WASHINGTON -- Refunding bonds will not become taxable private-activity bonds if a private company that is actually an "instrumentality" of a state authority benefits from the proceeds, the Internal Revenue Service said in a recent private letter-ruling.

Bond lawyers said the letter-ruling is favorable and will be helpful to the bond community, despite the IRS' usual cautionary statement in the ruling that its conclusions should not be regarded as precedent-setting.

"There has always been a question. if a state uses bond proceeds to acquire a private company and the company remains private, whether the proceeds remain tax-exempt," said one bond lawyer in New York City who did not want to be identified.

In this case, the IRS said the unidentified state authority could issue tax-exempt bonds to refund bonds that had been issued on a tax-exempt basis years ago to finance the acquisition of a private telephone company and some capital improvements made by the company. The company is wholly owned and operated by the state authority.

Participants of the proposed refunding were concerned that the refunding bonds would be taxable private-activity bonds because a private company would benefit from the use of the proceeds.

Under the tax law, bonds are private-activity bonds if more than 10% of the proceeds are used by a private entity and more than 10% of the debt service is derived from, or secured by, private payments.

The participants of the transaction were concerned that the bonds would exceed the 10% private use and payments tests, making the bonds private-activity bonds that would be taxable because they would not fall within one of the tax law's categories of tax-exempt private-activity bonds.

But the IRS concluded in the letter-ruling that the refunding bonds would not be private-activity bonds because the private telephone company is "an instrumentality" of the authority that "acts solely for and on behalf of the authority." According to the letter-ruling, the state authority issued tax-exempt bonds before 1983 to finance the acquisition of the private telephone company as well as capital improvements made by the company. A federal law enacted at the time stipulated the bonds would be tax-exempt.

The state legislature had authorized the authority's acquisition of the telephone company after determining the company was not providing adequate telephone service and that this was inhibiting the state's economy, the letter-ruling says.

Although the authority acquired the company's stock with some of the bond proceeds, the company remained a private company that was subject to certain corporate tax laws.

In 1983, Congress enacted tax laws under which bonds would only be tax-exempt if they met the tax code's requirements for tax-exempt bonds.

With the recent drop in interest rates, the authority wanted to refund the tax-exempt bonds that had been issued prior to 1983 to finance the acquisition of the company and the capital improvements. But participants in the proposed deal were concerned that the refunding bonds would be private-activity bonds because they would exceed the 10% private use and payment tests that were enacted into the tax law after 1983.

The IRS, however, ruled that the bonds would not be private-activity bonds because the telephone company is an instrumentality of the authority and acts solely on its behalf. The trade or business of the private company is the same as the trade or business of the authority for which it acts, the IRS said.

The IRS said its ruling was based in part on Revenue Ruling 57-128, which lists several factors that must be taken into account in determining whether an entity is an instrument of a governmental "unit" or authority.

Revenue Ruling 57-128 says that such a determination should be based on whether the organization is used for a governmental purpose and performs a governmental function; the performance of the function is on behalf of a state or political subdivision; there are any private interests involved, or the state or political subdivision has the power and interests of an owner; control and supervision is vested in a public authority; and, authority is necessary for the creation or use of the instrumentality.

The revenue ruling also says the determination should be based on the degree of financial autonomy of the entity and its source of operating expenses.

In the letter-ruling, the IRS noted that it plans to develop regulations on private-activity bonds. It said this letter-ruling could be modified or revoked if it is inconsistent with those private-activity bond rules, once they are published. The IRS, however, also noted that letter-rulings are usually revoked or modified only "in rare or unusual circumstances."

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