The Treasury and Internal Revenue Service have issued proposed regulations governing allocations of tax-exempt bond proceeds to facilities that combine governmental or 501(c)(3) use on the one hand and use by private for-profit entities on the other ("mixed-use" facilities). These regulations provide important guidance on how to include tax-exempt capital in public-private projects notwithstanding the presence of functions that are not eligible for tax-exempt financing and that exceed the allowable amount of such non-qualified use. The proposed regulations are detailed and lengthy, but the principal provisions include the following:

  • The regulations establish a general pro-rata allocation method that applies unless another permissible method is selected. Under the pro-rata method, tax-exempt bond proceeds and other sources of funds (including taxable bond proceeds and other funds not derived from a tax-exempt borrowing) are allocated ratably throughout a facility in proportion to the various funding sources. This fallback method requires the entire facility to have no more than the allowable amount of non-qualified use (5% or 10%, as applicable) and therefore does not facilitate mixed-use projects.

  • The regulations provide two special elective allocation rules, which are available for mixed-use facilities that are wholly-owned by governmental persons or 501(c)(3) organizations. These rules are intended to allow issuers and 501(c)(3) borrowers flexibility to use tax-exempt bond proceeds to finance a qualified portion of a facility and equity or taxable debt for the non-qualified remainder. These elective allocation rules are not applicable to other privately-owned facilities, except in the case of certain "output" facilities as described below. The two proposed special elective allocation rules are:
  1. The discrete physical portion allocation method: This method divides a facility into physically discrete portions, and capital expenditures are allocated to these portions using a reasonable, consistently applied method that reflects the proportionate benefit derived by the various users of the mixed-use facility. The percentage attributed to a discrete portion can be measured by relative cost, space, fair market value or other objective measure that is reasonable under the circumstances. A relative fair market value allocation must be used if that methodology would significantly increase the portion of the facility that does not qualify for tax-exempt bonding versus other allocation methods. The proposed regulations permit reallocation of funds from one discrete portion to another no more frequently than once every five years, which may facilitate relocation of non-qualified uses within a mixed-use facility while tax-exempt bonds remain outstanding.

  2. The undivided portion allocation method: This method is available when the bondable and non-bondable uses do not occur in physically distinct areas of the mixed-use facility, but can be measured using fixed percentages of the overall use. As an example, the proposed regulations apply this method to a parking garage in which a fixed percentage of unreserved parking spaces are allocated to a particular use. The undivided portion allocation method may be applied to an entire facility or within a discrete portion of a facility determined in accordance with the discrete physical portion allocation method described above. This allocation method is available when there is a reasonable expectation that the mixed uses will occur simultaneously on the same basis or will occur at different times. The percentage attributed to each use can be measured by number of units or space, fair market value, time of use, the present value of reasonably expected revenues (if no other method is available), or other measure that is reasonably workable under the circumstances. A relative fair market value allocation must be used if that methodology would significantly increase the portion of the facility that does not qualify for tax-exempt bonding versus other allocation methods (for example, if a private user uses the facility during prime hours and the governmental or 501(c)(3) user does so during non-prime hours.) The undivided portion allocation method (but not the discrete physical portion allocation method) may be applied to an output facility (for example, an electric transmission facility) owned in part by private parties if all owners have undivided ownership interests and share the ownership, output and operating expenses in proportion to their contributions to the cost of the output facility.
  • Anticipatory remedial action. Existing regulations permit a post-issuance change in the use of governmentally-owned or 501(c)(3)-owned facility to a use that does not qualify for tax-exempt financing if certain remedial actions are taken, such as the redemption of associated tax-exempt bonds. The proposed regulations respond to concerns that current regulations may not allow such remedial action in advance of a troublesome change in use. The proposed regulations provide guidance on when the redemption of a portion of a bond issue, in advance of a change in use of a governmentally-owned or 501(c)(3)-owned facility, can be allocated to specified portions of the financed facility rather than on a pro-rata basis for purposes of permitting use of such portions for purposes that do not qualify for tax-exempt financing. The proposed regulations provide that, to qualify as an "anticipatory redemption" that permits such a targeted allocation before the actual change in use occurs, the applicable bonds must be redeemed at least 5 years before their scheduled maturity date or mandatory sinking fund redemption date and no more than one year (nor less than 91 days) before the deliberate action that results in the change in use occurs. Also, the facility must have been used in compliance with the originally intended purposes for at least five years after the bonds were issued. If such requirements are satisfied, the redeemed bonds can be allocated to portions of the facility in accordance with the discrete physical portion or undivided portion methodologies described above.

The proposed regulations, particularly the provisions allowing issuers and borrowers to allocate tax-exempt and other forms of capital within undivided portions of a mixed-use facility, appear to facilitate financing of mixed-use facilities with a variety of funding sources. However, it is not readily apparent why similar guidance is not provided for mixed-use projects involving facilities with for-profit owners (other than output facilities) that are eligible for tax-exempt financing. The anticipatory redemption provisions, while providing welcome clarification that remedial action may be taken prior to a change in use, appear unnecessarily restrictive. As drafted, they may have the counterproductive effect of delaying the redemption of tax-exempt bonds in situations where future non-qualified use of the financed facility becomes foreseeable but is not yet imminent.

Comments on these proposed regulations may be submitted within 90 days of their September 26, 2006 publication in the Federal Register. With certain minor exceptions, the regulations will become effective as to bonds sold on or after the 60th day after they are finalized.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.