WASHINGTON -- The IRS' proposed private-activity bond rules would liberalize existing revenue procedures for both management contracts and changes in the use of bonds, and provide the first concrete guidance in a number of areas, including enterprise zone bonds.

Scheduled for publication in today's Federal Register, the Internal Revenue Service rules answer dozens of questions raised by issuers and bond lawyers over the last several years as to when a municipal bond fails the socalled 10% private-use test and becomes taxable.

Under the Tax Reform Act of 1986, bonds are considered public-purpose bonds only if no more than 10% of the proceeds are used by private parties, or if no more than 10% of the debt service is derived from or secured by private parties. The earlier law set the level at 25%. In addition, the part of a bond issue that may be loaned to private parties may not exceed 5% or $5 million, whichever is less.

The IRS is requesting comment on the 143 pages of regulations for the next 120 days, and will hold a hearing on the rules on June 8. The regulations will not become effective until 60 days after the final version is published in the Federal Register.

One major question answered by the proposed rules is whether an issuer's reasonable expectations on the date of issue are enough to classify a bond as a tax-exempt private-activity bond, or if the IRS looks to the actual use of the bond proceeds. The rules offer a mixture of sorts: a bond is not a taxable private-activity bond as long as an issuer's expectations are reasonable and the issuer later takes no deliberate action that causes the bonds to fail the 10% private-use test.

In measuring compliance with the private-use test, the proposed rules follow an older set of industrial development bond rules in stating that an issuer is not permitted to simply measure public versus private use over the time that the bonds are outstanding. Rather, "annual periods are used to measure the amount of private business use, and the private business use is equal to the greatest amount of private business use in any annual period."

In determining whether a bond violates the private-use test, an important consideration is the extent to which the use of the bond proceeds benefits the general public. The proposed rules, for the first time, define "general public use," and give several bright-line tests and examples to aid issuers in knowing how to use bond proceeds to pass the private-use test.

Within those guidelines, the IRS clarified that insubstantial improvements financed with bond proceeds do not cause the bonds to violate the private-use test if they are made to a system generally available to the public. For example, bond proceeds could be used to finance a small street or cul-de-sac serving very few people as long as the new road is open to the general public and connected to the issuer's existing public road system.

The regulations also offer a de minimis rule, allowing issuers to disregard certain small amounts of private business use in determining whether they run afoul of the private-use test.

Leases and similar arrangements may be disregarded if they have terms of less than one year and are not renewable. Certain temporary use by developers of property that will be sold to the general public can be disregarded, as can incidental use of a bond financed facility.

The regulations clarify that the prohibition against more than 10% of a bond issue being repaid with private payments does not apply to generally applicable taxes. The rules define "generally applicable," and say that such taxes do not include special assessments or payments for a special privilege or service.

Another question answered by the proposed rules is how the IRS views a "mixed-use facility," where part of the facility qualifies for bond financing and part does not.

The rules state that bonds may be used to finance the qualified portion, but only if it "is a separate and discrete portion of a facility (such as a floor of a building), or an undivided ownership interest in an output or similar utility facility."

The portion of the rules governing output facilities follows the way such facilities were treated under the old IDB rules. For example, issuers of output facility bonds are permitted to take into account private versus public use of the facility over the period the bonds are outstanding, something not allowed for other types of privateactivity bonds.

The regulations also contain several de minimis exceptions under which certain output contracts are disregarded in determining compliance with the 10% private-use limit.

Regarding management contracts, the rules build on Revenue Procedure 93-19, published in February 1993. Under 93-19, management contracts do not violate the 10% private-use test if they do not exceed five years and at least 50% of the compensation is based on a periodic fixed fee, or if the term does not exceed three years and compensation is based on a perunit fee.

The proposed rules say a management contract is also acceptable under two other conditions: if it does not exceed 10 years and 80% of the compensation is based on a periodic fixed fee, or if it does not exceed 15 years and all of the compensation is based on a periodic fixed fee.

As with management contracts, the proposed rules' treatment of changes in the use of bonds expands on an earlier revenue procedure. Revenue Procedure 93-17, also published in February 1993, permits issuers and borrowers who meet certain criteria to convert their bond-financed facilities to private use without undermining the tax-exempt status of the bonds.

The revenue procedure, however, left many unanswered questions that are settled in the proposed rules. For example, the rules state that when an issuer sells a bond-financed facility to a private user for cash, the use of the facility does not affect whether the bonds continue to be tax-exempt. Rather, the issuer must focus solely on properly disposing of the sale proceeds, either in defeasing outstanding bonds or purchasing a facility that would qualify for bond financing.

The proposed rules also clarify that only the portion of the bond issue equal to the sale proceeds would have to be defeased. Issuers had been concerned that the IRS might require defeasance of the entire issue, even if it exceeded the sale price.

For sale transactions that do not involve cash, the rules provide that an issuer can maintain the tax-exempt status of the bonds through several remedial actions. But those remedial actions are only available to the issuer if the possibility of a change in use occurring had been remote on the issue date. If that was not the case, the issuer would have to have special early-call provisions in his bond documents to be able to take the remedial actions and keep his bonds tax-exempt.

Though not included in the proposed rules, the IRS is also considering adding to the final rules an alternative to defeasing bonds. The agency said it may permit an issuer to enter into a closing agreement and pay a penalty equal to the present value of the interest rate differential between taxable and tax-exempt debt, according to a formula suggested in the rules.

The proposed rules also include regulations governing enterprise zone bonds, which are exempt facility bonds that may be used to finance loans to businesses in designated enterprise zones.

Following suggestions from bond lawyers, the rules state that current limits on the amount of issuance allowed in each zone and for each business apply at the level of the ultimate borrower in any loans-to-lenders programs.

Lawyers had also complained that the enterprise zone statute contained a highly technical and complicated definition of an enterprise zone business that could make businesses wary of using bond financing. The proposed rules state that bond issues will be considered in compliance with the law as long as borrowers and issuers "in good faith attempt to meet those requirements throughout the term of the issue."

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