Rev. Rul. 80-251

ISSUE

Will bonds that a city proposes to issue be "industrial development bonds" within the meaning of section 103(b)(2) of the Internal Revenue Code?

FACTS

In order to provide loans to developers of industrial buildings, city M proposes to issue general obligation bonds that will be secured by M's full faith and credit. Bond proceeds will be paid by the bond purchaser to the city director of finance, who will remit the proceeds to the board of finance (board) for deposit in the board's bank account. The board will disburse the proceeds for approved loans as directed by an administrative body of M. Repayment by developers of all loans made from bond proceeds will be made to the board. The board will transfer the funds to the director of finance for credit to the general fund of M.

In its annual budget, M includes in its general fund all debt service (principal and interest payments) on all outstanding general obligations. M is required by state legislation to levy ad valorem taxes at a rate and in an amount sufficient to produce revenue to pay debt service on such obligations.

Substantially all of the loans of bond proceeds will be used by the developers in connection with the purchase, construction, or reconstruction of industrial buildings that will be leased or sold to persons who are not "exempt persons" within the meaning of section 103(b)(3) of the Code for use in their trades or businesses.

The industrial buildings purchased, constructed, or reconstructed with bond proceeds will not be pledged as security for payment of debt service on the bonds. M will secure all loans to the developers financed with the bond proceeds with mortgages on the facilities financed by the loans. Payments by the developers of principal and interest due with respect to loans made from bond proceeds will not be pledged as security for payment of debt service on the bonds and such payments will not match or coincide with debt service amounts due with respect to the bonds. The interest paid by the developers on the loans made from bond proceeds may be less than, equal to, or greater than the interest paid by M on the bonds. However, it is anticipated that over the term of the bonds the principal and interest payments to be made by the developers and the total debt service on the bonds will be approximately equal in present value.

The bonds will not be "arbitrage bonds" within the meaning of section 103(c) of the Code.

LAW AND ANALYSIS

Section 103(a)(1) of the Code provides that gross income does not include interest on the obligations of a state or the political subdivision of a state.

Section 103(b)(1) of the Code provides that, except as otherwise provided in section 103(b), any industrial development bond shall be treated as an obligation that is not an obligation described in section 103(a)(1).

Section 103(b)(2) of the Code provides that the term "industrial development bond" means any obligation (A) that is issued as part of an issue all or a major portion of the proceeds of which are to be used directly or indirectly in any trade or business carried on by any person who is not an exempt person (as defined in section 103(b)(3)), and (B) the payment of the principal or interest on which (under the terms of such obligation or any underlying arrangement) is, in whole or in major part (i) secured by any interest in property used or to be used in a trade or business or in payments in respect of such property, or (ii) to be derived from payments in respect to property, or borrowed money, used or to be used in a trade or business.

Section 1.103-7(b)(3) of the Income Tax Regulations provides that the trade or business test relates to the use of the proceeds of a bond issue. The test is met if all or a major portion (more than 25 percent) of the proceeds of a bond issue is used in a trade or business carried on by a nonexempt person. For example, if all or a major portion of the proceeds of a bond issue is to be loaned to one or more private business users, or is to be used to acquire, construct, or reconstruct facilities to be leased or sold to such private business users, and such proceeds or facilities are to be used in trades or businesses carried on by them, such proceeds are to be used in a trade or business carried on by persons who are not exempt persons, and the debt obligations comprising the bond issue satisfy the trade or business test.

Section 1.103-7(b)(4) of the regulations provides that the security interest test relates to the nature of the security for, and the source of, the payment of either the principal or interest on a bond issue. The nature of the security for, and the source of, the payment may be determined from the terms of the bond indenture or on the basis of an underlying arrangement. An underlying arrangement can be inferred from all the facts and circumstances.

Example (14) of section 1.103-7(c) of the regulations, which illustrates the existence of an underlying arrangement, reads as follows:

J, a political subdivision of a State, will issue several series of bonds from time to time and will use the proceeds to rehabilitate urban areas. More than 25 percent of the proceeds of each issue will be used for the rehabilitation and construction of buildings which will be leased or sold to nonexempt persons for use in their trades or businesses. There is no limitation either on the number of issues or the aggregate amount of bonds which may be outstanding. No group of bondholders has any legal claim prior to any other bondholders or creditors with respect to specific revenues of J, and there is no arrangement whereby revenues from a particular project are paid into a trust or constructive trust, or sinking fund, or are otherwise segregated or restricted for the benefit of any group of bondholders. There is, however, an unconditional obligation by J to pay the principal and interest on each issue of bonds. Further, it is apparent that J requires the revenues from the lease or sale of buildings to nonexempt persons in order to pay in full the principal and interest on the bonds in question. The bonds are industrial development bonds because a major portion of the proceeds will be used in the trades or businesses of nonexempt persons and, pursuant to an underlying arrangement, payment of the principal and interest is, in major part, to be derived from payments in respect of property or borrowed money used in the trades or businesses of nonexempt persons.

An underlying arrangement will always be inferred if the payments to be made by the industrial user or users and the debt service on the bonds are approximately equal in present value. Other facts that tend to show an underlying arrangement are, first, that payments made by the industrial user or users are material to the security for the bonds, and second, that the identity of the industrial user or users can be determined with reasonable certainty at the time of issue.

In Rev. Rul. 75-403, 1975-2 C.B. 37, a state proposed to issue bonds in order to make loans to nursing homes to finance the costs necessary to meet federal and state safety standards. The bonds were to be secured by the full faith and credit of the state. The nursing home loan repayments, the assets financed by such loans, and any other security on the nursing home loans were not to be pledged as security for the payment of principal or interest on the proposed bonds. Rev. Rul. 75-403 holds that the security interest test contained in section 103(c)(2) (redesignated section 103(b)(2)) of the Code will not be satisfied and the bonds will not be industrial development bonds.

In this case the bond proceeds will be loaned to developers for use in constructing or reconstructing industrial buildings that will be leased or sold to nonexempt persons. Because the building financed by the bond proceeds will be used in the trades or businesses of the nonexempt persons, the bond proceeds will be considered used in the trades or businesses of nonexempt persons and the "trade or business test" described in section 1.103-7(b)(3) of the regulations will be satisfied.

Although payments of principal of and interest on the loans by developers will not coincide with debt service on the bonds, an underlying arrangement can be inferred because the payments to be made by the developers and the debt service on the bonds are approximately equal in present value. Consequently, the payment of principal of and interest on M's bonds will be derived from payments in respect of property, or borrowed money, used or to be used in a trade or business within the meaning of section 103(b)(2)(B)(ii) of the Code. See example (14) of section 1.103-7(c) of the regulations. Therefore, the "security interest test" described in section 1.103-7(b)(4) will be satisfied.

The Service has reconsidered Rev. Rul. 75-403 and because Rev. Rul. 75-403 did not focus on whether an underlying arrangement would cause the security interest test to be satisfied, the Service will no longer follow that revenue ruling.

HOLDING

The bonds to be issued by M will be "industrial development bonds" within the meaning of section 103(b)(2) of the Code.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 75-403 is revoked.

PROSPECTIVE APPLICATION

Pursuant to the authority contained in section 7805(b) of the Code, this revenue ruling will not apply to obligations sold prior to September 15, 1980, the date this revenue ruling is published in the Internal Revenue Bulletin.