WASHINGTON -- The IRS proposed a rule yesterday that would bar companies and municipalities from using tax-exempt, private activity bonds to finance facilities to pretreat, or to provide more advanced treatment, of their wastewater.

Several bond lawyers said they are unhappy with the Internal Revenue Service's proposed rule, which is intended to define sewage facilities, which can be financed with tax-exempt bonds.

The lawyers said the rule is too restrictive and could discourage companies and municipalities from doing what they think is necessary to clean up their wastewater.

One lawyer suggested that the rule is so restrictive that issuers may see "a window of opportunity" and rush to market with wastewater treatment facility financings to beat the rule's effective date.

The rule would become effective until 60 days after it is published in the Federal Register in final form, according to the rulemaking notice. The IRS asked for public comments on the proposed rule before July 5, and said it will hold a public hearing on July 26.

The proposed rule narrowly defines "sewage facilities" in an attempt to distinguish them from wastewater pollution control facilities, the bond lawyers and a Treasury official said.

Under the current tax law, tax-exempt private-activity bonds can be used to finance sewage facilities but not water pollution control facilities.

Until 1986, the tax law allowed both kinds of facilities to be financed with tax-exempt private-activity bonds. But Congress, in the Tax Reform Act of 1986, eliminated use of such bonds to finance water pollution control facilities, leaving issuers and bond lawyers with the task of having to distinguish between the two kinds of facilities.

The IRS further confused the matter in 1990 by revoking two favorable private letter rulings on sewage facilities that had been issued in 1989 and 1988. The rulings allowed a food-processing plant in Ohio and electroplating companies in California to finance facilities to pretreat their waste. The IRS gave no reasons for the revocations.

Ever since, bond lawyers and issuers have been urging the IRS to clear up the confusion by defining sewage facilities.

Yesterday, they got their wish, but most of them were not happy.

"It strikes me as a pretty narrow definition," said Robert Buck, a lawyer with Palmer & Dodge in Boston. "I'm somewhat disappointed that they weren't more generous is the pretreatment area."

"It's very disappointing," said William Conner, a lawyer with Squire, Sanders & Dempsey in Cleveland. "This doesn't appear to give you much opportunity to do private activity bond financings of wastewater treatment facilities," he said.

"It certainly sounds very restrictive from the point of view of whether you can pretreat industrial wastes," said William Loafman, a lawyer with Whitman, Breed, Abbott & Morgan in New York. "It doesn't seem to distinguish between a factory-owned sewage disposal facility and a municipally-owned sewage disposal facility that is managed or operated by a private company."

Loafman says the rule "seems to set a standard that says so long as you can discharge wastewater into navigable waters, ~we're not going to let you finance anything else to make it cleaner.'"

A Treasury official said, however, that in its definition of sewage the rule tries to embrace "what traditionally has been done at municipal sewage treatment works."

To IRS and Treasury, the official said, pretreatment and advanced treatment facilities looked more like water pollution control plants than sewage facilities.

"Congress revoked tax-exempt financings for water pollution control facilities and we thought that meant something," he said.

Under the proposed definition, sewage facilities would include secondary treatment facilities for treating wastewater whose average daily raw waste-load concentration of biochemical oxygen demand (BOD) does not exceed 350 milligrams per liter. Most sewage facilities have BOD concentration levels that average about 150-300 milligrams per liter, the Treasury official said. The definition also would include facilities used for the primary treatment of wastewater.

The proposed rule says issuers can use tax-exempt private activity bonds to finance the portion of a wastewater treatment plant that meets the definition of a sewage facility.

Primary treatment of wastewater typically involves removing solids or large particles in the wastewater, the lawyers and Treasury official said. Secondary treatment is when microorganisms or bacteria are added the wastewater to eat biological matter. Industrial waste often contains so many pollutants that it must be pretreated before it can move through a municipal sewer system or into a waterway.

"The Environmental Protection Agency has been encouraging and mandating pretreatment for a lot of companies. It's pretty costly. We were hoping they could tax-exempt finance these facilities under the sewage rules but it looks like that's not going to be possible," said Buck of Palmer & Dodge.

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