Over the past few weeks, we have written multiple posts (see here, here, and here) on the recently promulgated Final Treasury Regulations governing, among other things, allocating proceeds of tax-exempt bonds and other sources to projects that  involve both qualified and private uses. As we’ve described before, the new Regulations allow issuers and 501(c)(3) borrowers to allocate “Qualified Equity” (defined below) first to the private use portion of a mixed-use project, and then to allocate tax-exempt bond proceeds to the remaining uses of the mixed-use project.  This post will build on prior posts by explaining a few practical ramifications of this expansive definition of Qualified Equity coupled with the clarification of permissible allocation methods.

Allocation Rules – Clarifying Uncertainty

Prior to the promulgation of the new Regulations, tax-exempt bond proceeds and other sources of funding (“equity”) for a project were generally allocated on a pro rata basis[1] unless the issuer or borrower specifically allocated the different sources of funds to a discrete space (the “Specific Allocation Rule”).[2]  There were circumstances when deviation from the Specific Allocation Rule was permitted but they were somewhat limited.  In circumstances when deviation was not permitted, there were three significant downsides to the application of the Specific Allocation Rule:

The issuer/borrower had to know the physical location of the private use when the bonds were issued (or shortly thereafter) in order to allocate the equity accordingly;

To the extent that equity was allocated to finance a discrete portion of the project that was subject both to qualified use and private business use the portion of the equity allocable to the qualified use would be wasted (for purposes of reducing the amount of private business use); and

Equity allocated to finance a discrete portion of space that was originally subject to private business use but that subsequently moved at any point while any maturity of the issue of tax-exempt bonds was outstanding (often 30+ years), would be wasted once the move has occurred.[3]

The new Regulations finalize and expand on the “undivided portion” allocation method that was introduced in Proposed Treasury Regulations promulgated back in 2006.   Under the undivided portion allocation method, projects are divided into governmental use and private business use portions on a notional, rather than physical, basis with tax-exempt proceeds first allocated to the qualified use portion and any other funds first allocated to the private business use portion.  Put another way, any Qualified Equity that the issuer or borrower contributes to finance a portion of the project will be allocated first (i.e., it will “float”) to any private business use irrespective of whether the issuer/borrower identified the private business use on the issue date, or whether the private business use ‘moved’ (or arose) subsequent to the issue date!  Essentially, a taxpayer friendly allocation rule previously applicable in only very limited circumstances, is now the default allocation rule for all tax-exempt bond issues!   This change significantly enhances the value of identifying and using Qualified Equity!  (please forgive the exclamation points)

Qualified Equity

Quite simply, “Qualified Equity” includes any amounts, other than proceeds of tax-advantaged bonds (e.g., proceeds of taxable bonds and equity contributed by the issuer/borrower) provided that such amounts are spent within a specific time frame based on two typical tax-exempt bond milestones. That time frame begins on the earliest date on which the capital expenditure to which equity is allocated would be eligible for reimbursement if the tax-exempt bonds had been issued as reimbursement bonds. Generally speaking, this is 60 days prior to the date on which the issuer or 501(c)(3) borrower adopts a declaration of intent (also known as a reimbursement resolution) to use bond proceeds to reimburse prior expenditures that meets certain requirements.[4] The time frame ends on the date that is the beginning of the private business use measurement period for the project. This date occurs on the issue date of the bonds or the placed in service date of the project, whichever is later.  For those of you who work well with examples (like me), consider the following:

Example: University adopts a declaration of intent on January 15, 2015 for a $10mm issue of tax-exempt qualified 501(c)(3) bonds.  The bonds are issued on July 1, 2015 and the proceeds are applied to finance a portion of a $20mm project that is placed in service on December 1, 2016.

The time limits during which Qualified Equity can be contributed to a project:

Hard Costs: Any amounts other than tax-exempt bond proceeds spent on project costs between November 16, 2014 (60 days prior to the declaration of intent) and January 1, 2016 (start of measurement period) are considered Qualified Equity.

Soft Costs: To the extent that “soft-costs” are paid prior to November 16, 2014, they are likely eligible to be treated as Qualified Equity as well because the reimbursement rules provide that certain soft costs paid more than 60 days before adopting a declaration of intent are also eligible for reimbursement (see footnote 4).

By limiting Qualified Equity to amounts spent on capital expenditures, the new Regulations incorporate the general federal income tax principles that tell us when soft costs are considered capital expenditures.   Often, a soft cost will be treated as a capital expenditure when it has a close relationship to a capital asset (sometimes referred to as “inherently facilitative costs”).

Going Forward

One consequence of the expansive definition of Qualified Equity coupled with the clarified allocation method is that expenditures paid prior to the issue date are much more relevant even though the issuer/borrower decides not to use tax-exempt bond proceeds to reimburse them.  Soft costs, such as survey fees, legal costs, permit costs, valuation reports, and other costs that are often not reimbursed with bond proceeds are now extremely important because the costs associated with such expenditures constitutes Qualified Equity and can liberally be applied to offset private business use.  Bond counsel should revisit its diligence questionnaires surrounding reimbursement to be able to identify amounts eligible for reimbursement but for which the issuer/borrower is not seeking reimbursement.

Another consequence is that the value of Qualified Equity is increased such that issuers/borrowers may utilize Qualified Equity where they may otherwise choose not to do so. For example, an issuer/borrower in a private placement deal may choose to utilize a small “taxable tail” to float to any private business use that would otherwise occur.  This is especially appealing in light of the current interest rate environment where the delta between taxable and tax-exempt interest rates is historically small. In addition, the taxable tail can be amortized first to further reduce the costs associated with a taxable borrowing.  Issuers/borrowers should also factor in the reduced post-issuance compliance costs.  For example,  501(c)(3) borrowers will save money on Schedule K preparation costs when they only have to calculate and report private business use that exceeds the Qualified Equity that is allocated to it.

[1] Tax lawyers love the word “pro rata” in the allocation context because it makes a fairly simple concept sound more complicated.

[2] The new Regulations are effective for all tax-exempt bonds issued on or after January 25, 2016; however, they may be applied to bonds issued before that date.

[3] When writing this, I realized that the bookstore (a common source of private business use) at both my undergraduate college (The Ohio State University) and my law school (Catholic University) have moved in the time since I graduated.

[4] The earliest date on which the period to determine Qualified Equity could begin is presumably three years prior to the issue date of the bond issue because that is longest period for which pre-issuance capital expenditures can be reimbursed with the proceeds of a tax-exempt bond issue.