recently.

The Internal Revenue Service proposed the rule in May to clarify when wastewater treatment facilities are sewage facilities that, under the tax law, can be financed with tax-exempt private-activity bonds.

The rule would define sewage facilities as primary wastewater treatment plants and as secondary treatment plants that treat wastewater having an average daily raw wasteload concentration of biochemical oxygen demand, or BOD, that does not exceed 350 milligrams per liter as oxygen.

Pre-treatment and tertiary treatment plants would not be defined as sewage facilities under the rule.

But in written comments sent recently to the IRS, the EPA said the proposed rule would pose serious problems for state and local governments because its definition of sewage facilities is based on "operations historically performed at most publicly-owned treatment works."

This is an "inappropriate benchmark" because of the continuing regulatory, technological and financial changes in municipal sewage management, the EPA said.

Secondary treatment, for example, is only the "baseline technology" that is required under environmental laws for publicly owned treatment works, the EPA said. The Clean Water Act mandates additional treatment of wastewater in many cases to achieve water quality standards, the agency said.

In drawing the line at secondary treatment facilities, the EPA said, the proposed rule "does not take into account what a sewage facility is precluded from discharging."

Most municipalities with a sewage treatment plant that discharges into a river or other body of water must obtain a National Pollution Discharge Elimination System permit, the EPA said. The permit limits the quality and quantity of the waste discharged. The minimum limit is set at secondary treatment, but more stringent. limits may be set depending on the quality of the river or other water into which the waste is being discharged, the EPA said.

The EPA said it submitted a report to Congress in 1991 showing that 22.3% of publicly owned treatment works are not used for pre-treatment but are used for more advanced treatment than secondary treatment.

"These are facilities that receive no substantial industrial flows," the EPA said. "They typically are required to provide more extensive treatment because of the quality of the waters into which they discharge rather than the quality of the flows into the system."

The EPA said that it does "not believe these are the type of facilities that the IRS intended to proscribe from the universe of sewage facilities."

In addition, the proposed rule's biochemical oxygen demand limit of 350 milligrams per liter or less as oxygen for secondary treatment facilities "contradicts federal environmental policy" and "creates a disincentive for communities to pursue water conservation," the EPA said.

Federal environmental policy, the EPA said, emphasizes pollution prevention and is aimed in part at reducing residential, commercial, and industrial consumption of water. However, as the volume of wastewater decreases, the concentration ot pollutants such as BOD will increase, the EPA said.

Another problem with the proposed rule, the EPA said, is that it excludes from the definition of sewage facilities all plants that treat toxic, priority, and nonconventional pollutants. While these pollutants are not ordinarily treated at publicly owned treatment works, they can be, and they are not always discharged from industrial sources, the EPA said.

Residential home owners and commercial businesses sometimes dispose of wastes containing these pollutants down their drains, the EPA said.

"Publicly-owned treatment works already struggle to deal with this problem and their task should not be further complicated by the potential loss of tax-exempt financing as a source of funds to install the necessary technology," the EPA said. The agency suggested that the IRS consider allowing sewage facilities to treat some levels of these pollutants, perhaps within a specified limit.

The proposed rule would also hinder water reclamation and reuse of wastewater effluent by excluding as sewage facilities "property used to treat, process, or use wastewater subsequent to the time the wastewater can be discharged into navigable waters...." the EPA said.

Another major problem with the rule, the EPA said, is that it would discourage the creation of public-private partnerships to develop infrastructure facilities, including sewage plants.

One of President Clinton's initiatives, for the reauthorization of the Clean Water Act, is to define publicly owned treatment works in such a way that all public-purpose wastewater facilities are regulated equitably based on what they do and who they serve rather than on who owns them, the EPA said.

Turning to state revolving fund programs, the EPA said that while the proposed rule would have "little immediate, direct impact" on these programs, that could change if states begin using private-activity bonds rather than governmental bonds for leveraging.

In the revolving fund programs, the EPA provides grants to states. The states, in turn, provide low-interest loans to .municipalities. The states typically try to leverage the grant money by using it to secure tax-exempt bonds.

The EPA is worried that if states begin issuing private-activity bonds under these programs, "the tax-exempt status of the pools, or at least that of any segmented qualified exempt facility private activity bond portion, would be endangered if one facility ran afoul of the proposed regulation."

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