Rev. Rul. 59-41

Advice has been requested (1) whether income to be received by a nonprofit corporation, to be organized under the applicable provisions of the general laws of a state, is includible in gross income and (2) whether interest to be paid on bonds issued by the corporation is exempt from Federal income tax.

Corporation M was incorporated under the non-profit corporation law of the State at the request of the governing body of the City of N . The corporation was organized for the exclusive purpose of purchasing and operating a water system to supply and distribute water for municipal, domestic, and industrial uses in and near the City of N . The City of N , which had the right pursuant to law to purchase such water system, waived such right and by contract with the M corporation ratified and approved the purchase of the water system by the corporation. Under such contract the City of N ratified the terms of an indenture under which the company proposed to incur debt and issue bonds to finance the purchase and construction of the water system. The contract expressly set forth the terms of an option under which the City of N might at any time purchase the water system for an amount equal to the indebtedness then outstanding, together with interest, and also expressly provided that, without demand or further action of any kind, the City of N should become the owner in fee and entitled to immediate exclusive possession of the properties when the debt of the company is fully paid. The contract created an advisory board composed of the members of the commission council of the City, who were to be notified of meetings and have the right to attend and participate and make recommendations. Periodic reports are to be made, open to the City and bondholders.

All funds used for the acquistion of the water system will be borrowed through the issuance of the corporation's long-term first mortgage revenue bonds. At the same time additional bonds will be issued for extension and improvements of the water system. The bonds will be callable prior to maturity.

The indenture which secures the bond provides that all monies received by the corporation for the sale of water to its customers shall be used by the corporation, first, to pay reasonable and proper operating expenses, second, to pay the interest on and the principal of the bonds, and, third, to establish the reserves required under the indenture securing the bonds. So long as these payments are current, surplus receipts are to be paid to the general fund of the City of N .

Title to the system shall vest in the City of N free of all liens, claims, and encumbrances at the time the bonds and the accrued interest thereon have been paid in full. No part of the net earnings or other assets of the corporation shall inure to the benefit of any private shareholder or individual. The commission council of the City of N , by resolution approved by the mayor, stated its intention to purchase the system from the corporation or to take title to the system when the indebtedness of the corporation is paid in full.

In view of the above, including the responsibility which the City of N has assumed by reason of its actions, and the substantial control which it in effect has over the management and operation of the water system, it is held that income to be earned by corporation M from the operation of the water system will not constitute gross income within the meaning of section 61 of the Internal Revenue Code of 1954 and will not be subject to Federal income tax. See Keokuk and Hamilton Bridge, Inc. v. Commissioner , 180 Fed.(2d) 58. The mortgage bonds and other bonds to be issued to finance the purchase of the water system and the improvements to be made will be considered issued in behalf of the municipality and interest paid thereon will be exempt from Federal income tax under the provisions of section 103 of the Code. See Revenue Ruling 54-296, C.B. 1954-2, 59; I.T. 3772, C.B. 1945, 367; and Revenue Ruling 57-151, C.B. 1957-1, 64, each of which holds that interest on bonds issued under similar circumstances is exempt from Federal income tax.