WASHINGTON -- The Internal Revenue Service will ease its proposed rule on sewage facilities in the wake of criticism by municipal bond market participants that it is too restrictive, agency officials said yesterday after a public hearing on the rule.

The IRS proposed the rule last May to clarify whether wastewater treatment plants that have some private involvement can be defined as sewage facilities eligible for tax-exempt, private-activity bond financing under the tax law.

Under the proposed rule, the term sewage facilities would be limited to primary wastewater treatment plants and 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.

Pretreatment and tertiary or advanced treatment plants would not be defined as sewage facilities under the rule.

But IRS and Treasury officials said after the hearing yesterday that they will consider expanding the proposed rule so that the definition of sewage facilities includes plants that treat "septage" and wastewater carried off by sewers as well as advanced or tertiary treatment plants that are needed so that treated wastewater can be discharged into waterways.

The officials said they also will consider casing the rule's restrictions, under certain circumstances, on secondary treatment facilities with bio-chemical oxygen demand levels above the proposed limit and on treatment plants that treat wastewater with small quantities of nonconventional, priority, or toxic pollutants.

At the hearing, Kenneth Leary, a vice president of Northeast Environmental Management Company, urged the IRS to expand the proposed rule to cover the treatment of "septage."

Septage is concentrated sewage from the septic systems of residences, restaurants, schools, and other commercial facilities, Leary said. It is domestic rather than industrial waste, but may contain concentrations of biochemical oxygen demand that go as high as 2,000 milligrams per liter as oxygen, far exceeding the IRS' 350 milligram limit, Leary said.

Leary said after the hearing that his company is building a 100,000 gallon per day septic facility in Carver, Mass., with $6 million of tax-exempt, private activity bonds that were issued by the Massachusetts Industrial Financing Agency. The plant will treat septage from residences and businesses in a 25-mile radius around Carver. But such a facility would not qualify for tax-exempt financing under the proposed rule, Leary said.

Leary told the IRS officials that tax-exempt financing of septage facilities is especially critical for rural areas.

Robert Buck, a partner with Palmer & Dodge in Boston who spoke on behalf of the National Association of Bond Lawyers, told the IRS officials that the 350 milligram per liter BOD limit is "arbitrary" and will unfairly penalize many communities that treat sewage at higher levels, particularly those engaging in water conservation efforts which can lead to higher BOD levels.

Buck protested the proposed rule's prohibition against the use of private-activity bonds to finance tertiary treatment and pretreatment facilities.

The prohibition on financing of tertiary facilities "discriminates unfairly against communities that are in sensitive environmental areas and must, as a result, more fully treat their sewage," he said. "In addition, it constrains the ability of all communities to construct more technologically advanced sewage facilities."

While most pretreatment facilities are privately owned manufacturing facilities, IRS rules that existed before 1986 and that Congress endorsed said that sewage disposal facilities "may be part of a nonpublic facility such as a manufacturing facility," Buck said.

"We believe that restrictions on the level of treatment and the place of treatment are inappropriate," Buck said. "We suspect Congress intended that sewage be treated by these facilities to the fullest extent technologically feasible and environmentally practicable."

Both Buck and Jeffrey Kramer, a lawyer with McManimon & Scotland in Newark, N.J., said the IRS rules should have defined sewage rather than sewage facilities, which are already defined under existing regulations.

"In our view the definition of sewage facilities is preexisting and works," said Kramer.

Kramer said the IRS should define sewage as any wastewater that publicly owned treatment works are permitted to accept by municipalities.

Anthony Rosso, a lawyer with Chapman & Cutler in Chicago, said the IRS rules should cover facilities that treat the wastewater that is carried off by sewers.

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