1988 U.S. Tax Ct. LEXIS 56">*56
P proposes to issue bonds pursuant to an indenture between P and a corporate trustee and seeks a declaratory judgment that such bonds would be described in
90 T.C. 832">*833 OPINION
The Commissioner determined that certain obligations that petitioner proposes to issue would not be described in
1988 U.S. Tax Ct. LEXIS 56">*58 This case was submitted on the stipulated administrative record pursuant to Rules 122 2 and 217(b). The facts and representations contained in the administrative record are assumed to be true. Rule 217(b)(1).
Petitioner is an authority created under the California Health Facilities Act 3 empowered to issue obligations on behalf of the State of California. Petitioner maintains its principal office at Sacramento, California.
Petitioner plans to issue bonds in one or more series pursuant to an indenture between petitioner and a corporate trustee. Petitioner will deposit the bond proceeds net of costs, capitalized interest, and a reserve fund with one or more banks or other financial institutions (the lenders) 1988 U.S. Tax Ct. LEXIS 56">*59 90 T.C. 832">*834 pursuant to one or more loan agreements (the lender loan agreement). The deposits are cast in the form of loans to the lenders and are general obligations of the lenders.
The lender loan agreement gives petitioner firm control over the use of the bond proceeds. The lenders must account for bond proceeds separately from their other funds and must use all bond proceeds to make loans to health care facilities (the hospitals) specified by petitioner. The hospitals will co-sign the lender loans. A bondholder could look to the lenders for repayment if petitioner were to default and to the hospitals if the lenders were to default.
The hospitals will be either (1) nonprofit corporations qualifying as exempt organizations pursuant to section 501(c)(3) or (2) governmental units. The hospital loan agreements will provide that the proceeds of the loans may be used only to finance, refinance, or reimburse the cost of constructing, acquiring, or installing capital improvements or equipment at the hospitals. At least 95 percent of the net proceeds (proceeds less reasonably required reserve or replacement funds) of each bond issue will be used solely for the exempt purpose of "hospitals" 1988 U.S. Tax Ct. LEXIS 56">*60 as that term is used in
1988 U.S. Tax Ct. LEXIS 56">*61 Petitioner will issue two separate series of bonds. "Issue A" bonds will be issued in the principal amount of approximately $ 40 million to finance the acquisition and construction of new health care facilities by a single hospital described in section 501(c)(3). Issue A will consist of serial and term bonds and will have a final term to maturity not exceeding 35 years. "Issue B" bonds will be issued in the principal amount of approximately $ 30 million to provide a pool of funds to finance the acquisition of health care equipment by hospitals that apply to petitioner during a period ending approximately 2 1/2 years after the date of issuance of the Issue B bonds. Issue B will consist of term bonds having a final term to maturity of approximately 7 years. All bonds issued will be in registered form but will not be federally guaranteed. See sec. 149(a), (b). Petitioner will satisfy the information reporting requirements of section 149(e). Any management agreements or other operating contracts entered into with organizations not described in section 501(c)(3) will meet the operating guidelines set forth in
1988 U.S. Tax Ct. LEXIS 56">*63 Petitioner filed its ruling request on June 15, 1983. After extensive correspondence, respondent issued a favorable letter ruling on February 27, 1984, concluding that interest on the bonds was excludable from gross income under
We first consider whether, as respondent contends, the bonds are private activity bonds not described in
Petitioner argues that regardless of whether the bonds in issue satisfy the private business-use test, they are nonetheless exempt from tax as bonds described in
1988 U.S. Tax Ct. LEXIS 56">*67 90 T.C. 832">*838 Respondent contends that petitioner's bonds will not be "qualified bonds" because they will be used in the lenders' trade or business. If we conclude that the bond proceeds will be used in the lenders' trade or business, the bonds will not be described in
The lenders' authority over the bond proceeds is the equivalent of an agent employed by petitioner to promote an efficient distribution of bond proceeds to the hospitals. The lenders must account separately for the bond proceeds held by them and must use the proceeds exclusively to make loans to those hospitals specified by petitioner. 1988 U.S. Tax Ct. LEXIS 56">*68 Petitioner will also specify the principal amount, interest rate, term, and all other provisions required by the indenture and the lender loan agreement. Petitioner will specify the loan eligibility standards. The lenders must apply their customary underwriting standards and may refuse to make a loan after examination of the credit worthiness of a hospital specified by petitioner, subject to prior consultation with petitioner. To the extent that loans are not made within a specified period, the lenders must repay the unspent proceeds, and petitioner must use those funds to redeem bonds. The lenders thus will use the net bond proceeds as agents of petitioner to facilitate the hospital loans.
Petitioner has the option to purchase any hospital loan from any lender at any time by paying the unpaid principal amount plus accrued interest and any prepayment penalty. The lenders may not sell or otherwise dispose of the loans to any other person or entity without express written authorization from petitioner, and the proceeds of any such 90 T.C. 832">*839 sale must be used by the lenders to repay their obligation to petitioner under the lender loan agreement.
The lenders' role in credit support1988 U.S. Tax Ct. LEXIS 56">*69 of the bonds is substantially similar to that of the writer of a direct pay letter of credit which is assigned to a trustee for the benefit of the bondholders. We view the lenders' unconditional obligation to pay petitioner as the equivalent of lending their credit status to petitioner to guarantee the bonds. The lenders are obligated to repay the loan from petitioner regardless of whether the hospital loans are in default. The lenders' status as obligors is principally to provide necessary credit support for the bond issue, as if they had issued letters of credit which were drawn down to make the payments on the bonds.
The lenders may not charge fees, bonuses, or premiums, commonly referred to as points (other than the "program fee" discussed below) but may charge the hospitals reasonable fees and expenses customarily charged in the area in connection with origination of similar loans. The fees and expenses may include application fees, appraisal fees, escrow fees, inspection fees, credit report fees, engineering fees, fees or premiums for title examination or title insurance, document preparation fees, and such other fees as petitioner may expressly authorize.
The lenders will1988 U.S. Tax Ct. LEXIS 56">*70 be compensated for making and servicing loans and providing credit support for the bonds primarily by charging a "program fee" as a percentage of the loan to be divided between the lender and petitioner and by the difference between the payments due on the loans and the payments that the lenders are required to make to petitioner. The program fee will not exceed 1 1/2 percentage points of the original principal amount of a hospital loan. The interest charged on the hospital loans cannot exceed the interest on petitioner's loans to the lenders by more than 1 3/4 percentage points. The amount charged by the lender will be an arm's-length rate not in excess of amounts charged by financial institutions generally in connection with similar loans. Hospitals seeking financing from lenders not participating in petitioner's bond program would incur additional costs for insurance from the Federal Deposit 90 T.C. 832">*840 Insurance Corporation or Federal Savings and Loan Insurance Corporation and for reserve requirements.
We conclude that the lenders' contractual obligations to petitioner are sufficient to preclude a finding that they will use the bond proceeds in a separate trade or business. 1988 U.S. Tax Ct. LEXIS 56">*71 We agree with respondent's initial view of this matter which formed the basis for his favorable letter ruling to petitioner dated February 27, 1984:
The program is designed to make credit available to Hospitals at terms not otherwise offered by Lenders and to provide financing for Hospitals not qualified for loans from Lenders based on customary lending practices. The restrictions placed on the Lenders' role in the Program preclude the Lenders from exercising discretionary control over the loans or sharing in the profits and losses from the operation of bond-financed facilities. The Lenders will serve as conduits for bond proceeds and as providers of services rather than as active participants in the program or as proprietors of bond-financed facilities. The Lenders will thus act as agents of Authority, and will not be users of any bond-financed facilities (the Projects) in a trade or business.
There are, however, elements of petitioner's proposed bond transaction that point to an opposite conclusion. First, the lenders are entitled to collect a prepayment penalty in the event of prepayment by a hospital or if petitioner elects to purchase any hospital loan from a lender. 111988 U.S. Tax Ct. LEXIS 56">*72 Second, the lenders are entitled to a portion of the program fee collected from the hospitals at closing on the hospital loans and, in addition, may charge an interest rate on their hospital loans up to 1 3/4 percent in excess of that charged on their loans from petitioner. Both of these elements are compensation to lenders normally received by financial lending institutions on loans to borrowers and these factors suggest that the loans are being made to the lenders for their own benefit. The record, however, does not provide any basis for concluding that this compensation is greater than that which would be received by the lenders acting as agents of petitioner for their credit support of petitioners bonds. 12 In spite of these negative factors, we conclude that the restrictions and controls under the lender agreements outweigh the negative points and assure that the hospitals will 90 T.C. 832">*841 be the only "users" of the bond proceeds within the meaning of
Interest on the bonds nonetheless may be taxable if the bonds are arbitrage bonds within the meaning of section 148.
SEC. 148. ARBITRAGE.
(a) Arbitrage1988 U.S. Tax Ct. LEXIS 56">*74 Bond Defined. -- For purposes of (1) to acquire higher yielding investments, or (2) to replace funds which were used directly or indirectly to acquire higher yielding investments.
A "higher yielding" investment is any investment property that produces a "materially higher" yield over the term of the issue than the yield on the issue. Sec. 148(b)(1). In this case, the bonds to be issued are the "issue," and in respondent's view, the "investment property" is the hospital loans.
Yield is determined based on the issue price of the obligation. Sec. 148(h). The yield produced by an acquired 90 T.C. 832">*842 obligation is materially higher than the yield on the issue if "the yield produced by the acquired obligations exceeds the yield produced 1988 U.S. Tax Ct. LEXIS 56">*75 by the issue of governmental obligations by more than * * * one-eighth of one percentage point."
The parties have stipulated that on the date of issuance of the bonds, petitioner will certify in good faith that it reasonably expects that the bond proceeds will not be used directly or indirectly to acquire higher yielding investments or to replace funds which were used or will be used directly or indirectly to acquire higher yielding investments which are prohibited by section 148(a), except as otherwise permitted by section 148. Further, petitioner will not intentionally use any portion of the proceeds of the bond issue in a manner described in section 148(a). Section 148(d)(1) provides that an amount not in excess of 10 percent of the proceeds of the bond issue may be invested in a higher yielding investment if that investment1988 U.S. Tax Ct. LEXIS 56">*76 is part of a reasonably required reserve or replacement fund. The parties agree that the bond issue will satisfy this requirement. In addition, petitioner's bond issue will comply with the rebate requirements of section 148(f).
The fees and expenses charged by the lenders for appraisal fees, application fees, escrow fees, title fees, and insurance, etc., are administrative costs. Respondent argues, however, that the "credit support" fees that the lenders will charge the hospitals should be viewed as interest and not administrative expenses because their sole purpose will be to recompense the lenders for assuming the risk that the hospitals may default on their obligations. The "credit support" fees are the "program fee" and the interest differential charged by the lenders on the loans to the hospitals. Respondent reasons that only specifically identifiable costs may be allocated to administrative costs with the remainder allocated to interest.
90 T.C. 832">*843 Respondent's argument is again grounded on a mistaken view of the lenders' role in the bond transaction. The hospital loans represent an obligation to repay the bond proceeds used by the hospitals in accordance with the purpose1988 U.S. Tax Ct. LEXIS 56">*77 of the bond issue, not an
Moreover, even if we were to consider the issue of "credit support" fees, characterizing them as interest to the lenders is immaterial to their characterization as an administrative cost incurred by petitioner to recompense the lenders for acting as agents in the transactions. Petitioner argues, and we agree, that the thrust of the "administrative costs" provision is to permit issuers of governmental obligations to break even economically. All of the amounts retained by the lenders, representing compensation for credit support services, can be viewed as petitioner's costs of issuing, carrying, and repaying the bonds, i.e., as administrative costs. Petitioner notes, and respondent concedes, that the lenders' position under petitioner's proposed bond issuance is economically equivalent to that of an issuer of a letter of credit. 13 In each case, the lender assures timely payment of debt service on governmental obligations, which is essential to the issuance and marketing of the obligations. Respondent agrees that1988 U.S. Tax Ct. LEXIS 56">*78 letter-of-credit fees are costs of issuing and carrying governmental obligations because the credit enhancement ensures repayment of the bonds. Such fees for a letter of credit are administrative costs within the meaning of
1988 U.S. Tax Ct. LEXIS 56">*79 The report of the Senate Finance Committee on the 1986 Act indicates that yield on bonds, in effect, should be adjusted to reflect the cost of "credit enhancement devices:"
The bill retains the present-law rules under which bond insurance premiums are treated as interest [thereby increasing yield on the governmental obligations] if the bond insurance results in a reduction in the interest rate on the bonds. In addition, the committee intends that the Treasury Department amend its regulations and to [sic] permit the
S. Rept. 99-313, at 845 (1986). 1986-3 C.B. (Vol. 3) 845. The conference committee adopted the Senate's position. H. Rept. 99-841 (Conf.), at II-747 (1986), 1986-3 C.B. (Vol. 4) 747. We agree that the interest differential represents the cost of a credit enhancement device. The remainder of the lenders' compensation represents the costs of originating and servicing the hospital loans and is thus an administrative cost1988 U.S. Tax Ct. LEXIS 56">*80 pursuant to
Respondent argues, however, that depending upon the form chosen, profoundly different results will be produced pursuant to
90 T.C. 832">*845 To reflect the foregoing,
*. By order of the Chief Judge, this case was reassigned to Judge B. John Williams, Jr., for decision and opinion.↩
1. Although the ruling that petitioner requested and which respondent denied pertained to bonds to be issued pursuant to the Internal Revenue Code of 1954, the parties have stipulated that, except for the matters at issue before the Court, the bonds to be issued will satisfy the requirements and restrictions of the Internal Revenue Code of 1986 as amended. Furthermore, the 1986 Code did not eliminate the issues controverted by the parties. Consequently, an actual case or controversy continues to exist between the parties. See sec. 7478(a). The House report on the bill that became the 1986 Code explains,
"The bill reorganizes and amends the present-law rules governing tax exemption for interest on obligations issued by or on behalf of qualified governmental units. As part of this reorganization, the present-law rules contained in Code
Unless otherwise specified, all section references are to the Internal Revenue Code of 1986 as amended.↩
2. All Rule references are to the Tax Court Rules of Practice and Procedure.↩
3.
4. Sec. 147(g)(1) provides:
SEC. 147(g). Restriction on Issuance Costs Financed by Issue. -- (1) In general. -- A private activity bond shall not be a qualified bond if the issuance costs financed by the issue (of which such bond is a part) exceed 2 percent of the aggregate face amount of the issue.↩
5. The Conference report states that, "as is true of other private activity bonds, costs of issuance are not treated as spent for the exempt purpose of the borrowing." H. Rept. 99-841 (Conf.), at II-726 (1986), 1986-3 C.B. (Vol. 4) 726. The report further explains:
"The conference agreement requires that at least 95 percent of the net proceeds of all issues of private activity bonds be used for the exempt purpose of the borrowing. * * * Net proceeds is defined as the proceeds of the issue minus amounts invested in a reasonably required reserve or replacement fund. Thus, amounts used to pay any costs of issuance must be paid from the so-called 5 percent 'bad money' portion of an issue. [H. Rept. 99-841 (Conf.),
6. Sec. 1301(e) of the 1986 Act provides:
SEC. 1301(e). Management Contracts. -- The Secretary of the Treasury or his delegate shall modify the Secretary's advance ruling guidelines relating to when use of property pursuant to a management contract is not considered a trade or business use by a private person for purposes of (1) the term of such contract (including renewal options) does not exceed 5 years, (2) the exempt owner has the option to cancel such contract at the end of any 3-year period, (3) the manager under the contract is not compensated (in whole or in part) on the basis of a share of net profits, and (4) at least 50 percent of the annual compensation of the manager under such contract is based on a periodic fixed fee.↩
7. See sec. 601.201(1)(4), Statement of Procedural Rules.↩
8. The petition was timely mailed on Mar. 15, 1985. See sec. 7502.↩
9.
(a) Private Activity Bond. -- For purposes of this title, the term "private activity bond" means any bond issued as part of an issue -- (1) which meets -- (A) the private business use test of paragraph (1) of subsection (b), and (B) the private security or payment test of paragraph (2) of subsection (b), or (2) which meets the private loan financing test of subsection (c).
(b) Private Business Tests. -- * * * * (9) Exception for qualified 501(c)(3) bonds. -- There shall not be taken into account under this subsection or subsection (c) the portion of the proceeds of an issue which (if issued as a separate issue) would be treated as a qualified 501(c)(3) bond if the issuer elects to treat such portion as a qualified 501(c)(3) bond. * * * *
(d) Qualified Bond. -- For purposes of this part, the term "qualified bond" means any private activity bond if -- (1) In general. -- Such bond is -- * * * * (G) a qualified 501(c)(3) bond.↩
10.
(a) In general. -- For purposes of this part, except as otherwise provided in this section, the term "qualified 501(c)(3) bond" means any private activity bond issued as part of an issue if -- (1) all property which is to be provided by the net proceeds of the issue is to be owned by a 501(c)(3) organization or a governmental unit, and (2) such bond would not be a private activity bond if -- (A) 501(c)(3) organizations were treated as governmental units with respect to their activities which do not constitute unrelated trades or businesses, determined by applying section 513(a), and (B) paragraphs (1) and (2) of
11. The record does not indicate the amount of the prepayment penalty, but respondent does not contend that it is commercially unreasonable.↩
12. Indeed, the record suggests the contrary. See note 13
13. The parties agree that under the traditional arrangement to provide tax-exempt financing to governmental units and hospital organizations described in sec. 501(c)(3), the governmental unit would issue bonds and lend the proceeds, net of costs, directly to the hospitals. When necessary to improve the bonds' rating as in this case, credit support would be secured in the form of a direct pay or stand-by letter of credit from a bank. The net proceeds of the bonds would be lent directly to hospitals but the banks would either make payments on the bonds directly and seek reimbursement from the hospitals, or stand by to make payments in the event the hospital defaulted on its obligation.
Letters of credit generally have been used in short-term transactions. Banks are reluctant to commit themselves to letters of credit in long-term financings. Petitioner, however, found that certain lenders would provide long-term credit for its bond program at comparable cost if the transaction was structured as a formal loan of bond proceeds to the lender followed by a relending by the lender to the hospital. From the standpoint of all of the parties involved, the economic consequences are equivalent to those obtained through a direct-pay letter of credit.↩
