WASHINGTON -- An Internal Revenue Service memorandum that was recently sent to a taxpayer in Minnesota has distressed several bond lawyers and lead a few of them to halt tax increment revenue bond-related financings.
In the technical advice memorandum, which has not yet been published and does not identify the tax-payer, which is a company, the IRS concluded that the tax increment revenue bonds that helped finance the development of its industrial facility are taxable because of an underlying redevelopment contract.
In essence, the IRS said that because of some of the contract provisions, the incremental taxes backing the bonds are not generally applicable, and instead are private payments or a private loan. This makes the bonds taxable private-activity bonds.
Some of the lawyers in the state, who said such contracts were standard, feared that the IRS is saying any contract would make tax increment revenue bonds taxable. Other lawyers in and outside the state, who think the contract provisions might go too far or find some of the facts of the case troublesome, said they understand why the IRS could have a problem with the bonds.
But all o them agreed that the conclusions in the memorandum are so loosely worded and broad that they muddle and raise concerns about the IRS' overall stance on tax increment financing.
The memorandum was written to settle tax law issues about the bonds that emerged from an audit of the taxpayer company. The audit was conducted by the IRS' St. Paul, Minn., office, but the memorandum was written by IRS officials in Washington, and has the same effect as a private-letter ruling.
John Utley, a lawyer with the firm of Mackall, Crounse & Moore in Minneapolis, who believes the redevelopment contract in this financing was a "standard form contract," said he was very concerned about the memorandum.
"What it suggests to us is that if you have a contract with some of these same provisions, you don't have tax-exempt bonds," he said.
"And it appears to be retroactive, so that while we're not going to panic about outstanding bonds, it is shutting down some refundings of these bonds at a time when rates are historically low," he said. Utley said he was involved in a refunding that was about to close but that was halted because of the memorandum, at a cost of about $75,000 to the issuer.
Stefanie Galey, a lawyer with the firm of Holmes & Graven in Minneapolis, which was bond counsel on the transaction scrutinized by the IRS, agreed. "It is certainly a complete departure from what everyone understood before," she said.
An IRS official, however, said Tuesday that the IRS' general view on tax increment revenue financings is that the mere existence of a redevelopment contract does not make the bonds taxable. But the contract may contain certain provisions that do make the bonds taxable, the official said.
The official stressed he could not discuss the memorandum because it had not yet been published. He said such memorandums should never be considered precedent setting.
But even the lawyers who said they could see how the IRS could be troubled by some of the provisions in the contract provisions in this transaction were still concerned about some of the IRS' statements in the memorandum.
"It's one of those classic situations where bad facts make bad law," said Peter Seed, a lawyer with Briggs and Morgan in St. Paul. But the IRS "went off the deep end" with "some rather loose language," he said.
In the transaction in question, a city formed a tax increment financing district basically consisting of property that was eventually all acquired by the taxpayer company. The city issued tax increment revenue bonds that were to be used to reimburse the company for some improvements it made to the site where the industrial facility was to be built.
Bond lawyers said the city basically believed it was making a grant to the company because the improvements ultimately would be financed by the bonds and the debt service on the bonds would be paid solely from the incremental property taxes generated from the newly formed district.
The idea behind tax increment financings, bond lawyers said, is for tax-exempt bond proceeds to be used to provide financial incentives for private development, often in blighted areas. The bond proceeds are always used by a private party. But they are considered tax-exempt if they are backed by taxes that are generally applicable to taxpayers. The IRS said in a 1973 revenue ruling that generally applicable taxes would not be considered private payments or private security for such bonds.
If these bonds involved both private use and private payments, they would be considered taxable private-activity bonds. Under the tax laws, bonds are taxable private-activity bonds if over 10% of the proceeds are used directly or indirectly by private parties and over 10% of the debt service is derived from, or secured by, payments from private parties. Bonds also can be taxable if 5% or $5 million of the proceeds, whichever is less, is loaned to a private party.
The IRS concluded in its memorandum that the city's tax increment revenue bond issue was backed with taxes that, because of the redevelopment agreement, were not generally applicable but that instead represented private payments or a private loan. The private payments coupled with private use, or the private loan in and of itself, would make the bonds taxable private-activity bonds.
Under the redevelopment agreement, the city agreed to issue the tax increment revenue bonds and other bonds to be paid from incremental taxes, and the taxpayer agreed to pay all property taxes on its property within the district.
The taxpayer also agreed to construct certain minimum improvements to its industrial facility; to spend enough money on the improvements to result in a certain amount of assessed market value for the property that would generate enough incremental taxes to pay debt service on the bonds; and not to apply to defer any property taxes on its property while other general obligation tax increment bonds that had been issued at the same time were outstanding.
In addition, the taxpayer agreed to enter into another agreement providing that the assessed market value of the improvements and the taxpayer's property in the district upon which the improvements were made would be a certain minimum dollar value; and to maintain casualty insurance on the improvements in an amount sufficient to result in a minimum assessed market value of a certain dollar amount.
Utley and other lawyers said issuers always enter into such contracts with the private companies benefiting from the bonds to ensure the project will be completed and the bonds paid. "The issuer wants to make sure the subsidy isn't wasted," he said.
"State law requires that there be a redevelopment contract in place before you do a tax increment revenue financing," said Galey.
But Seed said he could see how some of the provisions, such as the taxpayer company's agreement to pay taxes and not to seek deferment of taxes, might have been troublesome for the IRS. He said, for example, that if the taxpayer company agrees to pay the taxes under the contract, the company becomes personally liable for those taxes. This is a departure from statutory requirements under which, if the taxes are not paid, a lien is put on the property but the company can walk away from those unpaid taxes.
"For taxes to be generally applicable, the manner of determination and collection of the tax also must be generally applicable," according to the IRS' traditional view of these financings, he said.
"If you start contractually manipulating the obligation to pay the taxes, then you've gone too far" and risk losing the bonds' generally applicable status, he added.
Sharon Stanton White, a partner at Jones Hall Hill & White in San Francisco, said she thought one concern about the transaction could have been that all of the incremental taxes were coming from one taxpayer. She said tax increment financing districts in California are larger and typically contain many different and diverse taxpayers. But the IRS did not focus on this point in the memorandum.
Although the lawyers were divided over aspects of the contract and financing, they were all concerned over the IRS' conclusion that "The agreements to raise the assessed market value of the property, to insure the property, and to not defer the payment of the property taxes were a plan to generate enough additional property tax from [the] taxpayer's property alone to pay the debt service on the revenue bond."
The IRS said that "this device to pay the debt service on the revenue bond indirectly from the property was really not a generally applicable tax on [the] taxpayer for the use of [bond] proceeds."
It said that the contract "established a nexus between the tax increment and private business use, causing the tax increment payments to be payments ... used for a private business use."
Seed said that "If this is the new standard for deciding whether it's a tax of general applicability, then we've a real serious problem." In such financings, he explained, "there is always a plan to have a project that will, among other things, generate enough tax to pay the debt service on the bonds that were used" to help fund development.
"The basic issue is whether the city has made a grant or a loan of the proceeds. I would argue it's a grant" and the bonds are tax-exempt, even with these contract provisions, he said.
Utley said the memorandum is confusing because "it doesn't tell us what is good and bad" in terms of contract provisions, he said.
He urged the IRS to issue a ruling to clarify its stance.
"I would love to discover that I'm Chicken Little on this," he said.