Rev. Rul. 80-171

ISSUE

Are bond proceeds reduced by the amount of a reserve fund for purposes of determining if substantially all of the bond proceeds will be used to provide exempt facilities described in section 103(b)(4) of the Internal Revenue Code?

FACTS

A political subdivision of a state proposes to issue 100x dollars of industrial development bonds to finance certain exempt facilities described in section 103(b)(4) of the Code for use by an industrial corporation. The cost of issuing the bonds will be 5x dollars and the political subdivision will use bond proceeds to establish a reserve fund of 15x dollars. This reserve fund will qualify as a reasonably required debt reserve fund. Of the remaining bond proceeds, 75x dollars will be used to construct the exempt facility and 5x dollars will be loaned to the corporation for working capital. Over the term of the bonds, the corporation will make periodic payments to the political subdivision that will equal total principal and interest payments on the bonds. The bonds will not be arbitrage bonds within the meaning of section 103(c).

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 a political subdivision thereof.

Section 103(b)(1) of the Code provides that, with certain exceptions, the interest on "industrial development bonds" is not excludable from gross income.

Section 103(b)(4) of the Code provides that section 103(b)(1) shall not apply to industrial development bonds if substantially all of the bond proceeds are to be used to provide certain exempt facilities.

The "substantially all" test in section 103(b)(4) of the Code will be satisfied if 90 percent or more of the proceeds of an issue of governmental obligations are used to provide an exempt facility. For purposes of this test, proceeds are reduced by amounts properly allocable on a pro rata basis between providing the exempt facility and other uses of the proceeds ("neutral costs"). Section 1.103-8(a)(1)(i) of the Income Tax Regulations.

The example in section 1.103-8(a)(6) of the regulations demonstrates that proceeds are reduced by the costs of issuing the state bonds for purposes of arriving at the amount of bond proceeds to which the substantially all test will be applied.

In this case, the portion of the bond proceeds (75x dollars) that will be used to construct the exempt facility will be a qualifying use of such proceeds. The portion of the bond proceeds (5x dollars) to be used to furnish working capital to the corporation will be a nonqualifying use of such proceeds. The proceeds used for the cost of issuing the bonds and the amount of proceeds to be placed in the reserve fund will be considered neutral costs because they will be attributable to both the qualifying and nonqualifying uses of bond proceeds. The example in section 1.103-8(a)(6) of the regulations illustrates that the cost of issuing bonds are deducted in arriving at bond proceeds. The amount to be placed in the reserve fund will qualify for similar treatment. See section 1.103-8(a)(1)(i).

HOLDING

Bond proceeds will be reduced by the amount of the issuance cost (5x dollars) and by the amount of the reserve fund (15x dollars). Because substantially all (75x dollars/80x dollars equals 93.75 percent) of the bond proceeds will be used to provide exempt facilities, the bonds will qualify for the exception provisions of section 103(b)(4) of the Code and the interest on the bonds will be excludable from the gross incomes of the bondholders under section 103(a)(1).

The result would be the same if the bonds were issued to finance industrial parks described in section 103(b)(5) of the Code or were issued as an exempt small issue under section 103(b)(6).