23 March 2018 Bonds related to acquisition of university medical center will be tax-exempt, IRS rules In PLR 201811009, the IRS has ruled that a university and the buyer of a medical center operated by the university are not related parties for purposes of Treas. Reg. Section 1.150-1(d)(2)(ii)(A). Accordingly, bonds proposed to be issued as part of an advanced refunding to redeem a portion of the buyer's taxable debt used to acquire the medical center will not fail to be tax-exempt. University and Buyer are both tax-exempt Section 501(c)(3) organizations. Buyer acquired from University an academic medical center that University formerly operated. Buyer's charter states that it is organized, in part, for the purpose of operating an academic medical center affiliated with University. Before Buyer's acquisition of the medical center, University used proceeds from some tax-exempt bonds (the Prior Bonds) to finance certain medical center assets. The Prior Bonds are qualified 501(c)(3) bonds that advance refunded tax-exempt bonds previously issued. To finance its acquisition of the medical center, Buyer used proceeds from taxable debt issued by Issuer (the Taxable Debt). University, in turn, used a portion of the proceeds received from Buyer from the Taxable Debt to defease the Prior Bonds. The Taxable Debt was issued more than 90 days before the redemption of the Prior Bonds, which remain outstanding. Issuer proposes to issue qualified 501(c)(3) bonds (the Proposed Bonds) and loan the proceeds to Buyer to refund the portion of the Taxable Debt used to defease the Prior Bonds. The Proposed Bonds and the Prior Bonds will be outstanding concurrently for more than 90 days. Buyer is governed by an 11-member board of directors. University holds the power to appoint and remove four of Buyer's 11 directors. With the exception of University's chancellor, no employee of University may serve as a director of Buyer. University has no power to compel Buyer to use its funds for any purpose, and Buyer determines its operating and capital budgets, issues debt and expends funds without University's approval. Buyer also has sole control over collection of its receivables and sole responsibility for satisfaction of its liabilities. University has no power to hire or to fire Buyer's employees. University has the right, however, to approve certain actions of Buyer — generally with respect to major actions outside of Buyer's ordinary course of business or actions that would affect Buyer's tax-exempt status or affiliation with University. The ruling addresses whether the Proposed Bonds will be an advanced refunding issue that would not be tax-exempt under former Section 149(d)(3)(A)(i) (portions of Section 149(d) were removed from the Internal Revenue Code through the Tax Cuts and Jobs Act of 2017 (TCJA), as discussed in the Implications section of this Alert). Former Section 149(d)(3)(A)(i) generally provides that a bond issue is described in Section 149(d)(3) — and therefore not tax-exempt — if the bond is issued to advance refund a bond, unless the refunding bond is only the first advance refunding of an original bond that was issued after 1985. Under former Section 149(d)(5), a bond shall be treated as issued to advance refund another bond if the refunding bond is issued more than 90 days before the redemption of the refunded bond. The IRS explained that former Section 149(d)(3)(A)(i) would prohibit the Proposed Bonds from being tax-exempt if the Taxable Debt (which the Proposed Bonds would refund in part) is: (1) a refunding of the Prior Bonds (which advance refunded other tax-exempt bonds previously issued); and (2) would be outstanding concurrently with the Proposed Bonds for more than 90 days. The IRS added that the Taxable Debt is not a refunding issue if Buyer (the obligor of the Taxable Debt) and University (the obligor of the Prior Bonds) are not related parties. The IRS stated that, as Section 501(c)(3) entities, Buyer and University are related parties if they are members of the same controlled group. Under Treas. Reg. Section 1.150-1(e), Buyer and University are members of the same controlled group if one directly or indirectly controls the other, or if another entity controls both of them. For purposes of this ruling, the IRS stated that the only relevant inquiry was whether University directly controls Buyer. The determination of control by one entity over another under Treas. Reg. Section 1.150-1(e) is made based on all the facts and circumstances. The IRS noted that University holds power to appoint and remove only four of Buyer's 11 directors (i.e., not a controlling share). In addition, University has no power to compel Buyer to use its funds for any purpose. Buyer controls its own funds and assets, as well as the hiring and firing of employees. The IRS stated that these facts support a conclusion that University does not directly control Buyer. Nonetheless, the IRS acknowledged that University can prohibit Buyer from taking certain actions, including prohibiting Buyer from: (1) completing major structural changes without University approval, or (2) taking any actions that result in a change in Buyer's tax-exempt status. The IRS stated, however, that this type of control differs from operational control. University cannot force Buyer to act, but rather can only prevent Buyer from taking certain actions that would cause Buyer to stray from quality standards established by University or deviate from Buyer's charitable mission. The IRS determined, based on the facts and circumstances, that University does not directly control Buyer. Therefore, University and Buyer are not part of the same controlled group and are not related parties. Accordingly, the IRS ruled that the Taxable Debt is not a refunding of the Prior Bonds, and the Proposed Bonds will not fail to be tax-exempt under former Section 149(d)(1)(3)(A)(i). This PLR provides a helpful framework for the facts and circumstances that may cause the IRS to view tax-exempt organizations as related under the tax-exempt bond regulations, specifically Treas. Reg. Section 1.150-1(e). In this instance, Buyer used Taxable Debt to acquire a medical center owned by University. University then used those proceeds to defease the Prior Bonds, which were part of an advanced refunding of tax-exempt bonds issued before the Prior Bonds. The primary issue addressed in this PLR is whether University's use of proceeds from the Taxable Debt to defease the Prior Bonds was part of an effort to avoid the limitations of former Section 149(d)(3)(A)(i) and therefore cause the IRS to view the Proposed Bonds as a second advance refunding of the bonds issued before the Prior Bonds. Historically, a bond issue could only be advanced refunded once with tax-exempt financing. Here the Proposed Bonds would serve as a second advanced refunding of the bonds issued before the Prior Bonds if the Taxable Debt was deemed a refunding of the Prior Bonds. To determine whether the Taxable Debt was a refunding, the IRS was required to determine whether Buyer and University were related for purposes of Treas. Reg. Section 1.150-1(e), the language of which was not altered or eliminated by TCJA. If the parties were deemed related under Treas. Reg. Section 1.150-1(e), then the Taxable Debt (for which Buyer was the obligor) used to defease the Prior Bonds (for which University was the obligor) would constitute a refunding. Essentially, parties are related for these purposes if they are members of the same controlled group — controlled directly or indirectly by the same entity — decided by all the facts and circumstances. Treas. Reg. Section 1.150-1(e) provides that an entity generally controls another entity if the controlling entity possesses either: (1) the right or power to approve and to remove without cause a controlling portion of the governing body of the controlled entity; or (2) the right or power to require the use of funds or assets of the controlled entity for any purpose of the controlling entity. When making the final determination on whether University and Buyer were related, the IRS focused its analysis on whether University exercised operational control over Buyer. While University and Buyer were affiliated, and University had the right to prohibit Buyer from taking certain actions, the IRS noted that University did not have the type of specific operational control required by the second prong of the test under Treas. Reg. Section 1.150-1(e). University only had the power to approve and remove without cause four out of 11 of Buyer's directors and Buyer maintained control over the operations of its finances (e.g., creating a budget, issuing debt, expending funds, collecting receivables). University's power amounted to merely limiting Buyer's ability to deviate from the charitable mission and standards of the medical center, which was originally established by and remains connected to University. As stated previously, the TCJA repealed the tax exemption for advanced refunding bonds, which included removing many of the Section 149(d) subsections cited in the PLR. The IRS's analysis of operational control, however, will still be useful to determine if organizations are related for purposes of Treas. Reg. Section 1.150-1(e). — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg
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