iWhen the Internal Revenue Code (“IRC”) says it does. (For those of you that want to remind yourselves of how a bill becomes a law, such as the IRC, see this video from Schoolhouse Rock).
As you may know, issuers of governmental-use bonds are generally permitted to use up to 10% of the tax-exempt bond proceeds of an issue for private business use (“PBU”) before the tax-exempt bonds run the risk of being characterized as taxable private-activity bonds (“PABs”). If the PBU exceeds 10%, then the issuer will also need to determine whether the private security or payment (“Private Payment”) test is met in order to determine if the bonds are PABs. (Remember, meeting the 10% PBU and Private Payment tests is generally a bad thing). However, because nothing is simple in the tax world, there is a second PBU/Private Payment threshold that you may not be as familiar with – the 5% unrelated or disproportionate test.[1]
The first step in applying the 5% unrelated/disproportionate test is to determine if the identified PBU is related to a governmental use.
What does “unrelated” (or “related”) mean in this context? It depends. The test is applied on a case-by-case basis, but the regulations identify some relevant factors. For example, in general, PBU will only be considered related PBU if it is within or adjacent to the governmentally used facility. By way of example, the legislative history to these provisions indicates that a privately operated cafeteria in a school building would be deemed related PBU, while a stand-alone administrative building for the private operator of all of a school system’s cafeterias would be unrelated PBU. [2] Also, simultaneous use of a facility for the same purpose by a private party and governmental user (e.g., parking) will generally make the PBU related, as long as the simultaneous governmental use of such facility is “not insignificant.” What does “not insignificant” mean? Other than it logically means the government use is “significant,” your guess is as good as mine, as there does not appear to be any specific guidance providing insight (e.g., a percentage) in this regard.
If the PBU is unrelated to a governmental use, and exceeds the 5% threshold, the unrelated PBU test is met (a bad result). If the PBU is related to the governmental use, then the issuer must determine if the related PBU is disproportionate to the governmental use.
What does “disproportionate” mean in this context? Excess. PBU is disproportionate to the related governmental use only to the extent that the amount of proceeds allocated to the related PBU exceeds the amount of proceeds allocated to the governmental use. By way of example, an issuer issues $50 million of bonds with $46 million of proceeds used for construction of an administrative building and $500,000 of proceeds used for improvements to a courthouse, neither of which have any PBU. The remaining $3.5 million of bond proceeds is spent on a private parking garage next to the courthouse. In this hypothetical, the total PBU is 7%, which is less than the general 10% permitted PBU. However, $3 million of the PBU bond proceeds would be characterized as disproportionate to the related governmental use ($3.5 million spent on the private parking garage next to the courthouse less the $500,000 spent on the courthouse). Because this $3 million results in 6% of the proceeds being used in PBU that is related, but disproportionate to the governmental purposes of the bond issue ($3 million/$50 million), the disproportionate PBU test is met (a bad result).
What happens if the 5% unrelated/disproportionate PBU test has been met? Then the issuer must determine whether the 5% Private Payment portion of the unrelated/disproportionate test is met. If it is, the issue will be deemed (taxable) PABs (unless a qualifying remedial action can be taken to avoid satisfaction of the 5% unrelated/disproportionate PBU threshold – a topic for another blog post).
What is the Lesson Learned? Given all the complexity that the 5% unrelated/disproportionate test adds to an already complex PBU and Private Payment landscape, it is too bad that the bill including these provisions did not die on Capitol Hill.
[1] The below discussion summarizes the provisions set forth in IRC Section 141(b)(3) and Reg. §1.141-9.
[2] Conference Committee Report to P.L. 99-514 (1986), H.R. Conf. Rep. No. 99-841, II-69
