WASHINGTON -- The IRS' proposed rule on sewage facilities would prohibit using tax-exempt private-activity bonds to finance many wastewater treatment facilities that are needed to meet state and federal environmental requirements, market participants said this week.

State and local officials, bond lawyers, and securities firms complained in written comments sent to the Internal Revenue Service that the proposed rule is too restrictive

They said the IRS should redraft the rule so that it is flexible and allows private-activity bonds to be used for more kinds of municipal wastewater treatment facilities, including those that either pretreat or provide more advanced treatment of wastewater.

The Council of Infrastructure Financing Authorities said the rule should allow private-activity bond financing for any sewage facility that is needed to meet state and federal requirements, no matter what level of treatment the facility provides.

The Government Finance Officers Association said the rule should allow tax-exempt private-activity bonds to be used for any facility that treats waste similarly to a publicly owned treatment works facility that was financed with governmental bonds.

The IRS proposed the rule in May to clarify when wastewater treatment facilities can be defined as sewage facilities that qualify for tax-exempt financing.

The clarification was needed because bond market participants were having trouble distinguishing between sewage facilities, which can be financed with private-activity bonds, and water pollution control facilities, which cannot.

Congress created the confusion in the Tax Reform Act of 1986 by removing water pollution control facilities from the list of projects that qualify for tax-exempt financing. Sewage facilities were kept on the list.

Most of the groups said they were pleased that the IRS is trying to clear up the matter.

In its proposed rule, however, the IRS defines 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 that does not exceed 350 milligrams per liter as oxygen."

Most of the commenters strongly objected to basing whether a facility is a sewage facility on the level of wastewater treatment it provides.

The generally agreed with the part of the rule that focuses on the character of the waste but said that the proposed limit on biochemical oxygen demand for secondary treatment facilities is too restrictive.

The National Association of Bond Lawyers said the focus on the level of treatment is "misguided" and will "likely lead to arbitrary results and prevent the tax-exempt financing of more technologically advanced sewage facilities."

"Sewage facilities are sewage facilities because they treat sewage, not because of the way they treat sewage," the lawyers said.

The lawyers told the IRS that "it is contrary to sound sewage treatment policy, and presumably congressional intent, to discourage the financing of pretreatment facilities."

In addition, they said, the rule could create confusion with regard to sewage projects that provide both secondary treatment, which would qualify for tax-exempt financing, and tertiary treatment, which would not.

The Government Finance Officers Association told the IRS that it is "inappropriate" to focus on the level of treatment.

"Advanced and tertiary treatment is a common ingredient in many current publicly owned treatment works facilities' permits," the association said.

The Council of Infrastructure Financing Authorities agreed that limiting sewage facilities to primary and secondary treatment "does not accurately correspond to the realities of municipal treatment system operations."

Most sewage facilities typically rely on tertiary treatment to remove excess suspended solids from water from lakes or estuaries, the council said.

The proposed rule "will inhibit efforts at water conservation and reuse in areas where high levels of treatment are necessary in order to protect public health," the financing authorities said.

They concluded that the rule will have the "unintended result of denying tax-exempt financing for certain legitimate municipal treatment facilities."

Most of the groups said the rule would discourage state and local governments from relying on private and public partnerships to develop and operate wastewater treatment facilities that meet environmental requirements.

"It is inconsistent for the Internal Revenue Service to be restricting governments' ability to finance facilities when the Environmental Protection Agency is mandating more local expenditures and providing less assistance to meet environmental standards," the finance officers said.

The financing authorities told the IRS that if the proposed rule is adopted, it could discourage New York City from proceeding with plans to privatize some of its 14 municipal sewage treatment plants.

The Public Securities Association complained that the rule "is inconsistent with the general support for creative infrastructure investment that has been repeatedly expressed by the Clinton Administration."

Most of the groups agreed with the IRS approach of partly basing the definition of a sewage facility on the character of the waste to be treated by the facility, but said the proposed rule is not flexible enough in this regard.

"Describing wastewater that may be treated at a sewage facility by reference to the biochemical oxygen demand is a useful approach and we endorse it," the bond lawyers said. "The 350 milligram per liter limitation, however, is arbitrary and likely to lead to illogical results."

The finance officers told the IRS that "since the strength of waste varies widely depending on the nature of the customer base, water conservation practices, and other factors, the 350 milligrams per liter is not necessarily reflective of the waste treated by publicly owned treatment works."

The proposed rule "appropriately" excludes from its definition of sewage facilities any plants that treat nonconventional, priority, or toxic pollutants, the lawyers said, but the exclusions "should not be absolute."

"Some of these pollutants, generally in low concentrations, are incidentally or intentionally treated at publicly owned treatment works," they said.

The lawyers were sympathetic with the IRS' dilemma of having to distinguish sewage facilities from water pollution control facilities.

"Any attempt to make this distinction ... is destined to failure," the lawyers said. "All sewage facilities are in fact water pollution control facilities."

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