Recently, Treasury proposed a new test for an entity to qualify as a “political subdivision” that is entitled to issue tax-exempt bonds on its own behalf.

The proposed regulations included transition rules that Treasury put in place to make sure that the proposed regulations would apply only prospectively if Treasury finalizes them. (Prop. Reg. 1.103-1(d)(2) – (4).)

One of the transition rules said that solely for purposes of determining whether outstanding bonds of an entity were issued by a political subdivision, the new, more restrictive definition of political subdivision would not apply to outstanding bonds that are issued no more than 30 days after Treasury finalizes the proposed regulations. We immediately noted a nasty trap lurking in these new rules. If Treasury finalized the rules in their current form, this transition rule would mean that existing bonds would be treated as issued by a political subdivision (under the current definition of political subdivision), but the issuer itself would be treated as a private user (because the transition rule only applies for purposes of determining whether the bonds were issued by a political subdivision, and no further). The fact that the transition rule ensures that the bonds are treated as issued by a valid issuer would be cold comfort because the issuer’s use of the bond-financed project would be treated as private business use, meaning that the bonds likely would lose their tax-exempt status anyway. The same trap would ensnare refunding bonds that were intended to qualify for the additional transition rule that would grandfather in refunding bonds that did not extend the weighted average maturity of prior bonds issued under the old definition of political subdivision.

Our immediate thought was that this trap could not have been what Treasury intended, and Treasury has agreed. Treasury corrected the proposed regulations yesterday. The corrections make it clear that the transition rules apply for all tax-exempt bond purposes, avoiding this potential trap. The revised provisions look like this:

The proposed regulations have many other substantive issues that the tax-exempt bond community will continue to discuss, based on policy disagreements between Treasury and the tax-exempt bond community. Treasury should be commended for fixing this obviously unintended result in the meantime.